WORLD BANK GROUP Country Economic Memorandum BOSNIA AND HERZEGOVINA Macroeconomics, Trade & Investment January 2024 3 Acknowledgments The Bosnia and Herzegovina Country Economic Memorandum has been prepared by a broad multi-sectoral team of World Bank experts led by Tihomir (Tish) Stuč- ka (Senior Economist, Task Team Leader) and Sandra Hlivnjak (Senior Economist, Task Team Leader). On Chapter 1, the team included Zuhra Osmanović-Pašić (Se- nior Governance Specialist), Jane Hwang (Senior Financial Sector Specialist), Ruvejda Aliefendić (Senior Private Sector Specialist), Meliha Kozarić Fanning (Labor Market Consultant), Steven Pennings (Senior Economist), Guido Damonte (Consultant), Fed- erico Fiuratti (Consultant), Amra Mujabašić (Consultant) and Srđan Kujundžić (Con- sultant). On Chapter 2, the team included Nicolo Dalvit (Economist) and Besart Avdiu (Senior Economist). Finally, on Chapter 3, the team included Rachel Bernice Perks (Senior Mining Specialist), Dzenan Malović (Senior Energy Specialist), Justine Morven Sylvester (Land Tenure Specialist), Efstratios Tavoulareas (Energy Consultant), and Ulrike Lehr (Senior Economist). The report was designed by Vigan Kada. The team is highly indebted to Shireen Mahdi (Lead Economist) and Harshit Agrawal (Senior Gas Specialist), who acted as peer reviewers for this report. The team is grateful to Xiaoqing Yu (World Bank Regional Director for the Western Balkans), Christopher Sheldon (World Bank Country Manager for Bosnia and Herze- govina), Jasmin Chakeri (Practice Manager), Richard Record (Lead Economist), Chris- tos Kostopoulos (Lead Economist) and the Western Balkans Country Management Team for their guidance and support throughout this task. The Bosnia and Herzegovina CEM benefited from the close cooperation with the Prime Ministers’ Offices in the Federation BiH and Republika Srpska, the Ministry of Finance in the Federation BiH and Republika Srpska, the Ministry of Energy in Repub- lika Srpska, and Republika Srpska APIF. The Bosnia and Herzegovina Country Economic Memorandum was in part supported by the Umbrella Facility for Gender Equality (UFGE). The UFGE is a multi-donor trust fund administered by the World Bank to advance gender equality and women’s em- powerment through innovation and knowledge creation to help governments and the private sector focus policy and programs on scalable solutions with sustainable outcomes. The UFGE is supported with generous contributions from Australia, Can- ada, Denmark, Finland, Germany, Iceland, Ireland, Latvia, the Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, United States, the Bill and Melinda Gates Foundation, and the Wellspring Philanthropic Fund. 4 © This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not neces- sarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encour- ages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attri-bution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, TheWorld Bank Group, 1818 H Street NW,Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Cover design, layout design and typesetting: Vigan Kada 5 Abbreviations BAM Bosnian Convertible Mark BD Brcko District BiH Bosnia and Herzegovina BIS Bank for International Settlements CBA Cost Benefit Analysis CBAM Carbon Border Adjustment Mechanism CEM Country Economic Memorandum EC European Commission ECA Europe and Central Asia ECI Economic Complexity Index ECS Energy Community Secretariat EPBiH Elektroprivreda BiH EPHZHB Elektroprivreda Hrvatske Zajednice Herceg Bosne ERP Economic Reform Program ERS Elektroprivreda RS ETS Emission Trading System EU European Union EUR Euro FBiH Entity of Federation BiH FDI Foreign Direct Investment FLFP Female Labor Force Participation GAP Gender Action Plan GDP Gross Domestic Product GFC Global Financial Crisis GHG Greenhouse Gases GNI Gross National Income GVA Gross Value Added GW Giga Watt HIC High Income Country IDA International Development Association IED Industrial emission Directive IMF International Monetary Fund LCP Least Cost Planning LCPD Large Combustion Plants Directive LFP Labor Force Participation LFS Labor Force Survey LHS Left Hand Side LIC Low Income Country LTGM Long Term Growth Model MIC Middle Income Country 6 Abbreviations MOFTER Ministry of Foreign Trade and Economic Relations MRIO Multi-Regional Input-Output MRV Monitoring, Reporting and Verification MT Metric Ton MW Mega Watt NACE Nomenclature statistique des Activites economiques dans la Commu- naute Europeenne NEET Neither in Education, Employment, or Training NEMO Nominated Electricity Market Operator NERP National Emission Reduction Plans NPV Net Present Value OEC Observatory of Economic Complexity PM Particle Matter (also called Particle Pollution) PP Percentage Point PV Photovoltaic technology RE Renewable Energy RE Renewable Energy RHS Right Hand Side RS Entity of Republika Srpska SAA Stabilization and Association Agreement SOE State Owned Enterprise SYNCON Synchronous Condensers TFP Total Factor Productivity TPP Thermopower Plant TWh Terrawatt-Hour UN United Nations USD US Dollar VAT Value Added Tax VET Vocational Education and Training VRE Variable Renewable Energy WB World Bank WDI World Development Indicator WTO World Trade Organization 7 Table of Contents Introduction and Summary 9 I. Macroeconomic context in BiH 22 I.1. BiH’s growth story 24 I.1.1. BiH’s transition through middle income status  24 I.1.2. Long-term output growth developments in BiH  27 I.2. Drivers of output growth 30 I.2.1. Expenditure approach  30 I.2.2. Production approach  35 I.2.3. Capital, labor, and TFP  37 I.2.4. Growth from the entities’ perspective Output growth developments  40 I.3. Labor market developments 50 I.4. Output growth simulations going forward and structural reforms 54 I.5. Conclusions and policy options 58 II. Private Sector Productivity and Dynamism 60 II.1. Aggregate Productivity Trends 63 II.1.1. Drivers of Productivity Growth  65 II.2. Business Dynamism in BiH 66 II.2.1. Business demography, density, and firm size in BiH  66 II.2.2. Market distortions in BiH  68 II.3. Firm-level analysis in RS 71 II.3.1. Productivity in RS  71 II.3.2. Business Dynamism in RS  73 II.3.3. Signs of misallocation in RS  75 II.3.4. SOEs in the RS economy  77 II.4. Conclusions and Policy Options 79 III. Energy transition in BiH 80 III.1. BiH’s legal obligations 84 III.2. BiH’s power supply 85 III.2.1. Coal  89 III.3. CBAM: design and regional developments 90 III.3.1. Background  90 III.3.2. Legislative carbon pricing developments in BiH and the Western Balkans   92 III.3.3. CBAM design and expectations  92 III.3.4. Simulation of more granular effects of the EU CBAM on output and jobs in BiH  99 8 Table of Contents III.4. Possible pathways of changes in energy generation and mining assets 103 III.4.1. Alternative Energy Technologies for Repurposing Existing TPPs and Coal Mines  104 III.4.2. Alternatives for the long-term decarbonization of BiH’s power sector   106 III.4.3. Key Findings and Implications for Power Sector Decarbonization in BiH   109 III.5. Managing the Impacts: A Just Transition 111 III.5.1. Policy Coordination and Governance Structures to Manage a Just Transi- tion  113 III.6. A Cost Benefit Analysis of the Just Transition and public debt implications of required investments 118 III.6.1. Cost Benefit Analysis  118 III.6.2. Budget outlays for the energy transition: a public debt sustainability sim- ulation  120 III.7. Conclusions and policy options 122 IV. References 124 V. Annexes 128 Annex for Chapter 1  128 Annex A1: BiH’s nomenclature  128 Annex A2: Country income classifications according to the World Bank  129 Annex A3: Benchmarking in this report: choice of structural and aspirational peers   129 Annex A4: The Fundamental Equilibrium Exchange Rate (FEER): is the exchange rate level still valid for the Convertible Mark after two decades of its introduction?   130 Annex A5: Domestic market integration in Bosnia and Herzegovina (BiH)  132 Annex A6: Assessing an introduction of a multi-rate VAT system in BiH  133 Annex A7: Job gains/losses by sector, 2011 – 2019 (public and private)  134 Annex A8: Long Term Growth Model  135 Annex Afor Chapter 2  136 Annex B1: Decomposing aggregate total factor productivity  136 Annex for Chapter 3  136 Annex C1: Assumptions for Cost Benefit Analysis  136 9 Introduction and Summary 1. Bosnia and Herzegovina (BiH) has made significant development progress since the last Country Economic Memorandum (CEM) in 2005, most notably in obtaining EU candidate status in 2022. Despite persistent political tensions, the country has enjoyed nearly three decades of peace. The infrastructure, severely damaged during the 1990s, has been rebuilt, with ongoing investments in improving road and rail con- nectivity. The policymaking process involves elected officials navigating a complex, politically fragmented landscape, characterized by national quotas, ensuring repre- sentation for Bosniaks, Croats, and Serbs. The representation of individuals who do not identify with any of these three national groups has not been resolved yet.1 These factors make BiH unique in Europe, rooted in the Dayton Agreement of 1995, which brought an end to a devastating war that claimed approximately 100,000 lives and displaced over half of the population.2 Now, almost two decades after the last Eco- nomic Memorandum, BiH features as an EU candidate country. 2. Three distinct administration centers define the political discourse in BiH: Ban- ja Luka in Republika Srpska (RS) and Sarajevo and Mostar in the Federation BiH (FBiH).3 These political poles extend to economic differences across the two enti- ties, including separate, independent fiscal spending policies and fiscal rules, health- care systems, labor markets, and other key economic and social domains. Despite the challenges posed by this multilevel political setup, the instituted framework of economic and fiscal management has brought lasting macroeconomic stability. This framework rests on three main pillars: a currency board pegged to the euro the level of which remains appropriate,4 BiH-wide single VAT tax rate collected by the Indirect Tax Administration since 2006, and the EU accession process. From a developmental standpoint, BiH stands out as the sole World Bank client country to transition from being an International Development Association (IDA) recipient to an IDA donor within a remarkably short span of 16 years. 3. The period of macroeconomic stability in BiH has yielded notable economic achievements. BiH has moved from low income in 1999 to upper middle-income status in 2010, with a per capita gross national income of over USD 4,000 (Figure 1). If the average growth rate of GNI per capita witnessed over the past two decades con- tinues, the country could reach high-income status within the next 16-17 years (Figure 2). The shift in employment has been accompanied by a transition from agriculture to industry and services, underscoring the transformative process in the economy. Furthermore, prudent fiscal policies since 2014 have resulted in a relatively low public debt ratio at the BiH level of around 30 percent of GDP, despite the substantial entity government spending aimed at supporting firms and households in the wake of the pandemic in 2020 and the subsequent 2022 inflationary shock. The currency board has maintained price stability, with low, single-digit inflation rates over the past two 1 https://hudoc.echr.coe.int/fre?i=001-96491 2 World Bank, 2017, Bosnia and Herzegovina: Two decades of peace and transition, Washington DC, http:/ /documents.worldbank.org/curated/en/686081474374448860/Bosnia-and-Herzegovina-two-de - cades-of-peace-and-transition 3 Brcko District is governed independently, whereas FBiH is constituted of ten cantons, each with its own govern- ment. Mostar in FBiH is another administration center that plays an important role as many FBiH government institutions are based there. 4 See Annex A4 and IMF, 2023, Bosnia and Herzegovina Article IV Report, Washington DC. 10 Introduction and Summary decades until the global inflationary shock, fostering welfare and a competitive real effective exchange rate. Finally, the external current account deficit improved signifi- cantly to a record-low of 2.5 percent of GDP in 2021, from about 16 percent of GDP in 2005. 4. Despite these achievements, BiH’s convergence with the EU has been slow. Per capita real GDP growth in BiH has outperformed regional peers (Albania, Montene- gro, North Macedonia, and Serbia) mainly due to the population decline resulting from significant outmigration,5 rather than higher output growth rates. Trend output growth in BiH has been stagnant over the past 15 years (Figure 3). Consequently, cumulative real GDP growth in BiH lags significantly behind its structural and aspi- rational peers (Figure 4).6 More importantly, convergence in real per capita expendi- ture, a more direct measure of living standards, has stagnated at around 40 percent with respect to the average EU27 country for the past 15 years (Figure 5). Meanwhile, regional peers have made progress in narrowing this gap, with Montenegro reach- ing 60 percent, Serbia 53 percent, and North Macedonia 51 percent of the average EU27 per capita real expenditure level in 2021. Only Albania remains below BiH, with 39 percent, but it started from a lower base of 26 percent in 2005. Thus, while Albania is rapidly catching up with the EU27 average country in terms of living standard, BiH is barely inching forward. 5. Moreover, BiH is likely to face an escalating challenge if long-term growth is left unaddressed through deep structural reforms. BiH’s current growth and en- ergy model cannot sustain growth, with trend growth expected to halve in two de- cades. This is likely to be further aggravated by worsening export competitiveness as the EU’s carbon border adjustment mechanism (CBAM) becomes increasingly binding. Thus, at the current pace of structural reform, BiH’s prospects to complete its transition to a functioning market economy and fulfill the economic criteria for becoming an EU member are remote. To turn this situation around, BiH would need to implement a series of deep structural reforms to enable a more private sector led and productive economy, and to reduce its coal dependency. 6. Structural weaknesses exposed during the Global Financial Crisis (GFC) of 2008 continue to hamper growth outcomes. These weaknesses include inadequate capital deepening, a disproportionately large public sector in part due to the consti- tutional setup, and labor productivity that has been stagnant since 2016. In addition, structural issues include a labor market characterized by skill mismatches, inactivity, and high unemployment rates, especially among youth and women. Finally, despite a consistently declining current account deficit over the past fifteen years, the export sector is based on lower value-added goods, and its competitiveness is threatened by the penalties on coal-based energy inputs into exported goods to be introduced by the EU in 2026, also known as the carbon border adjustment mechanism (CBAM). These issues are elaborated below. 5 https://www.oecd.org/south-east-europe/programme/labourmigrationinthewesternbalkans-page.htm; https://data.worldbank.org/indicator/SP.POP.TOTL?locations=BA&display=graph 6 SEE4 represents regional peers: Albania, Montenegro, North Macedonia, and Serbia. Introduction and Summary 11 7. Macroeconomic policies have tended to favor short-term objectives at the ex- pense of long-term growth, with a focus on fostering consumption rather than investment. Current budget spending, particularly on public wages, pensions, and social benefits has constrained capital expenditure over the past 10-15 years. Conse- quently, public capital expenditures in both entities are limited, with only half the size in comparison to their Western Balkan peers.7 Furthermore, there is a discernable lack of coordination across the entities within sectors such as transport infrastructure, particularly railways and roads that contribute to important intermediate input distor- tions, as well as digital and energy infrastructure. Moreover, while sharing the same priorities as reflected in the socio-economic reform package, the speed of reform implementation differs across entities. Foreign direct investment inflows, meanwhile, remain insufficient, and significantly below regional peers. Thus, a shift towards struc- tural and fiscal reforms with medium- to long-term benefits, such as a more efficient social transfer system using social cards, as well as higher and more coordinated capital expenditures across the entities could pave the way for higher productivity and thus a more competitive economy. Figure 1. Figure 2. Progress toward high …with HIC status possible income country (HIC) in 16-17 years if average status is good, based on growth rate of pc GNI pc GNI since 2005 is maintained. 15000 20000 12000 HIC threshold SEE4 15000 9000 BiH MDV US$ US$ 6000 10000 3000 0 5000 2005 2007 2009 2011 2013 2015 2017 2019 2021 t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10 t+11 t+12 t+13 t+14 t+15 t+16 t+17 t+18 Source: World development indicators. GNI per capita, Atlas method (US$). SEE4 consists of Albania, Montenegro, Republic of North Macedonia, and Serbia; MIC represents all middle-income countries; dotted line in Figure 2 represents HIC threshold 7 Capital expenditures averaged 2.2 percent of entity GDP in FBiH and 3.7 percent of entity GDP in RS over the period 2010 to 2019 based on data from the entities’ statistical agencies. 12 Introduction and Summary Figure 3. Figure 4. Yet BiH’s trend GDP and cumulative real growth has drifted output growth has downwards during the underperformed last 15 years… compared to peers. 11 GDP Growth 240 BiH HP Filter SEE4 Baltics YEAR 2000 = 100 190 MDV 6 SVK % 140 2009 1 2000 2003 2006 2012 2015 2018 2021 90 2000 2003 2006 2009 2012 2015 2018 2021 -4 Source: WDI. HP – Hodrick-Prescott filter; cumulative growth is in constant 2015 US$; SEE4 consists of Albania, Montenegro, North Macedonia, and Serbia; MDV is Moldova, and SVK is Slovakia Figure 5. Figure 6. Meanwhile, real per capita …and 43 percent of consumption in BiH has working age population seen little convergence is not in employment, toward average EU27 education, or training. level 62 BiH 60 Employed Male 743,000 ALB Working age population (age 15-64) 57 1,184,000 Female 441,000 MKD 53 Labor force 52 SRB 51 1,364,000 Unemployed Male 89,000 47 MNE 47 179,000 Female 90,000 EU27=100 2,879,000 42 40 41 37 37 39 35 In school Male 132,000 32 Out of labor 283,000 Female 151,000 27 26 force (age 15 -89) 1,515,000 NEET Male 440,000 22 1,232,000 2005 2021 Female 792,000 Source: Eurostat (LHS) and BHSA (RHS). Real expenditure expressed in volume indices of real expenditure per capita (in PPS_EU27_2020=100), where PPS is Purchasing Power Standard. 8. Productivity in BiH is stagnating due to a small private sector overshadowed by the presence of a large state-owned enterprise footprint. Business density and dynamism is low in BiH as market frictions disincentivize the creation of businesses, impeding com- petition, and with adverse effects on the job creation potential of the private sector. As a result, the contribution of total factor productivity to growth has been modest over the last two decades, impacted by the severe and prolonged effects of the global financial crisis. Furthermore, BiH’s labor productivity growth has been stagnant since 2016, and ranks only above North Macedonia, while it fell behind all other regional peers and Moldova. Mean- Introduction and Summary 13 while, the public sector in BiH is a large employer, particularly of more educated workers and women. It employs a high share of formal sector workers, among the largest in Eu- rope, and is a disproportionately large employer of highly skilled workers, with an estimat- ed 58 percent of all tertiary educated workers employed in either the entity/cantonal/ BiH Institutions administration or state-owned enterprises.8 Thus, the public sector is, on the one hand, constitutionally defined through its multilevel public administration, and, on the other, exists by design through numerous state-owned enterprises (SOEs), the privat- ization and restructuring of which has not been completed. The significant gravitational pull of the SOEs heavily distorts the labor market by absorbing most of the qualified labor force due to offered benefit packages and wage premium. The latter, however, does not match the SOEs’ productivity, most notably for smaller and medium-sized enterprises.9 The relative inefficiency of many SOEs can in part be attributed to the influence of politi- cal patronage, which sometimes prioritizes securing electoral support through strategic overstaffing, rather than focusing on productivity gains. 9. To prevent a deceleration in longer-term trend growth, measures aimed at bolster- ing total factor productivity (TFP) carry the greatest promise. Under a business-as-usu- al scenario, longer-term real output growth in BiH is anticipated to decelerate due to un- favorable population dynamics and a slowdown in TFP together with BiH’s regional peers. Facilitation of a higher TFP growth rate could take two forms: first, by re-initiating the tran- sition to a market economy through SOE privatization, restructuring, or bankruptcy, es- pecially of the smaller and medium-sized SOEs, thereby unleashing the potential of the private sector; and second, by enhancing the efficiency and governance of SOEs. Imple- menting these reforms is a formidable challenge, compounded by limited fiscal capacity to address existing SOE liabilities. 10. In addition to reducing the SOE footprint, addressing business environment bot- tlenecks is also key. The latter encompasses simplifying and automating business reg- istration processes in FBiH, harmonizing licenses and certificates across entities, as well as bolstering national quality controls to meet EU standards by aligning the regulatory framework with the EU and strengthening the quality control infrastructure such as lab- oratories, accreditation bodies, certification organizations, and quality control agencies. The implementation of digitalization, including leveraging digital technology to stream- line regulatory requirements, can significantly enhance private sector productivity. Finally, reducing the size of the informal economy, estimated at 25 to 35 percent of GDP in BiH, holds substantial potential to stimulate TFP growth. 11. High unemployment and inactivity rates, as well as a shortage of skilled workers remain significant economic challenges in BiH. In 2023, 43 percent of the working age population is neither in employment, nor education, or training (Figure 6). These issues, particularly high inactivity as well as high youth and female unemployment, contribute among others to outmigration and social risks. High rates of unemployment - with over 80 percent of the unemployed remaining jobless for over a year – pose a challenge for both the economy and society. The resulting population decline due to outmigration has had adverse economic consequences, including reduced output growth by an estimated 8 World Bank, 2023, Bosnia and Herzegovina: The public sector labor market and its implications, Washington DC, https://doi.org/10.1596/39844 9 EBRD, 2022, Bosnia and Herzegovina: country diagnostic, https://www.ebrd.com/bh-country-diagnostic.pdf; Cegar, B. and F. Parodi, 2019, State-owned enterprises in Bosnia and Herzegovina: Assessing performance and oversight, WP19/201, https:/ /doi.org/10.5089/9781513512181.001; and evidence from firm-level data in RS provided by APIF. 14 Introduction and Summary half a percentage point each year, on average, between 2009 and 2012, and about one percentage point, on average, between 2014 and 2019. 12. Jumpstarting job-rich growth, primarily for youth and women, would help counter the adverse effects of outmigration. The entity governments in BiH have been active in passing legislation in the labor market, but more is needed. They partly implemented some reforms such as the introduction of incentives for first work experience for youth (though without measuring the impact). The next big structural policy effort would be to reduce the tax wedge, which decreases the gap between the total cost of employment for employers and the net take-home pay for employees by adjusting downward social security contributions. This would reduce the cost of labor, enhance the firms’ competi- tiveness, and incentivize investment, as well as encourage a shift out of the informal econ- omy. The latter would also benefit from adjustments in the labor code and labor taxes to incentivize formalizing temporary workers. Also, implementing legislation that would en- sure transparent and merit-based pay and employment practices in SOEs would reduce labor market distortions and help improve productivity. 13. Policies targeted at enabling female labor force participation (LFP) are particularly potent. Labor market reforms that target the female participation rate can help in part offset the negative effect of population decline on growth. Simulations suggest that an increase in the female labor force participation rate of close to 20 percentage points by 2040 could add between 0.5 and 1 percentage point to economic growth.10 Implement- ing flexible working arrangements for women, including options for part-time work, job sharing, and telecommuting, to accommodate childcare responsibilities as well as es- tablishing affordable and high-quality childcare facilities, particularly in rural areas, would alleviate the burden on women and enable their full participation in the labor market. Fur- thermore, introducing paid parental leave policies that encourage men to take an active role in caregiving responsibilities would promote gender equality in parenting and ca- reer advancement opportunities. Finally, measures promoting women’s entrepreneurship and enhancing access to finance for women-owned businesses would complement the above-mentioned action to raise women’s LFP rates and employment. 14. Improved net exports over the past 15 years helped drive a steady decline in BiH’s current account deficit to low single digits in 2021 (Figure 7). This steep external bal- ance improvement was led, among others, by merchandise exports, supported by real effective exchange rate depreciation under the currency board (Figure 8). Sectors such as metals, machinery, minerals, and electricity have significantly contributed to exports. A large share of these exports, however, are lower value-added products such as raw aluminum, scrap copper and iron, as well as coke. Furthermore, exports of wood prod- ucts are dominated by sawn wood as well as fuel and rough wood, whereas the textile industry, which grew its value of exports four times since 2005, was boosted by so-called “lohn” jobs11 for brand names, where the value added is low. Medium- and high-tech ex- ports have dipped since 2005, only recently returning to early 2000s levels (Figure 9). To 10 This refers to the ambitious scenario that corresponds to the 75th percentile of EU-11 (the newest members of the EU from South-eastern Europe and the Baltics). 11 In the textile industry, a “lohn job” refers to a specific type of outsourcing arrangement, where a company contracts a production process to a subcontractor or manufacturer in a lower-wage country. In this arrangement, the contracting company provides the materials, design specifications, and sometimes equipment, while the subcontractor carries out the garment manufacturing, based on the provided inputs. A lohn job is therefore considered a low value-added activ- ity because it typically involves simple and labor-intensive tasks, such as cutting, sewing, and assembling garments or textile products. The subcontractor’s role is mainly focused on executing the production process as per the provided instructions, with limited involvement in the design, innovation, or strategic decision-making aspects. Introduction and Summary 15 put it in perspective, this means that BiH trails peers like North Macedonia, Moldova, and Serbia in export product complexity. Going forward, BiH exports will need to increase their sophistication up the value chain to strengthen competitiveness and further reduce the merchandise trade deficit. A possible approach is placing far greater emphasis on foreign direct investment attraction going forward, with reducing the country’s risk premium due to political uncertainty representing a key prerequisite to be able to catch up with regional peers (Figure 10). 15. In addition to the low share of product complexity mentioned above, BiH export competitiveness faces challenges over the medium term due to the gradual introduc- tion of the CBAM, mentioned also earlier. Exposure to CBAM depends on the relative emissions intensity of exported products and the volume of those products. The sectors in BiH targeted by CBAM are among the country’s main exporting sectors such as ma- chinery and metals, including iron, steel, and aluminium. Exports of the latter contribute over 5 percent to the country’s GDP. Furthermore, approximately 68 percent of electric- ity generation comes from aging coal-fired power plants -- 70 percent of them over 40 years old, producing less efficiently as a result. Carbon dioxide emissions from electricity production per GDP are more than five times larger in BiH compared to the average EU27 country. With an outdated, inefficient thermal power plant system and a carbon-intensive manufacturing sector, CBAM will negatively affect export competitiveness over time, es- pecially once intermediate inputs such as electricity are included. This will also make BiH a less attractive destination for foreign direct investments. These considerations make it in- creasingly costly to delay the transition to lower carbon alternatives. The adverse impacts are further compounded by the fact that nearly all coal mines are loss-making enterprises and receive government subsidies in various forms. Subsidized energy production kept electricity prices low during the recent energy crisis and has served as a social measure for citizens, but also supported the economy’s competitiveness. Figure 7. Figure 8. Current account deficit …with exports playing an is on a steep downward important role (% of GDP) trajectory (GDP, %) level 25 BiH 50 110 SEE4 45 100 Exports 20 40 90 15 35 80 Exports Imports 30 70 10 25 60 5 20 50 Imports 15 40 0 10 30 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 1994 1997 2000 2003 2006 2009 2012 2015 2018 2021 Source: BHAS, WDI and WB staff calculations 16 Introduction and Summary Figure 9. Figure 10. Meanwhile, medium- and …whereas net FDI inflows high-tech exports returned in BiH total 35 percent in 2019 to levels from of the average in regional 2005 (as share of total peers (average 2007 to manufactured exports, %) 2022, % GDP) 80 2005 2015 10 2010 2019 70 8 60 50 6 40 30 4 20 10 2 0 MDA HRV LVA EST SVK ALB MKD SRB LTU SVN BIH 0 BiH SEE4 Source: World Development Indicators 16. Structural reforms supporting the deployment of renewable energy sources are needed to modernize the energy sector and enhance BiH’s economic competitiveness in a decarbonizing world. While coal-fired power plants will remain the backbone of BiH’s power system for the foreseeable future (Figure 11), prioritizing the gradual transition to renewable energy (RE) sources is crucial due to the EU market’s significance for BiH’s ex- ports. In this context, the World Bank carried out a Least Cost Planning (LCP) study in 2022 to determine the optimum power generation mix for BiH over the period 2023-2050. The study discusses three scenarios: the baseline, decarbonization, and energy securi- ty scenario (Figure 12). To achieve a smooth transition, key priorities include increasing renewable energy generation through conducting competitive RE tenders, streamlining licensing procedures, and creating an efficient and liquid wholesale electricity market by establishing a power exchange. These measures are vital to attract private investments in the renewables sector. In addition, to improve opportunities for thermal power plant con- versions, the authorities could consider implementing a demonstration program of partial conversion to biomass. Based on the lessons learned, authorities could improve coordi- nation, address legal and regulatory issues, improve the information base, and eventually further expand capacity. To ensure the power system reliability once it accommodates an increase in variable RE, a strengthening of the existing grid infrastructure will be required as well as its expansion. . These measures are vital to attract private investments in the renewables sector. Considering that BiH will be impacted by the CBAM regardless, it is advisable to prioritize capturing revenues domestically through the implementation of an emissions trading system (ETS) or carbon tax. These revenues can then be directed to- wards new investment opportunities in the energy sector. 17. The entity governments in BiH have achieved notable legislative advancements in the energy sector; however, further action is imperative. The recent enactment of energy-related legislation in FBiH, encompassing the Renewable Energy Law, Electricity Law, and Law on Energy, represents commendable progress. Nevertheless, additional measures are indispensable, including the adoption of amendments to the BiH Law on Introduction and Summary 17 electricity and gas and the appointment of the Nominated Electricity Market Operator (NEMO), alongside establishing the power exchange and market coupling mechanisms. This undertaking presents an enormous challenge within the current political landscape characterized by contentious debates over the devolution of powers to the BiH Institutions level. Furthermore, it is crucial to acknowledge the potential of evaluating coal mining lands and other related assets as their utilization becomes non-profitable, which hitherto have received insufficient attention. This evaluation can serve as an opportunity to initiate economic diversification in coal-dependent regions, thereby offering fresh avenues for private sector driven investment and employment in these communities. Collaborating closely with both direct and indirect workers to identify viable economic alternatives and facilitate upskilling initiatives will enhance the prospects for a successful transition away from coal. These efforts, when coupled with comprehensive regional transition plans and integrated land use strategies in coal mining areas, will further bolster the likelihood of a smooth and prosperous transition to a low carbon economy. Figure 11. Figure 12. Electricity generation mix, Breakdown of capacity gross (% of produced GWh) additions per technology (in MW) thermal hydro wind/solar Baseline Decarbonization Energy Security 100 Coal Tuzla 7 450 - - 90 100% biomass 146 146 146 80 conversion 70 Hydro ROR 772 772 772 60 50 Hydro storage 212 376 1,008 40 Wind 3,177 3,138 2,391 30 PV 32 63 1,779 20 Battery 173 96 0 10 0 Pumped-storage 66 66 66 2017 2018 2019 2020 2021 2022 2023 hydro (I-VIII) TOTAL capacity 5,028 4,656 6,162 Source: BHAS, ENE_1; Least Cost 18. Against this background, unlocking BiH’s growth potential requires political and economic pragmatism. Inter- and intra-entity political gridlock have hindered much-needed structural reforms necessary for a functioning and highly competitive market economy. The movement toward a single economic space is predicated on re- ducing administrative obstacles BiH-wide, streamlining regulations, and promoting digi- talization. The latter would help lessen the administrative burden on private firms by im- plementing service digitalization economy-wide that relies on interoperable information systems across entities, information exchange and harmonization of the e-signature, for which a legal basis needs to be adopted. In addition, a single, BiH-wide supervisory body would need to be established, as also required by the EU acquis. Such legislative steps face a high bar as it requires delegating entity responsibilities to the BiH Institutions level, which is a highly contested area. Nevertheless, such measures would encourage private sector growth and attract foreign investment, ultimately accelerating economic development. Therefore, a more coordinated approach between governments towards 18 Introduction and Summary achieving a single economic space in BiH, as well as addressing political uncertainty, which increases the country’s risk premium, is crucial for improving the business environ- ment and boosting investor confidence. 19. To conclude, securing a more prosperous future for the people of BiH by addressing the mounting growth challenges, consensus to reinvigorate struc- tural economic and energy reforms should be deepened, and the coordination challenges that slow implementation need to be alleviated. While progress has been made since 2005, there is still untapped potential in BiH’s economy. Achieving sustained economic growth at a higher trajectory will require enhancing competi- tiveness, promoting entrepreneurship, and attracting foreign direct investment. This should go hand in hand with creating formal quality jobs, which demands deepening labor market reforms. It also necessitates improving social protection and reducing the cost of labor, while ensuring fiscal sustainability. Reducing the footprint of the public sector, particularly dealing with loss-making SOEs, and investing in key digital, transport infrastructure and energy transition are reform areas that can only be tack- led jointly. To fulfill the aspirations of BiH’s people, governments in both entities will need to work together to achieve common goals, delivering on a common reform agenda that expands economic opportunities BiH-wide. 20. Hence, to support the governments, this CEM aims to help better under- stand the structural policies necessary to overcome constraints to the economy’s growth potential. The goal of this growth report is to propose measures that address these constraints, facilitating faster convergence with EU living standards. The report consists of three sections: i. The first chapter describes BiH’s longer-term growth, its drivers and challenges since the last CEM published in 2005. Specifically, it describes the growth trajec- tory from various angles, including differences across the two entities, as well as fiscal space considerations relevant for the needed energy transition from coal- based to renewable energy. This chapter also explores developments in the labor market, particularly in the public sector. ii. Chapter 2 builds on the growth drivers, challenges, and labor supply aspects dis- cussed in the previous chapter by analyzing firm-level dynamics to identify mea- sures that will stimulate growth at the micro level. It delves into factors affecting productivity, business dynamism, market competition, and looks into the state- owned enterprises sector, offering insights into the microeconomic foundations of macroeconomic growth. In addition, this chapter includes a firm-level analysis in RS. iii. The third chapter focuses on the just energy transition. It discusses BiH’s coal-de- pendent electricity production, the coal mines, most of which are large loss-mak- ers, challenges posed by the CBAM, and provides an arithmetic exercise on the investment implications for public debt sustainability. This chapter offers policy options for a just energy transition, aligning the economy with global obligations for emissions reductions and the EU’s CBAM, while promoting greener and higher growth. 19 Summary of policy options short term - ST medium term - MT of the reform agenda long term - LT Policy options for supporting growth Time horizon I. Sound macroeconomic management and digitalization 1 Why: Improve fiscal policy dialogue and implementation of best MT practices How: Establish independent Fiscal Body within BiH Fiscal Council 2 Why: Improve quality of Economic Reform Plans ST How: Construct macro-structural model with medium-term outlook 3 Why: Increase firms’ efficiency, savings, access to information, and MT streamline regulatory processes How: Promote digitalization at BiH Institutions and entity level, as well as BD 4 Why: Better inform planning in BiH labor market MT How: Institutionalize central data sharing across governments on levels of staffing and remuneration practices to assess, among others, factors affecting high and dispersed nature of public sector wages II. Labor market development 5 Why: Improve coverage and targeting of social assistance ST How: Introduce Social Cards at the entity level and BD 6 Why: Stimulate formal employment and competitiveness ST How: i) Reduce the tax wedge; and ii) revise unemployment benefits to improve incentives for work 7 Why: Enhance transparency of hiring in public sector MT How: Reduce gap between good-quality public sector jobs vs. poor-quality private sector jobs 8 Why: Connect people to jobs, especially less employable and youth MT How: Adjust the labor codes and labor taxes to incentivize formaliz- ing temporary workers 9 Why: Offset in part decline in population MT How: i) Increase female labor force participation; ii) promote gender equality by introducing paid parental leave policies for men 20 Summary of policy options of the reform agenda III. Unleash firms’ productivity potential 10 Why: Re-initiate the transition to a market economy MT How: Ensure a fair and equitable competitive environment for both State-Owned Enterprises (SOEs) and private companies 11 Why: Raise productivity of SOEs ST How: Improve governance through better controls and supervision in established central units in the entity’s MoF and transparent publishing of supervision results 12 Why: Enhance business entry MT How: Reduce administrative barriers at entity level 13 Why: Facilitate exports to EU and enhance competitiveness MT How: Bolster quality control at BiH level to meet EU standards by aligning regulatory framework with EU and strengthen quality control infrastructure IV. Ease access to finance 14 Why: Promote gender entrepreneurship MT How: develop policies and pilot financial instruments targeting spe- cifically women-owned businesses 15 Why: Enhance alternative financing channels by deepening leasing, MT invoice finance, and asset-based lending How: i) address impediments to leasing; ii) remove constraints of invoice finance V. Enhance competitiveness through energy and extraction policies 16 Why: Increase renewable energy (RE) generation to facilitate a clean MT energy transition. How: Through conducting competitive RE tenders and creating effi- cient and liquid wholesale electricity markets by establishing a power exchange 17 Why: Ensure power system reliability to accommodate increase in LT variable renewable energy sources. How: Strengthen existing grid infrastructure and add storage re- sources, as needed 18 Why: Expand renewable energy availability MT How: Streamline licensing procedures for renewable energy produc- tion and expand grid 19 Why: Comply with EU energy directives in area of carbon taxation LT How: Implement an emissions trading system (ETS) or carbon tax Summary of policy options of the reform agenda 21 20 Why: Comply with EU energy directives in area of electricity market MT operations How: Appoint the Nominated Electricity Market Operator 21 Why: Comply with EU energy directives in the area of power ex- MT change markets How: Establish the power exchange and market coupling mecha- nisms 22 Why: Use natural assets in coal areas for new productive use. MT How: Take stock and evaluate coal mining lands and other related assets fit for repurposing 23 Why: Ensure a Just and sustainable transition in coal regions. MT How: Initiate economic diversification in coal-dependent regions 24 Why: Improve opportunities for thermal power plant conversion. ST How: Implement a demonstration program of partial conversion to biomass and based on the lessons learned improve coordina- tion, address legal and regulatory issues, improve information base, and enhance capacity. 25 Why: Prepare BiH and entity Just transition strategies and entity-wide ST plans for a Just Transition and restructuring of the coal mines How: Prepare and agree on policies to guide labor transition in the mines and thermal power plants I.  Macroeconomic context in BiH I. Macroeconomic context in BiH Key findings: 1. BiH is outperforming regional peers in real per capita GDP growth (due to outmigra- tion) but is lagging in cumulative real GDP growth, and convergence in living stan- dards with respect to the average EU27 country. 2. The decline in population shaved almost half a percentage point of economic growth each year, on average, between 2009 and 2012, and about one percentage point, on average, between 2014 and 2019. 3. Capital deepening was robust in the pre-GFC period; however, its growth impact fell significantly during the GFC, with no rebound being apparent in the post-GFC years. 4. While growth remains consumption- rather than investment-based, leakages have stabilized, and the current account deficit has declined to a record-low 2.4 percent of GDP in 2021 from 16 percent in 2005. Yet, after 2015, the weak business climate has resulted in a deterioration in FDI inflows, which is well below levels in peers. 5. Improved net exports helped with the decline in BiH’s current account deficit, yet a significant share are lower value-added products. To strengthen competitiveness and reduce the merchandise trade deficit, exports should increase their sophistication up the value chain. Emphasis on attracting foreign direct investment starts by reducing the country’s risk premium. 6. The production structure of the two entities, FBiH and RS, show significant differences, particularly in the size of the manufacturing sector, which is one of the largest employ- ers in BiH 7. The large SOEs footprint negatively affects productivity, on average, and distorts the labor market through a wage premium and other benefits; this leads to segmentation between good-quality public sector jobs and poor-quality private sector jobs. 8. Between 2011 and 2019, employment in BiH contracted by about 20 thousand jobs: the public sector net shed 64 thousand jobs, whereas the private sector generated 44 thousand jobs. 9. A key policy challenge is ongoing political frictions in combination with poor coor- dination between governing bodies. Despite improvements, BiH’s Economic Reform Plan lacks coherence, comprehensiveness, and strategic focus as assessed by the EU. Addressing these issues remains a challenge for the authorities, and a viable op- tion could be establishing an effective, independent Fiscal Body within the BiH Fiscal Council that is autonomous, transparent, accountable, and enshrined in legislation. This would serve the public and policy makers to form an opinion on domestic fiscal policies at the level of BiH, and could go a long way in facilitating BiH’s accession to the EU. 10. In the long run, total factor productivity growth is likely to decelerate, resulting in trend growth slowing to around 1.4 percent by 2040 under the business-as-usual scenario. Structural reforms are therefore needed to keep economic trend growth around 3.5- 4 percent over the longer run. 11. Structural reforms aimed at bolstering total factor productivity (TFP) carry the great- est promise and can take two forms: re-initiating the transition to a market economy through state-owned enterprise privatization, restructuring, or bankruptcy, especially the smaller and medium-sized; and enhancing the control, efficiency, and governance of state-owned enterprises. 12. Labor market reforms that target the female participation rate can help in part offset the negative effect of population decline on growth. Implementing flexible working arrangements for women, including options for part-time work, job sharing, and tele- commuting, to accommodate childcare responsibilities, as well as establishing afford- able and high-quality childcare facilities, particularly in rural areas, would alleviate the burden on women and enable their full participation in the labor market. 24 Macroeconomic context in BiH I.1.  BiH’s growth story I.1.1.  BiH’s transition through middle income status 1. Converging to high-income status is a difficult task that requires continuous, signif- icant institutional and policy improvements. Since 1990, 31 countries have successfully transitioned from middle- to high-income status, with 13 of them being EU members.12 With the help of the EU convergence machine, countries have managed to overcome the middle-income trap through institutional change, as well as enhanced trade, invest- ment, and flow of capital from richer to poorer countries. To achieve high-income status, middle-income countries must prioritize institutional and policy reform that promote eco- nomic growth. 2. Over the last decade and a half, Bosnia and Herzegovina’s (BiH’s) trend real out- put growth has slowed considerably and has underperformed compared to peers (Figures 1a and 1b). Since 2010, economic growth has been slowing in middle-income countries (MICs)13 and has remained well below pre‐GFC (2003‐08) rates. The protracted deceleration in MIC growth rates contrasts with the weak but steady recovery in high-in- come economies from 2012 onward. Against this background, BiH’s sharply decelerating trend real GDP growth record represented in Figure 1a (red line) is no exception to the MIC performance: the slowdown in real output growth has been remarkable, from an average of 5 percent from 2000 to 2008 to 1.6 percent over the next decade (2009 to 2019). Com- pared to Western Balkan peers (SEE4)14 and Moldova, cumulative real GDP started lagging significantly in the post-GFC period, while the gap to aspirational peers such as the Baltics and Slovakia (SVK) widened even further (Figure 1b). Part of the slowdown may be related to lacking reform progress but could also be due to a higher frequency of natural disas- ters. Natural disasters are estimated to cost BiH about 1.4 percent of GDP every year, the costliest in the region.15 The flood in 2014 alone resulted in damages of roughly USD 450 million16 or 2.5 percent of GDP. 3. As a result of the significant growth slowdown, BiH has exhibited sluggish progress through the middle-income stage. Per capita GNI performance in BiH was weaker com- pared to the average MIC (Figure 2a). Specifically, from 2005 to 2021, lower and upper-in- come MICs have more than tripled their GNI per capita, from US$1,807 to US$5,185, while Moldova, for example, raised its GNI per capita level five-fold over the same period. This compares to BiH’s increase of its GNI per capita two and half times during the same peri- od, from US$2,810 to US$6,810, based on the Atlas method which uses PPP. When BiH’s performance is compared to its regional peers, the SEE4, the country exhibited much low- er per capita income levels in the post-GFC period until 2017. At this point, an acceleration in outmigration compared to the peers shifted the GNI per capita to similar levels by 2021, due to a population decline rather than faster income growth. 4. If BiH’s GNI per capita grew at a rate of 5.3 percent, it would take the country al- most two decades to reach high-income country status. When it comes to closing the gap toward high-income status, BiH moved from 25 percent of the HIC level in 2005 to 52 percent in 2021 compared to the SEE4 that reached 50 percent in 2021 (Figure 2a). The 12 World Bank. 2023. Growing to High Income in Europe and Central Asia, Concept Note, June 13 The difference between LICs, MICs, and HICs, and between LMICs and UMICs is explained in Annex 2 14 See Annex A3 for a description of BiH’s structural and aspirational peers. 15 OECD, 2021 16 World Bank, 2020a. Macroeconomic context in BiH 25 annual compounded GNI per capita growth rate in BiH totals 5.3 percent for the period 2005 to 2021 compared to the HIC threshold increase of 1.3 percent per annum. Hence, using these long-term averages, it would take BiH almost another two decades at the minimum to reach the threshold for high-income countries. BiH’s long-term average rate, however, includes a period of significant outmigration, which is unlikely to repeat itself to the same extent going forward, and thus the time needed to close the gap with the HIC level is likely to be longer unless compensated by higher output growth rates. The issue of outmigration is discussed below in more detail. Figure 1a Figure 1b BiH’s trend GDP growth …and cumulative real rate has drifted downwards output growth has during the last two underperformed compared decades… to peers, 2000=100 (in constant 2015 US$) 10 240 BiH GDP Growth 8 HP Filter SEE4 Baltics YEAR 2000 = 100 6 190 MDV 4 SVK % 2 140 2009 0 2000 2003 2006 2012 2015 2018 2021 -2 90 2000 2003 2006 2009 2012 2015 2018 2021 -4 Source:World development indicators. HP – Hodrick-Prescott filter; SEE4 consists of Albania, Montenegro, Republic of North Macedonia, and Serbia; MDV is Moldova, and SVK is Slovakia Figure 2a Figure 2b GNI per capita, Atlas BiH GNI per capita reaching method (US$) HIC threshold 13000 BiH 17000 11500 SEE4 MDV 15000 10000 MIC 8500 13000 US$ 7000 US$ 5500 11000 4000 9000 2500 1000 7000 2005 2007 2009 2011 2013 2015 2017 2019 2021 t+1 t+3 t+5 t+7 t+9 t+11 t+13 t+15 t+17 Source:World development indicators. SEE4 consists of Albania, Montenegro, Republic of North Macedonia, and Serbia; MIC represents all middle-income countries 26 Macroeconomic context in BiH 5. In contrast to progress made toward high-income status, living standards in BiH relative to the EU have remained stagnant over the past 15 years. BiH has not managed to reduce the gap in real per capita consumption, one of the measures of standard of living, with respect to the EU27 average. Using a proxy that excludes the outmigration effect, real per capita expenditures have been hovering around 40- 41 percent of the EU27 average since 2008 (Figure 3a). Specifically, from 2005 to 2021, living standards in BiH have improved only at the margin vis-a-vis the average EU27 country; the distance between real consumption in BiH and the average EU27 coun- try declined by only 4 percentage points (Figure 3b). Most of this catch-up effect took place prior to GFC. Meanwhile, living standard improvements in structural peers have been more pronounced. For example, the largest jump in relative individual real con- sumption was achieved in North Macedonia with an increase of 16 percentage points, four times more than in BiH and reaching a level of consumption that is roughly half the size of the average EU27 country (Figure 3b). In Albania, in 2005 the difference between individual real consumption compared to BiH was almost 10  percentage points, and by 2021 this difference has all but disappeared. 6. BiH’s EU candidacy status granted in December 2022 is an opportunity to ac- celerate growth and escape the middle-income trap. Ten of the 31 countries that transitioned to high-income status between 1990 and 2019 benefited from joining the European Union, which improved trade and capital flows, enhanced enterprise liber- alization, and social inclusion during a period of healthy growth in Europe’s advanced economies. Based on this experience, technological change taking place during or post-EU accession could be an increasingly potent growth opportunity in BiH. De- clining working-age populations, including in BiH, could make productivity gains the main driver of growth17 and could induce firms to increasingly adopt automation tech- nology.18 Nearshoring of production processes, from older to newer member states, and associated better jobs could spill over into BiH in a more significant way provided BiH’s risk premium declines. To make progress on EU accession, difficult policy mea- sures need to be taken, starting in the area of 14 largely political measures covering democracy, rule of law and fundamental rights, and public administration. In parallel, BiH needs to meet economic criteria that require progress on the internal market and BiH institutional integration, strengthening of BiH supervisory and regulatory institu- tions, and reduction of an oversized public sector. 17 Bussolo, Koettl, and Sinnott, 2015 18 Acemoglu and Restrepo, 2017 Macroeconomic context in BiH 27 Figure 3a Figure 3b Volume indices of real Easing of the real per capita expenditure per capita (in consumption gap vis-a-vis PPS_EU27_2020=100) the EU27 average 90 84 62 BiH 76 60 80 ALB 57 MKD 53 70 52 SRB 51 60 MNE 51 47 EU27=100 47 EU27=100 50 41 42 41 40 40 39 30 37 37 32 35 20 10 27 26 0 22 SEE4 Baltics CSS BiH 2005 2021 Source: Eurostat. Real expenditure expressed in volume indices of real expenditure per capita (in PPS_EU27_2020=100), where PPS is Purchasing Power Standard. Baltics consists of Estonia, Latvia and Lithuania, CSS consists of Croatia, Slovakia, and Slovenia I.1.2.  Long-term output growth developments in BiH 7. Since 2000, real output growth in BiH has remained close to that of its struc- tural peers (Figure 4a). Prior to the GFC, BiH averaged 0.6 percentage points high- er growth compared to its regional peers but has fallen short ever since, including during GFC. In contrast, the region experienced a moderate expansion during the post-GFC period, and by 2019 the regional average annual growth rate was almost one percentage point higher. Consequently, cumulative real GDP in BiH lags its re- gional/structural peers for the period 2008 to 2022. In the subsequent analysis, three seemingly contradictory outcomes are discussed: how did BiH arrive at a below-par cumulative growth trajectory compared to its structural and aspirational peers, yet managed to narrow the gap toward high-income country status?; and, despite nar- rowing the gap toward high-income status, how is it possible that BiH made little to no progress in living standards in comparison to the average EU27 country, as mea- sured by real per capita consumption? 8. The GFC exposed BiH’s structural weaknesses. The repercussions of the cri- sis on Europe’s banks and the emergence of serious weaknesses in the Euro area had a deep impact on the BiH economy through multiple transmission channels: the decline in demand for BiH exports, which turned out to be short-lived; the re- duction in supply of FDI and remittances; and a weakening of the financial link- ages with Euro area banks. Euro area banks provided almost all the cross-border claims and local claims of foreign affiliate banks to BiH, according to BIS. As part of the deleveraging of Euro area banks, foreign claims on BiH declined by nearly 40  percent from their average 2008 value through 2015, down from 66  percent of GDP to 51  percent. The global financial and Euro area crises also exacerbated the difficulties inherent in accomplishing reforms, such as reducing the extent of excess public sector workers at a time in which few private sector jobs were being creat- ed to absorb them. At this time, the reform push to reduce the footprint of SOEs came to a sudden halt, impacting productivity. 28 Macroeconomic context in BiH Figure 4a Figure 4b Real GDP growth (%) Real GDP per capita growth (%) 15 BIH 14 BIH SEE4 12 SEE4 10 10 8 6 5 4 2 0 0 -2 -5 -4 -6 -10 -8 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: World development indicators. The broad blue lines indicate BIH’s average annual growth during the three growth phases (pre-GFC period: 2000–08, GFC: 2009–2012, post-GFC period: 2013–2019). SEE4 consists of Albania, Montenegro, Republic of North Macedonia, and Serbia. 9. The growth in per capita terms in BiH has surpassed the trajectory of real GDP growth, primarily due to the long-term decline in the total population (Figure 5a). Even during the economic downturn following the GFC, when real GDP contracted, per capita real GDP still grew by 1.3 percent annually. At the same time, the rate of the population decline in BiH outpaced the regional average. Consequently, BiH has ex- hibited stronger growth in real per capita GDP compared to the region in recent years, despite achieving a similar performance in the overall real GDP growth trajectory. 10. The population decline in BiH is primarily caused by labor outmigration to countries such as the EU, including Croatia and Slovenia, as well as Serbia, Swit- zerland, and the US. This outmigration represents a loss of valuable human capital, with an estimated half of the population residing abroad (Figure 5b). While the forced migration during the war from 1992 to 1995 contributed to this situation, structural issues within the country also play a role in permanent and seasonal labor outmigra- tion. 19 11. The root cause of outmigration in BiH include push factors such as lower liv- ing standards compared to destination countries, weak labor market outcomes, lower wages, high levels of corruption, political instability, and a challenging busi- ness climate. These factors hinder the development of the private sector and the creation of high-quality jobs, resulting in wage differentials between BiH and the EU. To reduce the wage differential, BiH needs to focus on unleashing productivity gains in both the private and public sector, 12. Visa facilitation and readmission agreements with the EU, as well as the EU accession of Croatia and Slovenia have acted as pull factors for migration from BiH. Labor shortages in Croatia and Slovenia, but also Montenegro and Serbia in tour- ism, construction, and agriculture have created opportunities for workers from BiH20 19 OECD, 2021; Leitner, 2021 20 Krasteva et al, 2018 Macroeconomic context in BiH 29 driving temporary seasonal and circular migrations from BiH.21,22 Resulting remittance inflows, which account for approximately 8 percent of GDP, have a significant impact on consumption, but have not led to real exchange rate appreciation. That said, the sizable inflow of remittances is likely to be a contributing factor of the high inactivity rate (which in BiH, together with Kosovo, is the largest in the region). Figure 5a Figure 5b Population growth (%) BiH outmigration in a global context 4.0 Emigrants (% of population),2019 BIH 3.0 SEE4 BiH 2.0 ALB 1.0 MKD 0.0 MNE -1.0 EU Average -2.0 SRB -3.0 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 GDP per capita, PPP, 2018 (constant 2011 international $) Source: World development indicators. Source: UN DESA 2019, WDI, World Bank staff calculations 13. Labor supply from BiH consists mainly of older and better-educated workers com- pared to other Western Balkan migrants. An estimated 48 percent of BiH migrants are in mid-skilled VET occupations, with a significant number in building and blue-collar manu- facturing, whereas highly skilled occupations account for an estimated 23 percent.23 How- ever, over 40 percent of migrants are overqualified for the work they perform. BiH migrants are relatively well-integrated into the EU labor markets, with high employment rates and low unemployment rates. BiH migrants are also relatively better integrated into the EU la- bour markets than other migrant groups from the Western Balkans, with an employment rate of over 70 percent, and an unemployment rate of 8 percent in 2015/16. 14. The gender distribution among emigrants from BiH remains stable, with women comprising a similar share as men. Women from BiH are more likely to participate in the labor market when residing abroad compared to their participation rates in their home country. Furthermore, the gender gap in labor market participation is the smallest for workers from BiH, with men accounting for 83 percent and women for 68 percent, result- ing in a 15-percentage point difference, a gap significantly smaller compared to Albania and Kosovo, where the gender gap is twice as large. 15. The surge in outmigration has led to a rapid demographic transformation, characterized by an aging population, and decline in the working-age segment. According to UN estimates, the median age in BiH has risen nine years, from 32.9 in 21 Kacapor-Dzihic and Oruc, 2012 22 The key difference between temporary seasonal and circular outmigration lies in the duration and purpose of the movement. Temporary seasonal outmigration is typically short-term and tied to specific seasonal work, while circular outmigration involves longer-term movement with repeated cycles of work and return. 23 OECD, 2022 30 Macroeconomic context in BiH 2000 to 42.1 in 2022. Hence, the aging rate in BiH has outpaced that of neighboring countries and even surpassed the rate observed in rapidly aging EU nations like Ger- many and Italy. This demographic shift has resulted in a shrinking labor force, labor shortages, and slower economic growth as described in more detail in the next sec- tion. I.2.  Drivers of output growth 16. Analyzing economic growth involves utilizing various frameworks, such as the expenditure approach, the production approach, and the Solow-Swan model. The expenditure approach explores the demand side of the economy by dividing GDP growth into components like consumption, investment, government spending, and net exports. Understanding the growth drivers—be it strong consumer confidence or business optimism—provides insight into the economy’s sustainability. Mean- while, the production approach examines sector-specific contributions to real output growth, shedding light on the economy’s structural changes over the long term. This supply-side perspective complements the demand-side analysis for policymakers, offering a comprehensive view of economic dynamics. The Solow-Swan model is employed to help understand long-term economic growth dynamics by assessing labor, capital, and total factor productivity as key inputs to production. This model evaluates how changes in labor force participation, capital investment, and techno- logical progress influence economic expansion. It also helps in simulating the poten- tial impact of structural reforms on the growth trajectory. This report uses the World Bank’s Long-Term Growth Model to first analyze longer-term growth contributions and simulate the possible impact of structural reforms on the growth trajectory. I.2.1.  Expenditure approach 17. Real GDP growth in BiH has been consumption- rather than investment-based. Consumption continues to drive the economy although its share has been declin- ing over time (Figure 6a). After lying well above GDP until 2014, total consumption’s24 share declined sharply in 2015. The share moved below unity in 2016 and has been contracting ever since. The drop in the household consumption share has been in- strumental in accounting for the aggregate decline in GDP growth. 18. Economic growth is constrained by a low investment rate that fell sharply during the GFC and failed to recover thereafter (Figure 6b). The average invest- ment rate during the pre-GFC crisis years settled at around 27.5  percent. With the financial crisis putting strain on capital, the average investment rate contracted by more than 5 percentage points during the post-GFC relative to the pre-GFC period. The weakness has persisted since and the average rate in the post-GFC years barely managed to stay above 22 percent of GDP. Such a low rate of investment is concern- ing given that it lies on average 3 percentage points per annum below the 25 percent threshold recommended by the World Bank’s Commission on Growth and Develop- ment to sustain high growth. While investment rates also fell sharply elsewhere in the Western Balkan region, the peer average has been higher compared to BiH each year of the post-GFC period except in 2014. 24 household and government consumption Macroeconomic context in BiH 31 Figure 6a Figure 6b Household and Gross fixed capital government consumption formation (GDP, %) (share of GDP, %) 105 HH consumption 27 31 BIH Government Consumption 100 Govtconsumption 25 SEE4 Household consumption 29 95 90 23 27 85 21 25 80 75 19 23 70 17 21 65 60 15 19 2000 2003 2006 2009 2012 2015 2018 2021 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Source: World development indicators, and investment and capital stock database of the IMF 25 19. During the last decade, investment activity has moved toward the private sec- tor. The private sector accounted for less than half of the total investment in 2000, but private investment has been growing in prominence since then. The private invest- ment share reached a peak of 73 percent in 2007 before the GFC derailed its surge. The latter is in part driven by the sharp drop in net foreign direct investment (FDI), which averaged 5.8 Percent of GDP in the five years prior to 2009, but permanently shifted to an average of just above 2 percent of GDP during the period 2018 to 2022. This has not only had an adverse impact on the level and composition of total private investment in the country, but also on the non-debt financing of the current account deficit. More recently, private investment gained momentum due to investments into renewable energy parks (windmills) in 2018/19. Meanwhile, public capital expendi- tures in BiH hovered below 3 percent of GDP, on average, over the last decade, with an increase to close to 5 percent of GDP in 2020 driven by the election cycle. 20. Construction of housing and commercial buildings dominates investment in machinery and equipment, affecting potential output. Specifically, from 2009 to 2019 not only did investment drop but construction works averaged annually 51 per- cent of gross fixed capital formation in new fixed assets, whereas machinery and transport equipment participated with 44 percent.26 As a result, the share of machin- ery and transport equipment participating in manufacturing value added declined in BiH from 10 to 9 percent, which seems to suggest lack of progress in technological sophistication of manufacturing production. In regional peers, this share improved from 8 to 12 percent over the same period, and in Moldova from 4 to 9 percent. In as- pirational peers, such as the Baltics machinery and transport equipment participation was rising from 14 to 17 percent, in Slovenia and Croatia reaching a share of 23 and 15 percent, respectively, whereas in Slovakia this share totalled 42 percent. 25 IMF Investment and Capital Stock Dataset, 1960-2019 (version: May 2021), https://www.imf.org/external/np/fad/ publicinvestment/data/info.pdf 26 See BHAS Gross fixed capital formation, issues 2005 to 2020, 32 Macroeconomic context in BiH 21. EU countries account for the majority of net FDI inflows (Figure 7a). FDI inflows serve as a catalyst for macro- and micro-economic growth: FDI generates capital inflow and allows host countries to expand their economies by opening their markets to higher volumes of international trade; it also stimulates domestic business com- petition, resulting in higher employment opportunities and GDP growth. FDI also pre- cipitates technological shifts that call for employee training and transferable skills, ultimately contributing to the advancement of host countries’ human capital.27 Since 2011, 40 percent of total FDI inflows in BiH ended up in the financial and wholesale/ retail trade sectors, with Austrian, Croatian, and Italian companies deepening their presence in the market. The wholesale/retail trade sector is at the same time the second largest formal employer with a share of 18 percent during the period 2017 to 2022, and the largest formal employer of women, with a share of 21 percent for the same period. Somewhat smaller FDI investments include manufacturers of basic and fabricated metal products amounting to 6 percent of total FDI, and with chemical products manufacturers taking a share of 3 percent. FDI inflows have also been lower than in peers. 22. Several reasons may help explain the low and declining levels of net FDI in- flows, despite BiH’s EU candidate status, proximity to the EU, and traditional trad- ing linkages with EU countries. Continuous political frictions raise the risk-adjusted returns on investment and, thus, undermine the attractiveness of the country for in- vestors, which seek political stability.28 In addition, investors must overcome legal/ regulatory uncertainty stemming from a complex and fragmented regulatory frame- work, endemic corruption, non-transparent business procedures, insufficient protec- tion of property rights, and a weak judicial system. This includes a high level of per- ceived corruption, and the Transparency International’s Corruption Perceptions Index continues ranking BiH relatively low. Finally, BiH has struggled with infrastructure development, including transitioning to greener electricity production, which going forward may adversely affect the competitiveness of FDIs and their access to export markets in the EU. 23. BiH has made progress in the external sector by strengthening its export share while curtailing its import share (Figure 7b). Since 2000, the export share in GDP has risen by a sizable 24 percentage points. Roughly two-thirds of these gains have ma- terialized in the post-GFC period. The average export share during the pre-GFC crisis years and the slump years stood around 25 percent of GDP. In contrast, the average share during 2013-22 was around 38 percent of GDP. Moreover, the upward trend that started in 2010 has sustained momentum, largely due to merchandise exports. The latter more than tripled during the period 2000 to 2021 to 30 percent of GDP, whereas services exports doubled to 14 percent of GDP, driven by a sharp rise in transport and travel that accelerated to 5.2 percent and close to 12 percent of GDP by 2022. After dropping sharply in 2020 on account of the pandemic, the export share rebounded to surpass the pre-pandemic levels. 27 Harvard Center for European Studies: Investing in FDI: How and Why do the Western Balkans Differ?; https://ces.fas.harvard.edu/news/2021/02/investing-in-fdi-how-and-why-do-the-western-balkans-differ 28 MIGA, 2014 Macroeconomic context in BiH 33 Figure 7a Figure 7b Net FDI inflows compared Exports and imports to inflows in regional (share of GDP, %) peers (% GDP) 10 50 Imports 110 45 Exports 100 8 40 90 35 80 6 Exports Imports 30 70 % GDP 4 25 60 20 50 2 15 40 10 30 0 1994 1997 2000 2003 2006 2009 2012 2015 2018 2021 BiH SEE4 Source: World development indicators. 24. The import share fell steadily driven in part by declining investment from a high of almost the size of GDP in 1998 during the reconstruction to under half of GDP in 2009 before recovering and holding around 56 percent of GDP. Overall, the prog- ress in the net foreign balance in the GDP accounts is the result of two developments: first, the compression in the merchandise trade deficit that peaked in 2008 at 39 per- cent of GDP and declined to an average of roughly 22 percent of GDP between 2018 and 2021 (Figure 6a); and second, an improving services surplus that in the post-GFC years bottomed out at 5.8 percent of GDP, but recovering to close to 7 percent of GDP during the period 2018-2021, which includes the drop to 4.3 percent of GDP during the pandemic. 25. Improved net exports in goods and services helped bring about a remarkable, steady decline in the current account deficit from over 16 percent of GDP in 2005 to 2.4 percent of GDP in 2021 (Figure 8a). The steep decline in the external balance is largely a story of merchandise exports, supported by the steady real effective ex- change rate depreciation made possible by the currency board, where the level of the exchange rate remains adequate (see Annex 4 on the Fundamental Equilibrium Exchange Rate - FEER). Traditionally, sectors such as metals, machinery, and mineral products, including electricity, contributed significantly to the country’s exports over the years. Steel, iron, and aluminium products continue to play a significant role, hav- ing almost tripled during the period 2005 to 2021, with a share of around 20 percent of total merchandise exports in 2021.29 26. Nevertheless, a significant share of these exports are low value-added prod- ucts such as raw aluminium totalling 4.9  percent of total merchandise exports in 2022, representing the second largest export product in BiH, whereas scrap copper, aluminium, and iron add up to 13 percent of total metals exports. A similar theme fol- lows exports of mineral products, where coke continues to be the 8th largest export product with a value of USD236 million or 2.4 percent of total merchandise exports. At the same time, exports of wood products are dominated by sawn wood as well as 29 https://oec.world/en/visualize/tree_map/hs92/export/bih/all/show/2021/ 34 Macroeconomic context in BiH fuel and rough wood that together account for 62 percent of total wooden products exported in 2021. Similarly, the textile industry has increased its value of exports four times since 2005, yet these products represent “lohn” jobs30 for brand names, where the value added is low. 27. Electricity exports have accelerated to become the number one export prod- uct, which distinguishes BiH from other regional peers. Electricity exports have roughly doubled from 2018 to 2022 to reach a total of 6 percent of total merchan- dise exports, or USD580 million. This is the equivalent to 2.4  percent of GDP. That said, around two-thirds of the power produced in BiH comes from coal, provided by loss-making lignite mines, and targeted by the EU CBAM that will be introduced in 2026 and will start having a larger impact after the first few years. We elaborate on this topic in Chapter 3, where we discuss the just energy transition. 28. The export complexity of BiH’s exports seems to have deteriorated over time31 (Figure 9), although other measures seem to suggest a slight improvement. The EXPY indicator estimates the level of technological sophistication embodied in a country’s export portfolio. The concept of export sophistication refers to the level of technological complexity, knowledge intensity, and value-added content embedded in a country’s exported products. It signifies a country’s ability to produce and export higher-value goods, often indicating a higher level of technological advancement and competitiveness. As products become more sophisticated, they tend to com- mand higher prices in the global market, leading to increased export receipts and economic growth. Despite a deterioration in the EXPY, BiH’s product complexity rank- ing according to the OEC has improved since 2010 and is currently in the 36th place based on the Economic Complexity Index (ECI), which measures the number and complexity of the products the country successfully exports. This is a better position compared to structural peers such as Montenegro, North Macedonia, and Moldova, yet still with significant gap with respect to Croatia, Slovenia, and Estonia, to mention some of the aspirational peers. That said, medium- and high-tech exports as a share in manufactured exports has followed in BiH a similar pattern as in Estonia and to some extent Albania. After 2005, medium- and high-tech share dropped for half a decade but then picked up in both BiH and Estonia, whereas it continued declining in the case of Albania (Figure 9). By 2019/20, BiH managed to catch up with its share of medium- and high-tech share in manufactured exports that it had in 2005 totaling 28 percent. This is significantly below the shares seen in Moldova (41 percent), Serbia (47  percent), and North Macedonia (65  percent), and with some aspirational peers around 70 percent and above (Slovenia and Slovakia). 29. In 2022, 71 percent of merchandise goods were exported to only six countries: Croatia, Germany, Serbia, Italy, Austria, and Slovenia. In other words, the demand for BiH export goods is heavily reliant on the EU, with Netherlands, France, Poland, Hun- gary, and other EU countries accounting for another 15 percent of BiH’s merchandise 30 In the textile industry, a “lohn job” refers to a specific type of outsourcing arrangement where a company contracts a production process to a subcontractor or manufacturer in a lower-wage country. In this arrangement, the contracting company provides the materials, design specifications, and sometimes equipment, while the subcontractor carries out the garment manufacturing, based on the provided inputs. A lohn job is considered a low value-added activity because it typically involves simple and labor-intensive tasks, such as cutting, sewing, and assembling garments or textile prod- ucts. The subcontractor’s role is mainly focused on executing the production process as per the provided instructions, with limited involvement in the design, innovation, or strategic decision-making aspects. 31 Hausman, Hwang, Rodrik (2005) What you export matters, NBER, Working Paper 11905, doi: 10.3386/w11905 Macroeconomic context in BiH 35 exports. These countries also account for the majority of the net FDI inflows in BiH. The latter has been trailing significantly foreign investments in regional peers. More- over, the way BiH manages the decarbonization efforts will also have an impact on new FDI inflows going forward. Overall, the Stabilization and Association Agreement (SAA) with the EU facilitated closer economic ties and trade liberalization. Therefore, BiH’s exports, including those from FDI firms, are heavily dependent on economic developments in the EU, and regulation introduced in the EU. In this context, ex- port could also be supported through bolstering national quality controls to meet EU standards by aligning the regulatory framework with the EU and strengthening the quality control infrastructure such as laboratories, accreditation bodies, certification organizations, and quality control agencies. Figure 8a Figure 9 Current account deficit edium- and high-tech (GDP, %) exports (as share of total manufactured exports, %) 30 BIH 80 2005 SEE4 70 2010 60 20 50 40 10 30 20 10 0 0 2007 2009 2011 2013 2015 2017 2019 2021 EST MDA HRV LVA SVK ALB MKD SRB LTU SVN BIH Source: BHAS Source: World Development Indicators I.2.2.  Production approach 30. BiH’s transition from agriculture to industry and services underscores the transformative processes in the economy. Over the last two decades, the reduction in agriculture’s share of 4 percentage points in gross value added has spilled over into industry, while the share of services has largely remained unchanged at 54-55 per- cent (Figure 10a).32 This stands in contrast to Serbia and Moldova, for example, where the share of agriculture, which typically exhibits lower productivity, has declined by 11 and 15 percentage points, respectively, over the same period, and spilled over into the services sector. Thus, while transformative processes are underway in BiH, they are much slower than in some regional peers. That said, the more prominent differ- ence with respect to aspirational peers arises in the employment structure. Jobs in agriculture account for 18 percent of total employment in BiH, yet it contributes only with 5 percent in gross value-added. Overall, both BiH and its regional peers (except Albania) have three times more workers employed in the agricultural sector com- pared to aspirational peers (Figure 10b). The nature of the transformation processes is further discussed in Chapter 2. 32 The individual sectors do not add up to 100 percent of GDP because of taxes on products and services and im- port less subsidies. 36 Macroeconomic context in BiH 31. BiH is among the most rural in Europe, with three-fifths of the population liv- ing outside urbanized areas. The observed slow transition out of agriculture activity means that a sizable share of BiH workers engages in relatively low-productivity and poorly paid jobs. Hence, BiH’s slow pace of urbanization and structural transformation causes lower productivity and lower incomes. The much larger share of agriculture in GVA in RS compared to FBiH implies therefore that a more pronounced shift to higher productivity sectors would help raise economic growth in BiH. Figure 10a Figure 10b Growth--production Employment across drivers (% of GDP) sectors (% of total) BiH 2021 5 26 55 BiH 2021 18 32 50 2000 9 22 54 2000 25 30 45 Aspirational 2021 25 60 Aspirational 2021 5 31 64 peers peers 2000 27 56 2000 10 35 55 MDA 2021 10 21 55 MDA 2021 21 22 57 2000 25 19 45 2000 51 14 35 SEE4 2021 9 21 54 SEE4 2021 18 25 57 2000 16 24 49 2000 29 25 47 0 50 100 0 50 100 Agriculture Industry Services Agriculture Industry Services Source: World development indicators. 32. Consumer durables and non-durables industries and the wholesale/retail trade sectors are the main drivers of gross value added in the economy. The main engines of the services industry in BiH have been the wholesale and retail trade sec- tors, growing on average 5.4 percent over the last two decades (2001 to 2022), driven by a consumption-led model fuelled by remittances and by tourism exports. The two trade sectors were also areas of significant FDI inflow as it was argued earlier. Inter- estingly, labor productivity in trade services is almost twice as high as in food and ac- commodation and exceeds even that in manufacturing. That said, labor productivity in trade is still less than half the size compared to information and communication and the financial industry. The strong rate of growth in trade resulted in its share in the economy rising from 11 percent of GVA in 2000 to 17.5 percent in 2021. Meanwhile, manufacturing also exhibited a sizable average real growth rate of 5 percent over the past two decades, mainly in consumer durables and non-durables. Specifically, the production of chemicals and basic pharmaceutical products has seen a long-term double digit real rate of growth, on average, followed by the production of rubber and plastic products and electrical equipment as well as fabricated metal products that all grew between 5 and 6 percent, on average. 33. BiH’s abundant natural resources enable a strong manufacturing sector. BiH has abundant resources in iron ore, bauxite, lead, zinc, and copper. Over the years, this has led to competitive salaries and expertise in various segments of the manu- facturing sector, particularly within metal processing. Capabilities include the pro- duction of a vast range of metals including iron, steel, and aluminium, as well as the production of various precious metals and non-ferrous metals. Technical capacities Macroeconomic context in BiH 37 and skills exist in sheet metal processing, welding, plasma cutting, bending, machin- ing, aluminium extrusion, castings and forgings. These technical capabilities enable metal associated industries to manufacture many parts and components used in the construction, energy, defense, and automotive sectors. 34. In contrast to trade and manufacturing, mining has been a drag on the econ- omy. Starting in 2009, mining exhibited a negative real growth rate, on average, and its share in GVA declined from 0.3 to 0.2 percent. Nevertheless, coal accounted for 54 percent of the national energy supply mix and contributed to about 66 percent in the electricity generation mix in 2020. Each of the five coal power plants have their own mines nearby, supplying a total of 1.9 GW. Electricity has also been propelled to the number one export product in recent years. Yet, despite the economy’s depen- dence on coal-fired electricity production, coal mines are not financially viable. For example, EPBiH coal mines booked a total loss of about EUR122 million over the peri- od 2019 to 2021, and have accumulated arrears of EUR257 million, whilst Ugljevik and Gacko coal mines averaged losses of EUR 0.6million and EUR0.4 million per annum over the last five years. Finally, the Banovici mine booked an average loss of EUR2 million during the period 2020-2021. Therefore, reducing reliance on coal-based en- ergy is strategically important given the declining competitiveness of coal mining in BiH, but also the EU legislation in the form of CBAM, for example, which will increas- ingly render BiH exports less competitive unless there is a shift to more sustainable sources of energy production. These issues are further discussed in Chapter 3. I.2.3.  Capital, labor, and TFP33 35. Robust capital accumulation has underpinned the economic expansion since 2000 and contributed 1.8 percentage points to annual real GDP growth on aver- age (Figure 11a). Total factor productivity (TFP) growth has made a relatively modest contribution on average (0.5 percentage points) with the weak impact also being ex- erted by changes in the labour market (0.7 percentage points). While TFP growth had a negative contribution in the aftermath of the GFC, it rebounded roughly around the mid-2000s, with a growth rate of about 2 percent, which is in line with TFP growth in regional peers.34 Digging deeper into the drivers affecting labour resources (Figure 11b), a moderate contribution from human capital growth (0.6 percentage points) can be established, whilst the expansion in labor force participation and the working-age population provided additional tailwinds. In contrast, the population decline ham- pered growth and shaved more than one percentage point each year, on average, between 2009 and 2012, and nearly one percentage point, on average, between 2013 and 2019. 33 This accounting exercise is based on the WB’s Long Term Growth Model, which adopts the Solow approach. 34 The exception is Serbia, which represents an outlier when it comes to TFP growth. 38 Macroeconomic context in BiH Figure 11a Figure 11b Growth accounted by Growth accounted, labor drivers (pp*) detail (pp*) 6.0 3.0 4.0 2.0 2.0 1.0 0.0 0.0 -2.0 -1.0 -4.0 -2.0 2001-19 2001-08 2009-12 2013-19 2001-19 2001-08 2009-12 2013-19 K/Y TFP LAB HC LFPR WAPR POP Source: Based on calculations using data from World Development Indicators, Penn World Tables. The growth contributions of drivers are in percentage points and TFP, K/Y, and LAB represent contributions of growth in TFP, capital, and labor. In the right panel, HC, LFPR, WAPR, and POP represent the contributions of changes in human capital, labor force participation, working-age population, and population; *Percentage points. 36. The relative importance of growth drivers has varied over the growth episodes (Figures 11a, 11b). Growth of both factors of production - labor and capital, has lost mo- mentum over the years. Capital deepening was robust in the pre-GFC period and con- tributed 2 percentage points to the growth expansion, on average. However, its growth impact roughly halved during the GFC, with no rebound being apparent in the post-GFC years. The fall in labor’s contribution to growth has been even more alarming. Labor ac- counted for almost 2 percentage points of the aggregate expansion during 2001-08, fell from this healthy level to 0.6 percentage points during the GFC, and turned negative in the most recent period (2013-19). The contraction in the labor stock shaved off 0.3 percentage points from the output growth rate on average in the post-GFC period. 37. BiH’s population plummeted from about 3.8 million to approximately 3.4 million between 2010 and 2019, and it is estimated that by 2050, the population will drop by another 20 percent to about 2.7 million (World Bank 2020a). Population ageing and out- migration have led to an annual shrinking of the working-age population and the labor force by 3 and 2 percent, respectively, since 2011, concurrent with an increasing depen- dency ratio. These demographic trends will continue to be a core challenge for better growth and labor market outcomes in the future, as fewer people of working age will need to support a larger number of old-age dependents and the associated fiscal costs of pen- sion payments and health services, to mention a few. 38. The population decline has had a major impact on output growth (Figure 11b). While the population decline has had a negative impact, this was compensated by the contribution of human capital, labor force participation and working age population during the period 2009-12. However, the combined effect of the decline in population and the drop in labor force participation has had a significant impact from 2013 to 2019. These two effects weighed heavily on growth, shaving off almost 1.3 percentage points per annum, and were in part offset by human capital and working-age population. The above trends imply that TFP growth has been the primary driver of growth in the post-2013 period, after the sharp decline during the GFC years (2009-2012, Figure 12a). Were it not for the produc- Macroeconomic context in BiH 39 tivity growth from 2013 onward, the economy would have stagnated.35 39. The sizable decline in population impacts real output growth in several ways. The shrinking labor force implies fewer workers are available, which in turn means that there is a reduced capacity for production and a potential decline in overall productivity. The significant outmigration has accelerated the aging of the population that was already un- derway. An aging population poses challenges such as increased healthcare and pen- sion costs, and decreased consumer spending. These demographic challenges can hin- der economic growth and put strain on public finances. Furthermore, a reduction in the population reduces consumer demand, and thus aggregate demand. With fewer people to purchase goods and services, businesses experience a smaller market size, smaller economies of scale, decreased sales and reduced incentives for investment, expansion, and new ventures putting downward pressure on growth. If a decline in population is not offset by any other growth driver, it can lead to reduced economic activity and slower real GDP growth. Finally, with fewer young individuals entering the workforce, there may be a decline in the acquisition of skills, education, and training. This can lead to a decrease in labor productivity and hinder technological progress and innovation. 40. The contribution of total factor productivity (TFP) to output growth can have sev- eral reasons. A composition effect could account for higher TFP growth if less productive workers leave the country, resulting in an increase in average labor productivity. This could in part explain the growth in TFP as the post-2008 outmigration push included an esti- mated 60 percent of medium-VET-educated individuals, followed by workers with low and medium general education. Under this possible explanation, the potential brain drain effect often quoted in public is not entirely clear.36 Another possible, and perhaps more likely explanation is the resource re-allocation that has followed the shrinking of the labor force, whereby remaining workers have access to more physical capital per worker. The latter could lead to increased productivity and efficiency, which in turn contributes to TFP growth. These explanations require some judgement calls since TFP growth is calculated as a residual and tends to exhibit noise, particularly in the short term. 41. The contraction of the labor stock is unique to BiH and puts the country at a dis- advantage relative to its structural and aspirational peers (Figure 12a, 12b). As men- tioned above, the population decline shaved over 0.5 percentage points from GDP growth each year during the period 2013-19. This was offset by capital deepening, like the one seen in Montenegro and North Macedonia, and significantly more than in other structural peers and aspirational countries. Other countries are also experiencing a population de- cline, such as Serbia or Albania among structural peers, and Croatia, Latvia, and Lithuania among aspirational peers. Yet, nowhere is the issue as acute as in BiH. More importantly, in all peer countries, the labor effect is positive, and the population decline in some coun- tries has been offset by the growth of human capital, working-age population, and labor force participation. The first two of these channels provide some relief in BiH as well. But 35 In the model, working-age population to total population, and total population are two (of three) different components of the labor force: labor force = labor force participation rate * working-age population to total population * total population. In the past (and specially from 2008 onwards) there was fall in total population, but at the same time an increment in the working-age population to total population. When one does the growth accounting exercise, the contribution of the growth of a variable over economic growth is analyzed in isolation from other variables. Therefore, a negative growth in population results in (ceteris paribus) a reduction of the labor force and therefore contributes negatively to GDP growth. On the other hand, a positive growth in the working-age population to total population results in (ceteris paribus) an increment of the labor force and therefore contributes positively to GDP growth. 36 ETF, 2021 40 Macroeconomic context in BiH unlike its peers, the labor force participation rate has been falling in the country and has put downward pressure on growth to the tune of 0.4 percentage points on average in re- cent years. In contrast, this channel has contributed 1.3-1.4 percentage points to growth in structural peers in Montenegro and Serbia, and among aspiration peers such as Slovenia and Lithuania. Figure 12a Figure 12b Growth accounted by Growth accounted: Labor drivers 2013-19, BIH and detail ‘13-19, BIH and peers (pp*) peers (pp*) 4.0 K/Y 2.5 HC WAPR TFP 2.0 LFPR POP 3.5 LAB 3.0 1.5 2.5 1.0 2.0 0.5 1.5 0.0 1.0 0.5 -0.5 0.0 -1.0 -0.5 -1.5 HRV EST LVA SVK BIH ALB MNE MKD SRB LTU SVN HRV EST LVA SVK BIH ALB MNE MKD SRB LTU SVN Source: Based on calculations using data from World Development Indicators, Penn World Tables. The growth contributions of drivers are in percentage points and TFP, K/Y, and LAB represent contributions of growth in TFP, capital, and labor. In the right panel, HC, LFPR, WAPR, and POP represent the contributions of changes in human capital, labor force participation, working-age population, and population.*Percentage points. I.2.4.  Growth from the entities’ perspective Output growth developments 42. With each of the government levels entailing their own fiscal laws, including in- dependent fiscal spending, regulations, and institutions, it is helpful to understand the growth drivers from an entities’ perspective. The two entities pursue independent fiscal spending policies, whereby the BiH Council of Ministers or BiH institutions play a minor role. In 2021, BiH institutions were responsible for 7 percent of total consolidated spend- ing and Brcko district for another 2 percent; the remaining 91 percent was split between the two entities, with FBiH accounting for 58 percent of the total and RS for 33 percent. Furthermore, each entity has jurisdiction over direct taxation, and other economic pol- icies and all social policies, especially education and health, including their own social security funds, and extra-budgetary funds. Finally, the entities exhibit a different economic structure, with the share of the agriculture, forestry and fishery sector in RS amounting to roughly 10 percent, twice the size compared to FBiH, and a correspondingly smaller service sector (Figure 13a). Overall, FBiH accounts for two-thirds of BiH’s GDP, while RS ac- counts for one-third, whereas the Brcko District accounts for around 2 percent of BiH GDP. 43. The difference in per capita GDP between the entities has narrowed sharply since 2020. During the pre-GFC period, RS grew faster than FBiH, at an average rate of close to 6 percent (2001 to 2008), recording an annual difference of 1.5 percentage point with respect to FBiH (Figure 13b). In the post-GFC period, however, both entities grew, on aver- Macroeconomic context in BiH 41 age, at the same rate of close to 2 percent. While this meant a halving of the growth rate in FBiH, the drop in RS was more pronounced, by a factor of three. Despite the same average rate of growth over the past decade, the larger outmigration flow in FBiH meant that the per capita GDP difference widened from EUR72 per capita in 2008 to EUR376 in 2019. In other words, per capita GDP in RS shifted from a peak of 98 percent in 2008/2009 before declining to 93 percent in 2019 (Figure 14a). 44. The production structures of the two entities, FBiH and RS, show significant dif- ferences, particularly in the size of the manufacturing sector, which is one of the larg- est employers in BiH. FBiH has a larger manufacturing sector, accounting for close to 17.5 percent of gross value added in 2021, a steady increase from around 14 percent in 2010 (Figure 14b). Over the last two decades, manufacturing in FBiH exhibited an average real growth rate of over 4 percent during (2011 to 2021). In contrast, the manufacturing sector in RS had a share of around 11 percent in gross value added in 2021. Unlike FBiH, the share of manufacturing in RS’ GVA has remained relatively stable over the past two decades, peaking at 12.5 percent in 2017 before returning to 2010 levels of 11 percent. Moreover, manufacturing grew at a much slower pace compared to FBiH, or rather at an average rate of 2.1 percent during the same period. As a result, in FBiH manufacturing contributed with 25 percent to the average long-term growth rate in gross value added, while in RS this sector contributed with 11 percent. 45. Agriculture is the fourth largest sector in RS and exhibits a negative long-term growth rate. With an average share of about 10 percent of GVA in 2021, the sector of ag- riculture, forestry and fishery is in size only behind manufacturing, wholesale/retail trade, and public administration. At the same time, this sector is larger than the construction sector and twice the size compared to the financial sector in RS. That said, agriculture has shown a real growth rate of -0.3 percent for the period 2011 to 2022, or even -1 percent for the period 2009 to 2022. While in both entities the agricultural sectors have shown large fluctuations, in FBiH the sector has demonstrated somewhat more resilience and has grown on average 1.3 percent during the period 2011 to 2022. Figure 13a Figure 13b FBiH and RS economy’s FBiH and RS real GDP sectoral shares, with growth rates agriculture double the size in RS 5% 8.0 RS FBiH FBiH Agriculture 6.0 28% 67% FBiH Industry FBiH Services 4.0 2.0 10% 0.0 RS Agriculture 30% 60% RS Industry RS Services -2.0 2001 2004 2007 2010 2013 2016 2019 2022 -4.0 Source: FBiH and RS Statistical Agencies 42 Macroeconomic context in BiH Figure 14a Figure 14b The differential between The manufacturing FBiH and RS per capita sectors show diverging GDP has narrowed since developments as a share 2018-19 (in EUR) in GVA (in %) 500 25% 19 FBiH % of expenditure Aggregate 450 RS 400 20% 17 350 15 300 15% 250 13 200 10% 150 11 100 5% 50 9 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 0 0% 1 2 3 4 5 6 7 8 9 10 Source: FBiH and RS Statistical Agencies 46. Finally, in both entities the mining and quarrying sector plays a minor role in terms of GVA. Specifically, over the last two decades, this sector’s share has fluctuat- ed between 1.5 and 3 percent. In FBiH, the mining and quarrying sector’s contribution is nearly negligible, accounting for only 1.7 percent of the GVA. However, in RS, this sector held a slightly more substantial share of 2.5 percent in 2021. Notably, this per- centage is higher than some other sectors, including lodging and restaurants. The performance of this sector in RS is significantly stronger than in FBiH with an average real growth rate of 2.1 percent during the period 2011 to 2021, whereas in FBiH this sector has recorded a growth rate of close to -1  percent during the same period. More recently, in 2021, GVA in the mining and quarrying sector declined a staggering 15 percent. Differences in the regulatory business landscape across entities and between FBiH and cantons 47. FBiH and RS have distinct business laws and regulations, including unique require- ments for company registration, licensing, and management. For instance, the FBiH operates under the Law on Companies, which recognizes various company types such as limited liability companies, joint-stock companies, and partnerships. Meanwhile, RS is governed by the Law on Business Organizations, and acknowledges similar company types but also includes additional categories like limited partnerships and limited liability partnerships. In terms of capital requirements, these laws stipulate different requirements: FBiH mandates a minimum capital of BAM 2,000 for limited liability companies and BAM 20,000 for joint-stock companies. On the other hand, RS stipulates a minimum capital re- quirement of BAM 5,000 for limited liability companies. Furthermore, the requirements for licenses, permits, application processes, and documentation differ between FBiH and RS. 48. Labor laws also diverge between the two entities, including variations in minimum wage rates and employment regulations. For instance, FBiH has a minimum wage of BAM 596. The minimum wage in FBiH is proscribed by FBiH Government decision and it is applied to FBiH, although this may vary only if a canton has proscribed a different min- imum wage by its own legislation. The RS has a higher minimum wage of BAM 700 per Macroeconomic context in BiH 43 month. The probationary period for new employees in RS is three months and can extend up to another three months, in total a maximum of six, so in a way the same as is in FBiH, which has specified a maximum of up to six months. Beyond the differences between the FBiH and RS, there are also disparities within the FBiH itself, as each canton has its own government and legislative assembly, which can enact laws and regulations specific to that canton. Consequently, business registration processes, environmental protection laws, and as indicated above minimum wages can differ across cantons. 49. The underdeveloped common economic space within the country, characterized by a lack of harmonization in legal and regulatory framework, hinders the activity of the private sector, including foreign direct investments.37 Investments are discouraged by barriers in the business environment, which include market fragmentation, excessive red tape, and a large grey economy. Specifically, businesses that wish to operate across the entire BiH economy still face technical and administrative obstacles and must fre- quently obtain the same licenses or permits in each entity or local government area (can- ton) and pay a range of different taxes and fees. This increases the costs of establishing a company and protects incumbent companies from competition. Over half of businesses in BiH identify burdensome procedures, red tape, and associated costs as a major obsta- cle to obtaining licenses. Businesses in BiH were also more likely than in any other country in the Western Balkans to cite the lack of a fully digitised process for applications and ap- provals of licenses as a major obstacle, with 76 percent of businesses citing this as at least a ‘moderate’ obstacle, compared with a regional average of 49 percent (Balkan Business Barometer 2022). 50. Finally, overlapping jurisdictions hinder the transition to a market-based economy. The highly decentralized governance framework raises the cost of coordinating among different levels of government, first between the two entities, and then between the FBiH entity level and its cantons. For example, in RS privatization is undertaken in accordance with the Law on privatization of state capital in enterprises, whereas in FBiH downsizing the SOEs’ footprint through privatization is undertaken in line with the Law on privatiza- tion of enterprises. However, in FBiH, cantons have significant implementing authority and each of the 10 cantons have established their own privatization agency operating under cantonal law. Hence, the fragmentation of authority and overlapping regulations on gov- erning SOEs can at times create legal uncertainty. Fiscal developments in FBiH and RS 51. BiH operates under a unique fiscal structure, characterized by its two largely au- tonomous entities. Each entity has its own fiscal revenues, except for Value Added Tax (VAT), which is collected at the BiH level and then distributed among the entities and the Brčko District (Box 1). Apart from VAT, the fiscal revenues of each entity are largely inde- pendent, with each having its own budget and spending policies. This decentralization allows for a large degree of fiscal autonomy, enabling each entity to tailor its fiscal policies to its specific needs and circumstances. However, it also presents challenges in terms of coordination and consistency across the country. 52. One of the most successful and impactful reforms was the replacement of the complex sales tax with an efficient, broad-based value-added tax (VAT) collected cen- trally by the Indirect Taxation Authority in 2006. Along with the currency board, this VAT 37 See also Annex 6 for a perspective of the common economic space from the perspective of the law of one price 44 Macroeconomic context in BiH reform has been instrumental in strengthening BiH’s fiscal framework, or rather the fiscal framework of the two entities. The VAT accounts for roughly 40 percent of total revenues in each entity. Other important reforms included introducing harmonized personal and corporate income taxes across entities and aligning excise duties with European Union standards. These measures have promoted fairness and transparency. Currently, BiH op- erates a streamlined VAT system with a single 17 percent rate applied broadly (see Box 3). This simple design minimizes compliance costs, avoids consumption distortions, and generates substantial revenue. Unlike many European countries, BiH does not utilize re- duced or zero VAT rates to achieve distributional objectives. 53. Government spending in both entities is targeting predominant- ly current outlays, which limits capital expenditures. The primary compo- nent of current spending in both FBiH and RS is social benefits. In 2021, RS spent 19  percent of GDP on social benefits, while FBiH spent 13  percent of GDP.38 This expenditure pattern has constrained the capital expenditure envelope over the past two decades. From 2010 to 2021, capital spending averaged 3.7 percent of GDP in RS (Figure 18a). Meanwhile, FBiH’s capital expenditures were on average 1.5  percent- age points lower during this period, at around 2.2  percent of GDP. Hence, both en- tities, and especially FBiH, spend significantly less on capital expenditures than the six Western Balkan peers, which averaged around 5  percent of GDP per annum over the same timeframe. Such a comparison is possible as no other country in the Western Balkans has sub-national governments with as much autonomy and independence in fiscal spending as FBiH and RS. Finally, the coordination of public capital outlays is in- adequately coordinated, which prevents synergy effects and higher returns from public investment on BiH level. 54. Considering the large infrastructure needs in FBiH and RS, capital expenditures are below levels that would help economic growth (Figure 15a). Spending on roads, railways, energy infrastructure, and broadband networks, to mention a few, reduces trans- portation costs, improves connectivity, and enhances competitiveness. This makes it eas- ier and cheaper for private firms to access inputs and markets, an issue explored in more detail in Chapter 2 of this report. Furthermore, public investment can crowd in and, thus, spur additional private sector investment as it creates complementary infrastructure. For example, government spending on roads may encourage private investment in trucking and logistics. 38 GDP on the entity level Macroeconomic context in BiH 45 Box 1.  Assessing the impact of splitting the single VAT rate through microsimulations. In response to inflationary pressures, the BiH Parliament has discussed a potential temporary multi-rate VAT system in August 2022, to provide support to poorer households. This proposed reform had three main components: (i) introduce a zero VAT rate on pharmaceuticals, forage for animals, seeds and seedlings, and a selection of basic food products including: flour, bread, milk, cooking oils, animal fats, salt, sugar; (ii) imposing a 22 percent rate on luxury items such as “high quality” alcoholic drinks, tobacco products, luxury perfumes, clothing and footwear made from fur or reptile skin, jewelry, watches, electrical and optical machinery, luxury vehicles (for transport of people on road, air and water), artwork, collector’s items, antiques, fireworks, lighters, luxury pens, and ammunition and weapons; and (iii) continue applying the 17 percent rate on all other items. While reduced VAT rates are common across the world, the case for their use is weak – and this in particular applies to BiH. The optimal indirect tax literature finds no redistributive role for reduced VAT rates when other more direct instruments are available. Furthermore, empirical evidence shows that cash transfers are a superior policy mechanism for achieving distributional goals. Even a universal cash transfer would better target support to poorer households compared to reduced VAT rates. These theoretical and empirical findings, together with practical concerns regarding the administrative and compliance costs associated with a multi-rate VAT system, have led to a broad (academic) consensus that redistribution is better achieved directly through the income tax and/or benefit systems. Microsimulations for BiH indicate that the proposed multi-rate VAT reform would be highly ineffective. The reform would lower the VAT burdens proportionately more for poorer households than for richer households. However, despite this mild progressivity, the proposed reform is highly ineffective at targeting support to poorer households: rich households would benefit from the new rate structure in absolute terms much more than poorer households. The gain from the zero-rate component vastly outweighs the loss from the 22  percent rate component (Figure below). In other words, the lower VAT rate would represent an indirect subsidy to the affluent households. Figure B1: Average gain/loss per household from proposed multi-rate reform 500 25% % of expenditure Aggregate 450 400 20% 350 300 15% 250 200 10% 150 100 5% 50 0 0% 1 2 3 4 5 6 7 8 9 10 46 Macroeconomic context in BiH Figure 15a Figure 15b Capital expenditures in Fiscal balances in FBiH FBiH and RS (entity GDP, %) and RS (entity GDP, %) 8.0 RS 4 RS 7.0 FBiH FBiH 2 6.0 5.0 0 4.0 3.0 -2 2.0 -4 1.0 0.0 -6 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Source: CBBH, FBiH and RS Statistical Institutes 55. FBiH and RS have generally managed their fiscal balances prudently since 2014 (Figure 15b). From 2010 to 2021, RS recorded an average fiscal deficit of 1.6 per- cent of GDP, whereas FBiH maintained a balanced budget, on average, of 0.1 percent of GDP. The balanced budget is largely the outcome of fiscal surpluses since 2014 that averaged 2 percent of GDP before the COVID-19 crisis. In both entities, howev- er, these prudent fiscal deficits came at the cost of limited capital expenditures, as mentioned earlier. Prior to the COVID-19 pandemic, RS also recorded fiscal surplus- es three years in a row. As such, both entities created the necessary fiscal space for government intervention once the crisis hit. However, during the crisis many fiscal measures supporting households were permanent rather than temporary in nature, further burdening current spending going forward and placing additional constraints on capital expenditures. RS was particularly hard hit in 2020, with the fiscal deficit jumping to about 5.6 percent of GDP (including the SOE Highways RS), according to RS MoF data. Meanwhile, FBiH saw its deficit widen to roughly 3.6 percent of GDP. The COVID crisis, therefore, further exacerbated the issue of public underinvestment through permanent increases in current spending. 56. Looking ahead, FBiH has more fiscal space then RS (Figure 16). Thanks to fiscal surpluses since 2014, FBiH’s public debt has declined to 22 percent of GDP in 2022, after peaking at 28 percent during COVID-19. At the same time, RS faces a more in- tricate situation for two reasons. First, RS’ public debt stands at 37 percent of GDP, which indicates reduced fiscal space compared to FBiH. Second, RS has a less favor- able repayment profile compared to FBiH, as evidenced by the maturity concentra- tion seen in 2023. Macroeconomic context in BiH 47 Figure 16. Public debt in BiH, FBiH, and RS (GDP, %) 55 BiH RS FBiH 45 35 25 15 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: CBBH, FBiH and RS Statistical Agencies BiH’s EU accession and its public administration 57. The overarching policy objective for BiH is EU accession. The EU has been the region with the fastest convergence of living standards over the last four decades. Over the years, the EU enlargement has helped accelerate the development of poor- er countries through its structural and investment funds, and its single market as evi- denced in other small Central and Eastern European countries that joined the EU. De- spite the 2008 global financial crisis slowdown and inequalities among EU member states, Europe’s ‘convergence machine’ has been resilient, particularly for its newest members. Following the ratification of the Stabilization and Association Agreement (SAA), BiH applied for EU membership in 2016. The country has officially received candidate status in December 2022. 58. A key challenge in adopting structural reforms that would facilitate EU acces- sion is ongoing political frictions in combination with poor coordination between governing bodies (Figure 17). The inherent political divisions hinder effective pol- icy making and coordination for reform efforts. The fragmented and decentralized governance structure complicates policy alignment between BiH institutions, line ministries, and entities. Vertical coordination proves especially difficult in FBiH, where responsibilities are shared between the entity and cantons, whereas horizontal co- ordination is hindered by political differences between entities. Coordination tends to be ad hoc rather than formalized, while mandates, roles, and responsibilities for certain tasks lack clarity at both the government and institutional levels. This cre- ates delays in decision-making, particularly for processes like the Acquis alignment. Formalizing coordination mechanisms and clarifying mandates could help address these roadblocks to effective policymaking. 48 Macroeconomic context in BiH 59. The coordination challenges are further exacerbated by capacity gaps. EU assessments highlight a general lack of executive capacity for policy planning and coordination, particularly in relation to EU matters. The lack of agreement on harmo- nization between entities on existing fiscal rules and control mechanisms, as well as the absence of a harmonized methodology for fiscal reporting, presents an additional obstacle to consolidation at the BiH level for fiscal planning and coordination. Also, for sound macroeconomic policy, BiH does not have a macro-structural model with a medium-term outlook, which is crucial for informed policy making. Thus, strengthen- ing macroeconomic and fiscal policy coherence across government levels and with the BiH Council of Ministers will be critical to boosting BiH’s credibility on the path to EU accession. The BiH Fiscal Council is a good example in this respect as it is tasked with fiscal coordination, yet its lack of independence questions its effectiveness. The result is limited fiscal coordination that is restricted to decisions on revenues from in- direct taxation whereas other entity revenues and spending is entirely in the domain of entity decision-making. Hence, the BiH Fiscal Council is not in a position to discuss, influence, monitor or advise on fiscal policy at the country level. It is set up to be a po- litical body and the voting within the Fiscal Council is part of the political process and does not resemble true needs of the BiH budget.39 To increase the traction of the BiH Fiscal Council, a higher level of autonomy as well as its scope and mandate need to be redefined to ensure it covers all aspects of fiscal responsibility. These new aspects can be delivered through amendments to the Law on the Fiscal Council, and a new concept and vision of the Council’s work, by introducing the expert Fiscal Body within the BiH Fiscal Council, which could coordinate the activities and together with the fiscal council in RS and fiscal coordination body in FBiH strengthen the capacity for assessing fiscal policies and the establishment of overarching fiscal rules applicable to BiH. 60. Meanwhile, at the decentralized level, the ability of institutions at the can- tonal level to fulfil EU membership obligations is deficient. EU coordinators as- signed to BiH institutions often lack clearly defined roles and the necessary expertise. The limited mandates and capabilities of BiH institutions such as the DEI, DEP, and FC, coupled with a lack of suitable guidelines and methodologies, further widen the capacity gap. Strengthening institutional capacities and implementing appropriate guidelines could help bridge these gaps and improve policy coordination. Further- more, it is crucial to prioritize reforms that enhance the performance and functions of BiH institutions in economic reform planning and EU integration, within the broader context of public administration reform. By addressing these challenges, BiH could build further its credibility, and make more progress on integrating into the EU. 39 World Bank (2023) BiH Fiscal Board, mimeo Macroeconomic context in BiH 49 Figure 17. Economic impact of BiH’s policy development weaknesses INEFFECTIVE POLICY UNDERLYING DEVELOPMENT OUTCOMES IMPACT DRIVERS SYSTEMS Decentralized No coherent country Delayed EU governance wide economic and fiscal Operational inefficiencies accession policy frameworks Poor governance coordination Ineffective Poor quality and Reduced transparency economic Unclear & alignment of key policy & accountability weak mandates documents Reduced competitiveness & growth Lack of political Opportunity Weak performance COST ownership monitoring frameworks Capacity Poor progress gap No country-wide with structural Ineffective EU plan for EU accession reforms accession policy Delayed approximation with Acquis Source: World Bank 61. BiH’s EU accession process requires the country to prioritize the rule of law, democratic institutions, public administration reform, and economic governance. The European Commission has outlined fourteen largely political priorities that BiH must fulfill to advance the accession process, including essential steps in public ad- ministration reform. In parallel and based on the Copenhagen economic criteria for EU accession, BiH is required to establish a functioning market economy capable of coping with competitive pressure and market forces within the EU. To be aligned with the latter the country needs to have coordinated and a higher level of quality of eco- nomic governance at the country level as well as establish an effective governance framework for a single economic space. Despite some improvements, the govern- ment’s ERP for 2022-2024 lacks coherence, comprehensiveness, and strategic focus as assessed by the EU. Clearly, the introduction of macro-structural modeling and capacity building of macro units would be highly beneficial for the quality of ERPs. Currently it appears that ERPs are a collection of individual fiscal and economic policy agendas from BiH institutions and various governments, rather than a unified, consis- tent, and growth-oriented country program. Such deficiencies in economic and fiscal planning as well as policy coordination result in delays in the systematic and coherent approximation with the EU Acquis. Therefore, a country-wide plan for the adoption of Acquis/EU integration that reflects tasks, deadlines, and roles of BiH institutions and different government levels needs to be adopted. Furthermore, a country-wide action plan for the implementation of priorities from EC reports should be introduced, as the last plan expired in 2020. 50 Macroeconomic context in BiH I.3.  Labor market developments 62. BiH’s modest output growth since the global financial crisis failed to generate enough jobs to significantly improve employment outcomes. Between 2011 and 2019, employment in BiH contracted by about 20 thousand jobs (Annex A7). The job losses can be analyzed from an ownership and sectoral perspective. In terms of own- ership, during the aforementioned period the public sector net shed 64 thousand jobs, whereas the private sector generated 44 thousand jobs. From a sectoral per- spective, the largest absolute losses have taken place in agriculture, public admin- istration, wholesale and retail, transport and communications, and health and social services. In relative terms, however, the largest reductions in jobs have taken place in public administration and coal and other mining, with a reduction of 23 and 21 per- cent of the employed in 2011, respectively. The finance/ICT/business services sector has been the largest employer with a gain of 164 percent compared to the number of jobs in 2011, and public utilities, which raised their employment 137 percent. While the latter is exclusively related to more public sector jobs, the former is, surprisingly, a combination of more jobs in the public sector (136 percent increase) and private sector (37  percent increase). The manufacturing sector should also be mentioned in this context as it generated 15  percent more jobs in 2019 compared to the 2011 level, creating more than 20 thousand jobs. As opposed to the finance/ICT/business services sector, in manufacturing all the additional jobs were created in the private sector, whereas jobs in the manufacturing public sector shrunk 36 percent from its 2011 level. 63. A large share of BiH’s working-age population is underutilized, whether un- employed, under-employed, or outside the labor force. The country’s high unem- ployment levels have improved markedly but remain significant. In Q1 of 2023, the unemployment rate dropped to about 13.3 percent, from 28 percent in 2011. Nev- ertheless, BiH ranks third in the unemployment rate level compared to its Western Balkan neighbors and is much higher than the EU and ECA regional averages (Figure 18a). BiH has one of the highest rates of long-term unemployment in the world; in the first quarter of 2023, 77 percent of those unemployed had been out of work for more than a year, notably higher than the Western Balkan average (67 percent), and 47 per- cent were out of work for four years and more. 64. Close to a half of the working-age population is inactive, with more than one- third neither in education, employment, or training. A snapshot of the labor market in 2019 shows that roughly 45 percent of potential workers were inactive, and 35 per- cent were neither in education, employment, or training (NEET). Working-age women accounted for two-thirds of all NEETs, almost twice as much as men (Figure 18b). According to the World Bank (2018b, p. 13), the average Bosnian woman loses about 35 years of productive employment over their lifetime due to reduced labor market opportunities. As a result, BiH’s labor force participation rate is the second lowest in the Western Balkans (trailing all but Kosovo) and is 16 percentage points below the EU average and 18 percentage points below the ECA average. Macroeconomic context in BiH 51 Figure 18a Figure 18b Unemployment Snapshot of the BIH labor rate (international market in 2023 (% of comparison) WAP, ages 15-64) Unemployemnt rate (%) 34 Employed Male 743,000 Working age population (age 15-64) 1,184,000 Female 441,000 32 Labor force 1,364,000 Unemployed Male 89,000 30 179,000 Female 90,000 2,879,000 28 Europe & Central Asia (IDA & IBRD countries) Europe & Central Asia Europian Union Kosovo North Macedonia Bosnia and Herzegovina Montenegro Albania Serbia In school Male 132,000 Out of labor 283,000 Female 151,000 force (age 15 -89) 1,515,000 NEET Male 440,000 1,232,000 Female 792,000 Source: WDI and BIH LFS 2019 65. The private sector exhibits a low degree of dynamic job creation in the last decade. Private employment is dominated by jobs in low-productivity, low-pay- ing sectors such as agriculture, manufacturing, transport, and wholesale and retail. Whereas the high-productivity and highly paid finance, IT and business services sec- tor added the most jobs – reflecting the best type of private sector growth – manu- facturing saw the second highest growth, followed by accommodation and food, all of which are characterized by low wages (Figure 19). Low-paying sectors continue to absorb the most workers, reflected by the large bubble sizes concentrated on the left side of Figure 19. The relatively small and shrinking coal sector, in contrast, lies at the right end of the wage spectrum, indicating a sizable decline in jobs, while at the same time exhibiting one of the highest mean real wages. This is a reflection of an industry suffering from poor performance and, consequently, resulting in largely loss-making enterprises. 66. The BiH labor market is highly distorted by a large public sector presence, leading to segmentation between good-quality public sector jobs and poor-qual- ity private sector jobs. The generally high unemployment rates observed in BiH and across the Western Balkans mask significant unreported informal employment and also reflect a marked preference for public sector jobs and a willingness to queue for them rather than taking a job in the private sector. Although diminishing in size, the public sector (including SOEs) still accounts for one-third of total employment. Public employees are spread across different sectors. Public administration and defense account for the largest share of public sector workers, followed by education, and health and social work. Men comprise three-fifths of all public sector workers. The public sector attracts a large and growing share of the most educated workers, pri- marily due to better salaries, benefits and working conditions. 52 Macroeconomic context in BiH Figure 19. Job creation within sectors, 2011-2019 8% Finance, IT & Business 6% services Accommodation & 4% food services Annual job browth (%) Public utilities 2% Maufacturing Health & social work Construction 0% 600 650 700 750 800 850 900 950 Agriculture -2% Education Coal -4% Other services Other mining & Transportation & Wholesale & retail quarrying communication Public administration -6% Private sector Mean Public sector Wage 679 wage 728 wage 814 -8% Mean real wage, 2019 Source: WDI and BIH LFS 2019 67. Public sector workers receive a significant compensation premium compared to similar private sector employees across all types of jobs and skill levels. Controlling for worker observable characteristics (i.e., worker age, gender, and education), a World Bank survey reveals that public sector workers earn on average 19 percent higher gross wages (including allowances) than comparable formal private sector workers.40 Other regression analyses of wage correlates reveals a public sector wage premium of 7 percent over the private sector, after controlling for factors such as education, gender, sector, and region, and a much higher premium for public administration jobs (around 24 percent). This wage premium is higher in BiH than most other European countries. The premium is even higher when pecuniary and non-pecuniary benefits are included as a higher proportion of public sector workers receive a job contract, health insurance, paid annual leave, parental leave, pensions, and most importantly, have greater job security as they are much less likely to be dismissed from their jobs. Workers in SOEs, who are in many ways the most compa- rable to private sector workers given that they are employed in, say, manufacturing jobs, earn an estimated 17 percent wage premium. Notably, the public sector premium is the highest for the most educated workers and for more technical jobs which, together with the large representation of tertiary educated workers in the public sector, suggests the presence of potential skilled labor shortages for the private sector. The gap in compensa- tion between the public and private sectors41 gives rise to queuing for public sector jobs, thus raising unemployment levels. 40 World Bank (2023) Bosnia and Herzegovina: The public sector labor market and its implications, 41 In 2019, wages in the public sector averaged 814 BAM, compared to an average private sector wage of 679 BAM. Macroeconomic context in BiH 53 68. The public sector is an outsized formal sector employer in BiH compared to oth- er European countries. The public sector is responsible for 30 percent of total employ- ment in the country. However, given that all public sector jobs are salaried workers with benefits, the size of the public sector relative to paid employment (which excludes those workers that are employed in non-paid occupations, as well as employers, and self-em- ployed individuals) is a better indicator of the importance of the public sector in the formal economy. The share of public sector employment is 40 percent of paid employment and 44 percent of formal paid employment. As a result, the public sector in BiH is the third largest in Europe, as a share of paid employment. Apart from Moldova and Montenegro, the difference to other structural peers ranges between 10 and 20 percentage points, with aspirational peers like Croatia, Slovakia, Slovenia, and Estonia clustering closer to the 20-percentage points difference. 69. Younger workers in particular struggle to access high-quality, permanent jobs, and are more likely to remain outside the labor force or migrate for work. Young peo- ple in BiH need on average about 60 months to find employment after graduation, which represents a long period during which skills can degrade (based on 2019 LFS). Youth who leave school with a secondary education require relatively more time to transition into work compared to those with tertiary education. Despite an apparent excess supply of youth entering the labor market, young people are still rejecting job offers because of un- attractive working conditions such as low wages (the most frequently cited reason), unac- ceptable working hours, and mismatch in qualifications, inter alia. Some youth opt to seek work abroad; thirty percent of those who migrated between 2015 and 2020 were between the ages of 18 and 35, suggesting that many young workers use international migration to access better labor market opportunities. 70. Employers are struggling to find qualified workers and are requesting increasingly work permits for foreigners. To address the labor market mismatch, employers’ asso- ciations in the Federation of Bosnia and Herzegovina (FBiH) and Republika Srpska (RS) have pushed for an increase in work permits for foreign workers. The Council of Minis- ters of BiH adopted the Decision on determining the annual quota of work permits for the employment of foreigners in BiH for the year 2022, which significantly increases the number of works permits that can be issued to foreigners. This Decision does not account for work permits for seasonal workers, which means that employers can import labor for any work up to three months, without work permit requirement. However, importing labor poses challenges of its own, including the retention risk of trained workers leaving for better-paying jobs. Vocational training can be provided by employers directly or through existing business support and educational institutions. 71. The incomplete transition to a market economy has hampered the growth of the private sector, and thus the private enterprise sector is not geared toward providing the dynamism required to support private sector growth and employment. The coun- try needs new fast-growing companies that can successfully compete internationally, be part of a regional value chain, and boost productivity performance. The new business density42 is the lowest in the region (1.13 percent compared to 1.76 percent in Serbia, 1.35 percent in Albania, 3.14 percent in Kosovo, 3.88 percent in North Macedonia, or 6.7 percent in Montenegro).43 BiH faces the twin challenges of improving the business environment 42 New business density represents new registrations of LLCs per 1,000 people ages 15–64. 43 World Bank Group, Doing Business, Entrepreneurship data, available at: http://www.doingbusiness.org/data/ exploretopics/entrepreneurship 54 Macroeconomic context in BiH and addressing bottlenecks to efficiency and productivity among firms. Endemic corrup- tion, complex legal and regulatory frameworks, and government structures, non-trans- parent and often overlapping business procedures, insufficient property rights protection, and a weak judicial system discourage private investment. Moreover, inefficient, fragment- ed, and cumbersome business services limit the potential of digital and collaborative economy models, while digital government services for enterprises remain limited. In the 2019 BiH Enterprise Survey, firms identified as their major constraints high tax rates (36.5 percent), corruption (29.5 percent), business licensing and permits (21.1 percent), informal economy (28.6), and poorly educated workers (24.3 percent). A more detailed account of constraints faced by firms is described in Chapter 2 of this report. 72. Jumpstarting job-rich growth would help counter weak labor market outcomes. The entity governments in BiH have been active in passing legislation in the labor market, but more is needed. They partly implemented some reforms such as the introduction of incentives for first work experience for youth (though without measuring the impact). The next big structural policy effort could be to de-link health contributions from unemploy- ment benefits and reduce the tax wedge, which decreases the gap between the total cost of employment for employers and the net take-home pay for employees and adjust downward social security contributions. This would reduce the cost of labor, enhance the firms’ competitiveness, and incentivize investment, as well as encourage a shift out of the informal economy. The latter would also benefit from adjustments in the labor code and labor taxes to incentivize formalizing temporary workers. Also, implementing legislation that would ensure transparent and merit-based pay and employment practices in SOEs would reduce labor market distortions and help improve productivity. In the next section, we also reflect on policies targeted at enabling female labor participation. I.4.  Output growth simulations going forward and structural reforms 73. This section examines BiH’s potential to accelerate trend growth44 over the longer run. Trend growth is influenced by population growth, the employment ratio, productivity per worker growth, capital deepening, and technological progress. Using the World Bank’s Long-Term Growth Model,45 this section looks at the implications of a set of ambitious re- forms that would allow BiH to keep real output growth around 3.6 percent over the next decade and a half, as opposed to significantly decelerating under the business-as-usual scenario. 74. BiH’s trend real output growth rate is expected to decelerate substantially over the longer run, in line with adverse population dynamics and productivity growth con- vergence vis-a-vis regional peers (Figure 20a, 20b). The baseline, marked in gray (Figure 20a), reflects a business-as-usual reform environment, where the growth drivers under discussion (total factor productivity, labor force participation, and investment-to-GDP) fol- low their historical or recent trends. Under this scenario, trend growth more than halves by 2040, from roughly 3 percent to 1.4 percent as growth through factor accumulation runs out of steam, and the population decline shaves almost half a percentage point from out- put growth each year. Negative population dynamics typically, ceteris paribus, drag the economic growth rate down, and its adverse impact is expected to grow over the years. 44 Trend output growth refers to the long-term average rate at which an economy expands its production capacity over time. It represents the underlying growth trend of an economy, abstracting from short-term fluctuations caused by business cycles or temporary shocks. 45 See Annex 8 Macroeconomic context in BiH 55 Figure 20a Figure 20b Ambitious reforms: summary of growth contribution of each trajectories reform to incremental GDP growth (pp*) Baseline FLFP Baseline Ambitious Reform gTFP MLFP 6% No Population Decline WDI (smoothed) 4% 0.3% 3% 0.7% 4% 3.6% 2% 1.2% 2.0% 2% 1% 1.4% 1.4% 0% 2000 2005 2030 2020 2040 2025 2035 2010 2015 0% 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Source: WDI and BIH LFS 2019 75. Improvements in productivity bring the largest growth dividend in BiH over the long run (Figure 20a, light blue area). Under the baseline, growth in BiH TFP decelerates from 2 percent on average since the mid-200046 to 1 percent by 2040, and 0.5 percent in 2050. The region-wide 1 percent growth rate in TFP by 2040 is estimated to be the conver- gence rate of the SEE4 and was established based on the median of the central and east- ern European countries. Under the baseline of no population decline in BiH, which reflects a sudden stop in outmigration, real GDP trend growth is somewhat higher in the long term, but decelerates nevertheless to 2 percent by 2040, as the population decline going on since 2001 onward is taking a toll. The ambitious reform scenario, which includes reforms affecting TFP and labor force participation (LFP), is estimated to keep trend real growth at a trajectory of around 4 percent, decelerating to roughly 3.6 percent by 2040 (the sum in Figure 20a, and red line in Figure 20b). In real GDP per capita terms, growth would under the ambitious reform scenario hover around 4.5 percent over the long term compared to the baseline growth rate of 2.1 percent in 2040 down from a rate of about 4 percent. This trajectory in the simulation is the outcome of a series of ambitious reforms aimed at raising productivity and increasing female and male labor force participation. 76. Raising TFP growth in BiH appears to have the largest poten- tial in lifting long-term growth compared to the baseline scenar- io (light blue area in Figure 20a). An ambitious reform agenda has the po- tential to gradually increase TFP growth to the 75th percentile of the EU-11 2000-2019 average.47 This would set TFP trend growth at roughly 2 percent and pre- vent it from decelerating to 1 percent by 2040. Policies needed to support growth in TFP include completing the transition to a market economy by reducing the footprint of an oversized SOE sector, where public ownership is not based on clearly defined policy objectives. Instead, SOEs often operate under significant political patronage, leveraging their influence to secure electoral support through the strategic practice of labor hoarding. 46 See TED data: https://www.conference-board.org/data/economydatabase/total-economy-database-productivity 47 EU-11 newest members of the EU from Southeastern Europe and the Baltics 56 Macroeconomic context in BiH 77. Jumpstarting the transitioning to a market economy would facilitate a robust TFP growth trajectory going forward. Privatization and corporate restructuring halted in the early to mid-2000s, while improvement in the business environment and alignment be- tween governance levels slowed, leading to uneven treatment of businesses across BiH and creating overlaps and space for rent-seeking. Facilitation of a higher TFP growth rate can take two forms in this context: first, jumpstarting the transition to a market economy through privatization, restructuring, or bankruptcy, and by doing so unleashing the poten- tial of the private sector, and second, improving the efficiency and governance of SOEs. In addition, implementing legislation that would ensure transparent and merit-based pay and employment practices in SOEs would reduce labor market distortions and help im- prove productivity as well as the quality of services. Reviving reforms in this field would facilitate maintaining a higher TFP growth trajectory as BiH needs more (and larger) pri- vate companies, vibrant small and medium sized enterprises, and a business environment that allows them to grow and expand output, employment, and exports. That said, this is a difficult reform to implement. Even if there were the political will to reform SOEs, the fiscal capacity to resolve outstanding liabilities, or private interest in viable SOEs, is limited. Civil service reform, and consequent layoffs, is much more challenging when the alternative private sector demand for labor is weak. 78. There are numerous bottlenecks in the business environment that need to be addressed to promote business density and competition. These bottlenecks include simplifying and automating the process of business registration in FBiH (like what has been done in RS and Brcko District), harmonizing, and mutually recognizing licenses and certificates across entities, improving national quality control to meet EU standards, and strengthening investor protection laws and practices to attract foreign direct investment (FDI). The regulatory framework, furthermore, needs to be streamlined as its current frag- mentation imposes an additional burden on the private sector. For instance, in FBiH alone, there are still over 350 separate licenses, permits, approvals, and consents related to busi- ness activities, while in RS there are over 300. At the national level in BiH, there are over 100 additional red-tape requirements. To foster a more conducive business environment, it is crucial to address these bottlenecks by simplifying and automating business registration processes, harmonizing licenses and certificates, which, among others, can be facilitated by employing digital technologies. 79. Reducing the informal economy, estimated at 25 to 35 percent of GDP in BiH, has the potential to boost TFP growth through various transmission channels. The infor- mal economy often lacks access to formal financial institutions, which hinders businesses from obtaining credit, thus preventing them to invest in technologies and processes that enhance productivity. For this reason, among others, the informal economy tends to lag behind in terms of technological adoption. Hence, creating a more favorable regulatory environment that reduces the informal economy would promote competition, innovation, and productivity growth in the formal sector. One key aspect of this approach would in- volve reducing the social security contributions to address the tax wedge, which would incentivize businesses to operate within the formal economy. In addition, adjustments to the labor code and labor taxes would be needed to incentivize the formalization of tem- porary workers through vouchers for social security contributions for seasonal and tem- porary workers, and social security deductions and benefits. Finally, by introducing social cards the opportunity for improving coverage and targeting of social assistance will be created, which can be oriented toward work activation to remove incentives to informality and inactivity. Macroeconomic context in BiH 57 80. Elevating the labor force participation rate, especially for women, would in part help offset the decline in population and add 0.7 percentage points to trend growth (Figure 23a, orange area).48 Low labor force participation, high outmigration, high unemployment, and extensive skills mismatch are all symptoms of inefficient allocation of human capital. This results in sub-optimal output because workers’ potential productivity is underutilized, which in turn acts as a drag on economic growth and constrains labor incomes and wel- fare. Hence, labor market reforms that target the female participation rates can help in part offset the negative effect of population decline on growth. Under the ambitious re- form scenario, the female LFP rate increases from 47 percentage points to 67 percentage points by 2040 (the baseline scenario assumes a constant rate of 47 percentage points).49 If such an FLFP trajectory were to be achieved, this could add 0.7 percentage points to trend growth over the longer term. Another 0.3 percentage points could be added if the male labor force participation rate could be raised from 69 percent to 80 percent over the long term. That said, all LFP scenarios are highly uncertain due to entrenched structural problems that impede output growth in BiH and would have to go hand in hand with re- forms that would unlock growth in TFP. 81. There are several reasons for women’s comparatively low employment, including gender stereotypes, a lack of affordable and high-quality childcare and elderly care, and inflexible working time arrangements.50 Educational attainment is decisive for women’s la- bour market participation, and gender employment gaps are smallest among the well-ed- ucated.51 Conversely, the gaps are largest among the low-educated, while low-educated women also work more often as unpaid family members than their male peers. Differenc- es in labour market outcomes are also related to occupational segregation, lack of access to finance and entrepreneurship support, and discrimination in recruitment and career progression. 82. Raising the female LFP rate would address the persisting, sizable gender dispar- ities in the labor market, characterized by lower female labor force participation and employment rates compared to men. To bridge this gap and promote gender equali- ty, targeted policy reforms are key beyond adopting legal and institutional frameworks and action plans.52 Specifically, reforms need to ensure legal equality and address gender-based pay gaps. This would enforce pay equity by eliminating gender-based wage discrimination, promote transparency in pay scales, and implement mech- anisms for reporting and addressing pay disparities.53 Furthermore, measures that would remove restrictions on women’s work, such as limitations on working at night 48 ILO estimates are used for the traditional 15-64 age group. 49 The ambitious scenario assumes that the female labor force participation (FLFP) rate reaches the level seen in recent EU accession countries. This is not to say that these countries managed to achieve this pace of increase in FLFP. For example, in Latvia, the FLFP rate rose 14 percentage points during the period 2000-19, and in Bulgaria and Hungary close to 13 percentage points. It is, however, feasible to achieve this rate of increase in FLFP as seen in the case of Malta (30 percentage points between 2000 and 2019), Peru (19 percent points), and Spain (17 percentage points) to mention a few. 50 World Bank, 2017; Haxhikadrija, Mustafa and Loxha, 2019; Stanojevic et al., 2016 51 WIIW/World Bank, 2020 52 BiH Gender Equality Law, Three consecutive Gender Action Plans (GAP), the latest for the period 2018-22; the institutional framework for gender equality in BiH consists of the BiH Agency for Gender Equality, and the FBiH and RS Gender Centres, as the key gender institutional mechanisms placed within the executive government. In the legislative branch, the most important gender institutional mechanisms are the Parliamentary Committee for Gender Equality in the BiH Parliamentary Assembly, Committees for Gender Equality/Equal Opportunity in the entity parliaments and the Brcko District (BD) Assembly, and the gender equality commissions in cantonal and municipal assemblies/councils. 53 World Bank (2023) Country Gender Assessment: Bosnia and Herzegovina, June 58 Macroeconomic context in BiH or in specific industrial jobs, would also help enable equal opportunities for employ- ment. Another important factor that impacts women’s economic participation is the gender-based division of care roles and responsibilities. Social norms dictate the ex- pectations for personal relationships and obligations, with women tending to assume a larger burden of caregiving responsibilities compared to men. These norms are often reinforced when access to high-quality public or private care is limited or re- sources to hire paid caregivers are scarce. As a result of women’s disproportionate participation in unpaid work, with less time to engage in paid labor, or work longer hours, combining paid and unpaid labor. Therefore, implementing flexible working arrangements, including options for part-time work, job sharing, and telecommut- ing, to accommodate childcare responsibilities as well as establishing affordable and high-quality childcare facilities, particularly in rural areas, to alleviate the burden on women and enable their full participation in the labor market. Finally, introducing paid parental leave policies that encourage men to take an active role in caregiving re- sponsibilities, would promote gender equality in parenting and career advancement opportunities. Implement tax incentives or subsidies to support families in access- ing care services, reducing the financial burden on women. Raise public awareness about the importance of shared caregiving responsibilities and challenge societal norms that perpetuate gender-based divisions of labor. 83. Measures promoting women’s entrepreneurship and enhance access to finance for women-owned businesses would complement the above-mentioned action to raise women’s LFP rates and employment. Facilitating these measures would involve creating entrepreneurship support programs that provide training, mentoring, and networking op- portunities specifically tailored to women entrepreneurs. It would also entail establishing. For instance, dedicated funds or grants to facilitate access to capital for women-owned businesses, which would address financial barriers they face. Finally, collaborating with fi- nancial institutions to develop gender-responsive lending products and improving access to loans and other financial services for women entrepreneurs has proven to be a viable avenue in other countries. I.5.  Conclusions and policy options 84. Despite significant ongoing political frictions, BiH has maintained macroeconomic stability over the past two decades. Moreover, employment has shifted from the public to the private sector, with a gradual structural transformation occurring from agriculture toward industry and services. Furthermore, in spite of a large public administration that is based on the Dayton Accord, public debt lingers around 30 percent of GDP. In addition, BiH is outperforming Western Balkan peers in real per capita GDP growth, although mostly due to the decline in population driven by outmigration. The decline in population shaved almost half a percentage point of economic growth each year, on average, between 2009 and 2012, and about one percentage point, on average, between 2014 and 2019. At the same time, while all other regional peers have made significant strides in converging to- ward living standards in the average EU27, BiH’s progress has been muted. Macroeconomic context in BiH 59 85. Over the longer term, BiH remains with an economic growth issue that will get worse over time, if left unaddressed. In the meantime, the country is losing an important share of its labor force (and youth), is ageing, and stagnating in terms of export sophis- tication. At the current pace of structural reform implementation, BiH cannot sustain its current economic trend growth trajectory of around 3 percent. Instead, it is estimated that trend growth would decelerate to 1.4 percent by 2040. 86. To turn these downside secular pressures on real output growth around, BiH would need to implement deep structural reforms to enable a more private sector-led and productive economy. Structural reforms aimed at bolstering total factor productivity carry the greatest promise. These can take the form of re-initiating the transition to a mar- ket economy through state-owned enterprise privatization, restructuring, or bankruptcy, especially the smaller and medium-sized firms, especially in cases where there is no clear rationale for public ownership. For those SOEs where there is a clear policy objective of public ownership, enhancing the control, efficiency, and governance of state-owned en- terprises would help improve productivity and reduce budget reliance, once hard budget constraints are introduced. That said, overlapping jurisdictions of the highly decentral- ized governance system in place raise the cost of coordination, reduce incentives, and create space for vested interests to slow the process; hence, a decisive reform push is required. In parallel, conditions need to be created for the private sector to grow more prominently to absorb the resulting shift in labor. This can be achieved by creating a more business-friendly environment and strengthening the single market in BiH by aligning the regulatory framework across entities and cantons and removing administrative obstacles. In addition, BiH needs more foreign direct investment that would bring new technologies and help with latching on to value chains. For this to happen, the political landscape needs to provide more certainty and predictability, which in turn would reduce the risk premium. The risk premium can also be reduced by a stronger EU accession effort. 87. Removing a number of obstacles would clear the way for a faster EU accession. A key policy challenge is the poor coordination between governing bodies. Despite some improvements, BiH’s Economic Reform Plan still lacks coherence, comprehensiveness, and strategic focus as assessed by the EU. Instituting structural macroeconomic models at the entity and BiH level would help addressing some of these issues. In addition, estab- lishing an effective national Fiscal Body within the BiH Fiscal Council that is autonomous, transparent, accountable, and enshrined in legislation would go a long way in enhancing the fiscal dimensions in BiH. Both measures would help significantly in facilitating BiH’s exchanges with the European Commission and BiH’s accession to the EU. 88. Labor market reforms can in part help offset the consequences of outmigration. Labor market reforms that target the female participation rate can help in part offset the negative effect of population decline on growth. Implementing flexible working arrange- ments for women, including options for part-time work, job sharing, and telecommuting, to accommodate childcare responsibilities, as well as establishing affordable and high-qual- ity childcare facilities, particularly in rural areas, would alleviate the burden on women and enable their full participation in the labor market. Finally, the large SOEs footprint distorts the labor market through a wage premium and other benefits, which leads to segmenta- tion between good-quality public sector jobs and poor-quality private sector jobs. II.  Private Sector Productivity and Dynamism II. Private Sector Productivity and Dynamism Key findings: 1. BiH’s labor productivity growth has exhibited a clear slowdown between 2016 and 2019. 2. The services sector is the most productive sector of the BiH economy, and the only sector where productivity did not decline between 2016 and 2019. 3. Business density is in BiH low due to market frictions that disincentivize the cre- ation of new businesses, impeding competition and adversely affecting job cre- ation in the private sector. 4. Reducing intermediate input distortions through upgrading transportation net- works (roads and the railway infrastructure), promoting investment in technology, and establishing digital registration in FBiH (like it was done in RS and Brcko Dis- trict) could promote business dynamism and competitiveness. 5. An important share of medium sized businesses in BiH operates under low com- petitive pressure, reducing their incentive to invest in efficiency. 6. Access to skills is a key constraint to the upgrading of BiH firms, particularly for larger private firms, manufacturing firms, and firms that do not export. 7. Stimulating investments through better access to finance could revert the nega- tive trend in physical capital accumulation observed since 2011. 8. SOEs in RS tend on average to be less productive than non-SOE firms, whereas large SOEs are more productive than comparatively large private firms. 62 Private sector productivity and dynamism Introduction 89. The first chapter of the report examined economic growth from macroeco- nomic perspectives, whereas this chapter investigates growth from a microeconomic, firm-level perspective. Specifically, the previous chapter looked at the expenditure and production angle of growth, as well as factor accumulation and TFP issues through the prism of the Solow-Swan model. This chapter shifts the focus to the firm level to under- stand the sources of productivity growth, business dynamism as well as other issues, and their connections to the economy (Figure 21). 90. Productivity gains and subsequent growth occur within sectors and through shifts from less productive to more productive sectors, which is known as structural trans- formation. For example, firm level productivity gains can come from strengthening tech- nical capacity and fostering innovation at the firm level. Policy areas that impact this in- clude openness to trade and investment, the supply of skills and public sector incentives for growth and innovation. Higher firm productivity can lead to less efficient firms exiting the market. Policy areas that impact this include the bankruptcy and insolvency frame- work, regulations for hiring and firing workers, degree of unionization, and unemployment benefits. The exit of less productive firms could release resources for more productive incumbents and new entrants. Policy areas that impact this area include business entry regulations, competition policy, financial sector depth, and R&D expenditure. This process of Schumpeterian “creative destruction” that reallocates resources to more efficient firms and sub-sectors can fuel productivity gains within a sector and enable that sector to grow. At a macro level, this can support a process of structural transformation as factor inputs shift to more productive and rapidly growing sectors. Policy areas that impact this include labor market flexibility, the quality of infrastructure, and the quality of public finances. The combination of productivity growth within sectors and structural transformation can help accelerate economy-wide productivity growth. Figure 21. Sources of productivity gains and their macro-micro links 6. Economy-wide productivity growth through structural and within-sector productivity growth 3. Entry of more productive firms through conducive investment climate 4. Within-sector 5. Structural transformation productivity growth as through factor inputs shifts resources shift to more from lower to higher efficient firms whose productivity sectors 2. Exit of less market shares increase productive firms through efficient institutions 1. Within-firm productivity growth through technical capacity, innovation Source: World Bank Private sector productivity and dynamism 63 91. This chapter is divided into four sections, the first two focus on BiH and the third analyzes firm-level data in RS. Specifically, Section 1 discusses aggregate productivity trends and drivers of productivity at the BiH level, whereas Section 2 describes aspects of business dynamism in BiH, such as business demography, density, markups, and market distortions, to mention a few. Section 3 shifts the focus to the productivity analysis, dyna- mism, market power and SOEs in RS using firm-level data, for which the World Bank has received an exhaustive dataset from APIF. 54 Such an analysis is done for the first time in BiH. Section 4 concludes and provides policy recommendations. Firm-level data analysis provides a wealth of indications, but firm statements can only be made after deep dives into certain areas considering that numerous factors, specific to the market, impact the outcome of the analysis. Hence, while providing interesting insights, the results and inter- pretation needs to be taken with a grain of salt. II.1.  Aggregate Productivity Trends 92. Labor productivity in BiH is on par with regional peers, yet remains low in levels compared to aspirational peers, and with adverse dynamics since 2016. Growth in BiH labor productivity was steady from 2009 to 2016, outpacing North Macedonia, but re- maining well below the sharp rise experienced in Serbia and many aspirational peers. In 2019, BiH’s labor productivity, measured as value-added per worker, was roughly US$14 thousand (constant 2015). This is significantly lower than the average of US$33.5 thousand among aspirational peers (Figure 22a). In other words, an average worker in BiH needs to work 2.4 times longer to produce the same output as their counterparts in aspirational peer countries. In fact, relative to its more advanced peers, BiH‘s labor productivity gap has widened since 2005, when a BiH worker needed to work only twice as long to achieve the same output. In comparison to regional peers, BiH’s labor productivity performs some- what better in absolute terms (Figure 22a), although it has been stagnating since 2016 in terms of growth (Figure 1b). In Serbia, for example, productivity surged from 2008 to 2013 (Figure 22b), but then plateaued and started decelerating, reaching US$13 thousand by 2019. Meanwhile, North Macedonia has experienced lower labor productivity growth in the post-global financial crisis (GFC) period compared to BiH, reaching US$ 11.9 thousand by 2019 (Figure 22a). Figure 22a Figure 22b Labor productivity (value BiH labor productivity added per worker) growth has slowed down since 2016. 50000 1.6 BIH EST HRV LTU 40000 1.5 LVA MKD 1.4 SRB SVK 30000 1.3 SVN 20000 1.2 1.1 10000 1.0 2006 2009 2008 2005 2007 2010 2016 2019 2018 2012 2013 2015 2014 2017 2011 0 MKD SRB BiH HRV LVA LTU SVK EST SVN Source: WDI. Note: Value added per work is defined as the ratio between the total value added generated by an economy and the total number of workers employed in the economy. Country code: MKD – North Macedonia; SRB – Serbia; BIH – Bosnia and Herzegovina; HRV – Croatia; LVA - Latvia; LTU – Lithuania; SVK – Slovakia; EST – Estonia; SVN – Slovenia 54 APIF is the RS Agency for Intermediary, IT, and Financial Services. This agency is responsible by law to collect firm-level data, and is the owner of the business registry. The World Bank was not able to collect data for FBiH, and thus could not undertake a more comprehensive firm-level analysis for BiH. 64 Private sector productivity and dynamism 93. Weak productivity led to stagnating living standards in BiH, despite robust per capita income developments compared to regional peers. Per capita income growth was primarily driven by an increase in the employment rate, which rose from 30 to 40 percent between 2005 and 2019 (Figure 23a). This rise resulted from a steady rise in em- ployment from 843 thousand in 2010 to 1.2 million in 2019, after which it remained roughly unchanged, and an increase in the inactive population from 1.4 million to 1.5 million, which shrinks the labor force, and thus affects the denominator. At the same time, the relatively weak pace of labor productivity growth had a negative contribution to income growth. In other words, growth was based on increased use of labor, i.e., factor accumulation, rather than advances in productivity. 94. Productivity in BiH lags that of aspirational peers across all sectors, yet value add- ed per worker in services is significantly higher than in structural peers (Figure 23b). Services are the most productive sector in BiH, and accounts for a much larger share of the economy in FBiH than in RS. Despite being the most productive sector in BiH, it is only about half as productive in terms of gross value added per worker compared to aspira- tional peers (Figure 23b). In contrast, productivity in industry and agriculture in aspirational peers is almost three to four times larger, respectively, than in BiH. The low productivity in agriculture in BiH is driven by RS, where this sector is almost twice the size compared to FBiH. While regional peers exhibit higher labor productivity in industry and agriculture compared to BiH, this is offset by BiH’s better performance in the services sector. Overall, the value added per worker in BiH is 17 percent higher than in structural peers (Figure 23b). 95. The observed trend in productivity growth from 2016 to 2019 in BiH is concerning as it indicates a persistent slowdown. During this period, BiH’s labor productivity growth ranked only above North Macedonia and fell behind all other WB5 countries and Moldova (Fig 24a). The decline in labor productivity in BiH is particularly evident in the agriculture sector, followed by industry (Figure 24b). In contrast, regional peers have experienced a surge in productivity in agriculture, while productivity in industry has remained stagnant. Overall, this results in a growth rate in labor productivity of 2.3 percent in regional peers, compared to a negative rate of growth totaling 0.5 percent in BiH. Figure 23a Figure 23b Employment rate BiH labor productivity (15 years or older, %) growth has slowed down since 2016. 40 40 Agriculture Services 35 34 Industry Overall 38 33 30 36 22 34 20 18 14 13 13 12 32 12 10 9 30 5 28 0 2006 2009 2008 2005 2020 2007 2010 2016 2019 2018 2015 2012 2013 2014 Aspirational Bosnia and Structural 2017 2011 Herzegovina Source: WDI. Employment rate is defined as the ratio of people 15 years or older that are employed over a certain year; Source: Staff calculations based on WDI (2023). Value added expressed as thousands of 2015 constant USD. Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Growth is in real terms. The straight lines in the left panel represent the average value among the depicted countries Private sector productivity and dynamism 65 Figure 24a Figure 24b BiH’s value added per BiH’s decline in aggregate worker is becoming worse labor productivity compared to regional peers between 2016 and 2019. Agriculture Services VA per Worker Growth 2019, 3-year average 8 Industry Overall Average growth of VA per worker Moldova 8 7 6 6 6 Lithuania 4 (2016-19) 3 4 Estonia 2 2 2 2 Latvia Slovenia 0 1 2 Montenegro 0 Serbia Slovak Republic -1 0 Albania Croatia -2 -2 0 BiH -4 -3 -2 North Macedonia Aspirational Bosnia and Structural 10 20 30 40 50 Herzegovina Overall VA per Worker 2019 Source: Staff calculations based on WDI (2023). Value added expressed as thousands of 2015 constant USD. Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Growth is in real terms. The straight lines in the left panel represent the average value among the depicted countries. 96. At existing wages, the slowdown in labor productivity since 2016 has adverse im- plications on firms’ competitiveness. Interviews with firms in the automotive component industry, for example, show unfavorable developments in wage-adjusted productivity. This is due to higher wages to retain workers than justified by labor productivity in BiH. Wage-adjusted productivity in automotive component firms in BiH is worse compared to firms in the Czech Republic and Hungary, which are strongly integrated in global value chains in this sector, taking advantage of the proximity to the German market. In addi- tion, international competition from Romania and Slovenia is important, given that in both countries sectoral labor productivity is noticeably higher than in BiH. Furthermore, in all four countries firms’ investment in this sub-sector is much higher than in BiH, which poses a challenge for future competitiveness of the local automotive industry. As with invest- ment in other economic sectors, the automotive components sector is subject to factors hindering economic development and investment attraction and retention, such as lack of predictability of the business environment, complex legal and regulatory frameworks across the entities and the slow and cumbersome judicial system. II.1.1.  Drivers of Productivity Growth 97. BiH’s rise in labor productivity (value added per worker) is due to within-sector pro- ductivity gains. Growth in value-added per worker almost halved in the post-GFC period to 3.4 percent from 6.3 percent in the eight years prior to 2009. This means that growth was based on resources shifting to firms that increased their market share. The growth in within-sector productivity remains the dominant factor during the pre-GFC period and after. Nevertheless, there is room for labor shifts from lower to higher productivity sectors, which would support real output growth, if we compare the current share of employment in BiH in the agricultural sector with that in aspirational peers. The bulk of the productivity growth would, however, have to come from within-sector productivity, which in turn is going to be a function of further capital deepening and exporting higher value-added products. 66 Private sector productivity and dynamism 98. Services have contributed most to labor productivity growth in BiH. A larger posi- tive rate of within-sector productivity in services suggests that productivity gains are being achieved through improvements in efficiency, technological advancements, process in- novation, or other factors specific to the services sector. It indicates that the services sector is experiencing productivity growth within its own boundaries, which can have significant implications for the sector’s competitiveness and overall economic performance. These factors are likely to have benefitted from net FDI flows into retail trade by large internation- al chains, in finance from Italian and Austrian banks, and the ICT sector. II.2.  Business Dynamism in BiH II.2.1.  Business demography, density, and firm size in BiH 99. A relatively smaller number of firms operate in BiH compared to structural peers (Figure 25a). The number of firms in BiH is relatively small when considering the size of the working-age population. This firm density in BiH is lower compared to North Macedonia, significantly lags behind Serbia, and is only 25-30  percent of the size seen in the Baltics. Slovakia has by far the highest density among the as- pirational peers. The low number of firms in BiH drives in part the poor job creation performance of the private sector (Figure 25b). At the same time, the low business density in BiH can potentially reduce the competitive pressure faced by firms oper- ating in the domestic market. While this is unlikely to be the case currently, as shown later, this could facilitate the concentration of market power in the future. The small number of firms relative to the market’s potential may also indicate significant entry barriers, entry costs, and/or recurrent operating costs. Furthermore, it could reflect the cost of doing business in BiH, including high transportation costs due to inade- quate infrastructure (which affects input and product prices), difficulties in accessing highly skilled labor, regulatory barriers, high tax burdens, and other expenses. Some of these aspects will be analyzed in the following sections. 100. Digitalization, including the use of digital technology to simplify the regula- tory requirements, could go a long way in supporting firm entry, and more broadly increase private sector productivity. The use of digital technology could, for exam- ple, take the form of e-registration, e-civil construction permits, eDelivery, ePayment, authentication, and interoperable e-signature system. Implementing the latter would be in line with the EU acquis and would enable secure electronic communication and digital transactions between businesses, citizens, and the public authorities. This would allow the public administration, taxation, customs, banking, and judiciary to operate in a more efficient manner, significantly improving the business environment. 101. Firms in BiH tend to be larger on average compared to its aspirational and structural peers. With an average of close to eight employees, BiH’s average firm size is more than twice the size compared to Slovakia, and about 60 percent larger on average than in Slovenia or the Baltics. This could be associated with the small size of the private sector in BiH, and conversely, the dominant, large SOE sector. The small share of private sector jobs per person could account for the low labor productivity55 due to labor hoarding, among others, in firms with public ownership. 55 Cegar B., and Parodi, F. (2019) State-owned enterprises in BiH: Assessing Performance and Oversight, IMF Work- ing Paper WP/19/201 Private sector productivity and dynamism 67 102. BiH’s exit and entry dynamics are on average in line with its peers for the period 2016 to 2019 (Figures 26a and 26b). While firms’ entry and exit rates are in line with those observed in peer countries, the yearly number of newly created firms relative to the potential size of the market is the lowest, together with North Mace- donia, among the group of country comparators. To put it in perspective, while in BiH in 2019 close to 5000 new firms (per million inhabitants) were created, in Slovakia and Lithuania this number is roughly four and five times larger, respectively. With exit rates lower than entry rates, the number of firms in BiH is increasing on the margin. To increase firm density more prominently, this process would need to be accelerated by promoting entry and reducing the aforementioned barriers to entry. Figure 25a Figure 25b BiH’s value added per Private sector jobs per worker is becoming worse person (16 years old or compared to regional peers more) 150000 0.7 0.6 100000 0.5 0.4 50000 0.3 0.2 0 0.1 0 HRV EST LVA SVK BiH MKD SRB SLO LTU BiH MKD HRV SVK SVN LVA EST LTU Source: WDI. Employment rate is defined as the ratio of people 15 years or older that are employed over a certain year; Source: Staff calculations based on WDI (2023). Value added expressed as thousands of 2015 constant USD. Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Growth is in real terms. The straight lines in the left panel represent the average value among the depicted countries Figure 26a Figure 26b Firms’ entry rate New firms per million (2017-19 average) inhabitants 25 25000 20 20000 15 15000 10 10000 5 5000 0 0 MKD SVN HRV SRB BiH EST LVA SVK LTU MKD BiH HRV SRB LVA SVK EST SVK LTU Source: Eurostat. Note: data on BiH cover both entities 68 Private sector productivity and dynamism II.2.2.  Market distortions in BiH 103. Extensive distortions are often a key constraint preventing private sector growth. In an economy without distortions arising from market failures, allocative efficiency would be maximized as long as firms and consumers are themselves optimizing. Hence, dis- torted economies are poorer in part because resources are sub-optimally allocated and this results in low aggregate TFP. To analyze distortions, this section relies on a procedure developed by Atkin and Donaldson (2022) that maps firm-level survey data to estimates of distortions these firms face, on the margin. In this context, distortions are measured as wedges between seller and buyer prices. 104. Distortions can be divided into sales and input distortions. Sales distortions stem from excessive or uneven enforcement of regulation, markups, or taxes and subsidies.56 Regulatory barriers impose an additional burden on firms resulting in distortions, while markups and taxes directly cause a wedge in prices. Markups are calculated as the ratio between prices and marginal cost of production. Higher markups suggest less compe- tition in a market. Input distortions, on the other hand, arise from markets for imported inputs, capital, labor, or intermediate inputs. Tariffs contribute to imported input distortions, while access to finance and labor market regulations can also distort resource allocation. Distortions on the prices paid for intermediates used in production can result from the cost of contract enforcement. Lastly, electricity distortions represent the disparity between the price firms pay for quality-adjusted electricity and the price in an undistorted market. 105. While estimated markups are lower in BiH compared to aspirational peer coun- tries, product market inefficiencies remain an important source of sales distortions in BiH (Figure 27a). In the absence of perfect competition, firms are likely to charge distor- tionary markups. Despite their lower-than-average level, market power remains an im- portant distortion in the BiH market (Figure 29a). This pattern aligns with the behavior of firms in regional peers. Not only are markups the most pronounced distortion in Albania, Montenegro, North Macedonia, and Serbia, but the extent of the distortion is similar in size. 106. Input distortions in BiH are mainly driven by two factors: intermediate input and labor market inefficiencies compared to regional peers (Figure 27b). Input distortions lead to a difference between the price that an input user pays for the input and the mar- ginal cost to the input producer of supplying the input. In BiH, intermediate input ineffi- ciencies are the leading factor in input distortions and may be associated with a host of factors that would need to be analyzed in more detail. In addition, supply chain disruptions can interrupt the smooth flow of intermediate inputs and result in delays in receiving input or production components. Labor market inefficiencies are likely associated with lack of labor market flexibility, informal employment, and skills mismatches. 107. Interviews with companies in the metals sector, for example, revealed a host of specific issues with respect to access to intermediate inputs. The procurement and import of raw materials are costly mainly due to limited local production, which in turn imposes additional costs related to imported inputs and transportation of materials. Lack- ing railway infrastructure forces companies to use much more expensive truck transport. Therefore, strengthening the competitiveness of local BiH production would require facil- itating the cooperation among companies at a local and regional level to improve value chains and reduce import costs. Such regional, nearshoring cooperation could potentially increase the footprint of the metals sector in global markets. Finally, addressing the limit- ed (affordable) support for technological development is essential in a rapidly developing 56 Atkin and Donaldson, 2022 Private sector productivity and dynamism 69 industry such as the machine industry. In addition to this, and from a cyclical perspective, companies continuously adjust to evolving difficulties in the supply chain triggered by ex- ternal shocks, order management of inputs and their processing, as they deal with longer periods of delivery and increased delays. 108. The skills mismatch seems especially pronounced as firms in BiH report a sig- nificant shortage of skilled workers. Whereas close to 40 percent of firms in BiH seem to offer training to close skill gaps, many still report issues with skilled labor (Figure 28).57 In fact, constraints in skilled labor in BiH seems to be more pronounced even compared to regional peers. Specifically, one-quarter of firms reported inadequately skilled labor as a major constraint compared to one-fifth in regional peers (Figure 28). Furthermore, 11 percent of firms list labor regulations as a major constraint, which is twice as much as in regional peers. The skills mismatch issue in BiH appears to particularly affect larger firms (over 60 percent), and in manufacturing (28 percent) more than in the services sector (22 percent). In addition, firms that do not export (27 percent) report skills mismatch as a major constraint compared to those that export (20 percent), possibly due to wage differ- ences (Figure 29). Finally, locational disparities are also evident, with RS reporting the skills mismatch to be less of an issue compared to FBiH, although this may also have to do with the structure of the economy as the agriculture sector is with a 10 percent share twice as large. Also, attracting skilled labor seems easier for firms in Sarajevo, BiH’s largest city, than in the rest of FBiH. 109. In sum, reducing intermediate input distortions and improving labor market in- efficiencies, and improving access to skills by investing in education and training are likely to be priorities in BiH. Enhancing the transport infrastructure, which BiH has in part embarked on, and streamlining customs and border procedures could facilitate a smoother flow of goods. Addressing the skills mismatch requires reforming the education and training systems that need to be aligned with the needs of the labor market, together with the promotion of vocational and technical training within and outside firms by foster- ing partnerships between firms and educational institutions. Figure 27a Figure 27b Sales distortions Input distortions (% of sales) (% of input costs) Aspirational Aspirational Bosnia and Herzegovina Bosnia and Herzegovina 40 Structural Structural 34 30 30 27 28 22 21 20 20 19 19 19 20 18 16 16 15 13 14 10 10 6 54 7 3 4 1 1 1 1 2 1 0 0 Regulation Crime Markup Domestic Imported Capital Labor Intermed. Electricity tax input Input Source: Staff calculations based on Atkin and Donaldson (2022). Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Distortions are measured as wedges between seller and buyer prices. Regulation, crime, markup, and domestic tax distortions are expressed as a share of firm sales. Imported input tariff, capital, labor, intermediate input, and electricity distortions are reported as a share of their respective input cost to the purchasing firm. 57 World Bank Enterprise Survey (2019) 70 Private sector productivity and dynamism Figure 28. Firms’ constraints in BiH and peers (%, firms or workers) 100.0 Aspirational Bosnia and Herzegovina 82.5 79.3 80.0 Structural 72.6 60.0 49.3 51.0 44.8 39.1 37.9 35.5 40.0 20.0 24.3 22.8 20.0 7.8 11.2 5.1 0.0 Firms identifying labor Firms identifying an Proportion of skilled Firms offering formal Workers offered formal regulations as a major inadequately educated workers (of all training training constraint workforce as a major production workers) constraint Source: Staff calculations based on the World Bank Enterprise Survey (accessed 2023, data from 2019). Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Figure 29. Skilled labor constraints across region, size, sector, and trade (%, firms identifying an inadequately educated workforce as a major constraint) Region Size Sector Trade 40 31.8 27.9 31.5 30 28 26.5 20.6 21.1 22.2 19.7 20 17.8 10 0 Sarajevo Region Small (5-19) Medium (20-99) Large (100+) Services Bosnia & Republika Srpska & Manufacturing Exporter Non-Exporter Hercegovina Region District Brcko Source: Staff calculations based on the World Bank Enterprise Survey (accessed 2023, data from 2019). Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania Private sector productivity and dynamism 71 II.3.  Firm-level analysis in RS II.3.1.  Productivity in RS 110. In RS, total factor productivity (TFP) growth has outpaced labor productivity growth (Figure 30a). Between 2011 and 2019, TFP growth has consistently exceeded labor productivity growth. This consistent growth in TFP has stalled during the pan- demic. The rise in productivity was not based on capital deepening as there has been a persistent negative trend in physical capital accumulation per worker in RS (Figure 30b). Reduced net investments (new investments net of depreciation of existing as- sets) per worker in physical assets had a gradual negative impact on labor productiv- ity. Hence, to reignite the process of TFP growth observed in RS before 2017, private sector investment would need to be stimulated. Figure 30a Figure 30b Value added per worker Physical assets to and TFP (cumulative log workers ratio changes) 0.6 LP 97000 TFP 95000 0.5 93000 0.4 91000 0.3 89000 87000 0.2 85000 0.1 83000 0 81000 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2011 2017 2012 2013 2014 2015 2016 2018 2019 2021 2020 Source: firm-level data for Republika Srpska. Note: data covers only firms with at least 2 employees registered in the Republika Srpska administrative region. Aggregate TFP and LP are computed as weighted average of firm-level log- productivities, weighted by each firm’s number of employees. Physical assets are computed as book value of physical assets (historical value – net depreciation) as reported in the data. The left panel plots the average (across firms) of the log ratio between physical assets and employment. 111. The structural transformation in the RS economy has made a positive contri- bution to overall growth. In the sample of firms in RS available for this analysis, this was primarily driven by a reallocation of employment away from lower TFP activities in the industry sector such as water supply, sewage, and waste management as well as manufacturing to higher productivity sectors like power generation and some high productivity services activities like retail and wholesale trade. If the distribution of employment across 1-digit NACE activities had remained the same as in 2011, the cumulative aggregate TFP growth between 2011 and 2019 would have been approx- imately 13 percentage points lower. 72 Private sector productivity and dynamism 112. The rise in aggregate TFP58 observed since 2011 in RS was driven primarily by improvements in the average efficiency of firm, or rather the firms’ upgrading. The average RS firm became 30 percent more productive between 2011 and 2019, driving aggregate productivity growth (blue line in Figure 31). Improvements in the allocation of resources between firms contributed to growth during the pre-pandemic period, but the bulk of this contribution happened between 2011 and 2012 and was thus likely cyclical rather than being part of a persistent structural trend (red line in Figure 31). Figure 31. Decomposition of TFP growth (cumulative, relative to 2011) 0.6 Within (firms' upgrading) Between (allocative efficiency) 0.5 Aggregate 0.4 0.3 0.2 0.1 0 -0.1 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Source: firm-level data for the Republika Srpska. Note: data covers only firms with at least 2 employees registered in the Republika Srpska administrative region. The graph plots the decomposition of aggregate TFP growth into the contributions of the changes in the unweighted average TFP across firms (within), the changes in the allocation of employment across firms with different TFP levels (between) 113. The drivers of TFP growth in RS differ significantly across sectors. In the RS in- dustrial sector, the main driver of productivity growth was the allocation of resources from lower to higher productivity firms during the period 2011 to 2019. In the services sector, by contrast, productivity growth was primarily driven by firm upgrading (i.e., within firm productivity growth). The contribution to TFP growth of improvements in allocative efficiency was much smaller in the services sector – about half the size as in industry – and was entirely explained by the cyclical effect of the 2011-2012 period. On the other hand, firms upgrading was the key driver of productivity in the services sector, playing a bigger role than among industrial firms. The evidence thus suggests that since 2011, relative to the industry peers, services firms where better at improving their average operational efficiency, while productive industrial firms benefited more from a reduction in market distortions. 58 See Annex B1 for description of methodology and explanation of terms. Private sector productivity and dynamism 73 II.3.2.  Business Dynamism in RS 114. In recent years in RS, there has been a noticeable decline in business dyna- mism. The dispersion in the growth rate of TFP, on the one hand, and of firms’ sales, on the other hand, has been declining since 2011. This trend indicates a reduced level of competition among firms and a potential threat to market efficiency.59 If this trend persists, then this could potentially contribute to an increase in the market power of the largest firms in the RS economy. 115. Market contenders in RS have not closed their productivity gap with mar- ket leaders. In other words, market contenders, representing firms in the bottom 95 percent of the sales distribution, have struggled to outperform the market leaders in productivity growth, which are firms in the top 5 percent of the sales distribution. If market contenders do not achieve faster growth in productivity, then they cannot become market leaders in the future. Because contenders are not able to achieve higher productivity than market leaders, the market leader’s status has become more persistent. This means that firms holding a market leader position in one year are more likely to maintain that position in the following year. The latter is the case in about 81 to 83  percent of market leaders. Although this trend has not yet been reflected in estimates of market power, the diminishing challenge posed by market contenders to market leaders could ultimately strengthen the leaders’ market power. This would have adverse effects on the efficiency of the RS economy and the welfare of house- holds. An important part of preventing excessive market power are well-functioning antitrust institutions that have a task to prevent potential threats to market efficiency that can arise from the described trend. 116. In RS, firms experience rapid growth in size after entering the market. From a firms’ life-cycle perspective, young businesses quickly increase their average em- ployment as they age (Figure 32a). This trend is explained entirely by the rapid growth of survivor firms, rather than by the exit of smaller young firms. In other words, there are not many firms that enter, but once they enter the market, they rapidly grow. Eu- rostat data that covers both entities confirms the fast increase in the average size of business, and this effect appears to be somewhat stronger in FBiH. The data seem to suggest that the size-age profile among BiH firms is one of the steepest in the region (Figure 32b). Only Lithuania shows a larger and more persistent rise in the average size of firms over time. 59 The reversal in TFP observed in 2020 is a typical characteristic of recessions and should not be interpreted as a long-term structural trend. 74 Private sector productivity and dynamism Figure 32a Figure 32b Firm size by age (number Average employment by of employees, growth age (relative to age 1) since year 1) 0.6 Size 1.5 EST HRV Size (stayers) LVA LTU 0.5 SVN SVK 1.4 0.4 1.3 0.3 1.2 0.2 1.1 0.1 0 1 1 2 3 4 1-year 2-year 3-year Source: firm-level data for Republika Srpska (LHS); Eurostat (RHS). Note: data in the left panel covers only firms with at least 2 employees registered in the Republika Srpska. Data in the right panel cover both entities. 117. RS exhibits good dynamism among private firms. The rapid growth in the size of new firms in RS coincides with an increase in their average productivity. This positive dy- namism is fueled by the exit of less productive firms from the market. Surviving firms, on the other hand, display a sizable increase in productivity between age 1 and 4 (red line in Figure 38a). However, this growth begins to decelerate after age 3. 118. This pattern holds true for the average productivity of firms that manage to en- dure at least to the age of four. Much of the increase in the average productivity of the pool of surviving firms after age 4 is attributed to the exit of unproductive firms from the market, as illustrated by the difference between the solid blue and red line (Figure 33b). The exit of young unproductive firms plays an important role in raising the average pro- ductivity of the pool of surviving young firms. This effect primarily operates by eliminating firms that are less productive than the average, indicating that, at this stage of the firms’ life cycle, markets tend to favor a reallocation of resources towards more productive young firms. This positive selection effect is evident in the productivity distribution among sur- viving firms (Figure 33b), where the bottom of the productivity distribution experiences a faster growth with age. 119. Overall, these exit dynamics provide evidence that, on average, markets reward more productive young firms. This is a positive message. However, the observed slow- down in (within) productivity growth of surviving firms (red line in Figure 38a) raises ques- tions about the capacity of surviving young firms to sustain their productivity upgrading over the longer term. If this pattern persists throughout the firms’ life-cycle, it may indicate the presence of constraints or reduced incentives for maturing firms to invest in upgrading and efficiency. This investment can take the form of advanced productive physical assets or the accumulation of intangible capital.60 The data also seems to suggest that firms may reach a point where they no longer perceive incentives to invest in efficiency. These firms appear to be growing in size but their productivity growth begins to stagnate. This occur- rence could signal limitations to the “good dynamism” that is currently observed. 60 It is difficult to be more precise as APIF cannot provide the date when a company was established Private sector productivity and dynamism 75 Figure 33a Figure 33b TFP by age (growth since Average employment by age 1, log change) age (relative to age 1) 0.4 TFP 0.25 p25 TFP (stayers) p50 0.2 p75 0.3 0.15 0.2 0.1 0.1 0.05 0 0 1 2 3 4 1 2 3 4 -0.05 Source: firm-level data for Republika Srpska. Note: data covers only firms with at least 2 employees registered in the Republika Srpska administrative region. II.3.3.  Signs of misallocation in RS 120. In RS, there is evidence of a misallocation of productive resources among medium-sized businesses. This is suggested by the size-productivity relationship among firms depicted in Figure 34. Typically, larger firms tend to be more productive on average, as medium-large (100-250 employees) and large firms (250+ employees) benefit from economies of scale, access to capital, innovation, and supply chain ad- vantages, among other factors. By extension, medium-sized firms (5 to 100 employ- ees) are expected to be more productive than small firms (1-5 employees). However, in RS the size-productivity relationship is relatively flat for small and medium sized firms (Figure 34). Specifically, medium-sized firms with 50-100 employees are only 5 percent more productive on average than firms with 5-10 employees, while firms with 25-50 employees are slightly less productive than 5-10 employee firms. This flat profile among medium-sized firms contributes to the non-linear shape of the overall size-productivity relationship in RS, with firms with 250+ employees being 180 per- cent more productive than firms with 50-100 employees, and firms with 50-100 em- ployees only 18.5 percent more productive on average than firms with 1-5 employees. This suggests a misallocation of resources among medium-sized firms, which in turn reduces overall allocative efficiency in RS. Addressing this misallocation can lead to significant productivity gains and stimulate GDP growth in RS, and BiH more broadly. 76 Private sector productivity and dynamism Figure 34. Decomposition of TFP growth by firm size (cumulative, relative to 2011) 10.1 mean 9.9 9.7 9.5 9.3 9.1 8.9 8.7 8.5 100-250 25-50 50-100 0-5 10-25 5-10 250 - Size class (employment) Source: firm-level data for the Republika Srpska. Note: data covers only firms with at least 2 employees registered in the Republika Srpska administrative region. Data used are for 2011 to 2019 only 121. Allocative inefficiencies in RS are driven by less productive medium-sized firms. More precisely, the overrepresentation of medium-sized firms among the least productive firms in the RS economy contributes to the allocative inefficiencies. This is represented by the flat curve in Figures 35a, and in 35b, where small and medium-sized firms have rough- ly the same TFP as indicated by the flat average size between the 2nd and 8th decile of TFP distribution. Firms nevertheless seem to be able to thrive despite being less pro- ductive, an indication that at least part of them might be operating in a weak competitive environment. This means that they enjoy higher market power due to lower competitive pressures. These misallocations could be the result of higher market segmentation (e.g., small local markets) that these firms face, their lower exposure to foreign competition, or more protective regulatory framework. Increased integration of smaller markets, i.e., be- tween the Federation and RS, for example, via improved infrastructure and connectivity, and reducing barriers to cross-entity and foreign competition, as well as entry in regulated markets (via a revision of the regulatory environment) are examples of policies that can alleviate these misallocation issues. 122. Low-productive medium-sized firms often operate in utilities, transportation, and mining. Low-productive medium-sized firms are over-represented in sectors where entry regulations play a larger role. These protected sectors drive in part the misallocation of productive resources. In particular, relative to the overall population of medium-sized firms, those in the lowest decile operate more often in some utilities, transportation, and mining. Some of the regulations limiting access to these markets could be generating a weaker competitive environment and reduce incentives to increase productivity. While some sectors, like water for example, are protected under the umbrella of safety, for oth- ers like transport this is more difficult to justify. A review of these regulations could help identify area for interventions that could stimulate growth by reducing market rents and increasing allocative efficiency. In general, a more in-depth analysis of business regula- tions in these markets would be needed to substantiate these claims and derive detailed policy options. Private sector productivity and dynamism 77 Figure 35a Figure 35b Average size (log Difference in size employment) by TFP distribution (share in decile 1st TFP decile – share in population of firms) 2.8 0.03 0.02 Average employment 2.6 0.01 2.4 0 2.2 -0.01 2 -0.02 1.8 -0.03 0 1 2 3 4 5 6 7 8 9 -0.04 TFP decile 0-5 5-10 10-25 25-50 50-100 100-250 250 - Source: WDI. Employment rate is defined as the ratio of people 15 years or older that are employed over a certain year; Source: Staff calculations based on WDI (2023). Value added expressed as thousands of 2015 constant USD. Structural peers are Albania, Montenegro, North Macedonia, and Serbia. Aspirational peers are Croatia, Slovakia, Slovenia, Estonia, Latvia, Lithuania. Growth is in real terms. The straight lines in the left panel represent the average value among the depicted countries II.3.4.  SOEs in the RS economy 123. While SOEs in RS tend on average to be less productive than non-SOE firms, large SOEs are more productive than comparatively large private firms (Figure 43a). As a result, the productivity of the average SOE worker is higher than that of the average worker employed in non-SOEs firms (left panel, Figure 36a). These results show that while large SOEs are productive, small and medium SOEs - and thus the majority of SOEs - are on average not as productive as non-SOE firms of a compa- rable size (right panel Figure 36b). Estimated markups (not shown) for SOEs tend nonetheless to be higher than those estimated for non-SOE firms, suggesting that at least part of the estimated TFP advantage of large SOEs might come from their dominant market position – and their willingness to exploit it by charging higher pric- es. Furthermore, better productivity may be related to their impact on the labor mar- ket, considering the employment pull of these firms with respect to highly educated workers as mentioned in Chapter 1. A more in-depth analysis of SOEs pricing deci- sions, based on direct information on product and services prices rather than on the indirect measures of markups used in this note could help shedding further light on SOEs efficiency and market power. 78 Private sector productivity and dynamism Figure 36a Figure 36b TFP in SOE and non-SOE Average employment by firms size: SOE vs non-SOE 2.8 0.03 0.02 Average employment 2.6 0.01 2.4 0 2.2 -0.01 2 -0.02 1.8 -0.03 0 1 2 3 4 5 6 7 8 9 -0.04 TFP decile 0-5 5-10 10-25 25-50 50-100 100-250 250 - Source: firm-level data for Republika Srpska. Note: data covers only firms with at least 2 employees registered in the Republika Srpska administrative region. SOEs are defined as firms that are at least partially controlled by a government entity. Left panel: “Average TFP” is the TFP of the average firm, “TFP for average worker” is the weighted average TFP across firms, where the weight is the employment size of each firm – this is the same measure used for the aggregated TFP used in the rest of the chapter. Data are for 2019 only. 124. Most SOEs in RS are active in sectors with strong natural monopoly charac- teristics – such as utilities, water supply, waste management, and social security services – rather than in competitive markets. The fact that most SOEs seem to be active mainly in natural monopolistic or only partially contestable sectors mitigate the concern that SOEs could represent a major constraint to competition in domestic markets and could at least in part explain the difference in average TFP among SOE vs non-SOE firms observed. A more in-depth analysis of the sectoral distribution of SOEs across sectors could shed further light on their potential role in altering the competitive environment in domestic markets. 125. SOEs tend to be active in less productive sectors, but their presence is not associated with more distortions in the allocation of productive resources. While SOEs are active in sectors that are on average less productive and where less pro- ductive firms tend to operate, there is no evidence of a correlation between high- er SOE presence and lower allocative efficiency at the 2-digits sectoral level. Once again, the concentration of SOEs in non-competitive sectors might explain at least part of these patterns. 126. In BiH more broadly, authorities have taken initial steps to introduce a sound institutional and regulatory framework to supervise SOEs. The Joint Reform Doc- ument for 2019-2022 provides a good basis for articulating the strategic objectives and vision for the sectors such as, for example, reducing fiscal risks, improving private sector development and job creation, or improving service delivery. Yet, these need to be supplemented by goals and criteria for ownership, ideally codified in law or reg- ulation. For those SOEs with the objective of improving private sector development, the aim is to invest in the capabilities of commercial SOEs to independently compete in the market, and gradually phase out government support. This policy objective would include phasing out unproductive companies that have no strategic or social relevance, so that the land, capital, and infrastructure they occupy can be put to more productive use. Private sector productivity and dynamism 79 II.4.  Conclusions and Policy Options 127. Labor productivity in BiH remains low, with sluggish growth over the past two decades, and a clear slowdown between 2016 and 2019. Moreover, productivity in BiH significantly lags that of aspirational peers such as the Baltics, Croatia, Slovenia, and Slovakia, across all sectors, although productivity in services outpaces that of regional peers. The decline in labor productivity in BiH is particularly evident in the agriculture sector, followed by industry. 128. Strategic policy interventions are required in BiH to stimulate business dy- namism. In light of low business density with respect to BiH’s potential, establishing electronic business registration in FBiH (like in RS and Brcko District), and fostering digitalization of public services, including adopting a law on electronic identity and trust services for electronic transactions with a single supervisory body could en- hance business dynamism and address reduced business creation incentives. Fur- thermore, ensuring that existing regulations are not granting preferential access to markets to certain businesses and are not imposing unnecessary costs to firms set- ting up and closing their activities can help promote an increase in the overall num- ber of firms active in the economy, also by shifting firms out of the informal economy. 129. Upgrading transportation networks such as roads and the railway infrastruc- ture are important aspects of improving access to intermediate goods. Improving the road and railway infrastructure would on the one hand facilitate better access to supply chains for inputs, and on the other reduce the cost of intermediate goods. Such measures would help promote business dynamism due to better and cheaper access to intermediate goods, and the competitiveness of BiH firms. 130. Attention should be given to markets where incumbent firms might be en- joying excessive market power due to natural, infrastructural, or regulatory con- straints. This is for example the case of local, poorly integrated, or regulated markets. In these markets, due to existing constraints, only a relatively small number of firms faces limited competitive pressure giving them the ability to charge inefficiently high prices and reducing incentives to invest in efficiency. Tackling these constraints by opening such markets can help improve the allocative efficiency of productive re- sources in the economy and thus help to provide another boost to the growth per- formance. 131. Workforce skills development represents a crucial government priority. FBiH and RS authorities could consider an assessment of learning losses among students and develop indicators on school quality including methodology for identifying at risk schools and introducing school self-evaluation as an integral part of a regular school planning cycle. Also, establishing additional work-based learning/dual VET, which would equip young people with the skills that are needed by enterprises, and facili- tate practical experiences in the labor market. Improving labor market governance by formalizing informal enterprises and reducing undeclared work through enhanced enforcement and compliance with labor, tax and social security legislations would help business dynamism. Furthermore, investing in digital/technological skills en- abling adaptation facilitates higher productivity and new high-growth service sector businesses, transitioning the economy. In addition, adopting new and modifying ex- isting immigration policies may be needed to attract workers from other countries to address labor shortages in specific sectors. III.  Energy transition in BiH III. Energy transition in BiH Key findings: 1. Close to 70  percent of primary energy generation in BiH is from coal; yet, coal mines, especially in FBiH, are loss-makers with large, accumulated arrears. 2. Ageing energy infrastructure, including coal plants older than 40 years, and lower production efficiency, is making it harder for BiH to delay transition. 3. Poor energy efficiency in the industry sector leads it to consume 3.27 times more energy per unit of output than the average upper-middle-income economy. 4. Decarbonization/transition to a low carbon economy is a key challenge for BiH with significant risks but also significant opportunities. 5. The system-level changes required and the whole-of-society impacts that decar- bonization will bring about mean that the entity governments in BiH must make plans and prepare very soon. 6. BiH is well placed to take advantage of international community support for its transition given it has developed a Road Map for transition. 7. Weak regulatory and legal frameworks, lack of institutional capacities, and low coordination and cooperation between government levels in the country have slowed progress and prevented BiH’s adherence to EU energy obligations. 8. Delaying the transition away from fossil fuels is likely to make exporting sectors (including electricity, aluminum, steel) both uncompetitive and uneconomical in the longer term once the EU cross-border carbon price adjustment is introduced and starts biting. 9. Since BiH will be hit by CBAM either way, it would be better to capture the rev- enues domestically through an ETS or carbon tax rather than losing out to the CBAM. 10. Raising renewable electricity generation is a key part of the transition, requiring a well-functioning, liquid wholesale and retail electricity markets, improved net- work connections and simplified licensing to allow much needed private invest- ment. 11. Taking stock of mining lands and other assets present an under-considered op- portunity to begin economic diversification in coal regions and offer new invest- ment and job opportunities to coal-dependent communities. 12. Working with direct and indirect laborers to identify economic alternatives and upskilling will strengthen the potential for a successful transition when combined with regional transition plans and integrated land use planning in coal mining ar- eas. 82 Energy transition in BiH Introduction 132. In BiH, and the Western Balkans more broadly, the negative consequences of high fossil fuel dependency, high energy intensity and outdated technology are visible beyond the direct economic impacts. Ageing coal power plants cause significant air pollution, with adverse consequences for human capital. Specifical- ly, legal limit values for sulphur dioxide (SO2) from coal power plants are frequently breached.61 Coal combustion is the second largest source of PM 2.5 emissions in the region.62 In 2019, annual mortality rates due to PM2.563 air pollution in the Western Balkans were more than double the EU27 average, with mortality rates in Bosnia and Herzegovina 140 percent above those in the EU27 average.64 BiH, like other Western Balkan countries, has failed to comply with air pollution limits set in their National Emission Reduction Plans (NERPs) also due to a lack of enforcement of pollution limits outlined in those plans. Most of the coal-fired power plants fleet is at least over 40 years old, with few units scheduled for decommissioning over the next few years and new plants in the pipeline. 133. With the EU as the main trading partner of BiH, and the carbon-intensive modes of production in the country, carbon pricing65 is a tangible transition risk. Exposure to carbon pricing depends on the amount of the specified product export- ed and the relative emissions intensity of that product. BiH and Montenegro show the largest exposure in the Western Balkans, partly driven by large power exports. The carbon intensity of production processes in BiH and the Western Balkans, more broadly, is also much higher than in the EU. According to the Energy Community Energy Tracker, GHG in manufacturing in the Western Balkans is ten times higher than the EU27 average.66 Carbon intensity of power is two to three times higher in the Western Balkans than in the EU27, especially in Kosovo, Serbia, BiH, and North Macedonia, leading to relatively higher embedded emissions in electricity-intensive goods produced in the region. Looking at trends for renewables’ shares in power generation, the risk of further carbon lock-in67 in the power sector is much higher in BiH, compared to, for example, Albania and North Macedonia (Table 1). 61 World Bank (2019) Air pollution management in Bosnia and Herzegovina, Washington DC, October 62 OECD (2022) Multi-dimensional Review of the Western Balkans: From Analysis to Action, OECD Development Pathways, OECD Publishing, Paris, https:/ /doi.org/10.1787/8824c5db-en. 63 PM2.5 refers to particulate matter 2.5 micrometers and smaller. It is particularly harmful to health because it can travel deeply into the lungs. 64 Belis et al. 2021, Figure 4. 65 In this report, carbon pricing refers to CBAM, planned for introduction in 2026. In parallel, for the power sector considerations, carbon pricing can refer to ETS that could be introduced in BiH as an alternative to CBAM. 66 Kantor, E3M 2021 67 “Carbon lock-in refers to the concern that investments in carbon-intensive infrastructure today will delay or fore- close a clean energy future by making it too difficult or too expensive to transition to alternative energies, thereby ‘locking’ a country into a fossil fuel-dependent development pathway” (Untangling ‘Stranded Assets’ and ‘Carbon Lock-In’ - Energy for Growth Hub). Energy transition in BiH 83 Table 1.  Western Balkan and EU27 energy mixes, GHG emissions, and renewable trends RE in power generation Carbon intensity of power Trend for RE in power mix (grams CO2/kwh) Albania 100 24(2020) Bosnia and Herzegovina 28.5 489(2021) Kosovo 5.2 778(2020) Montenegro 52.2 336(2021) North Macedonia 24.4 487(2021) Serbia 21.9 549(2021) EU27 38 265(2020) Source: IEA, BP Statistical Review of World Energy; Ember, Eurostat; see also Spotlight: Towards carbon pricing in the Western Balkans, in: World Bank (2023) Western Balkans Regular Economic Report, p. 58 Notes: the third column indicates how the share of renewable energy (RE) in power generation has changed in the last 10 years. Changes within +/- 3 pp are marked as 134. BiH has one of the highest shares of CBAM-applicable goods in its total ex- ports to the EU. Countries with the five largest shares are the United Arab Emirates (14  percent), Ukraine (14  percent), Belarus (13  percent), BiH (12  percent), and Iran (12 percent). Moreover, CBAM-affected BiH exports contribute over 5 percent to the country’s GDP according to the current definition of CBAM, which will be broadened going forward. BiH is also among the countries with the highest carbon intensity, measured in kg carbon per USD GDP, with a range of between 0.11 and 1.65 kg per USD of GDP. BiH is also the fourth most carbon-intensive economy among the EU’s 50 main trading partners in 2019. 135. There is broad consensus that a carbon tax or ETS could deliver benefits to the countries as they are transitioning to greener and more resilient growth. Car- bon pricing plays a key role in supporting a green transition: it unlocks rapid low-cost emissions reductions and generates government revenue that can be deployed for productivity-enhancing policy measures or to reduce distortionary taxes. It also re- duces a country’s exposure to carbon pricing and promotes readiness for EU acces- sion. Unlike in other countries, however, carbon prices in BiH cannot help managing energy security risks as the country continues to be a net energy exporter. During the transition period, it is very likely that the introduction of carbon prices will lead to an increase in the cost of power supply and likely affect retail electricity prices. This will have adverse spillover effects for household welfare and firms’ competitiveness, profitability, and investment. 136. The transition to renewable energy needs to be based on a coherent and adaptive Just Transition roadmap. This roadmap needs to mitigate the risks of ‘brown’ growth, protect those adversely impacted by the transition away from coal, and ensure an equitable distribution of the benefits of increased growth. BiH is set to adopt a first BiH level roadmap in the Fall/winter of 2023 with the expectation that more detailed Just Transition strategies will be elaborated at the Entity level starting in 2024. 84 Energy transition in BiH 137. The objective of this chapter is to link BiH’s energy transition to the country’s growth agenda and elaborate on the challenges to affecting a just transition of its energy sector. The chapter first provides an overview of BiH’s legal obligations and characteristics of its power supply (Section III.1 and III.2). The latter shows the small amount of renewable energy in the current mix and the challenges involved in ramping up renewables. The chapter then describes the liabilities already held by the two entities’ mines, which will require substantial financing to clear before any Just Transition of the mines can be affected. The onset of the CBAM, which will accelerate the need for a transition away from coal, will push many of the assumed mine and thermal power plant closure dates potentially even further up. In this context, Section III.3 discusses the Emissions Trading System (ETS) and Carbon-border Adjustment Mechanism (CBAM) and elaborates on the content and simulated impact of CBAM on the BiH economy. This is followed in Section III.4 by an analysis of possible pathways of changes in energy generation and mining assets and modelling to determine the optimum power generation mix for BiH until 2050, and an assessment of the policy environment in BiH and its readiness to implement a Just Transition (Section III.5). Finally, Section III.6 provides an analysis of possible benefits of a green transition in the long run through the lens of a cost-benefit analysis and looks into the feasibility of needed green public investments from a fiscal perspective using the public debt sustainability framework. III.1.  BiH’s legal obligations 138. BiH must transition to a greener growth model for internal and external rea- sons. Internally, BiH’s economy is still characterized by low energy and resource pro- ductivity, with significant adverse impacts on health, the environment, and the econ- omy going forward as production capacities age and financing for new capacities is difficult to obtain. Externally, as an EU candidate, the country is required to align domestic policies with the Paris global commitments, EU’s energy commitments, the Sofia Declaration68, and other environmental and climate legislation (including the 2050 target of a carbon-neutral continent), while at the same time avoiding adverse impacts of the EU’s Carbon Border Adjustment Mechanism (CBAM). BiH made these international commitments in November 2020, via the Sofia Declaration, effectively committing to align with the EU’s Green Agenda and work towards the 2050 target of a carbon-neutral European continent together with the EU. The Contracting Parties have further committed to a number of specific actions including introducing carbon pricing instruments and aligning these with the EU Emissions Trading Scheme (ETS); introducing renewables support schemes; and gradually phasing out coal subsidies. The Declaration also enshrines the Contracting Parties’ participation in the EC’s Plat- form for Coal Regions in Transition. 68 BiH also supported the Sofia Declaration in November 2020, committing to a number of specific actions including introducing carbon pricing instruments and aligning these with the EU Emissions Trading Scheme; introducing renewables support schemes; and gradually phasing out coal subsidies. Energy transition in BiH 85 139. In 2018, BiH implemented the Framework Energy Strategy 2035 to support a transition of BiH’s energy sector into a more sustainable, competitive, and modern system. This is in line with the relevant European Union energy acquis, as well as the activities that are obligatory for BiH under the Energy Community Treaty. Yet weak regulatory and legal frameworks, lack of institutional capacities, and low coordination and cooperation between government levels have slowed progress toward this goal and prevented BiH’s adherence to EU energy obligations. 140. BiH is a contracting party to the 2006 Energy Community Treaty. The Energy Community aims to create a single regulatory space for energy trade, enhance secu- rity of supply, promote renewable energy sources and compliance with generally ap- plicable standards of the EU. The Contracting Parties have committed to implement reforms to accelerate the pace of energy integration within the region, and eventu- ally to integrate into the EU’s internal energy market. Although all Contracting Parties have made progress towards harmonizing their legal and regulatory frameworks, the gap in absorbing European energy rules between BiH and the other Contracting Par- ties is widening. BiH has taken many significant steps towards compliance with the Treaty provisions, however it is yet to transpose fully the EU’s Third Energy Package. At the same time, under the Energy Community Treaty, BiH is required to comply with two key EU Directives: The Large Combustion Plants Directive (LCPD; 2001/80/ EC) and the Industrial Emissions Directive (IED; 2010/75/EU). The requirements of these directives are contained in the NERP, which was approved by the BiH Council of Ministers on December 30, 2015. In 2020, BiH was found non-compliant with the ceilings for three pollutants (Sulphur dioxide, nitrogen oxides and dust), with absolute amounts of emissions increasing compared to 2019 levels. To address this breach, the Energy Community Secretariat opened dispute settlement procedures in March 2021. III.2.  BiH’s power supply 141. BiH has abundant domestic energy resources, including potential for hydro, solar and wind, yet its energy sector remains heavily dependent on coal (Figure 37). Around 68  percent of primary energy generation is from coal, followed by oil (around 25  percent), with biofuels/waste, hydro, gas and wind/solar providing the balance.69 As of 2021, BiH had an installed capacity of around 4,610 MW with 2,065 MW (or 44 percent) in coal (mostly lignite), 2,077 MW (or 45 percent) of large hydro- power (over 10 MW), 180 MW (or 4  percent) of small hydro, 135 MW (or 3  percent) in wind, 57 MW (or 1 percent) in solar, while industrial power plants add 93 MW (or 2 percent) to the system. In other words, coal accounted for 44 percent of the national energy supply mix and contributed to about 66 percent of the electricity generation mix. As a result, BiH’s economy is one of the most carbon-intensive in the region with heavy dependence on lignite. 69 BiH Systematic Country Diagnostic Update (2020). http://hdl.handle.net/10986/33870 86 Energy transition in BiH Figure 37. Electricity generation mix in BiH, 2012 – 2021 thermal hydro wind/solar 100 90 80 70 60 50 40 30 20 10 0 2017 2018 2019 2020 2021 2022 2023 (I-VIII) Source: BHSA, ENE_1 142. The transition to clean energy may require regional political agreements and major infrastructure investments, particularly in hydro. According to the Energy Community Secretariat (ECS) Annual Implementation Report (2021), BiH registered a 37 percent share of renewables in 2019.70 BiH has an abundance of water resources that could be capitalised on for generating clean energy. Some of these water re- sources are shared—not only between the two BiH entities but also with neighbour- ing Serbia. For some of the most strategic hydro projects, regional political will be required to see these important energy transition projects succeed. For wind and so- lar, the main constraints are the high geographical concentration of viable wind and solar potential, a lack of transmission network and interconnections with neighboring countries, which would address investor requirements, and consequently a relative absence of private sector actors in this sector. That said, in RS there are currently 75 private enterprises in the sector of renewable energy, which receive government subsidies, of which 28 small hydro and 45 solar power plants, one powerplant on biogas, and one using biomass. Despite this large number of private producers, the share of electricity produced by renewable energy is relatively small in RS. Should BiH wish to attract investment in clean energy projects, it will need to consider the role to be accorded to the private sector. Balancing and storage capacities for ener- gy will be essential to manage the variations in electricity supply and demand. This remains a very underexplored area of investment—let alone innovation—for BiH and its two entities. 143. Across some of the Western Balkan countries, as exemplified in BiH, depen- dence on coal, coupled with ageing energy infrastructure and lower production efficiency, is making it harder for countries to delay transition. The primary source of energy in the Western Balkans is domestic lignite and coal (64 percent of electric- ity was produced from lignite and coal in 2020 and 47 percent of gross available en- ergy in 2020, down from 49 percent in 2015). Furthermore, material and energy-inten- sive modes of production in industry are driving up production costs and emissions. 70 In early 2021, a third wind park was commissioned with a capacity of 48 MW. In addition, 12 MW of solar PV and 10 MW of small hydropower were installed in 2020. Nevertheless, additional efforts are needed to increase the use of renewable energy in the electricity and transport sectors. Energy transition in BiH 87 Though declining, large fossil fuel subsidies and electricity tariffs below generation cost reduce incentives to achieve energy savings, improve energy efficiency, and switch to greener fuels. In the case of BiH, this is undermining potential output and contributing to air pollution and high emissions. By the end of 2023, all the coal plants of BiH (except Stanari) will be 35 to 57 years old (Table 2), reaching a milestone with regard to compliance with the EU’s Large Combustion Plant Directive.71 Specifically, a number of units (built in the 1970s) are approaching or have exceeded 50 years in operation (Tuzla 3, 4, and 5, and Kakanj 5 and 6), while others (e.g., Tuzla 6, Gacko and Ugljevik) are about 40 years in operation. Only Stanari is in operation for seven years. In RS, Gacko, Ugljevik and Stanari mines supply coal to each of the three namesake TPPs. In FBiH, Kakanj TPP is supplied by Kakanj, Zenica, Abid Lolic (Bila), Breza and Gracanica mines; Tuzla is supplied by Djurdjevik, Banovici and Kreka mines (Figure 38). All in all, stricter limits on certain pollutants from large plants may be the impetus for retirement of some older coal plants. Table 2.  Thermal Power Plants (TPPs) in Operation in BiH Plant Name Installed Available Startup Retirement Age in Heat Rate Capacity Capacity Year Year (EOY) 2023 kJ/kWh MW MW Gacko  300  276  1983  2035  40  11537  Ugljevik  300  279  1985  2035  38  11599  Tuzla 3  100  85  1966  2023  57  14580  Tuzla 4*  200  182  1971  2026 (2045)  52  11000  Tuzla 5  200  180  1974  2027  49  10503  Tuzla 6  223  188  1978  2035  45  11499  Kakanj 5*  110  100  1969  2026 (2045)  54  13759  Kakanj 6  110  90  1977  2027  46  14107  Kakanj 7  230  208  1988  2040  35  11729  Stanari  300  283  2016  2060  7  9000  TOTAL  2073  1876  Notes: retirement takes place on Dec 31st of the indicated year; * Indicates plants which will co-fire 10% biomass; in Ugljevik, a JICA loan worth EUR 80 million is also associated with desulfurization, according to RS authorities. 71 Directive 2001/80/EC, also known as the LCP Directive, sets stricter limits on emissions of certain pollutants into the air from large combustion plants (those whose rated thermal input is equal to or greater than 50 MW) which were licensed between 1 July 1987 and 27 November 2002. See: https:/ /ec.europa.eu/environment/archives/ industry/stationary/lcp/legislation.htm 88 Energy transition in BiH Figure 38. Map of the electric power system of BiH Source: Electricity Regulatory Commission – Bosnia Herzegovina/2021 Annual Report 144. Rising electricity consumption and peak demand underscore the impor- tance of coal-based electricity production, with BiH playing a significant role in net electricity export. Over the period 2015-2021, annual electricity demand aver- aged 12,408 GWh, peaking in 2017-2018 and experiencing a small decline in 2019- 2020. After an 8.1 percent decrease in 2020, total electricity consumption in BiH in- creased by around 7 percent to reach 12,170 GWh in 2021.72 Similarly, peak demand reached the highest level (2,198 MW) in 2017 and declined to 1,804 MW by 2020, while peak demand registered in 2021 was 1,909 MW. This is to say that without coal, and in dry years, the reduced capacity for hydroelectric generation could necessitate electricity imports. Figures 38 and 39a provide an overview of TPPs and coal mines in BiH, as well as wind and hydro power plants. The dark dots indicate the coal plants, while shaded areas indicate the distribution areas of electric power utilities whereas the associated numbers (1-4) indicate the transmission companies’ operational areas. Repeatedly, BiH and its entities have expressed the need to remain a net electricity exporter going forward. 72 SERC Annual Report 2021, p.39. Energy transition in BiH 89 III.2.1.  Coal 145. BiH is the second largest coal producer and consumer in the Western Bal- kan region, after Serbia. In 2020, BiH produced 13.56 million tons of brown coal and lignite, mostly used to generate electricity at power plants near the coal mines. At 2,264 million tons, BiH’s reserves of lignite are substantial. The largest coal deposits are located in the north-east of the country around Tuzla, in the Kreka-Banovići coal basin (Figure 39a).73 Although BiH has the largest number of operational mines in the Western Balkans (11 compared to 7 mines across the rest of the Western Balkans), neighbouring Serbia has a higher level of coal production in absolute terms – for ex- ample, in 2018, almost 68 million tons of lignite was produced in the Western Balkans (Figure 39b), more than half of it in Serbia (38.2 Mt).74,75 Figure 39a Figure 39b Location of major mines Coal production across in BiH Western Balkans (mil MT) Reference years: 67.5 BiH–2020 for FBiH, 2016-2019 for RS, Kosovo –2015, Montenegro –2020, North Macedonia –2019, Serbia –2016 38.2 14.3 8.2 5.1 1.7 Montenegro Kosovo Serbia Herzegovina Macedonia WB6 Bosnia and North Source: BiH Roadmap, 2019 Source: BiH Roadmap, 2019 146. Most coal mines are in the Federation of BiH, although both entities produce similar quantities of coal. A total of eleven mines are operated by four enterpris- es, spread across eleven municipalities and three cantons in the two entities. Out of eleven coal mines, eight are in FBiH (Banovići, Bila, Breza, Đurđevik, Gračanica, Kakanj, Kreka, Zenica), and three in RS (Gacko, Stanari, Ugljevik). The mines consist of 13 open cast sites (65 percent) and 7 underground pits (35 percent), with an annual production of about 7.5 million metric tons (MT) of lignite and 6.5 million MT of brown coal over the past five years. Coal production is almost equally split between FBiH (about 7 million metric tons) and RS (about 7.3 million metric tons). In FBiH, annual coal production is dominated by the BiH-owned power utility EPBiH, which operates all coal mines in the entity except Banovići and accounts for an annual production of about 5.2 million metric tons, with the remainder produced in Banovići. In RS, the 73 World Bank (2022) BiH Roadmap. 74 Ruiz P., et. al., 2021, Recent Trends in Coal and Peat Regions in the Western Balkans and Ukraine, EUR 30837 EN, Publications Office of the EU, Luxembourg, 2021. p. 12. https:/ /op.europa.eu/en/publication-detail/-/publicatio n/805def66-315a-11ec-bd8e-01aa75ed71a1/language-en/format-PDF/source-search 75 World Bank (2022). Overview of the Coal Sector in the Western Balkans. 90 Energy transition in BiH Stanari coal mine has an annual production of about 2.5 million metric tons, while the remaining two mines are operated by the power utility ERS and account for about 4.7 million MT of coal production. Overall, in 2020, about 80 percent of the coal produc- tion occurred in SOEs, whereas the remaining 20 percent took place in the private sector. More precisely, coal production totalled 4.6 mil MT from EPBiH (or 34 percent of total), 4.8 mil MT from ERS (or 35 of total), 1.6 mil MT from FBiH majority owned Banovici mine (or 12 percent of total), while the Stanari mine contributed 2.6 mil MT (or 19 percent of total). 147. Both ERS and EPBiH are facing significant challenges in operating their mines. In fact, both ERS and EPBiH cross-subsidize the poor financial performance of its mines. While EPBiH’s total electricity generation has grown by 3.5 percent annually over the last three years, its mines remain unprofitable and unsustainable. Although EPBiH remains profitable, its coal mines have incurred substantial losses. Similarly, ERS Holding has shown some growth and profits over the last five years, yet its two mines Ugljevik and Gacko are unprofitable and face liquidity risks. This is due to siz- able liabilities associated with taxes, social security contributions, and concession fee arrears. Limited available data suggests that ERS mines have total arrears of EUR 6 mil, RMU Banovići has a BiH liability totaling EUR 14 million (or 0.1 percent of 2021 GDP), and EPBiH mines have arrears of EUR 257 million (or 1.3 percent of 2021 GDP).76 These arrears exceed by far the annual revenues of the mines. In addition, EPBiH coal mines have a total loss of approximately EUR 122 million per year (or 0.6 percent of 2021 GDP) over the period of 2019-2021. The Banovici mine incurred an average loss of 2 million EUR, with a 7 percent reduction in revenue over 2021-2020. In general, the productivity of mines is low compared to EU standards. EPBiH has initiated a three- year mine reform plan (2021-2023) focused on restructuring, capital investment, and workforce reductions, while ERS issued a restructuring plan in 2019 but has not yet implemented reforms. III.3.  CBAM: design and regional developments III.3.1.  Background 148. Various initiatives suggest that in the long term, every product may be sub- ject to a carbon tax based on its carbon footprint.77 Important questions arise from this reality: first, how long would it take for such a situation to be achieved when all products will be subject to carbon taxes, and second, what do we mean by “long term”. The answer to these questions is uncertain and varies from region to region. While the ultimate objective is to achieve this globally, certain regions, especially Eu- rope, have made the most progress in this direction. Specifically, for broader Europe (including South-Eastern Europe) “long term” means at the latest 2050, and most likely earlier (2035-2045). 76 2021 GDP in million euros: 19,953 (BHAS, Gross domestic product – production approach – quarterly data, June 30, 2023) 77 footprint in tons of CO2e X price of CO2e Energy transition in BiH 91 149. In the long term, every product would have its carbon footprint quantified. For practical purposes, the EU will start monitoring the carbon footprint of the car- bon-intensive products such as electricity, cement, iron, etc. After methodologies, regulations and markets are established for these carbon-intensive products, ad- ditional products may be added to the same regulatory frameworks and markets, or new ones could be added as appropriate. From a theoretical point of view, there should be one carbon price globally for all products; and this is the long-term out- come, even though it is difficult to predict how long this will take. However, in a more well-defined market (i.e., Europe), the convergence of carbon prices will be achieved earlier. 150. In the context of carbon pricing, the Emissions Trade System (ETS) and the carbon-border adjustment mechanism (CBAM) are intertwined issues. The CBAM is closely connected to the ETS because it relies on the same principle of putting a price on carbon. The carbon price within the ETS serves as a reference for determin- ing the carbon cost of imported goods. By aligning the carbon price for domestic and imported products, the CBAM aims to create a level playing field for EU industries while incentivizing global partners to reduce their emissions. 151. The EU introduced the ETS (Emission Trading System) in 2005. An Emissions Trading System (ETS) is a market-based approach used to control greenhouse gas emissions. It sets a cap on the total amount of emissions allowed from certain sectors or industries. Under an ETS, emission allowances are created and distributed among participants, such as power plants or factories. These allowances represent the right to emit a specific amount of greenhouse gases. Participants can buy, sell, or trade these allowances among themselves. Over time, the cap on emissions is typically lowered, reducing the overall emissions from covered sectors. Initially, the ETS cov- ers electricity and heat generation, energy-intensive industry sectors, including oil refineries, steel works, and production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals, aviation within the European Economic Area and departing flights to Switzerland and the United Kingdom, and maritime transport. The ETS has been functioning well within the EU countries with carbon prices in the EUR80-90/tonne of CO2e in the last year. In gen- eral, ETS is viewed as a successful instrument judging from its impacts (i.e., reduced utilization of carbon-intensive fuels). 152. The timing of the implementation of the ETS in BiH is uncertain, whereas the EU CBAM will be implemented starting in 2026. As described in the sections above, given the heavy reliance of BiH’s energy sector on coal and its high share of CBAM-applicable goods exported to the EU, the introduction of the CBAM will have significant impacts on the BiH economy unless suitable energy policies are enacted. The introduction of an ETS in BiH requires a legal framework and at the same time regulating the area of climate change. The latter is defined at the entity level and BD. Meanwhile, while the specifics of the intermediate inputs, affected products, and the carbon prices are still subject to negotiations, it is a fair assumption that a more comprehensive CBAM beyond the initial sectors will be enforced by the EU in some form before 2030. 153. The analysis in this chapter focuses on the CBAM and the transition period, as many different options are being negotiated presently. There are no references 92 Energy transition in BiH to an ETS because it is not yet in place in BiH, but (as mentioned above) carbon prices under ETS and CBAM are expected to converge. In addition, ETS is the only source for historical carbon price data which can guide the analysis. III.3.2.  Legislative carbon pricing developments in BiH and the Western Balkans 154. Significant progress has been made in setting up the Monitoring, Reporting and Verification (MRV) frameworks for carbon pricing systems through national legislation and Energy Community proposals. In BiH, activities are underway to es- tablish a monitoring, reporting and verification framework for GHG emissions, where- as a legal framework has already been established in Albania, Montenegro, and Ser- bia. Currently, all Western Balkan countries report electricity production emissions and CO2 intensity through the Energy Community. In December 2022, the Ministerial Council of the Energy Community adopted the MRV regulation, and members will have until the end of 2023 to transpose the regulation (including the required institu- tional framework), with full implementation anticipated by 2026. 155. Recent carbon pricing roadmap proposals by the Energy Community Sec- retariat indicate the benefits of a coordinated approach. The Energy Community Secretariat prepared an options study in 2021 considering options for decarboniza- tion of power and district heating sectors by 2040. Considering the market size, the level of competition, the maturity of institutions, and the BiH of the economy overall in the Energy Community contracting parties, the study finds the most economically efficient scenario to be a fully integrated and interconnected power market coupled with a gradually introduced regional carbon market.78 This would address carbon leakage in the power sector, which would be an issue if countries moved forward alone or in an uncoordinated manner. It would also allow countries (even those with a high share of fossil fuel-based power) to import low-cost and carbon-free resources, invest in renewables, and leverage natural gas as a transition fuel. 156. Against the background of international energy commitments, sector re- forms and sustained momentum towards a clean energy transition also take on elevated importance. The deteriorating efficiency of TPPs as well as energy commit- ments will require the authorities in BiH to continue with the alignment of energy leg- islation with the EU acquis, carefully monitor compliance with its international climate commitments, and to accelerate the implementation of energy sector reforms at all levels towards greener energy production. III.3.3.  CBAM design and expectations 157. Electric power generation is a key sector for economic activity in BiH. The energy sector accounts for 6 percent of GDP and nearly one-third of BiH’s power gen- eration is exported.79 However, BiH’s carbon-intensive, coal-dominated energy sector 78 It is worthwhile mentioning that other approaches are currently under consideration, including the option of full convergence of WB6 carbon prices with EU prices by 2030. 79 Between 2015 – 2020 the average net exports were 3,562 GWh, while 2021 saw an increase of 11.4% in electricity exports, up to 6,173 GWh. https://www.derk.ba/DocumentsPDFs/BIH-SERC-Annual-Report-2021.pdf Energy transition in BiH 93 leaves it vulnerable to external shocks. The introduction of a domestic carbon tax, the upcoming CBAM, or the ETS platform and constraints on financing any new coal-fired power plants or rehabilitation/renovations of existing plants will adversely affect the viability of the sector and BiH’s energy landscape. To maintain its energy security and achieve alignment with the EU’s 2050 decarbonization goal, BiH will need to invest in lower carbon energy alternatives including utility‐scale hydropower, expand solar and wind power, and prioritize support for a Just Transition away from coal. That said, the transition needs to be based on a coherent and adaptive roadmap, which miti- gates the risks of ‘brown’ growth, protects those adversely impacted, and ensures an equitable distribution of the benefits of increased growth. Potential alternative ener- gy pathways and decarbonization options for BiH are analyzed further in Section III.4 158. The world is increasingly introducing carbon pricing instruments. Worldwide, 68 carbon pricing instruments are operating, covering approximately 23 percent of global emissions (World Bank 2022). Carbon pricing mechanisms comprise carbon or energy taxes: where prices are set, emission reductions or emission trading are the outcome; where the emission quantity is set, prices are the outcome of the market process.80 Many EU countries and several Canadian provinces have both systems in place, with carbon taxes at the country or province level and participation in a larg- er emission trading scheme. A new report (UNFCCC, 2022) by UN Climate Change shows that countries are “bending the curve” of global greenhouse gas (GHG) emis- sions downward, but efforts pledged are still not enough to limit global warming to 1.5 degree Celsius by the end of this century. 159. The European Union has decided to introduce a package called ‘Fit for 55’, with a key element representing the European emission trading system. The EU committed to reduce its net greenhouse gas emissions by at least 55 percent by 2030. The ‘Fit for 55’ package of legislation concerns all sectors of the member states’ economies and pursues a path to reach its climate targets in a fair, cost-effective and competitive way for the member states (European Commission, 2023). The EU emis- sion trading system (EU-ETS) is the carbon market for emission allowances for en- ergy-intensive industries and the power generation sector (Bruneau et al. 2023). This system will be tightened in several ways. The emission cap is tightened to 62 percent in 2030 compared to 2005 for power generation and energy intensive industries cur- rently participating in the ETS. New sectors will be included in the mechanism and the free allocation of allowances will be gradually phased out until 2034. Currently, allowances are given for free to sectors according to their presumed risk of carbon leakage. Meanwhile, sectors facing competition from industries outside the EU that are not subject to comparable climate legislation will receive more free allowances than those which are not at risk of carbon leakage (European Union, 2023). 160. To get buy-in from all member states, avoid carbon leakage and unfair com- petition, the EU will in parallel introduce an instrument that levels the price play- ing field for Europe’s carbon intensive industries. The EU energy-intensive industry has concerns regarding unfair competition with less committed regions to cutting emissions. To address this concern, the EU is working on price adjustments for im- ported carbon-intensive goods. Specifically, the EU adopted the European Climate 80 Another mechanism is carbon crediting, where tradable credits are generated through emission mitigation. These credits can be sold under different mechanisms, examples are the CDM mechanism of the Kyoto Protocol, or lately Article 6 of the Paris Agreement, creating international carbon markets. 94 Energy transition in BiH Law on 30 June 2021, with a set objective of climate neutrality by 2050 (Markkanen et al. 2021). In addition, a set of policy proposals, which are part of ‘Fit for 55’, outlines changes to existing targets for renewable energy, energy efficiency, revised fuel taxation, and reg- ulations on land use. Among new policy measures is also the Carbon Border Adjustment Mechanism (CBAM). This mechanism is expected to prevent carbon leakage as free al- lowances are phased out of the EU emission trading system (EU-ETS), with certificate prices anticipated to rise in parallel. In March 2022, the European Council had adopted its general approach to CBAM. 161. The operationalization of CBAM remains work in progress,81 with several propos- als considered. In the short term, CBAM is applied as a competitor equalization instru- ment for the aluminium, iron and steel, fertilizer, cement, and electricity sectors since they are covered by the EU ETS. Importers of products in these sectors originating from outside the EU must purchase and show proof of CBAM certificates covering embedded emis- sions in their imports for the previous year. Thus, the GHG emissions of imports are valued at the same price as direct carbon emissions under EU ETS. The price of the certificates will be linked to the weekly average price of all ETS allowances sold in the auction market (which the European Commission would calculate and publish the following Monday), making the mechanisms reasonably responsive to any sudden changes in the ETS price (Markkanen et al. 2021). 162. The CBAM will be introduced gradually, providing an adjustment period for ex- porters to the EU. Specifically, CBAM will be phased in at the same speed that the free allowances in the ETS will be phased out. To create level playing fields, energy intensive goods imported from outside of the EU need to have the same price increase as energy intensive production is facing in the EU from having to pay for increasing shares of allow- ances that were free before. If allowances are traded in the market in full (100 percent in Table 3), the price for the respective imports will raise by the same amount as certificates are traded for. Basically, CBAM is trying to simulate participation of non-member states in the EU-ETS with a price adjustment at the border. The gradual application of CBAM will therefore start in 2026 and be fully in effect by 2034. To make the mechanism fair, carbon prices paid by producers outside the EU (ETS or taxes, which might be higher than the re- sulting prices in the EU) as well as permits at zero price from grandfathering in the EU will be acknowledged. The methodology for such calculations, however, is still undetermined. Table 3.  Phasing out of free allowances in the EU ETS 2026 2027 2028 2029 2030 2031 2032 2033 2034 Phasing 2.5 5 10 22.5 48.5 61 73.5 86 100 out of EU ETS 163. Five sectors with the highest emissions (aluminium, steel, and iron, cement, and fertilizers) are included in the current CBAM proposal. This leaves another 58 sectors as identified by the EU for further regulation. Moreover, the current proposal covers di- rect emissions only, leaving out emissions embedded in inputs used for producing export goods. This area will be addressed through possible extensions of the CBAM regulation. 81 Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL Establishing a Carbon Bor- der Adjustment Mechanism 2021 Energy transition in BiH 95 164. Importers are responsible for the declaration of the direct emissions related to the imported good. If no measured value can be reported, default values apply. For aluminium, steel, and iron, cement and fertilizers, the proposal sets the default value at the level of the most polluting 10 percent of EU production. For electricity, the reference value for embedded emissions will most likely be determined either by the average GHG emission intensity of the EU electricity mix or the average GHG emission factor of the EU electricity mix (Markkanen et al. 2021). Countries partic- ipating in the EU ETS on a voluntary basis, or those that have a linked system, are exempt from CBAM. Furthermore, it is possible to have electricity imports in the EU exempted, if the contracting party’s electricity market is coupled with the EU inter- nal electricity market, and meets certain conditions related to climate and energy. The currently proposed practical implementation of the EU CBAM on EU importers is illustrated in Figure 40. Once the regulation comes into place, adjustments and amendments can be expected. Figure 40. Suggested implementation of an EU CBAM If all certificates are not used, some excess Deduct any certificates can carbon price a be sold back to producer has the European already paid Commission or Surrender the in their home kept for use the CBAM jurisdiction for following year. certificates the production Declare the corresponding of the imported quantity of to amount of goods, and an goods and the GHG in the amount reflecting Register embedded imports. the free carbon with national emissions in allowances authorities to those goods for received by buy CBAM the preceeding EU producers certificates. year, by 31 (specific May each year. methodology for If the actual this is yet to be emissions decided). cannot be verified, default values will apply. Source: European Commission (2021) Proposal for a regulation of the European Parliament and of the Council establishing a carbon border adjustment mechanism (COM/2021/564 final), https://eur-lex.europa.eu/legalcontent/ en/TXT/?uri=CELEX:52021PC0564 165. The EU has been exploring six implementation and design options of the CBAM. The objective is to assesses CBAM’s effectiveness in addressing the risk of carbon leakage and incentivizing third-country producers to move towards cleaner 96 Energy transition in BiH production processes. The first option is an import carbon tax, paid by the importer and collected at customs. The rate reflects the carbon content of the imported good. If countries produced goods in a less emitting way, they could reclaim parts of the tax payment. Option 2 mimics the participation of the origin countries in the EU ETS, by issuing certificates, which would need to be bought and surrendered when crossing the border, without actual participation or integration in the EU ETS. In this option, de- fault carbon content values are taken as the calculation base. Option 3 replaces the default content with actual country and industry-specific measured values. Finally, Option 4 assess the phasing in and implementation phases of 10 years, Option 5 with integrating value chain emissions, and Option 6 levies an excise duty on carbon-in- tensive materials. All options are similarly effective in attaining the goal of addressing incentives for carbon leakage and incentivizing countries to move towards cleaner production. The overall impacts on employment are found to be limited. Compliance costs, acceptance, and implementation costs seem to suggest that Option 4 is the least cost and thus by the EU preferred design. 166. The economic implications of introducing CBAM are sector-specific and em- ployment effects are likely to differ from output effects. For instance, a model- ling exercise with Cambridge Econometrics’ E3ME macroeconomic model scenario simulations shows small positive GDP effects in the EU, with labour outcomes de- pending on the revenue recycling scheme in the EU, and carbon-intensive sectors suffering among trading partners.82 The transmission channels of these effects are shown in Figure 41. CBAM costs exert upward pressure on EU import prices, resulting in a decline in imports from non-EU trading partners, and a rise in EU domestic pro- duction. This triggers investment within the EU, and, thus, together with less imports and higher output is estimated to have a positive impact on the EU economy. On the emission side, additional production within the EU increases emissions, yet these emissions are generated with less carbon-intensive technologies than before. The decline in production in non-EU trading partners due to smaller export demand by the EU should reduce carbon-intensive production unless the directionality of trade changes and new markets are penetrated by these firms. The overall assessment is, however, that overall emission will be reduced following the introduction of CBAM, which will be the desired outcome. 167. Employment effects are likely to be positive in the EU and negative or neutral outside the EU. The employment net effect outside the EU will depend on the re- spective economic structure and diversification, as well as the importance of the EU as a trade partner. The economic, sectoral and employment effect also depend on the use of revenues generated from the CBAM. Imposing a CBAM cement, fertilizers, iron and steel, aluminium, and electricity imports, and using revenues from CBAM in the EU to reduce VAT or income tax rates83 yields a small employment increase (0.3 percent) over the reference scenario in the EU. Outside the EU, the scenario re- sults in little overall change in employment. In the EU, retail, services, construction (and supporting sectors), as well as directly impacted sectors (non-metallic mineral products and basic metals) see increases in employment because the EU replaces imports with domestic production. Electricity exports to EU members will be reduced if exporters do not participate in the EU electricity market or have certificate regimes like the EU ETS. 82 Markkanen et al. 2021; Markkanen and Anger-Kraavi 2019 83 Markkanen et al. 2021 Energy transition in BiH 97 Figure 41. Envisaged CBAM impact within and outside the EU GDP within EU increases +0.4% CBAM cost Investment within EU increases +0.9% Import price increase Imports decrease Production towards EU members from outside EU within EU increases +6.5% -2.2% +1.1% Exports to EU Higher within EU decrease emission levels (lower intensity) +2.1 Mt Lower production Lower emission outside of EU levels globally 0% -9.9 Mt Lower GDP Lower emission levels outside of EU (emitters) (higher intensity) 0% -12.0 Mt Increase EU Outside EU Global Decrease Source: Markkanen et al. 2021 168. Similar simulation results and conclusions have been arrived at by other authors. Titievskaia and Morgado (2022) give an overview, while Kuusi et al. (2021) find CBAM, if designed realistically, would have a limited impact on GDP and on emissions. Fragkos, Fragkiadakis, and Paroussos (2021) find that the CBAM can also effectively reduce leakage but warned that legal and administrative obstacles may reduce its efficiency gains. Over- land and Sabyrbekov (2022) develop a multidimensional CBAM Opposition Index based on the trade with the EU, carbon intensity, litigiousness in the World Trade Organization (WTO), domestic public opinion on climate change, and capacity for innovation. For the trade dimension, the share of CBAM-applicable goods in their total exports to the EU is analyzed. Countries with the five largest shares are the United Arab Emirates (14 percent), Ukraine (14 percent), Belarus (13 percent), Bosnia and Herzegovina (12 percent), and Iran (12 percent). BiH is also among the countries with the highest carbon intensity, measured in kg carbon per USD GDP, with a range of between 0.11 and 1.65 kg per USD of GDP. BiH is also the fourth most carbon-intensive economy among the EU’s 50 main trading part- ners in 2019. Escaping carbon lock-in84 is most challenging for energy-intensive sectors, like in BiH, where the production technology has long lifespans. Exposure stems from low diversification of exports, and general export dependence of a country, while vulnerability reflects the country’s (in)ability to adapt. The distribution of risk varies globally, with coun- 84 Gallagher et al. 2021 98 Energy transition in BiH tries exporting manufactured goods or services being not as heavily affected as countries exporting steel, cement, aluminium, the three sectors analyzed under scenario 1. 169. BiH exhibits a high-risk pattern of high emission intensities and low trade diversification (Figure 42). The carbon footprint is almost twice the EU average. As of 2020, 72 percent of the country’s exports go to the EU, making up 26 percent of its GDP.85 The sectors targeted by the CBAM are among the main exporting sectors such as machinery and metals, including iron, steel, and aluminium. Exports of the latter contribute over 5 percent to the country’s GDP. BiH is closely linked to the EU and as an accession candidate is unlikely to substitute the EU as a trading partner. This sug- gests that decarbonization is the best way for BiH to increase its resilience. Figure 42. Global map with quintiles of country relative risk levels for an EU CBAM on selected sectors Source: Eicke et al. 2021 170. CBAM simulations show a wide range of possible impacts across Western Balkan countries, with one of the largest seen in BiH. Recent modeling for Serbia conducted by the World Bank86 shows only a minor negative impact on GDP totaling -0.2 percent change compared to business as usual by 2035. Meanwhile, a study un- dertaken by Magacho et al. (2022)87 shows a negative impact of 4 percent for Serbia, and up to 3.7 percent in BiH, with a smaller negative impact in North Macedonia of 2.6 percent, and Montenegro (1.8 percent). 85 Eicke et al. 2021 86 World Bank 2022c. A decrease in total exports to the EU, and domestic production of selected products in re- sponse to the CBAM would be widely offset by decreases in imports of intermediate and final goods, as well as reallocation of labor and capital to increase production of other sectors including downstream products. 87 Magacho, G., Espagne, E., and Godin, A. (2022) Impacts of CBAM on EU trade partners: consequences for devel- oping countries, Agence Francaise de Development, Research Papers, Issue 238, pp. 1-20 Energy transition in BiH 99 III.3.4.  Simulation of more granular effects of the EU CBAM on output and jobs in BiH 171. Under a business-as-usual scenario,88 the introduction of CBAM would reduce BiH’s output by roughly 1 percent in 2034. The business-as-usual scenario should be treated as the worst-case scenario as it assumes the same generation mix, and the ab- sence of a carbon tax introduction. This differs from the Cost Benefit Analysis outlined in Section III.6 of this Chapter, which aims to illustrate the advantages of implementing specific changes, such as a carbon pricing mechanism using a phased approach, starting at 6.6 Eu/ton in 2025 and gradually increasing to 80 Eu/ton by 2050. The simulations in this section are based on the World Bank’s Multi-Regional Input-Output (MRIO) MINDSET model (Box 2) and assess the impact at the time of the full termination of free allowances in 2034. This scenario covers coal, natural gas, and all oil products used in power gener- ation, fertilizer production, iron, and steel production as well as the cement industry. The outcome in terms of output losses and declines in employment for the BiH economy are hence solely attributable to the effects from CBAM, with all other things held equal across scenarios. In other words, under this scenario BiH is assumed to have maintained its ener- gy mix, has not embarked on coal mine reforms, and thus has not changed its input struc- ture with respect to the CBAM sectors or introduced an ETS. This is intentionally done so to simulate a worst-case scenario, whereas marginal changes in the energy mix will result in positive deviations from the presented estimates. 172. BiH loses exports to EU members in the following sectors: cement, iron and steel, aluminum, fertilizers, and electricity. The effects on the BiH economy come directly from lost exports, and indirectly through domestically lost business from purchases of intermediate goods, and services for their respective production. For example, if utilities can sell less electricity to EU members and do not find alternative markets, they will need less coal for electricity production. Coal mining in turn will need less machinery products, business services and other goods along the value chain. The model used for these sim- ulations captures such indirect effects along the respective value chains. Box 2.  Multi-Regional Input-Output MINDSET Model Developed by a multi-sectoral team of World Bank experts, the MRIO MINDSET model combines the strengths of Input-Output (IO) analysis – namely, short- to medium-term economic responses to exogenous demand changes, accounting for all multiplier effects from intermediate demand along the value chains in a consistent framework – with responses to exogenous price changes. It uses price-endogenous technology to simulate different demand shock scenarios related to climate-related policy action taken at the country and global levels. The MINDSET model connects all 140 countries in the dataset to each other through bilateral trade flows, thereby capturing trade effects from intermediate and final demand changes in one country on its trading partners. Combining it with the Leontief price model allows for changes in the intermediate and final demands as a reaction to exogenous price changes. The core elements of the model are the interindustry relations given by intermediate use at basic prices by economic sector and final demand vectors by country connected by respective bilateral trade. The model does not capture labor flows into or out of the labor force or unemployment. 88 The business-as-usual scenario assumes should be treated as the worst-case scenario as it assumes the same generation mix. 100 Energy transition in BiH 173. The overall effect on BiH in terms of relative output loss is estimated in 2034 at around 1 percent, although sector-specific results show a more granular story of winners and losers in the economy. Sectors producing goods subject to CBAM see output losses of up to 15 percent, while employment in some sectors declines by up to 10 percent, in an already difficult employment environment. The concomitant decline in labor demand reflects the labor intensity of the respective sector. In BiH, the sectors subject to CBAM price increases are typically sectors with high capital and energy intensity, and lower labor intensities. 174. Electricity exports, the number one export good in 2022, suffers the most, due to loss of trade with EU members (Figure 43). According to the simulations, the largest relative losses take place in electricity exports, leading to output losses of this sector on the order of 15 percent.89 In absolute terms, the next largest negative impacts of CBAM due to trade substitution occur in the basic metal industries. Figure 43 shows the direct trade effect as a light blue bar and negative effects from lower investment by the respective sectors suffering losses as a dark blue bar. For instance, the electricity sector, as it is suffering large losses, will reduce its investment in new power plants, or additions to existing ones, and even maintenance might be reduced over time, leading to negative impacts in the wholesale and retail sector, and wider other manufacturing sector. Considering that most produced electricity is generated from lignite or brown coal, output of the mining sector will be adversely affected by the decline in electricity generation. The mining sector output would decline, accord- ing to the simulations, around 9 percent. Other spill-over effects include an impact on transport, and wholesale/resale trade or services, although the losses are small in comparison. Figure 43. Driver Induced Invest. Change in sectoral output Trade subst. in 2034 Relative change EU-CBAM scenario. ISIC Rev. 4 at 1-digit level 0 0 Gross Output (in MM USD) Output Effect (in %) -50 -5 -10 -100 -15 Other Agriculture, forestry Electricity Education social work Accommodation and food service activities Activities of extra- territorial organisations Activities of households as employers Administration and support service and fishing Aluminum manufacturing Arts, entertainment and recreation Coal mining Construction and gas Financial and insurance activities Health and Information and communication Other mining and quarrying Other Service manufacturing Professional, scientific and technical activities Public administration and defence Real estate activities Steel manufacturing Transportation and storage Water supply and waste management Wholesale and retail trade Gross output in Bosnia and Herzegovina changes by -0.79% Source: WB staff calculations using MINDSET 89 This is represented by the black dot in Figure 43 Energy transition in BiH 101 175. In manufacturing, all energy-intensive sectors are impacted adversely, with steel recording the largest output decline (Figure 44). In the steel industry, 6 per- cent of jobs are estimated to be lost. Along the manufacturing value chain, the CBAM impact will be felt in transport, wholesale and retail, as well as construction, business services and real estate. The structure of intermediate demand for the steel sector, apart from iron ore, is shown in Figure 44. Some services only contribute small shares to intermediate production, but transport, retail and wholesale trade, the electricity sector, and the metal industry itself provide relevant inputs and will feel the losses in production in the steel sector. The mining sector is expected to experience the loss of demand for iron ore from the negative impacts on the steel sector. The same holds true for the production of aluminium, losing close to 5 percent of its output and per- petuating the effect along the value chain. 176. The results do not include induced effects from loss of incomes due to loss of jobs. Job losses of 3-6 percent in some sectors lead to income losses of the same or higher proportions in the respective region. Typically, jobs in the above-mentioned industries are better paid, hence the income reduction in the respective community will be disproportionately higher. Losses in household consumption will under such circumstances spread through the economy, ranging from food to housing, as well as non-durable and durable consumption good. Figure 44. Intermediate demand in the steel sector Private Households Education, Health and Other Services Public Administration Financial Intermediation and Business Activities Post and Telecommunications Transport Hotels and Restraurants Retail Trade Wholesale Trade Maintenance and Repair Construction Electricity, Gas and Water Recycling Other Manufacturing Transport Equipment Electrical and Machinery Metal Products Petroleum, Chemical and Non-Metallic Mineral Products Wood and Paper Textiles and Wearing Apparel Food & Beverages Fishing Agriculture 0% 5% 10% 15% 20% 25% 30% 35% 40% Source: WB staff calculations using MINDSET 102 Energy transition in BiH 177. Total employment losses are estimated on the order of 0.5 percent, but con- centrated in some sectors and, hence, with a larger micro impact in municipali- ties. Figure 45 details the drivers of the effects, i.e., some stem from the loss of trade directly, such as loss of exports of electricity, leading to losses in sales from lignite and brown coal mining. But the energy intensive sectors losing export opportunities and hence decreasing their output will adversely impact investment, which leads to a spill-over effects into other sectors, such as construction, or wholesale and retail trade. 178. Employment in several sectors is particularly hard hit (Figure 45). For instance, around 10 percent of jobs in the electricity sectors will be lost. Employment losses in coal mining match the electricity sector’s employment loss. Basic aluminium pro- duction sheds 7.5 percent of employment, and demands less inputs from the mining sectors, i.e., aluminium ore losing 5.5 percent of jobs. Steel trade is less price elastic than aluminium, hence output reductions are not as large. Still, in terms of jobs, the steel sector is estimated to see a reduction in labor demand by five percent. Along the value chain, iron ore mining loses more than three percent of jobs. Fertilizer and chemical minerals see a reduction of 4.5 percent. Cement, lime, and plaster products are not traded as heavily with Europe and hence the reduction in labor demand in this sector is milder, and job losses total around 1.6 percent. Interestingly, the resulting negative spill-over effect on the service industry, in particular, wholesale and retail trade is also impacted by an estimated reduction in investment (dark blue column in Figure 45), as demand for these services declines. Figure 45. Difference in labor demand by driver Private Households Education, Health and Other Services Public Administration Financial Intermediation and Business Activities Post and Telecommunications Transport Hotels and Restraurants Retail Trade Wholesale Trade Maintenance and Repair Construction Electricity, Gas and Water Recycling Other Manufacturing Transport Equipment Electrical and Machinery Metal Products Petroleum, Chemical and Non-Metallic Mineral Products Wood and Paper Textiles and Wearing Apparel Food & Beverages Fishing Agriculture 0% 5% 10% 15% 20% 25% 30% 35% 40% Source: WB staff calculations using MINDSET Energy transition in BiH 103 179. The implementation of the CBAM is, therefore, likely to increase the cost of emissions-intensive generation, which can encourage a shift away from coal. However, additional policies are necessary to promote the adoption of renewable energy sources in the Western Balkan region. Carbon pricing alone is not effective if low-carbon substitutes are not available or affordable. Moreover, a carbon price is likely to have limited effects without the necessary conditions for cost pass-through and economic dispatch. The Western Balkan region faces challenges such as artifi- cially low electricity prices (below production cost), monopolistic markets, and limited competition across suppliers. This consequently deters private investment in cleaner electricity generation capacity and maintenance. These challenges make it difficult to create a level playing field for renewables, especially wind and solar technologies. 180. To effectively transition to a greener and more resilient economy, carbon pricing should replace fossil fuel subsidies, below-cost electricity tariffs, and oth- er counteracting pricing instruments. Since BiH will be hit by CBAM either way, it would be better to capture the revenues domestically through an ETS or carbon tax rather than losing out to the CBAM. Different types of carbon revenue use could be evaluated, and additional policies to support energy-vulnerable consumers should be developed. The transition to a greener economy is not just a sectoral issue but also a community issue, particularly in regions where certain industries, such as coal and ferrous metals, are concentrated. III.4.  Possible pathways of changes in energy generation and mining assets 181. The Alternative Energy Transition Pathway emphasises the gradual phase- down of coal to 2050, and the subsequent utilisation of other energy sources. It revolves around the use of Renewable Energy Sources (RES), the development of en- ergy storage systems and the repurposing of existing coal-fired power plants. Due to falling costs of clean energy technologies and concomitant rising costs of carbon-in- tensive energy generation, BiH would benefit from exploring the potential of alter- native energy sources and energy storage, alongside possibly new hydro to support grid integration of variable renewable energy (VRE). The region’s natural and physical assets for alternative energy and energy storage include the well-developed trans- mission network, abundant post-mining lands, water bodies, and a workforce with energy-related skills and social identity. 182. There are several main challenges, as well as potential positive impacts, as- sociated with the planned changes in energy generation, particularly around the retirement of the existing coal plants. Firstly, one of the main challenges is to ensure adequate firm capacity and ancillary services, so the power system can operate re- liably and efficiently while meeting the ever-changing demand for electricity. In this regard, variable renewables provide energy in BiH, but with limited firm capacity and ancillary services, while the renewable market has not yet fully developed. Secondly, as described above, another primary challenge will be managing the social and eco- nomic impacts from affected jobs associated with retirement of the coal plants and closure of mines. And finally, attracting the investment required for new power plants (renewables and others to replace the retiring coal plants) and the power network 104 Energy transition in BiH (balancing services, transmission, and distribution). For BiH, under current conditions, the solar and wind power markets may be somewhat attractive to potential investors, while hydropower investments may be more challenging. Hydropower plants and energy storage would need regulatory and power market design changes or policy initiatives to secure revenues from providing firm capacity and ancillary services. 183. Decarbonization options for BiH could be divided into two complementary groups:  Options associated with re-purposing of the power plant and the mining facilities90 (described further below);  and power system options which can be de- ployed anywhere in the power system and are needed to satisfy the ever-chang- ing demand. Such options include new power plants (wind; solar; hydro; natural gas; biomass), batteries and regional trade. That said, coal-fired power plants are unlikely to be competitive after 2035, at which point carbon prices are projected to reach EUR40/tonne of CO291. III.4.1.  Alternative Energy Technologies for Repurposing Existing TPPs and Coal Mines 184. Based on analysis conducted by the World Bank, there are three key re-pur- posing options relevant for BiH. The first is fuel switching, where existing coal plants may be converted to burn natural gas or biomass. This conversion could be for full replacement of the coal or partial replacement (cofiring). If the power plants switch to biomass, an opportunity may develop to use reclaimed mining lands to produce such biomass (“energy crops”).  A second option is (re)using plant and mining facilities (including land) to install renewable power generation plants – mostly solar PV but wind and/or biomass also have potential. The third option is the use of the genera- tors of existing coal plants as synchronous condensers (SYNCON) for voltage control. Adding batteries at the coal plant assets is a complementary option. Fuel Switching Options for Existing Coal Plants: natural gas and biomass 185. Conversion of coal plants to natural gas is technically feasible, but the op- timum set of interventions would need to be determined through a unit-specific analysis considering the trade-offs. World Bank analysis, however, indicates that considering the operating conditions and low efficiency of the existing plants in BiH, as well as the high natural gas price, conversion options related to natural gas are likely to be non-competitive. 186. Switching to biomass cofiring (where biomass such as waste wood or agri- cultural by-products92 replaces part of the coal) may have potential for certain coal power plants. In general, biomass holds great potential in BiH; up to 15-20 per- cent of its energy needs could be satisfied utilizing forestry wastes, as well as agricul- tural residues, solid wastes, and energy crops (including in abandoned mining areas). However, several issues need to be addressed to realize this potential. As a first step, a biomass cofiring demonstration is recommended. 90 The re-purposing options in this section are energy-related. In addition, there are other non-energy related op- tions such as using the land for commercial and industrial facilities, agriculture, training centers, etc. 91 These CO2 prices are taken from the 2021 regional study developed by Energy Community Secretariat. https:/ / www.energy-community.org/news/Energy-Community-News/2021/01/20.html Some recent suggestion, though, indicate that the CO2 prices in WB6 could converge with the EU ETS prices by 2030. For most of 2023, EU ETS have been traded at a price of more than EUR 80/tonne (https:/ /www.statista.com/statistics/1322214/ carbon-prices-european-union-emission-trading-scheme) 92 For more detail on biomass availability across BiH, see: http://atlasbm.bhas.gov.ba/ Energy transition in BiH 105 187. Potential biomass cofiring has been studied in BiH and two power plants (Tuzla and Kakanj) were identified as suitable candidates for this option. If the biomass fuel represents less than approximately 15 percent of the heat input, bio- mass could be introduced in the boiler blended with the coal and would not require substantial modifications of the fuel handling and feed system, meaning that the re- quired investment (in modifying the fuel feed system and boiler) is minimal. EPBiH has already studied the possibility of cofiring at Tuzla and Kakanj and could proceed with the implementation on one of these two sites. Such a project will be value in finding ways to overcome issues throughout the biomass supply chain and securing the biomass supply agreements, which are necessary for larger biomass projects. Assuming that a reliable supply of biomass is secured for such a project, and subject to further economic analysis, biomass may present a viable option for reducing the carbon footprint of coal power plants. Renewables on existing coal plants and mining lands 188. Repurposing of an existing coal plant may involve the addition of renew- ables. Wind may be another option depending on the available wind resources at the specific site (power plants or mines). However, the most common option is solar PV which can be installed at existing structures of the plant, land adjacent to the power plant, repurposed mining lands or water ponds (i.e. – floating PV). In 2020, EPBiH car- ried out a pre-feasibility study93, which estimated that around 300 MW of PV could be installed at the five power plants and associated mines. Synchronous condensers (SYNCON) and batteries 189. The generators of the existing coal plants could be converted into SYNCON to support the operation of the power system, especially on voltage control. Gen- erators have been used as SYNCONs in numerous applications. However, determi- nation of the need for such services and the suitability of the specific generators requires site-specific evaluations. First, it needs to be determined whether the pow- er system needs additional balancing services over the planning period (next 20-30 years). Second, the operating condition of the specific generators needs to be as- sessed, as well as their cost-effectiveness to be converted to SYNCONs. The latter needs to be compared to the option of adding new SYNCONs. Finally, it should be noted that the market, in its present structure, does not provide compensation for such services and would need to be revised. 190. In summary, the following options are feasible for repurposing the existing power plants and mines of BiH: biomass cofiring and conversion to 100 percent bio- mass; addition of renewable energy installations (in most cases solar PV) at the plant site; and conversion of existing generators to SYNCONs. It is also feasible to add bat- teries which will utilize the existing transmission infrastructure. The competitiveness of these options is outlined in the following section (Least Cost Planning analysis), which takes into consideration the needs of the whole power system. 93 Analysis of Potentials for Photovoltaic Systems Development on Available Areas of EPBiH Mines and TPPs’ Slag and Ash Dumpsites, August 2020 – referenced in BiH Roadmap ibid. 106 Energy transition in BiH III.4.2.  Alternatives for the long-term decarbonization of BiH’s power sector 191. In 2022, the World Bank carried out a Least Cost Planning (LCP) study to de- termine the optimum power generation mix for BiH over the period 2023-2050. The LCP study utilizes the World Bank’s Electricity Planning Model (EPM) tool and evaluated three main scenarios, as shown in Table 4 below: Table 4.  Least Cost Planning Scenarios Scenarios Key features 1. Baseline 0.75 percent growth of electricity demand per year 2. Decarbonization Similar to the Baseline scenario and added more stringent targets of CO2 emissions. 3. Energy Security Similar to the Decarbonization scenario and added secured reliance on domestic energy sources while continuing BiH’s trade with neighboring countries. 192. For all three scenarios, the electricity demand forecasts provided by the BiH power system operator (NOSBiH) was used. The demand forecast reflects many important and is based on input provided by the three public utilities (ERS, EPBiH and EPHZHB), the main electricity suppliers in the country. BiH is the most energy-in- tensive nation out of the 30 countries in Europe94, with energy inefficiencies perme- ating the entire energy chain (production; transformation; transportation; and con- sumption). Hence, energy efficiency measures have very high potential and should therefore be considered as a government priority. For example, buildings represent 58 percent of total energy consumption and have the potential to result in annual savings of about 18 TWh. However, a total of around US$16-19 billion investment is required and other obstacles need to be overcome (e.g., inability of households to borrow) for this potential to materialize. 193. The baseline scenario was developed based on inputs from relevant BiH government agencies and is built on several key assumptions. These assumptions include95: (1) decommissioning of thermal power plants will follow current plans,96 (2) one new 450 MW new coal plant will come online in 2025, (3) two power plants are assumed to be converted to allow 10 percent biomass co-firing, and (4) additional two power plants will be converted to 100 percent biomass. As a result, the Baseline scenario encompasses a total of newly installed capacity of 5,028 MW. This scenar- io contains a substantial amount of new wind and solar power generating capacity (3,209 MW combined) plus additional hydro (772 MW of run-of-river hydro, 212 MW of hydros with storage capacity, and 66 MW of pumped hydro (Table 5). 194. The decarbonization and energy security scenarios are differentiated from the baseline in several major aspects. Both scenarios exclude the investment into Coal Tuzla 7. Apart from doubling the PV capacity, the decarbonization scenario does not compensate fully for the new thermal plant. This means that the total capacity 94 Countries: BEL, BGR, CZE, DNK, DEU, EST, IRL GRC, ESP, FRA, HRV, ITA, CYP, LVA, LTU, HUN, MLT, NLD, AUT, POL, PRT, ROU, SVN, SVK, BIH, MNE, MKD, ALB, SRB, TUR. 95 It should be noted that the analysis carried out focused on power generation and did not include the transmis- sion and distribution networks. A comprehensive assessment of the power grid is needed and should include both the high voltage transmission and low voltage distribution systems. 96 See Table 2 on page 74 for the list of coal plants operating in BiH. Energy transition in BiH 107 under the decarbonization scenario is 372 MW smaller in comparison to the base- line. The energy security scenario fully compensates for the missing thermal plant through installing significant capacity in PV and hydro. As a result, the total capacity under the energy security scenario exceeds the baseline capacity by 1,134 MW. Table 5.  Capacity additions -- breakdown per technology (in MW) Baseline Decarbonization Energy Security Coal Tuzla 7 450 - - 100% biomass 146 146 146 conversion Hydro ROR 772 772 772 Hydro storage 212 376 1,008 Wind 3,177 3,138 2,391 PV 32 63 1,779 Battery 173 96 0 Pumped-storage 66 66 66 hydro TOTAL capacity 5,028 4,656 6,162 Notes:  New hydropower plants considered under the scenarios are all larger than 10MW. 195. The three scenarios reflect the most likely electricity demand trajectories in BiH, and their outputs specify the optimum power generation mix that would satisfy this demand. As forecasts are by nature uncertain, evaluating alternatives scenarios helps narrow down the required outputs. Generation options which are se- lected by all, or multiple, scenarios should be considered robust, as they are part of the optimum solution despite the differences among the scenarios. To note, all sce- narios assumed that carbon prices will increase as follows: EUR6.6/tonne of CO2 in 2025, EUR16/tonne of CO2 in 2030, EUR40/tonne of CO2 in 2035 and EUR80/tonne of CO2 by 2040. These CO2 prices are taken from the regional study developed by Energy Community Secretariat. Throughout most of 2023., the price of CO2 in the EU exceeded EUR80/tonne. 196. Based on estimates from the LCP study, the decarbonization option makes economic sense (Table 6). The Baseline scenario has the highest costs at USD 4.78 billion (row 12), making it the most expensive scenario of all, while the decarboniza- tion scenario has the lowest NPV97 of costs at USD 4.24 billion. In terms of absolute, undiscounted investments (row 14), the additional cost of energy security over the study horizon amounts to USD 1.6 billion (compared to the decarbonization scenario). This translates into the additional cost of USD 358 million in terms of NPV of costs over the study horizon. Capital expenditures at the country level required to meet the demand in BiH by 2050 range from an estimated USD 5.87 billion in decarbonization to USD 7.51 billion in the energy security scenario (row 4). To assess the feasibility and a realistic trajectory of public debt, a more granular representation across entities would be required in terms of private and public investment (see Section III.8.2.). 97 NPV – net present value 108 Energy transition in BiH Table 6.  Main results of the analyzed scenarios Baseline Decarbonization Energy Security 1 Total generation (GWh) 563,582 516,017 537,895 2 Total demand/consumption (GWh) 410,631 410,631 410,631 3 Total capacity added (MW) 5,028 4,656 6,162 4 Total investment (USD million) 6,557 5,867 7,509 5 Fixed O&M costs (USD million) 4,198 3,558 4,481 6 Variable O&M costs (USD million) 1,506 1,458 1,566 7 Total fuel costs (USD million) 3,793 2,797 3,360 8 VRE curtailment (USD million) 317 161 305 9 Carbon costs (USD million) 2,050 1,111 1,847 10 Import costs (USD million) 2,540 3,690 2,299 11 Export revenue (USD million) 13,315 11,682 12,808 12 NPV of system cost (USD million) 4,776 4,237 4,595 13 Total net costs (USD million) 25,995 22,371 25,017 14 Total net nominal costs (USD 12,679 10,688 12,209 million) 15 Total emissions (million tonnes) 116 86 106 Source:World Bank, BiH Generation Expansion Planning Study for 2030-2050 (NECP scenarios) 197. For all scenarios, CO2 emissions decline faster than the stated targets of BiH (e.g., net-zero achieved by 2040 instead of 2050), driven mainly by carbon prices (Figure 46). Note that this reflects the technical potential to achieve net-zero. How- ever, more detailed assessments would be needed such as, for example, balancing requirements and power grid strengthening, as well as assessments of the ability to finance decarbonization efforts. The resulting CO2 emissions from the power sector based on the three scenarios are depicted in Figure 46 below. Figure 46. CO2 emissions in all scenarios 14.0 Baseline Energy Security & Baseline Demand 12.0 Decarbonization & Baseline Demand 10.0 8.0 6.0 4.0 2.0 0.0 2023 2024 2025 2026 2027 2028 2029 2030 2031 2035 2040 2045 2050 Source: World Bank, BiH Generation Expansion Planning Study for 2030-2050 (NECP scenarios) Energy transition in BiH 109 III.4.3.  Key Findings and Implications for Power Sector Decarbonization in BiH 199. Results of the LCP study indicate that BiH can decarbonize its power sector by 2050. This could be achieved by replacing coal-fired assets with clean renew- able energy technologies, retaining energy independence by meeting its internal demand, while remaining the leading electricity exporter in the region at the same time. If pursued, this approach would enable the country to meet its international commitments as well. 200. Transitioning to clean energy sources also makes economic sense for BiH. This is especially true considering the age of existing coal-fired assets, loss-making coal mines, substantial decline of renewable costs, and the introduction of carbon pricing through the EU ETS and/or the CBAM as described in Section III.3. Further strengthening the business case is the fact that carbon prices in the region are ex- pected to be significantly higher than the assumption used in the LCP analysis. Final- ly, as described further below, BiH’s long-term energy mix can make strategic use of the country’s natural resources (hydropower, wind, solar and potentially biomass), with limited need for additional storage solutions in the form of batteries – at least in the near future. 201. LCP results indicate that new coal and natural gas power plants are not competitive, especially after carbon prices reach EUR40/tonne, which is expect- ed to occur in the mid-2030s, if not earlier. Increasing carbon prices have a similar effect on the existing coal plants which become less and less competitive after the mid-2030s. As the coal plants retire, they need to be replaced by a combination of hydropower (run-of-river, storage, and pumped-storage), wind, solar and, possibly, biomass. In many cases, the existing coal plants could be repurposed with options such as solar PV, batteries, and synchronous condensers, providing firm capacity and ancillary services. This will help maintain the role of the power plant sites, utilize some of the existing assets (e.g., transmission, buildings, and generator) and continue pro- viding employment to some of the power plant workers. 202. Hydropower is shown to be a significant strategic option for BiH. The alter- native power generation pathways identify a substantial need for new hydropower generation capacities (1,050-1,846 MW of capacity, depending on the scenario, in- cluding 66 MW of pumped storage). Both wind and solar PV were also selected. Wind estimations ranged from 2,390-3,180 MW and solar PV up to 1,780 MW. Site-specific considerations are expected to have an impact on the final capacity of wind and solar which would be competitive to be added. 203. Biomass is an option to be considered in BiH, but its competitiveness needs further assessment. Present supply of biomass is not adequate for converting some of the coal-fired plants, but there is potential for growing energy crops, especially in abandoned coal mines. The key uncertainties relate to the amount of biomass which can be produced over a period of time and its cost, eventually affecting its price, too. However, as carbon prices increase, it is expected that biomass will become com- petitive especially considering that it can provide firm capacity and ancillary services. Furthermore, municipal solid waste should be considered for energy generation (heat and potentially electricity production). While it is not expected to be a substantial part 110 Energy transition in BiH of the power generation mix, it is an important option because it addresses environ- mental issues and contributes to the energy supply of the country. 204. Finally, batteries are expected to be needed as more and more renewables are added in the power system. The amount of energy storage required will depend on the hydropower capacity which will be commissioned, with the estimates indicat- ing that up to 170 MW of batteries would be needed mainly after 2030. Such assets could be very well added in the lignite power plant sites where transmission access is available, not requiring new transmission connections. 205. In the medium term (up to 2030), there is adequate supply to satisfy demand – including exports – and no major investments in new power supply sources are needed. The key actions for the short-term can therefore be summarized as: (1) clo- sure of old / inefficient coal plants nearing the end of their operating life, for which emission control retrofitting is not justified (this may also involve gradual closure of coal mines or individual pits supplying these plants), (2) initiation of partial cofiring of biomass at existing units where feasible, (3) in parallel, begin piloting energy crops in mining areas, (4) consider repurposing the retiring plants by installing renewable en- ergy technologies (such as solar PV), SYNCON and batteries, and (5) begin evaluating opportunities for repurposing of post-mining lands, especially options for supporting a greener economy and Just Transition goals. 206. In the longer term (2030-2040), potential key actions towards decarboniza- tion would be: (1) accelerate closure of coal plants, (2) evaluate potential conversion of units to 100 percent biomass, (3) significantly scale-up renewable energy projects (especially wind and solar), and (4) scale-up building hydropower of all types. In addi- tion, in the medium-term, BiH will need to consider steps towards strengthening the power grid (i.e. - digitizing and equipping the grid with more advanced capabilities). 207. A comprehensive assessment of the power grid is needed and should include both the high voltage transmission and low voltage distribution systems. There is cur- rently no breakdown of estimates available for investment costs needed for variable re- newable energy and hydro investments, although required investments are expected to be substantial. Regarding transmission, important considerations (among others), which should be taken into account are as follows: location of the new power sources; dealing with the intermittency of renewables; and the regional power market (imports and exports of power, but also firm capacity and balancing services). Given the substantial investments required, TRANSCO (the transmission company covering the entire BiH territory) is ex- pected to finance transmission line investments – the private sector is unlikely to enter into investments on the transmission side. As such, there might be a need to enhance TRANS- CO’s capacity and possibly adjust tariffs, although this should be balanced against consid- erations of passing along costs onto consumers. Finally, it is clear that further studies are needed to identify measures for attracting the vast private sector investments which will be required during the transition. Energy transition in BiH 111 III.5.  Managing the Impacts: A Just Transition 208. Supporting a Just Transition in the coal mines will require significant investments to clear social arrears. According to analysis done by the World Bank, the two entities and their utilities and mines will need to resolve social contribution arrears and ensure adequate financing available for the retrenchment packages for miners. There are an es- timated 16,200 workers employed directly by coal mines and TPPs – 11,500 in FBiH and 4,700 in RS.98 The profile of those employed in the coal sector are mostly male (90 per- cent), mostly rural, and relatively high paid. Lower-skilled mining employees are paid an average of BAM 954 per month (USD 500), much higher than the national average of BAM 752 (USD 390) for low-skilled workers. Higher-skilled coal sector workers earn 17 percent more than the national average for higher-skilled workers. As most coal sector jobs are in the public sector, and most are unionized, they receive good non-wage benefits. This means that coal sector workers who seek jobs in other sectors may struggle to find com- parable compensation. Impacts will be localized given the high concentration of coal-related employment in relatively few municipalities (Figure 47). The local economies of Gacko (RS), Banovići (FBiH) and Ugljevik (RS) – where direct and indirect employment represents between 51 and 68 percent of total employment – are likely to be particularly affected, as are the mu- nicipalities of Breza and Kakanj. Coal-related jobs are geographically concentrated along two major axes along the areas with the largest lignite deposits around Tuzla in North-East BiH, and along the Kakanj-Zenica-Breza mining basin (Figure 47). In addition, three very large sites comprising both extraction sites and mine mouth TPPs are located in Gacko, Stanari, and Ugljevik. As a result, coal-related employment displays market integration and spatial concentration, with most sub-contracting value being spatially concentrated close to extraction sites or in BiH’s major urban centers: the two largest cities (Sarajevo and Banja Luka) supply mines and TPPs within their entity, while contractors located in smaller municipalities supply mines and TPPs located nearby. 98 According to data from end of 2020. 112 Energy transition in BiH Figure 47. Representation of coal mines and coal sector employment Source: The size of the dots is proportional to the total number of employees in the mines and TPPs. Kakanj mine employs 1,539 workers, and Kakanj TPP employs 577 (2020 data). Stanari mine employs 750 workers, while Stanari TPP employs 200. Mines are grouped by conglomerates, i.e. EFT = Energy Financing Team; EPBiH = Elektroprivreda Bosne i Hercegovine; ERS = Elektroprivreda Republike Srpske; and RMU Banovići majority owned by FBiH. 209. Considering the potential labor impacts of a coal phasedown, policy mea- sures will be needed to (i) support local labor demand to absorb the local economic shock on employment and on business activities linked to the mines, (ii) provide ad- equate social and economic support to affected workers, and (iii) strengthen the ca- pacity of the public employment services to absorb the increase in need for employ- ment services and better support the transition of affected workers. Because coal phase-down will not be immediate, there is time for policymakers, mine owners, and workers themselves to plan for future, economic shocks. 210. It will be imperative to work upstream with coal mines, TPPs, municipal and regional authorities, and the business community to map job transitions where possible. This is a two-step approach: (1) understanding the demand coming from the local economy and, (2) establishing the skills base of present workers. As an example, jobs forecast related to remediation and repurposing of mining lands and TPPs may be conducted (for example, labor demand related to solar PV installation parts, bio- mass production). Relatedly, re-training/upskilling workers with skills in demand or with forecasted demand will likely be needed. Energy transition in BiH 113 211. Another potential policy entry-point is to design integrated social and eco- nomic support tailored to the needs of affected workers. Transition support pack- ages for eligible workers should be designed (and budgeted) in advance, encom- passing referral to social services (psychological support, health support, eligibility to social assistance benefits) as well as employment or training support through public or private institutions. Outsourcing to non-government organisations should be considered for the provision of social support services. Additional benefits may also be provided temporarily to compensate for the short duration of unemployment benefits (depending on work history) and on the size of severance payments, after a careful analysis to limit disincentives to work. The delivery of transition services and the capacity of public employment services (PES) could be expanded to absorb the increase in need for employment services. Transition services will encompass both intermediation services (job counselling, placement) and active labor market pro- grams providing training and/or work experience opportunities to return to the labor market. A model will need to be determined for each coal mine site in terms of ac- tors and responsibilities (such as in-house HR services, private employment services, public employment services). 212. Finally, support will need to be imagined in addition for those that are not di- rect employees of the mines but dependent on the coal value chain for their prime income. In addition to these “direct” coal sector workers, another 2,400 workers are employed upstream in the coal value chain in firms dependent on mines and TPPs, particularly direct suppliers with coal sector contracts. Taken together, an estimated 18,600 workers are employed in the coal sector. In addition, a significant source of employment are local businesses in and around the coal regions. While the com- bined total still represents less than three percent of total employment across BiH, the impact will nevertheless be felt, particularly in the mining regions where coal-re- lated jobs are concentrated and the main driver of local economies. Although income support can address immediate and short‐term needs, longer‐term interventions are needed to help workers move into alternative employment and to create an envi- ronment conducive to business development, entrepreneurship, and private job cre- ation. Thus while social impacts from a coal phase-down in BiH could be substantial but geographically contained to the major mining areas. III.5.1.  Policy Coordination and Governance Structures to Manage a Just Transition 213. A Just Transition will require considerable coordination across all levels of government and between Ministries (Table 7). This will be a particular challenge given the division of responsibilities between BiH, Entity, Canton and Municipal level governments. Governance of the energy sector at the BIH level is the responsibility of the BIH Ministry of Foreign Trade and Economic Relations (MoFTER). MoFTER’s man- date is to formulate energy sector policies at the BiH level and coordinate activities and harmonize plans related to the energy sector with the two BiH entities. At the BiH Institutions level, the BiH Electricity Regulatory Commission (SERC), an indepen- dent institution established under the Law on Transmission of Electric Power, Regulator and System Operator of BiH, has regulatory authority.99 In FBiH, the Ministry of Energy, 99 SERC‘s mandate focuses on creating conditions for unhindered trade in electricity and reliable electricity supply in compliance with international treaties, national laws, the relevant European regulations and directives and other internal electricity market rules. 114 Energy transition in BiH Mining and Industry (FMERI) and Regulatory Commission for Energy in Federation of Bosnia Herzegovina (FERK) are the key institutions. The sector is primarily governed by the Law on Electricity (2013). In RS, the Ministry for Energy and Mining of Republika Srpska and Regulatory Commission for Energy of Republika Srpska are the key policy and oversight institutions; the sector is governed by the Law on Electricity of 2020 and the Energy Law of 2009 (49/09) and 2023 (16/23). Table 7.  Structures involved in BiH’s coal and power sector Name BiH FBiH RS BD Government Institutions Ministry of Foreign Trade and Economic Relations of BiH √ Ministry of Energy, Mining and Industry of FBiH √ Federation Electricity Regulatory Commission (FERC) √ Ministry of Energy and Mining of RS √ Republika Srpska Energy Regulatory Commission (RSERC) √ Major companies responsible for Electricity Distribution, Generation, and Power Supply Elektroprivreda Bosne i Hercegovine (EPBiH) √ Elektroprivreda Hrvatske Zajednice Herceg-Bosne (EPHZHB) √ Elektroprivreda Republike Srpske (ERS) √ Komunalno Brčko (KB) √ EFT √ Companies responsible for Transmission BiH Electricity Regulatory Commission (SERC) √ √ √ √ Elektroprijenos BiH √ √ √ √ Independent System Operator in Bosnia and Herzegovina (ISOBIH) √ √ √ √ 214. A starting point to ensure good coordination and policy effectiveness would be the establishment of relevant governance structures which would initiate strategy work at the BiH and Entity levels. It is expected that the Council of Ministers will adopt a Road Map for Just Transition in 2024, once the entities are in agreement. As part of the roadmap’s implementation, a Committee on Just Transition could be set up and appointed by the Council of Ministers of BiH to enable the implementa- tion of the Just Transition Road Map, and would consist of the representatives of BiH institutions, and institutions, universities and companies from both BiH Entities RS and FBiH, and Brcko District (BD) of BiH. It is recommended that the newly set up Committee be chaired by the Chairman of the Council of Ministers of BiH, while co- chaired by the Prime Minister of both Entities. In addition to chair and co-chairs, the Committee would include key members from BiH Institutions. The Committee would be equipped with a Technical Secretariat, which provides day-to-day administrative functions. 215. At the Entity level, Just Transition Ministerial Committees will be required, and established by the governmental decisions, and in the case of Brčko District a Just Transition Office. These committees would coordinate on all matters relat- ed to Just Transition. The Just Transition Committees are entity-level coordinating body and are the guarantor of the entity-level Just Transition strategy or action-plan. Energy transition in BiH 115 The Just Transition Committees are supported by a Just Transition Task Force, which serves day-to-day administrative and operational functions, as well as Cantonal Just Transition Office100 and Municipal Just Transition Office, which are lower-level govern- ment counterparts. The Just Transition Task Force would include working level staff members selected from line ministries, who will take on their responsibilities on a full-time basis during the years of Just Transition. 216. Planning and executing a well-managed transition in BiH, as in any other coal-dependent region, will be a multi-year and multi-level process. Considering the general system of government in BiH—one country, two Entities and BD with sig- nificant autonomy—a hybrid governance model is recommended. This would allow for BiH-level framework strategic planning, while at the same time, leaving room for the entities to make decisions on detailed action plans for transition. In this model, the Council of Ministers of BiH, in exercising its rights and duties, makes decisions, con- clusions, adopts drafts and proposals for laws, analyses information, drafts strategic documents (including programs) and signs agreements, protocols and other acts, in line with the Law on Council of Ministers of Bosnia and Herzegovina.101 217. Given the policy implications of transition, several levels of decision-mak- ing and implementation will be required. At the BiH level, the Council of Ministers of BiH—being the highest-level of government decision-making authority—confirms BiH level political commitments on the Just Transition with the international commu- nity and provides guidance for strategic direction on Just Transition for the country as a whole. Throughout the entire Just Transition process, the Council of Ministers of Bosnia and Herzegovina (1) adopt BiH-level strategic documents, in line with the prescribed legal procedure, upon having obtained positive opinion of the govern- ments of the Entities FBiH and RS and the Government of BD, (2) facilitates inter-en- tity coordination and regulation when needed at the BiH level, (3) provides BiH level diplomatic support on Just Transition when needed, and (4) reports on the progress of the implementation of the relevant international agreements, such as the Energy Community Treaty, Paris Agreement and Sofia Declaration. 218. An important feature of the government’s work will be stakeholder engage- ment. Although several elements are needed for a successful transition – such as early planning, a clear strategy, multi-level governance structures, adequate financ- ing, and political agreement – without effective participation and inclusion of those impacted, a Just Transition will be difficult to achieve. Stakeholder dialogue and citi- zen engagement provide powerful mechanisms for addressing the concerns of coal industry workers and other members of coal mining communities. Early engagement and information campaigns in potentially affected communities can significantly re- duce the risk of social conflict – lessons from past engagements led by the World Bank (for example in Greece) have reinforced the important role that regular, timely and targeted information dissemination on mine and TPP closures and other import- ant milestones can have on positive transition outcomes. 100 To be set up in the three Cantons (Tuzla Canton, Zenica-Doboj canton and Central Bosnia Canton) that are im- pacted by coal mine closure. 101 (“Official Gazette of BiH”, no. 30/03, 42/03, 81/06, 76/07, 81/07, 94/07 and 24/08), Law on Ministries and Oth- er Administrative Bodies of Bosnia and Herzegovina (“Official Gazette of BiH”, no. 5/2003, 42/2003, 26/2004, 42/2004, 45/2006, 88/2007, 35/2009, 59/2009, 103/2009, 87/2012, 6/2013, 19/2016 and 83/2017) and other laws. 116 Energy transition in BiH 219. As such, stakeholder involvement from the beginning is critical for the suc- cess of the Just Transition and must be understood as an ongoing process. A stake- holder mapping exercise conducted by the World Bank in 2021 indicated at least 109 stakeholders in BiH to be engaged in the Just Transition process.102 Among these are the stakeholder groups comprising mine operators and TPPs, public utilities, trade unions and employer’s associations, sub-contractors and service providers along the coal value chain, government agencies at BiH, entity, cantonal (in FBiH) and municipal levels, local and international civil society organizations, think tanks and universities, mining institutes, national and local media, and the European Union. The diversity of stakeholders in the energy transition highlights not only the complexity of the pro- cess, but also the necessity to ensure that the full range of stakeholder are engaged throughout the process – particularly vulnerable groups and those directly affected by the transition (i.e., coal sector employees, women, youth and minority groups). 220. Furthermore, policies to incentivize further private investment in the energy sector – especially in renewable energy projects – need to be enacted at the En- tity levels.  For example, the permitting process for repurposing former mining land into renewable energy-related uses is complex (described further in the section on ‘Renewables on existing coal plants and mining lands’ below), and there are current- ly no incentives in the legal and regulatory framework. In an effort to demystify the permitting process for potential investors in the energy sector, in 2018 BiH released the Guidelines for Investors in the Electricity Sector. The Guidelines set out the required steps for obtaining permits, administrative procedures, relevant institutions, docu- mentation, and deadlines for potential investment in power generation assets in BiH. 221. Indeed, coal mining lands present an opportunity for future job creation. BiH is rich in natural resources, including former coal mining lands with economic poten- tial for reclamation and repurposing. Conservative estimates indicate that at least 42 km2 of lands are currently occupied by coal mining activities – however, empirical ev- idence collected at three pilot sites (Banovici and Zenica in FBiH, and Gacko in RS)103 suggests five to 10 times this amount. As such, between 200-400 km2 of post-mining lands could likely be made available for reclamation and future redevelopment / repurposing. 222. Yet reforms will be required to fully capitalize on land repurposing oppor- tunities. Current spatial planning requirements and permitting procedures for recla- mation and repurposing of lands in both entities are rather complex, involving multi- ple agencies and levels of government. As an added layer of complexity, most land repurposing projects in BiH will require existing spatial plans to be modified, due to the land use changing from its original use. In both entities, amendments to existing spatial plans follow the same procedure as adopting a new spatial plan. Under the current legal framework, the preparation of a new or modified spatial plan (and its accompanying strategic impact assessment on the environment and requisite stake- holder consultation procedures) requires a long period of time. To simplify proce- dures and attract investment, BiH policymakers may consider introducing legislative reforms to designate post-mining lands as ‘special zones’, with pre-defined legal and regulatory incentives for attracting certain types of investment – such as renewable 102 World Bank (2022) BiH Roadmap 103 Information collected during World Bank mission fieldwork in July 2022. Energy transition in BiH 117 energy installations – in these zones. 223. In conjunction, a new legal regulation (a “special procedure”) could be for- mulated to create streamlined conditions for investors to carry out certain in- vestments in ‘special zones.’ These specially selected areas would, for example, be post-mining lands or other brownfields which have undergone upstream due dili- gence, having been investigated for suitability and potential impacts, and deemed ‘high potential’ areas for low-carbon facilities, RE installations, carbon offsets, etc.104. A special legal procedure would also allow for integrated and streamlined actions regarding reclamation and repurposing in these zones, including permitting -- such regulatory incentives may also serve to attract investment in repurposing.105 Legis- lative reforms for creating special procedures and special zones may be combined with the drafting of a “Special Spatial Plan”, with attached preconditions. The Spe- cial Spatial Plans would enable certain land parcels with specific typologies to be pre-classified as suitable for uses such as low-carbon economic development. 224. Other countries undergoing energy transition in the region have established a Special Purpose Entity (SPE) to facilitate the streamlining of permitting and co- ordination of all stages of the mining transition, from mine closure to productive repurposing of post-mining lands. While there is no single legal nor universally ac- cepted definition, an SPE in the context of post-mining lands repurposing may have the following characteristics: a legal entity formed for a specific purpose (i.e. – man- aging a mining transition) with significant executive powers and a pre-defined man- date to achieve specific objectives during a certain time period. Responsibilities of the SPE may include assuming ownership / control of post-mining lands, acting as a receptor of financial means (investments, public funds, subsidies, etc.); acting as a turnkey contract manager for required civil works; leading the acquisition of required permits for reclamation and repurposing. 104 The creation of a comprehensive national database of soon-to-be-available brownfields would also be an important enabling factor in productive land repurposing. Such a database, complete with attached geospatial information, appli- cable incentives, notable environmental and social impacts, and other relevant data from the upstream due diligence phase, not only has the potential to support responsible investment in brownfields over greenfields, but also to pro- mote transparency and information access for potential investors to invest in repurposing projects. 105 In BiH there are currently no specific incentives in the policy or legal framework for attracting renewable energy investors to repurpose post-mining lands. 118 Energy transition in BiH III.6.  A Cost Benefit Analysis of the Just Transition and public debt implications of required investments III.6.1.  Cost Benefit Analysis 225. In 2022-23, the World Bank completed a cost-benefit analysis (CBA) model to provide an estimate of the costs and net benefit of a Just Transition away from coal for BiH.106 The CBA model assesses impacts on coal assets and coal-dependent communities and determines the potential net value of a just transition. In this way the model can underpin dialogue and assistance to government authorities in mak- ing informed decisions related to the coal phasedown. To date the model has been applied in BiH, Serbia and Ukraine. The CBA model follows a methodology based on the World Bank’s ‘three-by-three’ framework. Together with the country’s macro-eco- nomic narrative, the identified costs and benefits are grouped into this framework and phased over the transition period (pre-closure, closure, and regional transforma- tion phases). The analysis evaluated the phasedown of ongoing coal mine and TPP operations and assessed the national impact of closures on these coal assets and coal-dependent communities. The phasing over the transition period was informed by the asset closure sequence i.e., the TPP decommissioning scheme and the mine closure schedule.107 226. The output for the total costs of the Just Transition were categorized into asset decommissioning, land reclamation and repurposing, social support, and renewable energy investments. Total benefits included: healthcare co-benefits, net power export revenue income and repurposed land value growth. Like benefits, to- tal impacts on healthcare, BiH revenue and subsidies, and economic activities were also quantified. The final NPV was generated by applying a discount rate.108 Given the long-term outlook of the energy transition, it is important to note that these outputs have an uncertainty range. Renewable energy investment has an indicative cost ac- curacy range of -20 and +30 percent. 227. The CBA model followed a set of assumptions for all scenarios. Firstly, in terms of financial assumptions, the BiH Institutions budget contribution includes net loss, price subsidies and BiH liability. Relevant BiH liabilities are tax, contributions, concession arrears and direct loans, which will be written off upon dissolving an enti- ty. The loss of BiH revenue income is included as a negative benefit. There is no com- pensation payment in the event of foregone coal reserves, suspension of long-term contracts (coal, electricity) and investments made in coal mining and TPPs which are yet to reach break-even point. In terms of labor social support, the model assumes that coal mine sector employment involves 16,141 people, out of which 85 percent are mine workers (both direct and indirect workers were expected to be given the same package of support). Retirement age demographics were also considered (22 percent retiree, 33 percent early retiree and 55 percent prime-age workers). 106 A more detailed account of the assumptions is provided in Annex C1 107 The year of TPP retirement is predominantly determined by the planned introduction of a national carbon pricing mechanism. The mine closure date is driven by the TPP unit, coal type and unit coal consumption. 108 BiH has a 3.3 percent yield. Energy transition in BiH 119 228. In terms of assets and environmental assumptions, a carbon pricing mecha- nism is introduced with a gradual approach from EUR6.6/tonne in 2025 to EUR80/ tonne in 2050. Reduction in national health care expense (non-occupational, mor- bidity, mortality) are expected to be fostered by improved local air quality due to TPP closures. Repurposed land value increase (water quality, alternative usage) relates to former coal mine lands – TPPs areas are excluded due to unavailability of data. In all scenarios the TPPs are decommissioned in six phases over the period 2024-2050. The retirement year is predominantly determined by the planned 2025 introduction of a national carbon pricing mechanism. Coal closures occur across the 2026-2050 period. The closure date is driven by TPP unit, coal type and unit coal consumption. The proposed renewable energy investments start displacing thermal power plants in 2024 up to 2050. Some additional regional power export capacity is created during TPP displacement from renewable electricity generation. That said, the current ca- pacity of the transmission network is unlikely to satisfy the requirements of the ener- gy replacement. It is assumed that the current transmission network facilitates these incremental exports. Finally, some exclusions are applied, including municipality so- cial support (as no data was available). In addition, given the large uncertainty around pace and financing of the Just Coal Transition, the macro- economic upside (GDP, job creation) was not able to be defined at this stage. 229. The Just Transition away from coal provides a net positive benefit in all sce- narios (Table 8). The decarbonization scenario provides the largest NPV at USD 3.4 billion, while a baseline scenario provides an NPV of USD 2.1 billion and an energy security scenario USD 1.3 billion NPV. As above, the baseline scenario also has the highest overall costs associated, at USD 22.2 billion – this represents a USD 3.6 billion higher cost than a decarbonization scenario. Table 8.  CBA Results Summary for all scenarios Scenario OPEX RE Total Healthcare Net Repurposed Total NPV investment costs co -benefits export land value benefits power increase revenue Baseline 9.1 11.2 22.2 3.8 10.4 12.1 27.3 2.1 Decarbonization 7.5 9.2 18.6 4.4 7.7 13.6 26.9 3.4 Energy Security 9.1 10.8 21.7 4.1 10.1 10.5 25.6 1.3 Notes: all figures are in USD $billion. Scenarios generated by LCP study. All timeframes are 2030-2050. 120 Energy transition in BiH III.6.2.  Budget outlays for the energy transition: a public debt sustainability simulation 230. The BiH public debt sustainability analysis (DSA) should be seen as an arith- metic exercise due to uncertainties surrounding investments in renewable energy. At both the BiH and entity levels, comprehensive plans for long-term investments for renewable energy generation, grid integration, and storage infrastructure are lacking. Furthermore, the specifics of these investments and the contributions of each entity remain unclear. As detailed in Section III.4.2, the LCP study estimates the total cost of decarbonization at around USD 10.7 billion over a decade or more (as shown in Table 6 above). 231. The DSA is based on the following assumptions: i. the total net cost in BAM is 19.3 billion, with an assumed exchange rate fixed at 1.8 for the projection period; ii. half of the investment (BAM 9.6 billion), comes from the public sector, the other half from the private sector; iii. decarbonization investments occur in parallel with downsizing the coal industry, necessitating repayments of tax and social security contributions arrears estimated at BAM 0.6 billion or 2.1 percent of GDP.109 Tax arrears repayments take place in three phases, with 27 percent of the total amount in 2024, 49 percent in 2026, and 24 percent in 2028.110 The breakdown of the tax arrears repayments is arbitrary, and the nominal amount of tax arrears is assumed to remain constant over time; iv. investments in renewable energy start in 2025 and 2026 with a total of BAM 600 million, increase to BAM 900 million in 2027, BAM 1.3 billion in 2028, and reaching BAM 1.9 billion in 2029, the final year of the projection. 232. Based on this investment dynamic, entity and Council of Ministers in BiH would invest a total of BAM 5.3 billion into renewables over five years, or 55 per- cent of the estimated total needed. This corresponds to public expenditures of around 10 percent of GDP, including the repayment of mining tax arrears.111 Annual amounts gradually rise from 0.3 percent of GDP in 2024 to 1.5 percent of GDP in 2026, 2.3 percent of GDP in 2028, and 2.9 percent of GDP in 2029. These budget outlays are in addition to other public investments planned in the budgets for the next five years. 233. The financing mix consists of mainly long-term external and some domestic debt, with domestic financing interest rates ranging between 2 and 6 percent for do- mestic financing (depending on the maturity). Foreign debt instruments are assumed to carry interest rates ranging from 2 to 4.5 percent, with maturities spanning 5 to 15 years. Therefore, external financing is presumed to benefit from specialized financing lines for energy transformation in BiH. Alternatively, one can think of higher market interest rates that are combined with grants, which could result in the same outcome, conceptionally. 234. The simulation shows a sharp reversal in public debt and primary balance (Figures 56a and 56b). Under the baseline, the consolidated BiH primary surplus is close to 1 percent of GDP. This corresponds to the average outcome during the peri- od 2015 to 2022.112 Public debt declines from 30 percent in 2022 to 20 percent of GDP 109 FBiH tax arrears as of June 30, 2023; https://pufbih.ba/v1/public/upload/files/DUG%20PREKO%2050000%20 KM%20NA%20DAN%2030_06_2023_.pdf 110 2024 corresponds to Zenica and Banovici, 2026 to Kreka and Breza, and 2028 to others such as Kakanj, Travnik etc. 111 The GDP ratios use projections of nominal GDP for the relevant years. 112 The exception is in 2026, when the next elections are scheduled for. Energy transition in BiH 121 in 2029. Under the decarbonization scenario, primary deficits reach over 2 percent of GDP by 2029, and public debt returns to 30 percent of GDP, a 10-percentage point difference. While this maintains a low and sustainable debt trajectory, it is prudent to view this through a probabilistic lens, considering how the decarbonization path might evolve if the projected primary surpluses in the business-as-usual baseline do not materialize. For instance, if public debt remains at roughly 30 percent of GDP, similar to its 2022 level, then one must anticipate a scenario where the decarboniza- tion trajectory could potentially result in public debt between 40-50 percent of GDP. This would surpass the public debt levels that peaked in BiH in 2014 and 2015, which necessitated a concerted fiscal consolidation effort. Figure 48a Figure 48b Primary balance under the Public debt under the business-as-usual baseline business-as-usual baseline and decarbonization and decarbonization scenario (% GDP) scenario (% GDP) 1.5 31 1.0 29 27 0.5 25 0.0 23 2027 2022 2023 2024 2025 2026 2028 2029 -0.5 21 Baseline -1.0 19 Decarbonization 17 -1.5 2022 2023 2024 2025 2026 2027 2028 2029 Baseline -2.0 Decarbonization Source: WB staff calculations using BiH governments data 235. In the context of decarbonization, it is imperative to examine amortization payments, especially given BiH’s sporadic access to international capital markets. Under the baseline scenario, the amortization schedule demonstrates a relatively even repayment profile, without maturity concentrations. The exception is in 2026, when amortizations peak at an estimated 4.2  percent of GDP primarily due to the maturing of the EUR300 million bond issued by RS. This contrasts with the otherwise stable repayment profile, which ranges between 1.8 and 2.8 percent of GDP. This is an important feature for a country that has sporadic access to the international capi- tal market as evidenced by the domestic debt rollover of the international bond that matured in 2023, issued on the Vienna Stock exchange by RS. 236. Under the decarbonization scenario, the balanced repayment profile under- goes a notable transformation. During the period from 2024 to 2029, amortization payments almost double in size from 2.6 percent of GDP to 4.6 percent of GDP, on av- erage. Furthermore, the maturity concentration shifts, with consistently higher amor- tization payments in the outer years, amounting to 5.7 and 6.4 percent of GDP in 2028 and 2029, respectively (Figure 57). 122 Energy transition in BiH Figure 49. 7.0 baseline Amortization repayment decarbonization 6.0 profile under the baseline and decarbonization 5.0 scenario (% GDP) 4.0 3.0 2.0 1.0 0.0 2024 2025 2026 2027 2028 2029 Source: WB staff calculations using BiH governments data 237. In conclusion, the decarbonization simulation suggests that BiH may possess the fiscal space to absorb the estimated investment costs, despite a significant shift in public debt and primary balance trajectories. Specifically, the decarbonization scenar- io projects a 10-percentage point deviation from the baseline, returning public debt to 30 percent of GDP by 2029. This debt level and the related repayment profile is considered sustainable. However, in the context of an uncertain fiscal environment and BiH’s sporadic access to international capital markets, there are risk of public debt rising to 40-50 percent of GDP. Ultimately, the available fiscal space within each of the two entities, coupled with their concrete, long-term investment plans supporting the transition to renewable ener- gy production, will be the linchpin in evaluating the fiscal feasibility and dynamics of the decarbonization transition. With this in mind, a reduction in current spending and prudent debt management is paramount to ensure fiscal sustainability and a smooth transition towards a decarbonized economy. III.7.  Conclusions and policy options 238. BiH must transition to a greener growth model for internal and external reasons. As an EU candidate, the country is required to align domestic policies with the Paris glob- al commitments, EU’s energy commitments, the Sofia Declaration79, and other environ- mental and climate legislation (including the 2050 target of a carbon-neutral continent), while at the same time avoiding adverse impacts of the EU’s Carbon Border Adjustment Mechanism (CBAM). 239. Multiple factors such as coal-based energy dependency, ageing energy infra- structure, lower coal production efficiency, and the introduction of CBAM for electrici- ty exports (amongst other high emitting sectors) are making it harder for countries like BiH to delay transition. The primary source of energy in the Western Balkans is domestic lignite and coal (64 percent of electricity was produced from lignite and coal in 2020 and 47 percent of gross available energy in 2020, down from 49 percent in 2015). Furthermore, material and energy-intensive modes of production in industry are driving up production costs and emissions. Though declining, large fossil fuel subsidies and electricity tariffs be- low generation cost reduce incentives to achieve energy savings, improve energy effi- ciency, and switch to greener fuels. In the case of BiH, this is undermining potential output Energy transition in BiH 123 and contributing to air pollution and high emissions. By the end of 2023, all the coal plants of BiH (except Stanari) will be 35 to 57 years old (Table 2), reaching a milestone with regard to compliance with the EU’s Large Combustion Plant Directive.82 Furthermore, coal-fired power plants are unlikely to be competitive after 2035, at which point carbon prices are projected to reach EUR40/tonne of CO2103. While both ERS and EPBiH cross-subsidize the poor financial performance of its mines. While EPBiH’s total electricity generation has grown by 3.5 percent annually over the last three years, its mines remain unprofitable and unsustainable. Lastly, according to the simulations, with the introduction of CBAM, the largest relative losses will take place in electricity exports, leading to output losses of this sector on the order of 15 percent. 240. Despite the challenges, BiH has the opportunity to model a Just Transition of its energy sector, with a focus on coal phase down and clean energy optimisation. BiH has abundant domestic energy resources, including potential for hydro, solar and wind which puts it in a positive position to build a more diversified and clean energy sector in BiH. The use of Renewable Energy Sources (RES), the development of energy storage systems and the repurposing of existing coal-fired power plants combined can lead to a fully de- carbonised but vibrant power sector. Due to falling costs of clean energy technologies and concomitant rising costs of carbon-intensive energy generation, BiH would benefit from exploring the potential of alternative energy sources and energy storage, alongside possibly new hydro to support grid integration of variable renewable energy (VRE). The region’s natural and physical assets for alternative energy and energy storage include the well-developed transmission network, abundant post-mining lands, water bodies, and a workforce with energy-related skills and social identity.  Based on estimates from the LCP study, the decarbonization option makes economic sense with an NPV of USD 3.4 billion. However, more detailed assessments would be needed such as, for example, balancing requirements and power grid strengthening, as well as assessments of the ability to fi- nance decarbonization efforts. 241. Supporting a Just Transition in the coal mines will require significant investments to clear social arrears, responsibly close mines and transition the coal regions eco- nomically. A starting point will be the need for a comprehensive Just Transition Plan at the entity levels which forecasts all impacts and seeks to address them in a systematic way. Even if impacts will be localized given the high concentration of coal-related employment in relatively few municipalities, concerted policy measures will be needed to (i) support local labor demand to absorb the local economic shock on employment and on business activities linked to the mines, (ii) provide adequate social and economic support to affect- ed workers, (iii) strengthen the capacity of the public employment services to absorb the increase in need for employment services and better support the transition of affected workers; (iv) engage with communities in a regular fashion; and (v) work with utilities, mines and the government to diversify mining land uses for new productive use. 242. A Just Transition will require considerable coordination across all levels of government and between Ministries. 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World Bank, 2023, Growing to High Income in Europe and Central Asia, Concept Note, June 128 V.  Annexes Annexes Annex for Chapter 1 Annex A1: BiH’s nomenclature BiH has a unique political structure established by the Dayton Agreement in 1995, which ended the war. The political landscape is dominated by three main ethnic groups: Bosniaks (Bosnian Muslims), Croats, and Serbs. BiH consists of two entities: the Federation of Bosnia and Herzegovina (FBiH, predominantly Bosniak and Croat), and Republika Srpska (predominantly Serb), each with its own government and par- liament. At the BiH level, there are several key institutions that play significant roles in gov- ernance: i. Presidency: The Presidency consists of three members, each representing one of the major ethnic groups (Bosniaks, Croats, and Serbs). The Presidency is the col- lective head of BiH Institutions and responsible for foreign affairs, and it operates on a rotating basis with a member from each ethnic group serving as the chair for eight months. ii. Council of Ministers: The Council of Ministers is the main executive body at the BiH level. It is responsible for implementing decisions made at the BiH level and managing BiH-level institutions. iii. Parliamentary Assembly: The Parliamentary Assembly consists of two chambers: the House of Representatives and the House of Peoples. The House of Represen- tatives is the lower house, and its members are elected directly by the citizens. The House of Peoples is the upper house, and its members are chosen by the entities’ legislatures. It plays a role in ensuring power-sharing among the ethnic groups. iv. The Central Bank of Bosnia and Herzegovina: Responsible for monetary policy and maintaining the stability of the national currency. Within FBiH, the political structure is further partitioned into 10 cantons. These cantons are semi-autonomous administrative units, each with its own government and specific jurisdiction over various local matters. The cantonal divisions in the Fed- eration are intended to accommodate the ethnic diversity within the Bosniak and Croat communities. In addition to these entities and cantons, there is the Brčko District, which is a separate self-governing administrative unit. The Brčko District was established as a neutral, multi-ethnic area under international supervision to resolve disputes over this strategically significant region. Annexes 129 Annex A2: Country income classifications according to the World Bank The classification of countries into different income groups is based on their Gross National Income (GNI) per capita. The World Bank uses this method to categorize countries into income groups. The income classifications are listed in the below table for 2022 and expressed in USD (Atlas method): Group July 1, 2022 from FY23 (new) Low income > 1085 Lower-middle income 1086-4255 Upper-middle income 4256-13205 High income >13205 Source: https://blogs.worldbank.org/opendata/new-world-bank-country-classifications-income-level-2022-2023 Annex A3: Benchmarking in this report: choice of structural and aspirational peers In this report, a benchmarking exercise is adopted that classifies BiH’s peer coun- tries in two groups: structural and aspirational peers. A structural peer country is a country that is similar to BiH in terms of its economic structure. Hence the first filter applied was the level of development, size of population, capital index, and poverty headcount. The second filter was the existence of similar economic and institutional transition (from socialism to capitalism), and, equally important, that structural peers are well known to the policy makers in BiH, which renders comparisons intuitive. By comparing a country’s economic performance to that of its structural peers, policy- makers can gain insights into BiH’s strengths and weaknesses and identify areas for improvement. BiH’s structural peers come largely from the region, and the majority has a common political, and economic history stemming from the period of former Yugoslavia. These peers include Montenegro, North Macedonia, and Serbia. Addi- tional structural peers include Moldova and Albania as both also had a socialism leg- acy and are similar in size compared to BiH. An aspirational peer country is a country that BiH aspires to in terms of econom- ic development and success. By studying the policies and practices of aspirational peer countries, policymakers can gain insights into how to improve their own coun- try’s economic performance and achieve their goals. Aspirational peers in this report are chosen from the list of 13 successful convergers in Europe that have reached high income status (in the year in parenthesis) and can be compared to BiH in terms of size and socialist legacy. These countries include Croatia, which reached high income status in 2008, Estonia (2006), Latvia (2009), Lithuania (2012), Slovak Republic (2007), and Slovenia (1997). 130 Annexes Annex A4: The Fundamental Equilibrium Exchange Rate (FEER): is the exchange rate level still valid for the Convertible Mark after two decades of its introduction? The fixed exchange rate of 1.956 BAM for 1 euro remains appropriate 26 years after it was established under the currency board. To assess the appropriateness of the ex- change rate level, the Fundamental equilibrium exchange Rate (FEER) model is used. In this model, the error-correction model assesses whether the exchange rate level is in line with fundamentals, defined in this case as trade openness, terms of trade, total investment, and government spending. The error-correction model assesses the speed at which the exchange rate adjusts to deviations from its equilibrium level. By examining the estimated error-correction coefficient, one can gauge the strength and direction of the adjustment process. The empirical approach applies a single equation approach and a two-step Engle-Granger cointegration and error-correction approach. The results, pre- sented in Table B5.1, demonstrate statistical significance of all fundamentals in the long run, except for terms of trade. Diagnostic tests, including recursive residuals, confirm the stability of the estimated parameters, supporting the validity of the model. Long run and short run estimation REER (dependent variable) Cointegrated Regression Error Correction Model Variable (static OLS) t-stat Variable (dynamic OLS) t-stat OPEN_LN 0.09*** 2.99 D(OPEN_LN) 0.05*** 2.76 INVEST_LN -0.03* -1.82 D(INVEST_LN) 0.02* 1.94 GCGDP_IN -0.01** -2.46 D(GCGDP_LN) -0.01*** -3.24 TOT_IN -0.02 -0.55 D(TOT_IN) 0.00* 1.95 C 1.86*** 0.00 C -0.20* -1.94 ECM(-1) -1.82 ADF test for Prob. residual test statistics: -3.37 (0)*** 0.02 test critical 1% -3.61 values: 5% -2.93 10% -2.61 Note: The symbols ** and *** denote rejection of the null hypothesis at the 5% and 1% critical values, respectively. Annexes 131 The error-correction model reveals a negative and highly significant adjustment co- efficient on the lagged error-correction mechanism, indicating a long-run cointegrat- ing relationship between the identified fundamentals. The estimated adjustment speed coefficient for BiH is -0.19, implying a stable and relatively quick adjustment process. The findings suggest that it would take slightly more than one quarter to eliminate 95 percent of a shock to the real effective exchange rate in BiH, which is consistent with the country’s fixed exchange rate regime and the equilibrium level of the REER. Figure A4.1 Stability tests for Cointegrated regression and ECM (cusum in blue, 5% significance in red) 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 2013 2014 2015 2016 2017 2018 2019 2020 2021 2014 2015 2016 2017 2018 2019 2020 2021 Source: WB staff calculations 132 Annexes Annex A5: Domestic market integration in Bosnia and Herzegovina (BiH) The Law of One Price (LOP) acts as a driving force for market integration by eliminat- ing price discrepancies through arbitrage activities. In Bosnia and Herzegovina (BiH), the dynamics of Consumer Price Indices (CPI) between the Federation of BiH (FBiH) and Republika Srpska (RS) suggest an increasingly integrated market. Empirically, the overall inflation differential has declined from 2009 to 2014 (see Figure B1 below), with a sharp widening only in 2022 as a result of the overlapping crises. The LOP states that in an efficient market, identical goods should have the same price regardless of location. Integration allows for free trade between markets, reducing bar- riers and promoting price convergence. However, factors like transportation costs, trade barriers, and market imperfections may hinder complete convergence. An analysis using the cointegration approach examined monthly CPI data for tradable and non-tradable goods across 12 major groups and 39 subgroups in the two entities over ten years. Cointegration tests confirmed a long-run relationship between CPI indices in several categories such as general index, food and non-alcoholic beverages, alcoholic beverages and tobacco, housing, water, electricity, gas, other fuels, and transport. The analysis suggests that general CPIs closely track each other, with a 2.7 month time needed to eliminate 50 percent of deviations. Convergence was found in certain CPI groups at the group level, with half-lives ranging from 1.1 to 1.9 months. At the subgroup level, 11 out of 39 CPIs showed evidence of cointegration, with half-lives varying from 1.1 to 26.8 months. Overall, the analysis indicates weak compliance with the LOP at the subgroup level in BiH, suggesting partial integration of entity markets for many goods and services. Figure A5.1 15 difference Inflation in FBiH and RS RS 10 FBiH and their differences (in % and percentage points) 5 0 -5 -10 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: FBiH and RS Statistical Institutes and WB Staff calculation Annexes 133 Annex A6: Assessing an introduction of a multi-rate VAT system in BiH In response to inflationary pressures, the BiH Parliament has discussed a potential tem- porary multi-rate VAT system in August 2022, to provide support to poorer households. This proposed reform had three main components: (i) introduce a zero VAT rate on pharma- ceuticals, forage for animals, seeds and seedlings, and a selection of basic food products including: flour, bread, milk, cooking oils, animal fats, salt, sugar; (ii) imposing a 22 percent rate on luxury items such as “high quality” alcoholic drinks, tobacco products, luxury perfumes, clothing and footwear made from fur or reptile skin, jewelry, watches, electrical and optical machinery, luxury vehicles (for transport of people on road, air and water), artwork, collector’s items, antiques, fireworks, lighters, luxury pens, and ammunition and weapons; and (iii) contin- ue applying the 17 percent rate on all other items. While reduced VAT rates are common across the world, the case for their use is weak – and this in particular applies to BiH. The optimal indirect tax literature finds no redistributive role for reduced VAT rates when other more direct instruments are available. Furthermore, empirical evidence shows that cash transfers are a superior policy mechanism for achiev- ing distributional goals. Even a universal cash transfer would better target support to poorer households compared to reduced VAT rates. These theoretical and empirical findings, to- gether with practical concerns regarding the administrative and compliance costs associated with a multi-rate VAT system, have led to a broad (academic) consensus that redistribution is better achieved directly through the income tax and/or benefit systems. Microsimulations for BiH indicate that the proposed multi-rate VAT reform would be highly ineffective. The reform would lower the VAT burdens proportionately more for poorer house- holds than for richer households. However, despite this mild progressivity, the proposed re- form is highly ineffective at targeting support to poorer households: rich households would benefit from the new rate structure in absolute terms much more than poorer households. The gain from the zero-rate component vastly outweighs the loss from the 22 percent rate component (Figure below). In other words, the lower VAT rate would represent an indirect subsidy to the affluent households. Figure A6.1 500 25% % of expenditure Aggregate Average gain/loss per 450 household from proposed 400 20% multi-rate reform 350 300 15% 250 200 10% 150 100 5% 50 0 0% 1 2 3 4 5 6 7 8 9 10 Source: World Bank staff calculations 134 Annexes Annex A7: Job gains/losses by sector, 2011 – 2019 (public and private) Sector Employment 2011 2019 Net job creation 2011-2019 Agriculture Public 18996 27008 8012 Private 141030 117205 -23825 Coal* Public 12049 9868 -2182 Private 1306 970 -336 Other Mining Public 1462 1264 -198 Private 2781 1802 -979 Manufacturing Public 27838 18084 -9755 Private 101743 131548 29805 Public utilities Public 6261 9459 3198 Private 1991 1807 -184 Power generation Public 13542 15165 1623 Private 1145 818 -327 Construction Public 7647 6857 -790 Private 57934 56958 -976 Wholesale & Retail Public 9412 7413 -2000 Private 101671 94261 -7410 Transport and Public 22802 10556 -12245 Communications Private 22929 27570 4640 Accommodation and Public 3098 1715 -1383 food services Private 24937 31383 6446 Financial, ICT and Business Services Public 9929 23458 13529 Private 27851 38390 10539 Public Administration Public 63793 48379 -15414 Private Education Public 44787 35700 -9087 Private 3270 6573 3304 Health & social work Public 45098 33618 -11480 Private 3270 6915 3645 Other Services, Unspecified Public 39311 13679 -25631 Private 4555 24285 19730 Total Public 326025 262223 -63802 Private 496413 540485 44073 Overall Total 822437 802708 -19729 * LFS data reported here does not fully capture coal sector workers, due to limits in survey coverage. Figures here differ from the administrative data reported by the mining and TPP companies, where total coal sector employment was 16,800 in 2019. Source: BiH LFS 2011, 2019 Annexes 135 Annex A8: Long Term Growth Model The LTGM is a simple and transparent Excel-based tool designed to analyze long-term growth scenarios, building on the celebrated Solow (1956) Swan (1956) growth model. The LTGM combines assumptions on growth fundamentals -the drivers of growth- such as investment, education, and productivity-to produce a trajectory for future growth. This box provides a brief overview of the LTGM Public Capital Extension (LTGM-PC), which allows for a decomposition of physical capital into public and private portions. More specifically, GDP is given by a simple Cobb-Douglas production function: Equation 1: GDPt = A t ( KG ϕ P 1− β − ϕ t ) (K t ) (h t L t ) β where At, is the total factor productivity (TFP), KtG and KtP denote public and private capital stocks, and ϕ is the usefulness of public capital for production. htLt is effective labor used in production, which is decomposed into ht, human capital per worker, and L, the labor force. The labor force is further decomposed into Lt=QtωtNt, where Qt is the participation rate, ωt is the working-age population to total population ratio, and Nt is total population. The parameter β is the labor share. The stock of public capital follows Kt+1G = (1 - δG) KtG +ItG where ItG denotes public investment and δG is the depreciation rate. An analogous expression determines the dynamics of private capital. One can express GDP in per capita terms by dividing Equation 1 by Nt. After some algebraic manipulations, we can write GDP PC growth in terms of the drivers of growth: Equation 2: A +β( h + Q + ω ) + g t+1 GDPPC ≈ g t+1 g t+1 g t+1 g t+1 +( 1β − − ϕ) [ P It KP / t − GDP t GDP t δ −g G N + t+1[ [ ϕ IG G t / Kt − GDPt GDPt δ −g t+1 P N [ X where gx t+1 denotes the annual growth rate of variable X in period t + 1. In the short and medium terms, TFP growth has the largest effect on growth: a1 percentage point (ppt) increase in TFP growth (ga t+1 ) leads to an exact 1ppt increase in GDP PC growth. A 1ppt increase in the growth of human capital, labor force participation, and working-age population (gh t+1,gQ t+1,gω t+1) increase GDP PC growth by ẞppts. Population growth (gN t+1) reduces GDP PC growth because it reduces capital per worker. Note that the effect of an increase in public (private) investment depends on the public (private) capital to GDP ratio. Hence, an investment-led growth strategy will become less effective over time, unless it is accompanied by reforms to other drivers that mitigate the increase of KtG /GDPt. In the long run, the effect of drivers of growth is amplified because they induce further capital accumulation. As a rule of thumb, a 1ppt increase in TFP growth would boost GDP per capita growth by 1/ẞppts, and there would be a one-to-one effect of gh t+1, gQ t+1, or gω t+1. 136 Annexes Annex Afor Chapter 2 Annex B1: Decomposing aggregate total factor productivity Decomposing aggregate productivity growth helps understanding its drivers. Fig- ure 7 follows Olley and Pakes (1996) and decomposes changes in aggregated log TFP since 2015 into two components:113 (1) a within term, which isolates how changes in the average productivity of incumbent firms―in how efficiently they use their re- sources―contributed to aggregate TFP growth; (2) a between term, capturing the effect of the reallocation of value added across firms with different levels of produc- tivity―how efficiently productive resources are reallocated across firms. Albeit the same policy, such as better enforcing competition across firms, can influence several of these components, this decomposition provides a useful conceptual framework to study the drivers of aggregate productivity growth. These components can then be further decomposed to control for changes in the structural composition of the econ- omy – reallocation of activities across sectors – and isolate the role of the dynamics taking place within each sector.114 Annex for Chapter 3 Annex C1: Assumptions for Cost Benefit Analysis 1) Methodology of the Cost-Benefit Analysis Model # Step Country Indicator 1 Frame drivers for coal phase down • NDC goals • Coal sector state reform program • SOE’s financial performance • Carbon pricing mechanisms • Electricity export position 2 Define macro-economic narrative • Timing of coal sector closure • Mining operations and coal-to-power: history, scale, ownership • Status & future energy sector plans • Labor market • GDP trends • Regional imparities 3 Agree expense reference i) Historical performance of sector restructuring, ii) Administrative plans of current authorities, iii) World Bank’s guidance around International Best Practices 113 Olley, S. and Pakes, A. “The Dynamics of Productivity in the Telecommunications Industry.” Econometrica, Vol. 64 (1996), pp. 1263–1298. 114 When data on firms’ entry and exit are available this decomposition can be extended to account for the contribu- tion of firms’ entry and exit (Melitz, Polanec, 2015). When this information is not available, productivity differences between new firms, exiting firms and incumbents are captured by the within and between components. Annexes 137 # Step Underlaying action 4 Determine costs & benefits using • Assure an across GP team, multidisciplinary views, counterpart Bank’s 3x3 Matrix for JT in Coal consultation Regions as a structure • Collect data & evaluate, capture assumptions and agree value • Preference for bottoms-up approach • In absence of certain data, top-down approach - using • analogues/benchmarking - may derive reasonable value. 5 Group costs & benefits, together Categorize in Social Support, Asset Decommissioning, Land with macro-economic narrative Reclamation & Repurposing, Healthcare, State Revenue & Subsidies, Economic Activities 6 Phase costs & benefits over • Propose asset closure sequence & use as an anchor point for Pre-Closure, Closure, Regional transition period Transition Phases • Year of TPP decommissioning set by i) plant retirement age, • ii) national carbon pricing mechanism • Mine closure date set by TPP unit, coal type and unit coal consumption. • Stand-alone mine closure set by state burden, safety, (export) production capacity, municipality economic resilience • Determine energy transition scenario’s translating in different closure schemes 7 Run CBA model • Agree timespan • Input cost - benefits on an annual basis in today’s USD dollars into deterministic excel software • Capture indicative cost accuracy range of investments • Generate Net Present Value of net benefits (total benefit minus total costs) by applying external bond yield as discount rate 8 Derive outcome • Conclude expected net value of coal mine sector closure • Over the Pre-closure, Closure and Regional Transition phases, output is categorized in similar (sub) categories as in Step 5. • Compare different energy transition scenario’s 2) Data collection to determine costs and benefits. Discipline Key Data Sources Economics • IMF/WB SCD & SOE reform evaluation • Coal mine sector subsidy benchmark study • Carbon pricing mechanism impact assessment • (WB Climate Policy Assessment Tool) • Office of Statistics • Company’s financial statement, annual report, business plan Energy • National energy strategy • Country’s INECP • Least Operating Cost Model for Power Plants • Long Term National Power Generation Plan • WB/ International Donor Coal Mining Sector Diagnostic reports Environment • Land Reclamation Cost Scoping Tool • Coal mine basin survey • Environmental impact assessment 138 Annexes Discipline Key Data Sources Social • Labor market job diagnostic and implication assessment of coal transition • Country policy for labor costs at dismissal • Socio-economic assessment of municipalities • Labor market survey/Job creation analysis for job transition pathway’s Healthcare • WB Healthcare Co-benefit Tool 3) Cost input for BiH Phase I Phase II Phase III Pre-Closure Planning Closure Regional Transition Efficiency Financial state contribution Repurposed land value increase 5% per annum savings • $320 mln total state liability • $ 661 m gradually phased in for a for more effective/efficient write off's total of 321 sq km industrial mine mine closure planning • $128 mln total net land from 2025 to 2050. Once loss from entities phased out repurposed, land sustains its value. gradually from 2025 to 2050 upon individual SOE closure Increased macro economic activity - GDP growth (Future State Revenue diagnostic work) • Zero revenue impact as • GDP growth might be generated by customer loyalty in the i. Improved trade competitiveness domestic market is anticipated. ii. Development local RE industry • $ 10,4 bn potential incremental iii. Clean energy project netelectricity export income re-investments from state revenue (thanks to RE investments) over carbon pricing income 2023-2050. iv. Public private partnership Healthcare co-benefits investment Air quality improvement due to decline in local pollutants. Job creation (Future diagnostic work) $ 3.6 bn mortality • Employment opportunities from phased in over 2025-2036 increased macro economic activity 4) Benefit input Phase I Phase II Phase III Pre-Closure Planning Closure Regional Transition Environmental Feasibility Asset decommissioning Land repurposing & monitoring & Permits • TPP's: $117.000 $/MW • $ 0,75 m per underground mine $ 0,4 m per mine • Mines: $10 m's for underground / • $5,6 m per open pit $100 m's for open pit Social Support Planning Power plant operating costs Regional social support (Risk assessment, gender $9,1 bn-O&M, fuel, thermal to RE (Future Diagnostic work) action plan, Stakeholder Land reclamation engagement, citizen (water, waste, emissions) Attracting new investments communication plan) • $ 2,9 m per underground mine • $ 11,2 bn renewable energy (Future diagnostic work) • $ 8,7 m per open pit capital expenditure (wind, biomass, • $ x m per municipality hydro, PV) • $ x m per mine Severance package • $ 30.000 per (early) retiree at once • $ 11.000 per prime age worker at once Retrain & Retrench package • $ 2.000 per prime age worker at once Regional social support (Future diagnostic work) Annexes 139 5) Thermal Power Plant decommissioning scenarios Significant TPP coal Cost-Benefit consumption reduction inclining (2023-2060 period) Healthcare co-benefit decline health care co-benefits due to data unavailability 2036> 2,000 1,500 Incremental net power export revenue 1,000 increasing over time Gradually repurposed land value growth as mine closure spread 500 $ million 0 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 -500 Last TPP / mine closure totaling 5 TPP's/ 11 mines -1,000 First TPP/ set of mines shutdown -1,500 Preliminary: RE investments & OPEX dominating costs over entire Benefits Estimated NPV $1,3 bn period Large scale up of RE investments > 2031 Major Costs Total costs $21,7 bn OPEX reductions in first 10-15 years Net Benefit Total benefits $25,6 bn Baseline Energy Security 2,000 2,000 1,500 1,500 1,000 1,000 500 500 $ million 0 0 2050 2030 2040 2050 2030 2036 2040 2026 2046 2038 2028 2048 2036 2026 2046 2038 2028 2048 2032 2034 2044 2042 2024 2032 2034 2044 2042 2024 -500 -500 -1,000 -1,000 -1,500 -1,500 Decarbonization Preliminary: 2,000 ·Baseline has highest total costs (due to new 1,500 TPP) and highest total benefits (thanks to net power export income) 1,000 500 ·Decarbonization has highest NPV as $ million accelerated phase out of assets, less 0 coal/biomass consumption and faster 2050 2030 2040 2036 2026 2046 2038 2028 2048 2032 2034 2044 2042 2024 -500 plateauing repurposed land value growth -1,000 ·Estimated NPV ranges $ bn 1,3-3,4 -1,500 ·Total cost ranges $ bn 18,622,2 Benefits Costs Net Benefit ·Total benefit ranges $bn 25,6-27,3 140 Annexes 6) Total cost estimate Phase I Phase II Phase III Pre-Closure Planning Closure Regional Transition Social support: Social preplanning: Future work 630 Labor / Municipality - Future work Environmental preplanning: 6 Decommissioning assets: 1.144 Power plant operating cost: 9.149 Land reclamation: 92 Municipality support: Future work Land repurposing & monitoring: 45 Renewable energy investment : 11.200 7) Total benefit estimates Phase I Phase II Phase III Pre-Closure Planning Closure Regional Transition Improved efficiency: 0,3 Financial state contribution: - 190 Incremental state net regional export revenue income : 10.381 Repurposed land value increase: 12.106 Reduced health care expenses: 3.838 Macro - economic benefits: Future work WORLD BANK GROUP Country Economic Memorandum BOSNIA AND HERZEGOVINA Macroeconomics, Trade & Investment January 2024