Privatization Monopol

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The Privatisation of Natural Monopolies

Early Warning System

Special Edition

This Report ushers in a series of specialised reports designed to

give national voices an important contribution to

the development of BiH and on meeting the challenges of 2015.

We hope you enjoy them.

Moises Venancio

Deputy Resident Representative

UNDP Bosnia and Herzegovina


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FOREWORD

The question of privatisation continues to generate much controversy in Bosnia and Herzegovina.

Certain powerful stakeholders, not least the international financial institutions, are lobbying hard for the rapid

transfer of various public enterprises to the private sector. On the other side of the debate are strong national

voices advocating for a less radical and more considered approach. For this section of opinion, privatisation

is far more than a narrow financial process, but one which has very considerable social and economic risks.

This special Early Warning System (EWS) Report reviews this ongoing policy dispute in the context of

the so-called 'natural monopolies' given by the water, telecommunications and electricity sectors. Like other

industries, the case for their privatisation is justified in terms of improved economic efficiency and ensuring

the success of other transition reforms. Yet these particular enterprises are special.

First and foremost, because natural monopoly status brings with it certain production and delivery

'realities' that fundamentally constrain the potential for competition. In short, the bulk of these industries are

monopolies by definition and not by policy choice. This has the effect of limiting both the scope of the

efficiency gains to be had, and the contribution private, as opposed to public, ownership can make to the

transition process.Second, each of the sectors has a distinctly strategic character; their strength is central to the performance

of economy, and they constitute national assets of some considerable value. Transfer of ownership inevitably

carries with it inherent dangers and pitfalls, both for ordinary citizens and the country as a whole.

The debate over these matters is also somewhat coloured by the failures of the existing privatisation

process in BiH, and it is worth noting that surveys of public opinion, point consistently to widespread and

growing levels of disquiet and cynicism. This is unsurprising given that the wider transition reforms have

taken place with little regard to the social impacts of change, whilst also, certain large privatisations have

spurred a series of allegations, if not clear instances, of impropriety and corruption.

Moreover, there is an ongoing absence of accountability for the privatisation process. We have seen

national experts blaming the internationals for the introduction of wrong laws, weak responses to requests

for assistance, and the introduction of voucher privatisation schemes which have already proved a disasterin many other transition countries, and in turn the internationals blaming the nationals for the tardiness of

decision making and the eventual options selected. The bottom line is that neither party has accepted, nor

seems willing to assume responsibility for these activities.

This report, which has been prepared by a high level group of national academics and policy advisers,

carefully reviews the evidence from both within BIH and around the globe. It concludes in favour of an

'eclectic' approach to privatisation; this position neither rejects the potential benefits nor accepts them

uncritically. It recognizes that a variety of alternative models exist for managing these industries and that a

non ideological, case by case approach, should be taken which brings the wider social and longer term

consequences into the decision making process. To quote George Bernard Shaw, 'the only golden rule is that

there is no golden rule' and this most definitely applies when it comes to the scope and nature of

privatisation.

The history of these reforms throughout the former socialist world is neither a happy nor a successful

one, and it would be a great pity if policy makers in BiH repeated the well-documented mistakes which have

been made. Yet this remains a very real danger, so long as we, the politicians and the international

community, continue to regard ourselves as the real stakeholders, and not the ordinary BiH citizens who live

with the social, economic and political consequences.

Thus I close with a demand for dialogue and inclusiveness, and I commend the findings, conclusions

and recommendations of this report, as a positive contribution to such a process.

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Jens Toyberg-Frandzen

Resident Representative

United Nations in Bosnia and Herzegovina


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United Nations Development Programme

EARLY WARNING SYSTEM

Senior Portfolio Manager Armin SIR^OProject Coordinator Tarik ZAIMOVI]

Admir SALKI]

Review Moises VENANCIO, Deputy Resident Representative

Armin SIR^O, Senior Portfolio Manager

Editors Tarik ZAIMOVI]

Richard MARSHALL MSc (Econ)

Authors Tarik ZAIMOVI]

Aleksandar KALMAR Ph.D.

Slavo KUKI] Ph.D.Fikret HAD@I] Ph.D.

Kasim TATI] Ph.D.

Armin AVDI]

BH version proof-reading Mufid MEMIJA

Translation Reza M. KEIVNZADEH M.A.

English version proof-reading Reza M. KEIVNZADEH M.A.

Photo & Design Tamara KOREN

DTP & Layout Samira SALIHBEGOVI]

Print Arch design d.o.o.

For the printing house Esad ]ESOVI]

Although publication of this report is supported by

the United Nations Development Programme (UNDP),

the opinions stated in this Report

do not necessarily reflect the official position of

the United Nations Development Programme (UNDP)


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EXECUTIVE SUMMARY

This report examines the case for the privatisation of the so-called 'natural' monopolies in Bosnia

and Herzegovina, specifically the Electricity, Telecommunications and Water Sectors.

It is argued by many mainstream economists, that the presence of state owned monopolies in

transitional economies 'locks-in' inefficiencies and impedes the progress of other essential reforms,

including liberalisation and restructuring. Thus in BiH, as elsewhere in the transitional world, the clamour

for privatisation has become a 'mantra' of the Bretton Woods institutions and other influential voices

within the international community.

But is the case for privatisation as solid as is claimed when applied to cases of 'natural monopoly'

where the patterns of production and supply, mean that the potential for competition, the key ingredient

for securing economic efficiency, is extremely limited? Indeed, some form of monopoly in these sectors

seems both inevitable, and arguably the most 'efficient' outcome. The privatisation process implies, in

the case of these industries, the transformation of a public monopoly into a private one.

Furthermore, a review of the empirical evidence of past privatisations in the transitional and

developing worlds gives few grounds for optimism. As the research for this report shows, time aftertime, privatisation programmes have failed to live up to their promised economic pay-offs, and have

at the same time contributed to significant social dislocation, felt in terms of bankruptcies and

unemployment.

Yet, the history of privatisation within the advanced industrial economies of Europe and North

America has yield somewhat better outcomes. Moreover, it is not true that all sub-sectors of the industries

examined in this report constitute 'pure' forms of natural monopoly, and thus competition in theory at

least, should be both possible and beneficial. This added to the potential for the introduction of overseas

management experience and crucially, capital investment, underlines the reality that a dogmatic stance

against all forms of privatisation is ill-advised. Indeed, there is no doubt that these sectors, like others in

BiH, require rationalization, investment and a fundamental reorientation in their approach to their

business dealings, and the quality of service provided to consumers.However, although the report does not suggest retaining the status quo as the best solution, it also

does not argue for a rapid mass transfer to private ownership either, rather it presents a series of options

and models, some of which do not require the effective privatisation of public assets at all. These include

using innovative partnership arrangements and measures to improve the organization, management and

efficiency within the existing utility companies.

Overall, a more considered and consultative process to deciding the future shape and ownership of

these necessarily strategic industries is recommended. The ongoing goals should be securing the

maximum benefits and value for BiH citizens both in the short and long term, whilst also minimising the

costs and inherent risks

It is concluded at the strategic level that:

A consensus needs to be established on the objectives and goals of privatisation, and the

commitments to be sought from potential new owners and operators. The strategic long-term interest

in some of these areas must be a major decision-making factor and future position of BiH in the

region.

That the process should be properly phased and well managed; ensuring that appropriate and

socially responsible restructuring takes place prior to the transfer of ownership; and that tough

regulatory structures are put in place to protect both the interests of the state and citizen, as the

current owner of the assets in question.

That all sectors, and the conduct of all operators, state, municipal and privately owned, should be

regulated by strong and independent agencies, in the interests of the consumer. And this is a

fundamental prerequisite of the wider liberalisation process.

A variety of forms of ownership and management arrangements should be considered, including

models of partial privatisation (of sub-sectors and certain functions) and schemes in whichmajority and/ or effective ownership remains within public hands. These include various

partnership mechanisms (public-private and public-public), management contracts and operating

concessions.

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And at the industry level:

For the Electricity Sector; restructuring to be followed by the privatisation, using a mixture of

methods, of the distribution companies as regional concessions, recognizing that some may remain

in public ownership. Retention of existing power generation, in state ownership as a strategic long-

term export resource for BiH. With the privatisation of unexploited potential, to be done on

concession and time limited basis. And for the transmission mechanism, which represents a 'pure'

natural monopoly to remain as a state owned, but arms-length, managed entity.

In the case of theTelecommunications; the report acknowledges that technology has done much to

permit effective competition to operate. And thus authors conclude in favour of a more liberal

approach and see no benefit for retaining the existing companies wholly in state hands, save for the

need to ensure access to the fixed line networks they operate.

In contrast, they find that Water Services presents the clearest example of natural monopoly, and

thus should be retained in state or municipal ownership. However the authors also recognize that

this sector would benefit from the introduction of modern and commercial management practices;

and that there is a desperate need to make substantial new investment in infrastructure. Therefore,

it is concluded that there are potential benefits to be secured from management and partnership

arrangements.

The report is throughout, anxious to underline the political and social dimensions that surround thisdifficult issue. There are considerable 'knock-on' consequences, both external to the industries in

question, and to the time frame typically used to appraise the outcomes of privatisation. These range

from the poverty fallout of rapid downsizing, to the diminution of public accountabilities. In sum the

challenges which confront us are neither simple to overcome nor short in duration. Most of all this report

counsels the authorities against proceeding with unnecessary haste, or taking decisions based on a

dogmatic or politicised position.

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CONTENT

1. INTRODUCTION 9

2. KEY CONCEPTS 92.1 The Dangers of Monopoly and the Case for Privatisation 92.2 Natural Monopolies 92.3 Policy Developments: Regulation, Privatisation and Liberalisation 11

3. INTERNATIONAL EXPERIENCE AND THE BiH CONTEXT 143.1. Discussion 143.2. Water as a Major Local Natural Resource 16

3.3. Electricity Production - the potential for recovery and long term gains 173.4. The Dynamic Telecommunications Sector 18

4. DETAILED REVIEW OF THE KEY SECTORS 184.1. The Energy sector in BiH 18

Background and Key Issues 18Specific International experience 22Prototype models of organisation for the electricity sector inthe transition period 23

4.2. The Telecommunications Sector 24Telecommunications in BiH 24Reform activities being undertaken 24The current position of the telecom sector and the privatisation process 25The socio-economic impacts of privatisation 25Proposed privatisation models and reform of the telecoms sector as a task for the future 25What privatisation model to apply? 26Next Steps: priorities for the sector 26Government decisions on divestiture 27The International experience 27

4.3. The Water Supply System 28The International Conetxt - Water as a limited resource 28Privatisation of the Water Sector 29Experience of Developed Countries 31Experiences from the region 32The Situation in BiH 32Recommendations 34

5. CHARTING A WAY FORWARD:

CONCLUSIONS AND RECOMMENDATIONS35

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1. INTRODUCTION

In spite of much rhetoric to the contrary, the

occurrence of monopoly, or near monopoly,

market conditions is far from rare in the modern

world. Moreover, the tensions and pressures

which give rise to such conditions are particularly

strong in transitional economies, where an

institutional history of state ownership is

supplemented by invariably small and structurally

constrained national and regional market places.

The formal causes and the factors which sustain

monopolistic behavior can be complex, but are

frequently rooted in the domestic legal and political

environment. It is argued by many mainstream

economists, the 'problem' of monopoly and its

claimed fundamental inefficiencies, runs in parallel to

the dominance of state ownership. It is unsurprisingthen that in the BiH context, as elsewhere in the

transitional world, the clamor for privatisation as an

antidote to monopoly power, and inter alia, the

elimination of economic inefficiency, has become a

'mantra' of the international financial institutions and

others within the international community.

But is the case for privatisation as solid as is

claimed? And specifically, what is to be done

about so-called 'natural monopolies', where

productive and delivery (typically infrastructural)

realties mean that some form of monopoly isinevitable, and the arguably the most efficient

outcome?

This report examines these very questions in the

BiH context for three sectors which exhibit natural-

monopoly characteristics; electricity generation and

supply; water and sewerage services; and tele-

communications. The report has three principal parts:

the first section provides a conceptual discussion

of the issues; the second investigates the BiH

situation in the context of relevant international

experience; whilst the third and most substantial

part looks in detail of each of the sectors in

question. Following this, overall conclusions and

recommendations are presented.

2. KEY CONCEPTS

2.1 The Dangers of Monopoly andthe Case for Privatisation

Different from other market participants,

monopolists are in a position to be able to pursue

price policies that ensure maximum profits,

disregarding allocation and cost pressures.

Operating in a competition-free environment,

monopoly producers are less motivated to

introduce new technological solutions, which results

in reduced effectiveness, compensated for by higher

prices which exceed the real value of the product.

In Bosnia and Herzegovina, as was the case

in the majority of transitional economies, natural

monopolies are state-owned. It is generally

believed that such an arrangement perpetuates

inefficiencies slowing the general trend rate of

growth, and discouraging positive social and

institutional development of society and the

economy.

Thus the economic case for privatisation is

bound up both with the market failures implied

by monopolistic forms of production and the

claimed inefficiencies of state ownership. Three

principal arguments are usually advanced insupport of this:

The efficiency and productivity case; this

come in two forms, first it is argued, that

producers by adopting a profit maximization

objective, minimize costs and optimize

output, achieving what is termed 'productive

efficiency'; and secondly, via the operation of

effective competition, the system better

matches demand with supply, thus

consumers, producers and the wider society

benefits, as 'allocative efficiency' is secured.Fiscal Gains; being the direct receipt of the

proceeds of the sale of assets by the state,

and the ongoing benefit of higher tax

revenues or lower subsidy payments, from/ to

the newly private and (as is claimed)

revitalized, industries.

Institutional development; being the

intangible economy-wide behavioral spin-offs

and values which it is argued follow mass

privatisation.

Problematically though, these arguments rest

not merely on privatisation, but the creation of

effective competition, and this is fundamentally

limited in the case of natural monopoly. A proper

appraisal is therefore required of each an every

sector, to determine the real scope of the gains to

be had.

2.2 Natural Monopolies

A 'natural' monopoly represents a situation in

which the technology or the character of theindustry are such that the demand can be met,

achieving the lowest costs and the greatest social

benefit, through the existence of a single producer.

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Under these conditions, a key assumption is that

the free entrance1 of other companies would lead

to an irrational waste of limited factors of

production, requiring cycles of excessive

investment, which would result in excessive rivalry

between companies (stimulated by a large

difference between marginal and average costs).

Moreover, if the pressure of excessive

capacity leads to a price war, a consequence could

be the suppression of prices to a level very close

to the critical short-term marginal costs, which can

jeopardize companies' capacities to maintain

production at a satisfactory level of production, to

carry out necessary adaptations and the

modernization of production, and to continue

offering high quality services.

The basic characteristic of a natural monopoly

is an inherent tendency for average costs to

decline over the whole production range. Thissituation appears when the scale economies are so

large to overwhelm normal rules of production.

The main source of this tendency is a necessity to

undertake extensive investment in order to meet

the effective market demand2.

This outcome is most clear in relation to

industries requiring expensive large scale infra-

structures; water, electricity, gas transmission and

distribution, and telecommunications, companies

must dig up the streets, lay down infrastructure and

physically connect output to every potentialconsumer. These costs can be absolutely static

regardless of the quantity of the end product

produced. Thus, average costs per product or service

unit will decrease disproportionately with the

number of units sold. This tendency is emphasized

by certain common and mutually dependant

characteristics:

Fixed and essentially non-transferable physical

connections between the supplier and

consumer or locality;

No, or very limited, possibilities to store

productive output;

Stringent delivery obligations, a need to meet

the demand instantly, in accordance with

consumers' wishes (flipping an electric

switch, switching on a thermostat, or lifting a

telephone receiver);

Significant fluctuations in demand - both by

individual consumers and the system as a whole

All of these characteristics lead to a need to

make large initial investments in capacity and to

maintain a considerable margin of safety, i.e.

sufficient infrastructure and plant, in order to meet

the demands even under peak load conditions. This

can be most efficiently accomplished by a singlesupplier, with one fixed connection to each

consumer.

These infrastructure or 'network economies',

which are apparent in the electricity, tele-

communications and water industries can lead to

the formation of vertically integrated monopolies.

These large firms ensure there is scope for

production costs to be minimised, and secure

supply (including via in some cases, the right to

import supply), through transmission, and

distribution networks to the end user. Yet equally,in some areas, particularly the energy sector, the

precise borders between which parts of the supply

chain represent natural monopolies, and which do

not, are difficult to define. For example, whilst

electricity transmission clearly exhibits all of the

characteristics of natural monopoly, electricity

generation does not.

1 In microeconomic analysis, a theoretical model of a monopoly is built on the following assumptions:

- There is only one seller and a multitude of small buyers. A monopoly market also recognizes the modalities of a monopoly,consisting of one buyer and a multitude of small sellers, and a bilateral monopoly, where there is one seller and one buyer.

- There are no substitutes or complements to the product or group of products sold by a monopoly. This assumption ensures

that events on other markets have no impact on the events on the monopoly market. In other words, cross-demand

elasticity on a monopoly market equals zero.

- There is no freedom of entrance for new companies. The effective demand volume on the local market represents a specific

form of a barrier to entrance. An example can be a sparsely populated area where there is usually only one shop in which

one can buy almost everything. Opening specialized shops, considering the demand volume, would not be lucrative. "This

example indicates two important things related to market monopolization: (1) a monopoly relates to the market size and

(2) a monopolistic company does not necessarily have to be large" .

- Both buyers and sellers are in possession of perfect (and free) information on market conditions. This assumption is least

realistic but is necessary. For example, the most important thing for a monopolist is to have a complete knowledge of

demand, but, at the same time, the demand schedules are the hardest to determine. Without this assumption, we would be

unable to claim that a monopoly has the knowledge of its average and marginal revenue curves, and thus, that it is capable

of determining its optimal production.2 Economies of scale can also be external for some companies. External economy of scales represent a reduction of average costs

of a company in a situation of production growth, caused by factors on which the company has no influence. For example, in

the case when a whole sector grows, companies have an opportunity to acquire their inputs at lower average costs.


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Natural monopolies, which dominate the

infrastructure sector in any economy, are

extraordinarily important. The added value they

provide often accounts for considerable part of

gross domestic product (GDP) while investment

into infrastructure is even a greater percentage

share of the total investment. Still, their

importance, to a great extent, arises from the fact

that their services and products are sizeable inputs

for all other sectors.

The two most important features of network

infrastructure providers are the following:

Extensive investment can pay off only over a

relatively long period of time, and

The phenomenon of accumulated costs make

divestiture practically impossible, in the case

that a decision is made to leave a particular

market, the function cannot be reprogrammed

and rearranged for rendering different services.

By using network infrastructure, a monopoly

company is in a position to use the effects of the

economies of scale (the sheer scale of services

rendered to end users) to amortise the costs which

are accumulated by the necessarily high level of

activity. This is one of the main reasons why the

state decides to preserve a monopoly in the form of

a public company and a reason to decide to regulate

or control the business of such a natural monopoly.

The state tries to preserve the advantages withregard to the potential low costs while at the same

time finding adequate ways to limit the monopolist's

market power; it forces them to increase production

while reducing the price, in order to move closer to

the manner in which a fully competitive market

would function (were this option available).

It is necessary to emphasise the characteristics

of these sectors in order to show clearly the

difficulty and complexity of the measures and

activities which are directed to achieving the full

liberalisation of the market and the development

of competition as a mechanism to change the

behavior of the existing dominant participants,

and thus to secure a reduction in prices and an

improvement in the quality and range of services

for the end users.

Network services (telecommunications,

electricity, water, gas) can be either:

Intermediary services, maximising efficiency

in managing the traffic in the network

infrastructure; and

Final services, meeting the demand of the end

users of the network.

It should be noted that a natural monopoly is

not necessarily present in the field of services,

whether intermediary or final. In fact, investment

in the field of services should aim to address the

sources of monopoly with regard to intermediary

costs (in order to direct better the oscillations of

traffic in network infrastructure) and final services

(in order to adequately respond to the demands of

end users, in particular businesses whose effective

demand for this kind of service grows very

rapidly). Flexibility of offer and short-term

adjustability in the field of services are vital and

suggest that the most adequate market structure

would be made up of several service providers

who would then be mutually competitive.

It could be said, therefore, that the periodwhen integrated monopolies necessarily managed

and used infrastructure with the objective of

rendering all services has passed. The appropriate

future industry structure of these companies

should be a compound model, where the

dominant operator maintains its monopoly

position in that segment of the business which is

subject to the conditions of natural monopoly but

is exposed to competition from several operators

in other segments.

Competitive operators or those proposing theintroduction of services which the dominant operator

does not offer, may find themselves represented only

in some links of the vertical supply chain. Therefore,

they have to gain access to other parts of the chain

and obtain dedicated connection to the key

resources, most frequently to the basic infrastructure,

from the dominant operator who exclusively operates

the given infrastructure.

2.3 Policy Developments: Regulation,

Privatisation and LiberalisationNatural monopolies in the sphere of

infrastructure play a key role in the process of

economic development and can have a considerable

impact on living standards and economic growth. By

the mid 1980s, a large number of underdeveloped

countries relied on public monopolies for the

funding and management of infrastructure3. In the

mid 1990s, the world began turning to the private

sector to take over the management and ownership

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3 Assessments are that technical inefficiency in the sphere of electricity, water, roads and railways alone caused losses of about

55 billion US dollars per year in the early 1990s, which is an equivalent to 1% of the total GDP of all underdeveloped countries

or a fourth of the annual investment into the infrastructure sector.


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of the existing infrastructures as well as to finance

new investment4.

Deciding to privatise, governments were

simultaneously oriented towards economic, political

and financial goals. The goals were often

interdependent, yet were also sometimes in

opposition. Different countries ranked some of the

goals in accordance with adopted macroeconomic

policy aims, some with the sectoral characteristics

and/ or priorities, and specific conditions in their

respective countries. Moreover, it was not unusual

for a country to change the ranking of goals adopted

over time. Reliance on the private sector in terms of

finance and management culture was introduced

with the expectation of numerous beneficial effects.

The most important aspects of this were the need to

facilitate access to private capital in financial markets,

an increased motivation for more efficient business

practices, and a reduction in demand for constrainedand often meager public funds.

It is worth noting that natural monopolies

(with the characteristics of legally regulated

monopolies) in practice unify commercial and

regulatory functions of the government. And in the

field of infrastructure, countries have opted for

different programs of deregulation and privatisation

with a view to separating these two functions5.

Following the general trend of liberalisation

and deregulation, and in order to achieve the best

possible economic efficiency and rational use ofprecious resources, a large number of countries

made the decision that it was necessary to ensure

a much greater level of competition in the delivery

of infrastructural services which was dominated by

public monopolies. This encompasses following

three separate processes6:

Privatisation- the transfer of ownership from

the public to the private sector;

Liberalisation- the introduction of competition into

markets which were either monopolistic or

oligopolistic; and

Deregulationor perhaps more accurately Trans-

regulation- the change, or introduction of new

and independent regulatory mechanisms with a

view of monitoring and controlling these

markets. The expression trans-regulation is

argued to be appropriate because it makes it

clear that this is not about abandoning or

eliminating, but about reshaping regulatory

mechanisms and practices to new realities.

Privatisation is a process which refers to

changes to the legal form and ownership of

companies in terms of the transformation from

government (through the process of

incorporation7) into public and finally into private

hands. Indeed, process issues like the speed of

transfer and the phasing of necessary legal

institutional issues dominate the policy debate;

best practice suggests there are a number of stages

to be followed in a systematic manner.

The first stage in the process of privatisationmay be partial privatisation or 'commercialisation'

of the enterprise, which results in greater

transparency, permitting better performance

evaluation of the company, increased financial

flexibility, the introduction of performance-based

incentives for managers (through vehicles like

stock options), better corporate governance and

pressure on management to realise value for

stockholders (increased shareholder value) rather

than political goals. In many countries, the

ownership dimension of partial privatisation(disposing of a portion of the equity capital) was

undertaken as a strategy to gradually introduce

companies to the financial market because of the

limited absorptive power of the financial markets.

This was the case with many British (British

Telecom, British Gas), Spanish (Telefonica,

Argentaria) and Italian companies (ENI, Telecom

Italia). In other cases, partial privatisation was the

end of the process not an intermediate stage;

Deutsche Telecom, France Telecom and Dutch

Royal KPN were only partially floated on the

financial markets with the State as the majority

owner. This approach has some advantages and

4 In the period 1992-2000, the scale of investment into private infrastructure projects in underdeveloped countries amounted to

over 680 billion US dollars.5 An important function entrusted to public monopolies was that of protecting citizens' living standards through the maintenance

of low prices for services, often much below average or even below marginal costs of their production. The difference to full

costs was compensated by the State through a system of the subsidies . However, an accepted conclusion in the field of

contemporary welfare economics is that this policy of redistribution of revenues could be much more effectively implemented

by means of direct transfers or transfer of the purchasing power or targeted subsidies than is the case with non-selective

subsidies when prices of products are kept low for all buyers. A direct consequence of such an approach is reflected in the

excessive use of production inputs (in particular of energy). Whilst a somewhat less obvious consequence, is that this is also

reflected in the lack of funds for modernization and expansion of activities in the infrastructure sector.6 In this Report we will focus only on the first two.7 Incorporation of the British Telecom lasted nearly two years.


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the experience of certain countries, which

preserved majority ownership in former public

companies by selling only small packages of stock

to strategic foreign investors, may be useful for

Bosnia and Herzegovina. The most relevant

examples are telecommunications in the Czech

Republic and electricity management in Belgium.

The move from the partial to final

privatisation may be the most sensitive stage in the

privatisation process. It must be borne in mind

that a certain period of time must elapse after

incorporation, a period long enough for the

company to adjust to new commercial and cultural

realities and working within the framework of the

market economy. The company in question must

go through a process of adjustment and of

building new management and business

structures. The fact that this period has usually

taken five years in Holland tells us best howsensitive this process is. Clearly we must take note

that a long period of time is required even in very

stable countries with long traditions of operating

liberal market economies with sophisticated

demonstrates legal environments. Bearing in mind

the current economic-political and legislative

situation in Bosnia and Herzegovina, we must be

utterly scrupulous in setting down and observing

the timing and phasing of strategies to be used in

the privatisation of publicly owned companies.

Final or full privatisation is an obvioussolution for those sectors where commercial or

profit-oriented goals are more pronounced and

dominant in relation to the public interest, and

particularly when they can be viewed separately.

When commercial goals are narrow and limited in

comparison to the public interest (in particular in

the area of rendering services such as health care,

education, public security, basic services)

advocating privatisation is far less justified.

Separation of these two functions (commercial and

public) in the process of full privatisation

improves economic efficiency by:

Eliminating traditional conflicts of interest,

and the insufficiently defined and non-

transparent role of the state as the owner,

operator and sometimes the regulator, of a

business entity8;

Increasing motivation for managers to run

companies in more effective ways; and

Ensuring relevant and reliable information is

available, about the value of the company to

potential investors and its performance by

way of shares on the financial market.

We should bear in mind that privatisation is

often a part of a wider reform (often transition)

strategy which aims to change the role of the state

in the economic sphere - and thus, includes

regulatory reforms, to introduce (or strengthen the

existing) competition policies, in order to

stimulate an increase of material and social wealth.

Privatisation has interdependent and often

conflicting political, economic and financial goals.

The projected goals of privatisation can be

summarised as follows:

Changing the manner in which public

companies are managed and improve their

productive efficiency and business results by

introducing incentives based on private

ownership instead of bureaucratic supervisionand control.

Ensuring better access to necessary financial

sources of additional investment.

Creating considerable revenues for the state

budget and an improvement of certain

macroeconomic indicators, particularly a

reduction of the public debt and demand for

borrowing by the public sector.

Increasing the use of equities in financial

markets and the creation of a critical mass of

stockholders, as well as increasing the equity-ownership route for the channeling of savings

into the economic system.

Introducing competition into markets that were

closed until recently, leading to reductions in

prices and an improvement in the quality of

infrastructure, products, and services.

However, we need to emphasize that in the

context of a transitional economy, privatisation is a

necessary, but not sufficient condition for improving

the performance of the economic system as a whole.

In a formal sense, privatisation does nothing other

than change the structure of the ownership relations

between market participants. However, its potentially

powerful beneficial effects are manifest only when the

structure of the market adapts and other reforms are

progressed successfully. In other words, if we can not

fulfill the above mentioned reform goals then the

question arises; why privatize at all?

Liberalisation concerns the structure,

flexibility and openness of an industry. Key issues

13

8 In the majority of OECD countries, responsible ministries abandoned the function of managing shares of public companies

regardless whether they were partially privatized later. This ensures a better separation of commercial goals (for example,

returns of the invested funds)


15/39

14

are whether a single company or a number of

companies make up a certain sector, and the

conditions under which these companies operate

or are connected in some way (vertically or

horizontally). The criterion of efficiency, which is

relevant here, refers to the cost structure and the

degree of the economies of scale. The entry of

new companies competing with the dominant

operator in a network economy can ensure greater

efficiency so long as this competition occurs in a

field in which there are not constantly increasing

returns to scale, and if the entrance of new

companies is accompanied by lower costs and

consequently lower prices for services. When

these conditions are fulfilled, a fragmented market

structure would enable the adjustment of supply

to the constantly changing needs of the users,

expressed as a diversified, flexible and dynamic

perfectly competitive market place.Market liberalisation inevitably leads to

disturbances, and can result in the overlap of

regulatory goals. The former clear goal of ensuring

incentives to a monopoly company, public or

private, is replaced by the goal of disabling former

monopoly companies of abusing their still

dominant position in the market - and terminating

the practice of 'cross subsidy'. This is the practice

of realising insufficient revenues by calculating

low competitive prices (often below actual costs)

in those market segments where competition ispresent, and cross-subsidizing by the revenues

made from the sale of services at unjustifiably high

prices in the still monopolised part of the market.

De-regulation or perhaps more appropriately

Trans-regulation is concerned with changing the

governance and management of economic

activity, by (but not necessarily) governmental

agencies. The objectives of regulatory policy are

bound-up with securing the public good in the

face of competing private interests and market

failures. Regulatory reform has to accompany both

privatisation and liberalisation if social and

economic goals are to be realized, at least in the

early stages, and in the case of natural monopoly

and/ or market dominance, on an ongoing and

permanent basis.

Best practice has shown that a crucial issue in

the privatisation process is the proper phasing of

reforms and policy instruments. Both empirical

evidence and theory, suggest that there are very

significant risks of rapid, ill-prepared programs of

divestiture. To succeed in securing the potential

economic and social benefits, policy makers need toensure appropriate regulatory structures are in place

and are functioning well before full divestiture

takes place. Liberalisation also requires a phased

and considered approach tailored to local

circumstances; chiefly the level of competition and

the presence of supportive market institutions,

ranging from commercial law to modes of business

conduct.

3. INTERNATIONALEXPERIENCE AND THEBiH CONTEXT

3.1 Discussion

It has been argued that de-monopolisation,

aided by the privatisation of major enterprises, will

permit the restructuring process to occur in BiH.But is privatisation the best way to move ahead

and in which manner? In the light of the above

conceptual discussion, it is necessary to build a

market that will ensure competition for the

purpose of securing greater efficiencies, given by

profitability for producers and lower prices for

consumers, and where competition is not

possible, such as in the case of natural

monopolies, establish regulatory structures which

result in the same desirable outcomes.

Market structures and institutional changesare particularly important. In the case of the

energy sector for example, two market models are

possible for the production, transmission and

distribution of electricity:

The one buyer market model where pro-

duction and transmission are managed within a

vertically integrated electricity system. Under this

model, production can be privatised partially or

fully, without major disturbances in the system

itself. The entry of new producers from outside the

existing system can certainly improve efficiency,

leading eventually to lower prices within a central

pool or exchange system. This model builds on the

discussion above, recognising that whilst

transmission and distribution have 'pure' natural

monopoly characteristics, production does not.

The open market model presupposes a full

separation of the existing units in the system. This

model implies a total restructuring of production,

transmission and distribution - and their complete

separation and eventual privatisation. Under the

open market model, vertically integrated units

disappear. This model ensures competition inproduction and eventually in supply, which leads

to greater efficacy when using limited energy

resources. But, dangers do exist, not least the


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threat of leaving the country without its own

energy sources, and a lack of emergency capacity9.

Indeed, the telecommunication sector in BiH

already somewhat mirrors this model in relation to

the provision of mobile telephony services, and it is

one of the most liberal in the Central and Eastern

Europe (CEE) region. We have three state owned

operations and two of them have their own GSM and

Internet operations. There is also one GSM operator

linked to Croatian Telecom and DeutscheTelecom

and working without the licence for more then eght

years. The present independent Communications

Regulatory Agency (CRA) has set a number of rules

and conditions for operators (but of course, the rules

and regulations do not apply to illegal operators

present in BiH); they are obligated to share basic

infrastructure, links, GSM space and infrastructure,

and provide services to the entire territory of BiH.

Moreover, the operators are required to makepreparations in order to attain European Union

standards and management practices.

The water supply industry is in a completely

different place. This sector has never been one

state owned company, but smaller local

monopolies that operate in municipal areas with

licenses, with the authority and the responsibility

to provide every household with drinking water in

their limited local community areas. The

privatisation of these entities would be a locally

driven process and questionable when it comesthe overall efficiency gains and income generated.

This is unsurprising as the water supply industry is

the sector which most clearly approximates

conditions of natural monopoly.

It is important to recognise that the questions

raised by these different models of production and

supply are not solely related to the nature of the

ownership model adopted. Indeed, securing

efficiency particularly if a wider social calculus is

employed rests more on the structures and regulatory

institutions which are in place. And the existence of

public companies represents a certain advantage

because such companies, regardless of how

imperfect have some, though not guaranteed, interest

in maximizing overall social welfare rather than

private gain. The presence of often substantial market

failures, costs and benefits external to the productive

process, termed 'externalities', make a socialised

approach to provision more favorable in the context

of natural monopolies.

Expressed in microeconomic vocabulary, we

could speak of an approximated or 'second-best'

accomplishment of allocative efficiency; services

are mainly ensured in the required quantities and

mix; prices are calculated for end users within

acceptable boundaries; and the benefits from

public services accrue to the users regardless of

location or supply constraints. Considerable

progress in the work of public companies was

made by many countries, by improving the

internal management and culture of such

companies10. Water supply is an example which

suggests that publicly owned enterprises such as

those in Holland, Japan and the USA operate more

effectively than private companies in England and

France. In the area of electricity, too, the resultsshow that privatisation often does not yield the

desired results. The emergence of an energy crisis

in California in 2001, where it became apparent

that consumers in Los Angeles were the only ones

in California who were spared electricity

restrictions because production and distribution of

electricity in this city is in the hands of a public

company owned by the city government, provides

a valuable lesson.

The public sector can be as effective if not

better than the private sector in increasingproductivity. An analysis of privatised industries at

the time of Margaret Thatcher's government shows

that the greatest improvements occurred before and

not after privatisation. Where partial privatisation

was implemented, as in the refuse collection and

disposal sector, companies which remained in the

ownership of local governments improved their

work as much as private companies. Finnish

economist Johan Willner, concluded in a study

published in 2001, that political control, realised

through public ownership, may lead to better

economic results, in particular in those sectors

which are "natural monopolies"11.

In Honduras, for example, the branch trade

union played a leading role in the process of

successful, restructuring the water sector.

It advocated the preservation of existing jobs,

15

9 Rumania is importing electricity produced by Rumanian power-plants and fueled by Rumanian coal.10 The function of managing the entrusted assets was improved by many countries by introducing the required flexibility which

was so far a characteristic of the private sector. In Sweden, for example, a new government department for managing assets

of public companies was established in 1999 with a mandate to govern commercially state participation in the 59 main

industrial companies (including telecoms and air companies). The new department is authorized to sell stock of these

companies when it is decided that withdrawal of the state from the given sector is the best investment decision.11 Johan Willner: "Ownership, efficiency, and political interference", European Journal of Political Economy, Volume 17, Issue 4,

November 2001.


17/39

16

however, the private sector commonly as a first step

towards improving efficiency, reduces the numbers

employed. This example indicates the fact that the

current employees of public companies constitute

an important resource of expertise imbued with a

service ethic. State institutions in some countries

have increasingly come to acknowledge this fact.

Also, it is important to note that three of the most

advanced and most powerful telecommunications

operators in the Europe, DeutscheTelekom, Telenor

and France Telecom, remain mostly-state owned.

Moreover, the service provider with the best quality

of service in CEE has been judged to be Slovenian

Telecom which is still 67% owned and managed by

the government. Examples of negative experiences of

post-privatized firms include; Macedonia where

Matav Telecom, 51% owned by Deutsche Telekom

(following privatisation of Hungarian Telecom),

increased GSM service prices to the highest levels inEurope (3 times higher then in BiH); and in Croatia,

where Deutsche Telekom, after majority privatisation

and restructuring, raised prices for fixed telephony by

an average of 250%.

One of the doubtless advantages of public

corporations over private companies is that in hard

times and unfavorable economic environments

public companies can not simply stop operating

and abandon a certain sector or segment of the

market, and go in search of better profit in another

sector. In the private sector, firms possess incentivesto do just that12. While the private sector often

cannot afford to continue providing certain

services, a public company is not permitted to

abandon provision. A current example is the EU

telecoms market, where large operations,

recovering from considerable outlays, are trying to

find ways to cover their debt anywhere they can.

Here, one must wonder how many of them would

have been closed down had they not had

government support at a time of global recession.

Also, in many cases CEE Governments have been

forced to intervene when weak management and

foreign investors threatened the survival of telecom

operations and the service provided to the local

population in general.

Therefore, the process of privatisation of

natural monopolies, or transfer from public to

private management, can first be understood as an

intention to secure direct realisation of productive

efficiency which results from the care and

endeavors of managers of private companies to

increase their profits - in order to enlarge their

own revenues - under the control exercised by

stockholders and creditors. With regard to

allocative efficiency, this is partly realised in the

form of increased production efficiency (lower

expenses largely lead to lower prices) which is

partially guaranteed by the interventions of the

regulatory bodies.

It must be recognised though that the

realisation of socially efficient outcomes within

public ownership and management cannot simply

be assumed either. Indeed, although public

companies are often tasked with, and claimed to,

operate their businesses in line with wider social

and public interests, they often manifestly do not.Without oversight and regulation, publicly owned

monopolists can behave as badly as unregulated

private ones do.

What is required is a balanced and strategic

approach to these matters. Privatisation of natural

monopolies should be accomplished as a long-

term and strategic process, rather than simply a

matter of divestiture of assets. It should be kept

in mind that when it comes to the sectors of

energy production and distribution, water supply,

and telecommunications, that the long-termbenefits should rank as the first priority, then the

mid-term, in the form of liberalisation of the

sector, and finally the short-term gains in the form

of privatisation receipts and higher tax earnings.

3.2 Water as a Major Local NaturalResourceWater reserves per inhabitant are shrinking on

all continents. The greatest reductions of water

resources are in Asia, Africa and South America.

This trend is a consequence of several factors;

population growth, climate change, emergence of

so-called 'mega-opolis' cities and more and more

extensive pollution, in particular of surface waters.

A dramatic increase of the population began in

1950 when Earth was populated with 2.5 billion

12 An American company operating in transmission and sale of electricity, AES, simply abandoned its work in 2001 in Orrisa,

one of the poorest states in India, because it was not able to realize sufficient profits. A leading world company in the field

of water supply, Suez, simply terminated supplying water to more than a half of Manila as it could not pay debts and realize

profits. A British company, National Express, simply broke a contract in 2002 that it had in the province of Victoria, Australia,

leaving the local bus company with a 55 million dollar debt. These are not exceptions, the basic goal of a private company

is enlargement of its equity and if the circumstances are not right for that the private company simply terminates its business

and searches for more profitable activities.


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people. Forty years later, in 1990, there were 5.3

billion people. According to some projections, by

2025 there will be 8.3 billion people, and by 2050

a critical 10 billion people on this planet. A trend

towards the concentration of people in large cities

is more and more pronounced. In 1950, 29% of

the world's population lived in cities, while in

2000; this number had grown to as much as 47%.

In 1950, only 78 cities in the world had more than

a million inhabitants, while in 2000, there were

408 such cities. Large cities are in need of greater

quantities of water within a relatively small area.

After use, this water becomes waste which is let

out into the environment and can pollute the

scarce remaining water reserves.

Water consumption increases constantly.

Although a human being needs between 1 and 5

litre of water a day to sustain life, depending on

climatic conditions, the actual consumption ismuch greater. To maintain a good quality of life

and hygiene in urban conditions a minimum of 40

to 50 liters of water is consumed daily per person.

The consequences of drinking water

shortages confirm a deep division in the world

between the rich and the poor (the developed

versus the undeveloped). The rift between these

segments will continue to widen in the future.

Developed countries will probably rectify some of

the current situation as they anticipate stagnation

in population growth, further development of'clean' technologies, building waste water

purification plants, environment-friendly waste

disposal, introduction of environment-friendly

agro-technical methods and the building of

desalinisation plants. The situation with water with

respect to the undeveloped world, could well

worsen in the future, as they are going through a

cycle of demographic explosion that will put

pressure on living and health standards and in

extreme situations, people may face starvation or

poisoning because of shortages of water and/or its

pollution.

Bosnia and Herzegovina is relatively rich in

water resources. This, among other things, is

indicated by the number of rivers on its territory; the

Bosna, the Neretva, the Vrbas, the Una, the Sava and

the Drina. There are a number of natural lakes and

impounded reservoirs created by the construction of

hydro-power plants on the Rama, the Neretva, the

Trebisnica, the Drina, the Vrbas and the Pliva. These

resources are vital to BiH's development for a

number of reasons. The potential offered by hydro-

energy is most worthy of attention. Thanks to this

fact, BiH is today the only country in the Balkans

which has a surplus of electricity. Waters in BiH are

also relatively free from pollution. This opens

opportunities for more investment into the

production of drinking water as one of BiH's

strategic natural resources.

3.3 Electricity Production - the potentialfor recovery and long term gainsSuccessful energy management is a general

precondition for the economic and social

development for every society, and this is

fundamentally true of Bosnia and Herzegovina.

Enormous efforts have lately been invested in BiH,

and its entities, to ensure as much energy as

possible is secured from local resources and thus

energy dependency on others, is reduced.

Coal remains the main energy resource inBosnia and Herzegovina. Coal production in the

1980s surpassed 13 million tons. Performance of

the local coal mines in this period was at

European levels. In the last 50 years, considerable

changes have taken place in the BiH energy

sector. Energy consumption was considerably

reduced because of the conflict and the transition

to the market. As a result of these events, coal

production today is between 30% and 40% of pre-

war production levels. Yet, we should have in

mind that water-based energy plants are designedfor maximum use and their true potential in BiH

has yet to be exploited. Their export potential in

a world of growing electrical energy demand

could provide a strategic competitive advantage

for BiH13.

Aside from coal and water-based resources,

the electricity sector also includes non-

conventional resources, primarily solar energy. It

is well known that BiH abounds in these resources

and their potential for growth including export

supply is high. Hydro-electricity provides the

strongest potential. We should also have in mind

that the average number of sunny days in BiH is

also well above the European level.

Energy management today has an extremely

important impact on the development of the social

system and on changes in the natural environment.

The level of social development is directly

correlated to the quantity of energy produced.

Impacts on the environment are also strongly

related to this. Therefore, it is important to address

two questions: First, what is the quantity of energy

produced in our country? And second, what

17

13 BH is already regularly exporting electricity to the neighboring countries - Croatia, Slovenia, Serbia, Montenegro etc.


19/39

measures are necessary in order to increase it in an

environmentally sustainable manner?

3.4 The DynamicTelecommunications SectorWhat was once a fairly stable and sedate,

state-owned and monopoly-dominated sector has

worldwide become a dynamic engine of growth.

Competition aided and abetted by privatisation,

new entrants and perhaps most significantly rapid

technological change has grown exponentially.

The new competitors that have appeared are no

longer telecommunications companies, but

horizontally integrated conglomerates including,

cable TV operators, utility companies, software

producers, financial institutions - indeed, even the

French state water supply corporation has entered

the telecom sector. Telecoms spurred bycontinuing technological innovation has reached

the pinnacle of political priorities.

Across Eastern Europe the demand for

telecommunications services continues grow at

dizzying rates. In countries such as Albania, where

land lines are rare and links bad, satellite networks

have sprung up in an attempt to catch up with the

expansion of the long suppressed demand. But this

growth is not confined to basic services. Several

years ago, Russian connections to the Internet were

notorious for their unreliability. Today, however,connection quality and speed are close to Western

standards. Even the most lagging transitional

countries are not been spared this hunger for new

services. For example, in 1900, Russia had only

1,000 international telecommunications channels

and one international exchange - in Moscow.

Leningrad serviced an area of 12 million inhabitants

with only 11 channels. Today, Russia has 45,000

international channels and all regions, and

practically all telephones, have international access.

In some countries, such as Poland, dozens of

private operators, often supported by Western

companies, directly face the one-time state

monopoly in competing for subscribers.

In spite of technological innovation,

telecommunications still contain an element of a

natural monopoly, in the form of the basic fixed

line network. A new operator must be in the

position to be able to connect to the existing

network, but inevitably, this infrastructure is

owned by the former monopolist with whom the

new operator has to compete. Many former state

monopolies have abused this control; eitherovertly, like the Polish TP SA, who smothered

competition directly, blocking new competitors

from accessing their network; or implicitly through

controlling the allocation of access lines. Equally,

business users are rarely keen to change their

telephone company if they have to change their

number because they risk losing customers and so

things often remain as they are.

Bosnia and Herzegovina is going through a

phase of developmental transition. The

telecommunications sector is relatively well

undeveloped. A stimulus to its development was

given with the separation of the

telecommunications and the postal service

providers. Telecommunications facilities and

installations have been considerably renewed and

modernized, powerful digital transmission systems

and digital mobile telephony for GSM standards

have been built, stet large on before ISDN

technology has been introduced since 1999, and

integrated enterprise recourse planning systems

have been introduced to support the managementand finance controll processes.

There are three companies in BiH providing

services in the domain of telecommunications: BiH

Telecom, RS Telecom and Croatian

Telecommunications Mostar. Relations in this

sector at the state level are regulated by the

Communications Regulatory Agency (CRA). The

level of service is relatively good, and thanks to

roaming, direct access to a large part of the world

is offered. Mobile telephony is also going through

expansion as well as internet networking. All thiswill ensure better links with the world, increases

in the scale, types and quality of services, but also

by improving the profitability of the

telecommunications sector.

4. DETAILED REVIEW OFTHE KEY SECTORS

4.1 The Energy sector in BiHBackground and Key Issues

The privatisation of energy companies in

transition countries is largely complete, particularly

in the case of small and medium size enterprises.

There are some delays in the case of larger

corporations, with differences between countries.

BiH belongs to the countries in the region which

have implemented about 70% of planned

privatisation. The majority of large companies are

still fully or partially in state ownership (about35%), the approach adopted is generally for

restructuring to be carried out before privatisation,

and this matches with established best practice.

18


20/39

Some of the remaining large companies represent

natural monopolies and considerable attention

must given to conducting social and economic

impact analyses in order to fully appreciate the

consequences which will arise from their

privatisation. Impacts will be felt by consumers and

the state as the former owner, and other enterprises

including those in neighboring countries. Given this

reality, it is necessary to analyse in detail, the

implications of the method and speed of the

privatisation process for these companies.

As noted, a natural monopoly is held by a

company which can produce the total output at

lower costs than several companies, and under

such conditions, greater efficiency can be secured

if there is only one large company rather than

several operating within the market. Privatisation

has been carried out so far in many countries, with

different levels of coverage and utilizing a varietyof methods. In Eastern Europe, Hungary and

Poland have gone the furthest in the privatisation

of energy companies and it is instructive to

examine their experiences in some detail.

Since the energy sector inherently possesses

elements of natural monopoly, it is vital we

determine the most desirable regulatory

framework. A first question is; who should be

operationally responsible for regulation? And there

are two generic solutions to this: (a) an

independent regulatory agency, or (b) aresponsible ministry. Experiences from other

countries show that it is much more favorable to

establish a regulatory agency which is

independent from the relevant ministry and

external political and economic influences. It is

important to recognize that the forms out

influence to be resisted often include attempts by

the monopolist being regulated to gain effective

control or 'capture' the regulatory agency.

A second question is the nature of price or

economic regulation; three distinct alternatives are

put forward:

1. Control over the rate of profit, a method used

commonly in the United States which

involves setting a ceiling or threshold above

which penalties apply on the profits to be

made as share of, typically, the capital

employed.

2. Price-ceiling determination, an approach which

specifies the maximum rate of change in end-

user (consumer and commercial user) prices

paid. This is a method pioneered in the United

Kingdom by Professor Stephen Liittlechild,

typically, with increases being linked to the

consumer price index less or plus a judgmental

factor to reflect efficiency savings or investment

needs over and above the rate of inflation

(some times referred to as a 'CPI - X approach').

3. Profit distribution limitation, being the

limitation of profits to be distributed to

shareholders, commonly specified by a

threshold defining extra profits. In contrast to

method one, profits are permitted but have to

be retained within the company.

Considering that there is significant

inefficiency in the management of generation of

electricity in BiH, a price-ceiling determination is

considered the most favorable method of

economic regulation. This is also the increasingly

generally favored approach in that the welfaregain is directly linked to prices paid by consumers,

and given the high level of transparency the

control is difficult to evade.

Turning to the process of privatisation of the

energy sector, itself five key questions should be

addressed:

How rapidly should the division and restructu-

ring of the sector be carried out before

privatisation, including the establishment of

functioning regulatory agency?

How much will prices be permitted rise afterprivatisation?

What return rate on the invested capital is

considered a normal return?

In what way will redundancies in these

companies be taken care of?

How can an open energy resource market is

established, and what structural reforms are

required for this?

At the beginning of this analysis, it is worth

noting several trends which are pertinent to the

region:

1. The average growth of energy consumption in

the region is between 2 and 5% per year14. For

the period 1989-1998, energy consumption

grew in Poland by 8%, in Slovenia by 20%, in

Slovakia by 56% and Romania by 84%15.

2. All countries in the region have insufficient

energy potential from renewable sources, such as

water and wind generated energy. This also applies

to BiH's neighbours, and in particular to Croatia

and Serbia and Montenegro.

19

14 In Croatia, the annual level of electricity consumption grows by about 4% (HEP report for 2002).15 Reform of the Electricity Market In Transition Economies: How to Avoid Traps of Deregulation, Martin Siner and Jon Stern


21/39

20

3. Croatia imports about 24% of its total

electricity consumption (3,724 Gwh per

year16), while Serbia and Montenegro import

about 5% (1,711 Gwh a year17). This trend is

growing at a fairly constant rate.

4. There are many agreements at the

international level related to the reduction of

pollution by means of reducing the production

of energy from coal, oil and other sources

which contribute to the pollution of the natural

environment (chiefly the Kyoto agreement).

5. BiH has the largest hydro potential per capita

in Eastern Europe.

6. BiH is second in the region in terms of exports of

electricity after Bulgaria18 and with only about

40% of expected hydro capacity exploited.

7. Collection rates for electricity supplied are

good (at about 87%).

It can be concluded on the basis of these points

that BiH is rich with renewable energy sources

whose importance will grow in the coming years.

Returning to the five key considerations noted

above; in the majority of European countries, the

energy systems are divided into three areas:

production, transmission and distribution. Attempts

are currently being made to divide the current

electricity management in BiH into these three

segments. This process attempts to address the

questions about restructuring and market formation.

The follow on questions which arise are; which of

these parts of the electricity system should be

privatised? and in what way, and to what extent? In

different countries, this procedure and the

subsequent regulation of the constituent parts of the

system has been accomplished in different ways.

Before beginning the process in BiH it is likely

to be necessary to merge the three existing vertically

integrated companies (EP Republike Srpske, EP

Herceg Bosne and EP BiH) into one company

which would operate on the territory of the entire

country19. Only after this would the privatisation

process be commercially realistic, given the need for

the new enterprise to achieve economies of scale

sufficient to compete in the regional market place.

Thus changes in the electricity sector should be

undertaken in the following order:

There are five basic models for the

privatisation infrastructure companies:

1. Management agreement2. Services agreement

3. Cession of facilities

4. Concession

5. Privatisation of equity capital

Each of these models has its advantages and

disadvantages. The table below summarizes the

characteristics of each model of privatisation by, the

economic efficiency of companies, new investment

needs, transfer of know-how and applicability.

The table above shows that the full pri-

vatization of company capital is the only relevant

model of privatisation of the energy sector

considering its strong effects on all four criteria.

Privatisation can then be carried out by

means of applying several essentially different

divestiture options:

Public sale of stock

Sale to institutional investors

Sale to financial investors

16 Ibid17 Annual Report for 2002 by Electricity Management of Serbia and Montenegro18 OHR Report - www.ohr.int19 Note that this process is likely to begin shortly.

Restructuring

Regulation

Privatisation

Liberalisation

Market strengthening

Privatisation model Economic efficiency New investment Transfer of know-how Applicability

Management agreement * - * Yes

Services agreement * - - Yes

Cession of facilities ** - ** Conditional

Concession ** * ** Yes

Privatisation of

company capital ** ** ** Yes

- there are no effects * moderate effects exist ** strong effects exist


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Sale to strategic investors

Distribution (assignment) to local investors.

The table below evaluates the potential

energy sector privatisation methods.

From the above, the greatest value for the

State can be obtained from the sale of electricity

companies to a strategic investor, either local or

foreign.The next factor that should be taken into

consideration is the likely social impact of

privatising production and supply of electricity.

The policy of privatising energy companies

should be based on three basic elements:

1. Partial and necessary restructuring of the

electricity sector before privatisation;

2. Definition and development and efficiency

goals to be achieved through privatisation;

3. Reform of the market and pricing policies,

which in many cases implies growth of existingelectricity prices (price based on the coverage

of total costs, which is not the case now).

Restructuring should serve to rehabilitate the

business and lead to the fundamental restructuring

of EP BiH. Restructuring should be based on

vertical separation, i.e. separation of production,

transmission and distribution. In the domain

of production several mutually independent

production companies need to be established.

This will enhance competition between the

production companies, but this does not

necessarily mean reduced electricity prices. What

is certain is that productive efficiency will be

enhanced. Surface coal mines should remain

integrated with the companies using their coal for

electricity generation. This would ensure a more

efficient business for both the coal mines and the

energy production companies.

The State should retain majority of control/

ownership in the areas of transmission and some

generation, as opposed to distribution that could be

offered to strategic investors, either local or foreign.In this way citizens would have local distribution

companies that would be enable to purchase

electricity from any producer at the best possible

condition and price, while Government could focus

on management and production. In time through

the concession arrangements, there should be a

number of local generating companies that would

compete for both local and international business.

We recommend distribution should be

organized through a number of companies on a

regional level. Privatisation of distribution will also

lead to an increase of efficiency in this part of theelectricity system. Transmission of electricity

would be organised as one company, which

would operate on the whole territory of BiH and

would be owned in full by the state. In this way

the state could retain an effective control over the

production and distribution companies.

The next factor that needs to be considered is

what social impacts will the privatisation of the

production and sale of electricity have within BiH?

Considering that a very sizeable proportion of the

population live in or close to the poverty line, it willbe necessary to make a specific assessment of the

effects of privatisation on this segment of the

population. It is generally known that electricity

companies owned by the state had an important

social role and that they often produced losses, failing

to cover even their average production costs. The

current situation in the BiH is such that households

spend on average between 10 and 12% of their

overall income on energy. In comparison with OECD

countries, where the population spends between 2

and 3%, we can conclude that the population of BiH

is much more vulnerable to price increases than the

populations in developed countries.

Therefore, privatisation of the electricity

sector should primarily enable price reductions for

household consumption. The Polish and

Hungarian experiences show that prices in these

countries grew on average up to 25%. Prices have

risen in most other countries which have carried

out privatisation - Finland, Argentina, Chile and

Australia.

Another factor which needs to be kept in

mind is price changes for commercial customers.Companies in BiH pay nearly the most expensive

unit rates for electric in Europe and this considerably

diminishes their competitive advantage in relation to

21

Privatisation model Economic efficiency New investment Transfer of know-how Applicability

Public sale of stock * - * No

Institutional investors * * - Yes

Financial investors * * - Yes

Strategic investors ** ** ** Yes

Local investors ** * - Yes

- there are no effects * moderate effects exist ** strong effects exist


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22

neighboring countries. If the price of electricity

increases for these large consumers also, the

companies will be still less competitive. And this will

certainly worsen the overall socio-economic situation,

ultimately in turn causing reduced consumption by

households, implying still further pressure to increase

prices again. It seems inevitable that prices will rise in

the short term at least simply because prices will be

based on the principle of full cost recovery.

An increase in business efficiency will

inevitably cause a reduction in the number of

employees in the electricity sector. There are 6,095

employees in the BiH electricity production sector,

while the other two companies employ 4,000

people. It is known from the experiences of other

countries that the average rate of layoffs is

between 25 and 40% of the total staff. Provisional

estimates suggest that the number of employees in

BiH would be reduced by about 30%, which areabout 3,000 people. A sum of money would have

to be provided from the national insurance funds

(e.g. 5%) to take care of redundancies and ensure

training and employment in other sectors.

With regard to the consumption of electricity by

the general population, a 13.5% reduction was

recorded last year, while gross consumption

increased by 0.1%. This is indicative of a saturation

of demand in the market. This leads to the conclusion

that surplus electricity will probably be exported in

the future, bringing considerable revenues to the stateand eventually the operating companies.

The privatisation of natural monopolies has

many detractors in the countries in which it was

carried out. Many start from the assumption that

the right to energy is a basic human right and that

production, transmission and distribution of

electricity should be left to the state. This is

supported by the experience of California in 2002,

was without electricity for 38 days because private

producers could not agree with the state on the

conditions under which they should supply

electricity. There is also the possibility of creating

an informal oligopoly between production and

distribution companies, which may again lead to a

conditional monopoly in the electricity market.

It is necessary to assess the dynamics and

manner of privatisation of the electricity sector in

BiH in detail and with the participation of all

interested parties. This is the only way optimal

solutions for the privatisation of this extremely

important sector can be found.

Specific International experienceDuring the last decade, regulation of the

electricity sector has changed fundamentally in

many developed - and some less developed,

countries. Economic and technological develop-

ments have stimulated an evolution of regulatory

systems, changes of ownership structures through

the privatisation process, and changes in the

structure of the sector itself. Since transmission and

distribution networks are natural monopolies, the

whole electricity sector can be considered to be

dominated by monopolistic pressures. Countries

have adopted two basic models in this sector:

State integrated monopoly, and

The regulation of private companies.

Many countries (for example, Ireland, France,

Greece and Italy) consolidated and nationalised

their resources in the field of electricity in the form

of state monopolies, assuming that state

monopolies would operate with the primary goal

of ensuring social welfare rather than profit. In

Germany, there are regional state monopolies.Another model is found in the USA and Japan,

where private companies are regulated on the

basis of costs and indicators of profitability of the

invested capital. In the largest number of countries,

regardless whether this sector is centralised, state

owned or private, electricity production and

distribution companies always remain vertically

integrated. But there are variations.

Approaches to liberalisation and the degree of

liberalisation in this sector are considerably different

in the countries that have carried out reforms.Essentially, the reforms have been directed at:

A functional division between generation and

transmission networks,

The introduction of competition in electricity

production, and

Expansion

Documents

Privatization Monopol