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World Bank and Reform of the Utilities Sector in Azerbaijan

During the recent public debate regarding the current increase of the utility tariffs it was mentioned that the Government followed the World Bank recommendations in this respect. While it is true that the WB recommended the tariffs increase, it may be useful for the public opinion to better understand the broader context of this recommendation, its role in the recommended reform of the utility sector, and complementary reforms of the fiscal policy and the social protection.

Status of the Utilities Sector and Need for Reforms

Azerbaijan inherited from the Soviet past a utility sector in worse shape that already poor quality of utilities in most of the other post-Soviet republics.
While recent investments in the water supply system in Baku, including World Bank (IDA) assistance, have rehabilitated facilities and improved maintenance, and access to drinkable water, in other parts of the country drinking water safety remains a serious concern. Water coverage drops sharply in rural areas, with just 58 percent having access to improved sources of water. Lack of metering undermines collection rates and incentives to rationalise the use of water.
Reliability and coverage of the electric power system, particularly outside Baku, is very poor. Issues include inadequate generation capacity to meet household and industrial demand; frequent shortages, sub-optimal system operation; and inadequate levels of investment and maintenance.
Some areas of the country receive only a few hours of electricity a day, and there are frequent localized outages and occasional widespread system failures. The gas transmission system also needs large-scale rehabilitation, and gas treatment and storage facilities are inadequate.
Failing utilities infrastructure, such as bad roads, deteriorating access to drinkable water, power outages, imposes very high social and economic costs on households and industries as they try to adapt to the requirements of the market economy.
Lack of reliable electricity and other infrastructure has been a major factor discouraging investment and commercial activity outside the oil sector. The unreliability of electricity and gas supply remains a constraint to business operation and daily life. One in four firms surveyed in the 2005 BEEPS identified electricity supply as a problem in doing business, and almost 7 percent of total annual sales were lost due to power outages.

Tariffs Increase as Part of the Reform Program

The utilities sector until the latest tariffs increase was far from financially viable. Azerenerji, the state electricity company, depends heavily on SOCAR to provide power plant fuel but lacks the ability to pay for it. Azerigas, the state gas company, is in a similar situation. Explicit subsidies were provided from the state to cover SOCAR deliveries in both cases. Subsidies to energy utilities were in the order of about US$320 million in 2006
This dire financial situation of the utility providers resulted from the fact that this is the first time since 1997 that electricity tariffs have been increased. At the same time, since 1997 the average wage has increased many times, and the minimum wage has increased 5 times. Also other costs, including fuel, increased many times. There was some urgent catching up to do.
The World Bank has supported and will continue to support the Government’s five-point program of reforming the utilities sector: (1) moving to cost-recovery tariffs; (2) increasing collections; (3) proper regulation of natural monopolies; (4) financial accountability of utilities providers through adoption of international financial reporting standards (IFRS) and improving their governance; and (5) implementing a targeted social safety net to alleviate the impact on the poor.
This program requires, in particular:
• Strengthened financial position of Azerenerji and Azerigas due to tariffs that cover full costs and improved corporate governance and accounting;
• Improved tariff policy in the utility sector
• Fully functional utility regulatory framework
The Government is strongly committed to the program. In July 2006, the President instructed the Cabinet of Ministers to increase collection rates for public utilities. September 2006 collection rates had doubled to 83 percent for gas and 70 percent for water. Meters are rapidly being installed. The new Accounting Law requires IFRS. The targeted social safety net started July 1, 2006.
In result, in the medium term, the subsidies will be eliminated by a combination of tariff increases, better collections, and improved cost efficiency of energy producers. Recent initiatives to ensure full collection of electricity and gas fees and speed up the universal metering process are commendable and will lead to desired results. In the longer run Azerbaijan will benefit from undertaking steps towards aligning its tariffs with rationalized cost-recovery levels. We expect the tariffs increase will provide public utilities with investment resources necessary to improve the quality of services to households and businesses, as well as encourage greater efficiency in the use of fuel and energy by consumers.
The Government program reflects the World Bank assessment about the inefficiencies and waste in the utilities sector which originated from the tariff subsidies to all consumers irrespective of their welfare status and lack of end-user payment discipline. At the same time, it reflects the Bank emphasis on the adequate and targeted social assistance to the poor as an integral part of the cost recovery program.

Social Safety Net

While the increase in tariffs should lead in the medium term to improved provision of the services, it may produce temporary hardship, particularly to the more vulnerable groups of the poor, pensioners and other social groups at risk. That is why the government, with the agreement of the Bank, was delaying tariffs increases which from the economic point of view were overdue for the long time. In result, electricity and fuel prices in Azerbaijan had been substantially below those in the neighboring transition economies with similar per capita incomes.
The situation changed during the last few years when poverty has been declining rapidly, particularly in Baku. At the national level, the proportion of poor people fell from about 44.6 percent in 2002 to 24.0 percent in 2005. Extreme poverty fell from 26.9 percent of the population in 2002 to 9.2 percent in 2005.
Reasons for the sharp drop in poverty are two-fold. Wages and salaries have more than doubled, with the minimum wage raised fivefold since 2001, albeit from a very low level. There has also been a significant surge in transfer incomes for poorer households. Government social transfers to the poorest 20 percent of households increased more than 35 percent in 2004, while pensions, the main component of the government social program, increased about 44 percent. Remittances from a significant number of Azerbaijanis working abroad are also an important source of households financing and has helped reduce poverty.
Systemic reforms to improve the targeting and administration of social assistance and modernize the pension and social insurance system are well underway. A new targeted social assistance scheme was rolled out in July 2006. Its impact needs to be carefully monitored.

Inflationary Side Effect and Mitigation Measures

The WB experts used a number of approaches to look at the impact of the recent tariff increases on the CPI. Those results, suggest a first round increase in the rate of inflation of about 3-4 percentage points on account of the tariff increases. Assuming expected changes in norms or in consumption of utilities will affect their weight in the CPI, and may lead to a smaller CPI increase.
In the short term the adjustment of the prices is expected to result in some cost-push inflationary impact. Given that energy, public transport and utilities account for less than 5 percent of the consumer basket, the direct impact on inflation will likely be modest (an additional increase in CPI by 3- 4 percentage points). Second-order effects will likely somewhat augment this initial direct impact. The table below gives the weight of utilities in the CPI, although those weights can change as usage changes.

Azerbaijan: Direct Inflationary Implications of Public Utilities, Transport and Energy Price Increase, January, 2007 (in percent)

Product rise	Weight in CPI	Price increase in Jan	Direct contribution to CPI
Petrol Brand Name A95	0.1704	50	0.09
Petrol Brand Name A93	0.3975	52.7	0.21
Diesel fuel	0.3407	25	0.09
Electricity	1.2753	212.5	2.71
Sewerage service	0.042	80	0.03
Water (population)	0.1861	80	0.15
Water (industry)	0.1241	80	0.10
Within city/suburban bus	0.7289	29.4	0.21
Intercity bus transportation	0.31 24	29.4	0.09
Total	3.5774		3.68

Source: Bank staff calculations

All in all, given the strong income growth in recent years, the deferral of price adjustments, and adjustments in behavior that come from tariff increases and the introduction of metering, the impact of the tariffs increase on broad living standards should be modest.
There is much more risk of the secondary increase of prices of variety of products and services, induced by the initial tariffs increase. It is a well known international phenomenon that producers and traders have a tendency to overreact in increase of prices of their products. Moderation of this type of price increase is difficult and, in a market economy, cannot be effectively done by any form of administrative control. There are two broad instruments which may effectively reduce the inflationary pressure: prudent fiscal policy and improved competitiveness of the economy.
The key to keeping inflation in Azerbaijan under control is the prudent fiscal policy. In particular, it is essential to maintain oil-financed government spending and other injections of oil revenues into the economy at the level which allows building up physical infrastructure and human capital while, at the same time, keeps growth of monetary aggregates under control and limits the pace of real exchange rate appreciation so as to maintain the competitiveness of the non-oil sector of the economy.
Poor competitiveness remains a serious problem in Azerbaijan. Azerbaijan is ranked 99 in the World Bank 2007 Doing Business Report (out of 175 countries), and five areas need urgent attention: tax rates and administration; customs; licensing regime; and corruption. Despite some improvements in 2005 and in 2006, Azerbaijan still ranks low in international corruption and economic freedom rankings, factors widely perceived as an obstacle to doing business. It should be noted that of the 21 areas of “Problems Doing Business� surveyed in BEEPS, Azerbaijan fares better than the ECA average on 15, nevertheless much still has to be done to improve the international rankings by improving the business environment.
The comprehensive State Programme on Combating Corruption was developed in cooperation with civil society and international organizations. The government has undertaken several initiatives such as passing new anticorruption legislation, strengthening anticorruption institutions, and creating an anticorruption office in the Prosecutor General’s Office and an anticorruption department in the Ministry of Interior.
The WB commends institutional strengthening of the MED with the new State Antimonopoly Service; and State Service for Control of the Consumer Markets. We look forward to the rapid approval of the draft Competition Law which has already passed the first reading in the Parliament, and which will strengthen the legal framework for these important functions protecting the consumer and the poor. We support the full implementation of the President’s Anti-Inflation Decree. We also look forward to the approval of the draft Investment Law.

World Bank Assistance

The WB supports in Azerbaijan a large development agenda, particularly in regard to managing and implementing essential infrastructure projects. This should lead to:
• Improved electricity and water supply and sanitation networks in targeted urban centers, small towns and selected villages;
• Improved revenue collections and improved incentives to rationalize consumption of water and energy
• Strengthened financial position of AzerSu and Azerenerji due to tariffs that cover full costs, and by improved their governance and accounting.
To improve performance of the utility companies, the WB is preparing a Corporate and Public Sector Accountability Project.
The Bank will further support structural reform of the social safety net. The Bank is active in supporting the government’s reform program through its ongoing Pensions and Social Assistance Project. The project aims to assist the government in better administering social protection programs, making the pension system more sustainable, and building capacity to better target social assistance benefits to the most vulnerable groups. The project will also help mitigate the social impact of utility sector reform. The Bank will continue to benchmark and monitor progress in social protection reform and development of social services and safety nets.
In conclusion, the World Bank position is that like in all countries of the world, Azerbaijan’s households and Azerbaijan’s businesses need a good quality and stable supply of utilities services in order to improve living standards and to develop. The stable supply of utilities can only come from financially viable and better managed companies. Financial viability comes from utilities recovering their costs, which implies tariff adjustments, although this may lead to short-term social hardhip of increased costs of leaving and pressure on competitiveness of the economy through initial inflation. Azerbaijan has taken good measures to mitigate the impact of tariff increases on the poor, by preceding the increases with the introduction of the targeted social assistance scheme. On the competitiveness side, the impact of tariff increases needs to be taken in the context of the country’s other inflationary and competitive pressures. In the case of Azerbaijan, fiscal policy and the business environment are the largest determinants of competitiveness, through the real effective exchange rate and the openness to domestic and foreign investors, especially in the non-oil sector.

by Gregory Jedrzejczak
World Bank Country Manager for Azerbaijan