Energy Price Reform and Household Welfare: The Case of Turkey.

• Author: Zhang, Fan

1. INTRODUCTION

   With energy security and climate change becoming growing concerns, policy makers have increasingly come to realize that energy prices will have to rise in order to reflect the full cost of consumption. In developing countries, this often involves removing subsidies to bring energy prices closer to market rates; in the developed world, the goal is to internalize environmental costs in energy prices. At the same time, however, there is concern that higher energy prices will create economic distress, particularly for poor households.

   Recent reforms in Turkey illustrate these issues. The country's residential electricity tariffs remained constant during 2002-07 even though fuel costs increased. In 2008 the government approved a cost-based pricing mechanism that led to an increase in the retail electricity tariff of more than 50 percent over the course of one year. Price reform is a key part of the electricity market reform launched in Turkey in 2001. It is considered essential for encouraging energy efficiency, attracting private investment, and improving the financial position of the state-owned electricity utilities. Nonetheless, the magnitude of the price increase was unprecedented. How it would affect household consumption and welfare has prompted policy debate.

   The purpose of this paper is to present a partial equilibrium analysis of the welfare impact of the tariff reform in Turkey. (1) I estimate a short-run residential demand function for electricity that can be used to quantify the welfare effect of price increases on different income groups. By allowing price elasticities to vary with household income, the model reveals a highly differentiated distribution of demand elasticities in the population: all else being equal, the wealthiest households are three times as responsive in adjusting consumption to price changes as the poorest households are.

   This result has noteworthy welfare implications. Because poor households are less adaptable to rising tariffs, they suffer a disproportionately larger welfare loss. Although this issue has received attention in the literature, few studies have addressed it in a systematic way. (2) The model also indicates a smaller aggregate price elasticity of demand than would a model that ignores the heterogeneity in households' price elasticities, suggesting that a homogeneous estimator will both neglect the variance and underestimate the aggregate impact on the population.

   I estimate the demand model using disaggregated consumption data for a representative sample of 8,572 Turkish households from the 2008 Household Budget Survey of the Turkish Statistical Institute. The data set provides rich detail on appliance ownership, dwelling features, income, and demographic characteristics. The large number of observations combined with the substantial rate changes under the price reform helps identify both price and non-price segments of the demand function.

   A common issue in using survey data for statistical analysis is that it results in only selective observation of those who choose to report. In the Turkish Household Budget Survey, about 20 percent of households with access to electricity did not report electricity expenditure. To address potential sample selection bias, I apply Heckman's selection model (Heckman 1979). I, however, find no find evidence of selection on unobservables, which suggests that sample selection bias is not a concern in this study. I then use the model to estimate the distributional impact of the 2008 tariff increase in Turkey. To lend credence to the specification and results, I also conduct out-of-sample tests of the model that show how well it predicts consumption responses to new price changes in 2009.

   Overall, I find that a 10 percent increase in the electricity price will cause households in the bottom income quintile to reduce electricity consumption by 1.6 percent on average, and those in the top income quintile to reduce it by 5.6 percent, all else being equal. Poor households are less flexible in adjusting electricity consumption because they use electricity for basic needs and are close to their minimum consumption levels. By contrast, wealthier households are more likely to own price-elastic appliances (such as air conditioners and dishwashers) and exhibit greater responsiveness to rising electricity prices.

   Not surprisingly, lower-income households experienced a greater welfare loss as a percentage of income. The welfare loss from the 2008 price increase, approximated by the change in consumer surplus, is on average about 164 Turkish lira (TL), or 2.16 percent of household disposable income, for a household in the bottom income quintile, compared with 330 TL, or 0.75 percent of income, for a household in the top quintile. These results are robust to alternative model specifications and modeling techniques.

   Although the electricity reform has resulted in price increases, it also provides opportunities that would not otherwise exist to improve the quality and reliability of power supply and to redirect public resources more transparently to the poor. Analyzing the broader impact of electricity price reform is beyond the scope of this paper. (3)

   The rest of the paper is structured as follows. Section II provides background on the Turkish electricity price reform and a literature review. Section III discusses the empirical strategy. Section IV describes data and descriptive analysis. Section V presents the estimated price elasticities, robustness checks, out-of-sample validation tests and consumer welfare change. Section VI concludes.

2. BACKGROUND AND LITERATURE REVIEW

   1. Turkish Electricity Market Reform

      The Turkish Government has pursued a comprehensive electricity reform program since 2001. The reform is aimed at establishing a competitive electricity market so as to increase private investment, improve energy efficiency, and ultimately strengthen Turkey's energy security. Under the reform the vertically integrated state-owned electricity utility was split into separate generation, transmission, distribution, and trading companies. An independent regulatory agency was established that regulates the sector and oversees prices. In 2006 a competitive wholesale electricity market was introduced, and in 2008 the Government started to privatize the distribution company.

      Despite these achievements in the overall reform program, a potentially significant energy supply shortage was expected, in part because of the lack of progress in electricity tariff reform. During 2002-07, the retail tariff had remained constant, though the price of inputs in electricity production--notably the natural gas prices--had increased substantially. The disconnect between prices and costs contributed to the declining supply margin because inadequate tariffs limited the funding available for the maintenance of existing infrastructure and for new investments. In addition, without appropriate price signals, demand may have increased at a faster pace than it otherwise would have. Finally, a cost-reflective tariff was considered necessary for the continued privatization of electricity distribution.

      To address these concerns, the government started pushing for full cost recovery in the electricity sector in 2008. In January the electricity price was increased by 20 percent from the fixed level of the previous five years. In March, the government approved a cost-based pricing mechanism, allowing automatic quarterly tariff adjustments to cover changes incurred for electricity supply. The new pricing mechanism became effective in July 2008, resulting in price increases of another 24 percent in July and 9 percent in October. In October 2009, the Government announced a 10 percent price hike from the previous month. Figure 1 illustrates the percentage change in electricity tariff during 2008-09. All prices are in 2008 TL.

   2. Literature Review

      How do higher energy prices affect consumer welfare? The literature has focused on both direct and indirect mechanisms through which changes in energy prices may affect consumption. In a direct effect, higher energy prices are expected to reduce discretionary income because consumers have less money to spend after paying their energy bills. Consumers may also increase their precautionary savings and delay or forgo purchases of energy-using durable goods. These effects imply a reduction in aggregate demand in response to an energy price increase. In an indirect effect, higher energy prices are likely to cause a reallocation of capital and labor away from energy-intensive industries as consumers switch toward more energy-efficient durables. In the presence of frictions in capital and labor markets, these sectoral shifts will cause resources to be unemployed, thus causing further cutbacks in consumption. See Kilian (2008) for a review of the direct and indirect effects.

      This paper focuses on a partial equilibrium analysis of the short-term welfare effects of higher energy prices while ignoring the spillovers to income, employment and demand in other sectors. To measure the partial welfare effects of price changes, previous studies, such as Delfino and Casarin (2001), assume different levels of price elasticities and estimate the upper and lower bounds of the welfare impact. In this paper, I estimate a short-term demand function for electricity in order to pin down price elasticities and to calculate the change in consumer surplus associated

      with price changes. (4)

      There are two strands of literature using econometric methods to estimate residential electricity demand. Studies based on traditional demand analysis usually assume homogeneous price elasticities (especially when using data aggregated over time and regions) and model electricity consumption as a function of income, price, and household characteristics.(5) See Taylor (1975), Hartman (1979) and Bohi and Zimmerman (1984) for reviews of such studies.

      A second...