Climate Change Mitigation Options: Demand-Side Management in Formerly-Planned Economies

Meredydd Evans
Pacific Northwest National Laboratory
(Operated by Battelle for the Department of Energy)

I am going to talk about some of the demand side options for mitigating climate change. My focus will be on options in Central and Eastern Europe, for a couple of reasons. Central and Eastern Europe have a great potential for mitigation, and many of the lessons countries in transition are learning about the effects of energy subsidies and other policies apply throughout the world.

I will begin by discussing emissions and energy in Central and Eastern Europe; I will then address the cost of emission reductions and problems with estimating costs in the formerly planned economies; and finally, I will cover energy scenarios and some specifics about mitigation options and barriers to mitigation.

Emissions and Energy Use in Central and Eastern Europe

This chart describes global carbon emissions. Non-OECD Europe represents Central and Eastern Europe, which is responsible for about 20 percent of world carbon emissions. Central and Eastern Europe are also responsible for 21 percent of global energy consumption. While the per capita emissions and energy use of Central and Eastern European countries are similar to those in Western Europe, the Gross Domestic Product (GDP) and per capita income in the countries of this region are not very high in comparison with Western countries. The reason for this discrepancy in energy use and emissions in comparison with economic well-being is that Central and Eastern European countries use a lot of energy inefficiently. It is a very energy intensive region, so it does not get the economic benefits of its energy use.

The primary energy mix in this region varies from country to country. The former Soviet Union is heavily dependent on natural gas, and to a lesser extent on coal and nuclear energy. Renewables play a small role, with hydropower the leading form of renewable energy. In Poland and the Czech Republic, coal and to a lesser extent natural gas are the main sources of primary energy. Thus, overall, the region is heavily dependent on fossil fuels for its energy.

Cost of Emission Reductions

Costs are key to demand side options for mitigation. The costs of mitigation in Central and Eastern Europe are quite economical in comparison to the West. In some cases, the costs are even negative, which bodes well for mitigation. Nevertheless, there are market distortions and barriers in countries in transition, which inhibit the implementation of energy efficiency measures.

Modelers have developed very different assessments of how much it will cost to reduce carbon emissions. Their cost estimates vary from 6 percent of GDP to negative, which is a wide range (see table "Cost of Carbon Dioxide Emission Reductions"). These estimates are important because actual costs are going to determine the feasibility of the options. If is too expensive to install controls or installation, for example, individuals and businesses will not implement these energy efficiency measures. William Chandler, a senior scientist at PNNL, surveyed models of Central and Eastern European carbon emissions. He found that the bottom-up models estimate much lower costs for carbon emission reductions than top-down models. This holds true throughout the region: in the former Soviet Union, Hungary, Poland, the Czech Republic. He also found that there is a much higher correlation between cost and model type than between cost and any other factor, including percent of emission reductions.

There are some important differences between top-down and bottom-up models. Top-down models often over-estimate the cost of mitigation because they assume that formerly-planned economies are in equilibrium, which they are not. However, bottom-up models have another problem, in that they do not have a feedback mechanism to adjust the price of energy based on other inputs.

There have been a few attempts to create models which incorporate both top-down and bottom-up methodologies. FEWE, the Polish Foundation for Energy Efficiency has developed one such model, and Jae Edmonds of PNNL has developed another. The advantage of such models is that they can aggregate the effects of demand-side mitigation measures, like bottom-up models, but they also provide a top-down feedback mechanism between energy prices and inputs such as demand.

Estimating Costs in Formerly Planned Economies

Countries in transition are in economic dis-equilibrium. Of the Central and Eastern European countries, the Czech Republic is probably the closest to equilibrium. Most of the other countries in this region, particularly in the former Soviet Union, are quite far from equilibrium.

Energy prices, in particular, demonstrate why this disequilibrium is important to consider when modeling. Energy prices have been very heavily subsidized, and in many countries are still subsidized. Demand patterns and price elasticity of the past are not representative of what will happen in the future because past demand was not market-driven. Central and Eastern European countries are energy-intensive because energy prices were subsidized and the governments of the region promoted the growth of energy-intensive heavy industry. As energy prices rise, and their economies have time to restructure, we see that energy intensity decreases. It is difficult to estimate the future price elasticity because there is no record of market- based demand on which to base such an estimate. Top-down models often overestimate the cost of mitigation because they use past prices and demand as a surrogate for price elasticity, and they therefore predict that energy use will increase with economic growth in the same way that it did under Communism.

Energy Scenarios

Formerly-planned economies are very energy-intensive. To a large extent this is because they have a large heavy-industry base: metallurgy, defense production, machine production. They have small service sectors, and relatively little light industry. Services and light industry were never a major focus of the Communist regimes.

There are many different scenarios predicting future energy supply and demand in post-planned economies, including:

Business as usual means that the structure of energy supply and demand will continue to look like it did in the past. The business as usual scenario is useful for comparison. There are also a few countries in the former Soviet Union, particularly in Central Asia, which may in fact continue to use and produce energy as they did in the past. Most formerly-planned economies, however, are undergoing structural change. This change will certainly have an impact on energy demand, although, as noted earlier, modelers differ on the extent to which energy efficiency will decrease demand in economies undergoing structural change.

The changes taking place in Central and Eastern Europe will have an impact not only on the levels of energy supply and demand, but also on the energy mix. Whether these countries use coal, natural gas, or nuclear energy will have a profound effect on their greenhouse gas emissions. For environmental and economic reasons, Central European countries may begin relying more on natural gas, which will decrease emissions. On the other hand, some former Soviet republics, primarily Ukraine, may shift away from imported natural gas to domestic coal, since coal is seen as a more secure source of energy. Given the dwindling supply of domestic Ukrainian coal, it is not clear that coal solves the problem, and most Ukrainians realize that there are severe environmental problems associated with the use of coal.

Some countries are building new nuclear power plants, or are keeping old ones open despite safety problems. The Czech Republic is building the Temelin nuclear power plant. In Ukraine, Chernobyl continues to operate despite the accident because of problems with Ukrainežs supply of natural gas. Armenia recently reopened a nuclear power station that was damaged in a major earthquake, although many Western experts think the threat of an accident is great if another earthquake occurs. While the overall environmental impact of such reactors may not be desirable, nuclear energy will decrease greenhouse gas emissions, so the reactors need to be considered in scenarios for future emissions.

Mitigation Options and Barriers

Energy efficiency is an appealing mitigation option in Central and Eastern Europe because it is very cost-effective. Since the economies of these countries are so energy-intensive, the potential for energy savings is truly enormous. However, many cost-effective projects are not being implemented because of financial, legal and institutional barriers. For example, most countries in this region have subsidized residential energy, which discourages energy efficiency. The municipalities and the residents both pay a portion of the energy costs. In this situation, neither party has a strong financial incentive to pay for efficiency, so both continue to waste energy.

The Polish Foundation for Energy Efficiency, FEWE, did a comprehensive study of the costs of demand-side and supply-side efficiency options in Poland. Some of the measures are extremely cost-effective. Steam traps, for example, have an internal rate of return (IRR) of 335 percent. Other cost-effective options include residential gas boilers (instead of district heating), efficient street lighting and high-efficiency electric motors.

FEWE then extrapolated how much energy could be saved throughout the Polish economy. FEWE staff first looked at the technical potential for energy savings, which they estimated at approximately 900 PJ/year. Then they looked at how much of this potential was cost effective, and about half of it remained. Finally, they estimated how much of the potential had an IRR of over 18 percent, and found that 400 PJ of potential energy savings met this criterion.

This is an important cutoff point, because most Western investors, either banks or companies, realize that there is greater risk in these countries, and they will not get involved in a project unless it has a very high rate of return. Eighteen percent is about the minimum that any Western investor is willing to accept.

While there are barriers to demand-side mitigation options, overall carbon emissions have decreased significantly since 1990. The main cause of this decrease is the drop in production associated with the general economic decline and structural change. Some of the emission reductions are also because of efficiency, particularly in Central Europe--Poland, Hungary and the Czech Republic--where most industrial companies have been privatized. These companies are trying to modernize and increase efficiency in order to stay competitive.

Examples of Mitigation

While the problems associated with climate change mitigation may be daunting, there are many examples of successful energy efficiency projects in Central and Eastern Europe. No single project will solve the problem of global warming, but they are all steps in the right direction.

One example is the Russian Enterprise Housing Divestiture Project. It is one of the first large World Bank projects focusing on energy efficiency. The goal of this project is to increase residential efficiency in order to help enterprises divest themselves of worker housing. When enterprises are privatized, they want to get rid of worker housing to consolidate their holdings and avoid the high costs of residential utility bills. However, because this housing is expensive to maintain, the municipalities do not want it, and the residents are wary that if they privatize their apartments, their energy bills and taxes will go up. As a result, the enterprises cannot even give this housing away. To make housing divestiture more feasible by reducing the burden of high energy bills, the World Bank would loan municipalities $300 million to pay for energy efficiency measures, such as insulation and weather stripping. The World Bank is currently assessing this loan.

Another potential project targets four industrial enterprises in Ukraine for energy efficiency upgrades. The total cost would be about $100 million and the European Bank for Reconstruction and Development has expressed an interest in financing it. This would pay for controls, steam traps, steam pipe insulation, efficient motors, and some modernization costs. This project began as an effort to find alternatives to the power generated at Chernobyl, which would allow the Ukrainians to close Chernobyl. The Ukrainian Government argues that it cannot shut down Chernobyl until alternative sources of power are established. Industry in the Ukraine is the major energy consumer, so this project would tackle both the problem of industrial inefficiency, and that of excess electrical demand in Ukraine.

An example of a private project is the work of ESCOs in the Czech Republic. One U.S. ESCO signed $30 million worth of contracts with Czech organizations during the first meetings with these organizations. The contracts are with hospitals and industrial enterprises. The Czech organizations saw the need for efficiency, and decided to invest their own money in it. This indicates that there are cost-effective mitigation options in the Czech Republic despite the barriers.

Barriers to Demand-Side Mitigation

Subsidized energy is a very important barrier to demand-side mitigation, because as long as energy prices are very cheap, people will continue to waste energy. Lack of hard budget constraints is also a barrier in many cases. If an enterprise knows that the government guarantees to purchase its goods and to bail it out if it goes into debt, the enterprise does not have to worry about running up the energy bill. In this situation, the enterprises have little incentive to save energy. In fact, under the planned economy, enterprises were actually given incentives to consume energy because their payments from the government-- profit as they called it--were based on production costs. The more they spent, the more they earned.

The tax and business laws create institutional barriers. For example, if a Hungarian firm wants to start producing energy efficiency equipment, the firm must overcome enormous problems associated with high taxes and the risky business climate. Customers may not pay, and contract laws are not well defined, so investors may not have recourse options. These uncertainties and risks significantly increase the transaction costs.

There are also technological barriers. Most of the equipment at industrial plants is outdated and inefficient. If you look at a typical steel plant in Eastern Europe, the technology in place is what we used 30 years ago. For example, continuous casting is rare in most steel plants. Another technological problem is the lack of energy efficiency equipment, like controls and insulation.

The financial barriers are also inhibitive. There is very little capital available for energy efficiency measures. The large international development banks prefer large projects because they are easier to assess and manage than a multitude of small ones. Energy efficiency projects tend to be small because they do not involve creating new infrastructure, like building a new coal plant. As a result, institutions such as the World Bank and the European Bank for Reconstruction and Development rarely get involved in energy efficiency projects.

In the West, commercial banks are an important source of financing. Unfortunately, commercial banks in Central and Eastern Europe are not well-developed, and generally have only limited amounts of capital to lend. Western commercial banks shy away from lending money for project financing in this region because the risk is too high.

Most of the Western assistance to this region has focused on energy supply: upgrading fossil and nuclear power plants, repowering hydropower plants, and building new district heating plants or gas distribution systems.

Recommendations

As I mentioned in the beginning, Central and Eastern Europe are important to climate change mitigation not only because of the mitigation potential there, but also because of the lessons they can teach. This region is coming to grips with the reality that energy prices must reflect the full cost of energy if the region is to thrive economically and environmentally. Rationalizing energy prices is important the world over because until energy prices reflect the true costs, people will continue to waste energy.

Adjusting taxation policy is also important to promote mitigation. Taxes can help internalize the environmental costs of economic activity. Many Central European countries have carbon and other environmental taxes on the books, but they are not well enforced. Russia and Ukraine have both proposed energy taxes in recent years, but for political reasons, have not been able to adopt them nationally.

More financing is also needed for energy efficiency, both at national and international levels. Ironically, Central and Eastern European countries are increasing budget allocations for energy efficiency, despite their economic hardships, at the same time that the more prosperous United States is cutting back on energy efficiency funding. In the international arena, development organizations have a tendency to spend more money on energy supply than on energy efficiency or environmental protection. The World Bank, for example, argues that structural reform should create incentives for efficiency, so there is usually no reason to provide additional financing for energy efficiency. One could also argue that if the prices are right, energy suppliers will recover all their costs and so there is no need to provide financing for supply. The World Bank, however, spends most of its energy budget on loans for energy supply.

The World Bank is right about the need for restructuring in Central and Eastern Europe. Countries in transition generally have fundamental imbalances in their economies. These imbalances often lead to higher energy use and higher carbon emissions. Thus restructuring the economy as a whole--privatizing enterprises, reforming the prices, etc.--can also help to reduce carbon emissions.

This is a crucial moment in the development of Central and Eastern Europe. The changes which are now taking place will determine the future of the region, and the future of their emissions. These changes also create many opportunities for climate change mitigation.

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