VZCZCXRO6404
PP RUEHAST
DE RUEHVJ #1634/01 2011531
ZNR UUUUU ZZH
P 201531Z JUL 06
FM AMEMBASSY SARAJEVO
TO RUEHC/SECSTATE WASHDC PRIORITY 3991
INFO RUEATRS/TREASURY WASHDC PRIORITY
RUEHZL/EUROPEAN POLITICAL COLLECTIVE PRIORITY

UNCLAS SECTION 01 OF 04 SARAJEVO 001634 
 
SIPDIS 
 
SIPDIS 
 
EUR/SCE (FOOKS/RIEHL), EUR/ACE (VISOCAN), D (SMITH), P 
(BAME) 
TREASURY FOR GAERTNER 
DEPT PLEASE PASS TO USAID FOR AA/EE AND EE/ECA 
 
E.O. 12958: N/A 
TAGS: ENRG ECON AID BK
SUBJECT: BOSNIA'S FRACTURED ENERGY LANDSCAPE 
 
REF: A. 05 SARAJEVO 1591 
 
     ¶B. 05 SARAJEVO 560 
     ¶C. 05 SARAJEVO 495 
     ¶D. 04 SARAJEVO 905 
     ¶E. 04 SARAJEVO 251 
     ¶F. 04 SARAJEVO 60 
 
SARAJEVO 00001634  001.2 OF 004 
 
 
¶1.  Summary:  The energy market in Bosnia and Herzegovina is 
a reflection of the ethnic politics that have caused damage 
and hindered progress in the country as a whole.  The 
electricity sector is still separated between the 
sub-national government "entities," and there is an ethnic 
identification with the three electric companies.  U.S. 
government and other international assistance has contributed 
to significant progress in infrastructure reconstruction and 
institutional strengthening.  However, more reforms are 
needed, all of which will pose significant political 
challenges.  The principal challenge will be the unification 
of the internal electricity market, a key element of which is 
the unbundling of the vertically-integrated and 
ethnically-aligned electricity companies and establishment of 
new independent companies for generation and distribution. 
The transmission function has already been broken out into a 
new national transmission company, but that company is 
struggling against vested interests.  In order to comply with 
international obligations to the EU and a new regional energy 
market treaty, BiH must consolidate its three regulatory 
bodies into one.  All of these needed reforms will help 
eliminate the corruption that has long been present in the 
sector, although that same corruption will be the key 
challenge for movement on the reforms.  If BiH can succeed in 
continuing its progress in the sector, it has the potential 
to provide a significant source of export revenue and 
contribute to the country,s economic development.  End 
Summary. 
 
Background 
---------- 
 
¶2.  After the 1992-1995 war, the once-integrated power system 
in BiH was split into three vertically-integrated companies, 
with ownership residing in the new sub-national government 
"entities" of the Republika Srpska (RS) and the Federation of 
BiH.  Each company (called "Elektroprivreda" or EP) covers a 
distinct territory, and is perceived to have an 
identification with one of the three principal ethnic groups: 
 a "Serb" EP headquartered in Banja Luka, a "Croat" EP 
headquartered in Mostar, and a "Bosniak" EP headquartered in 
Sarajevo.  As a result, the EPs became a source of revenue 
and influence for the nationalist parties in power since the 
war.  The market became fractured, without any national 
coordination. 
 
¶3.  Early international assistance focused on reconstruction 
of the physical infrastructure that was destroyed in the war. 
 As part of this effort, USAID spent $150 million from 
1996-2001 on the reconstruction of facilities and networks. 
Although international financing for physical improvements 
continues, particularly through the World Bank, the U.S. 
government focus since 2001 has been on institutional 
strengthening and restructuring the EPs. 
 
¶4.  U.S. government efforts have produced significant 
successes and progress for the sector.  A State (national) 
Electricity Framework Law and an Electricity Law in both 
entities were enacted.  USAID assistance to the EPs resulted 
in gains in market-based pricing, significantly improving the 
EPs, bottom line.  State and entity regulatory commissions 
were established and are now up and running.  Both entities 
have approved plans for the unbundling of the EPs into 
separate generation, transmission, and distribution 
companies.  USAID advice to the State Ministry of Foreign 
Trade and Economic relations (MOFTER) helped it prepare for 
signature of the newly-established Energy Community Treaty 
for Southeast Europe.  State laws for the establishment of a 
State-level Transmission Company (Transco) and Independent 
System Operator (ISO) were passed, and both the Transco and 
ISO are now separate registered companies. 
 
¶5.  These gains have laid the groundwork for a more 
transparent, functional, and unified electricity market in 
BiH.  All of this progress was painful and slow due to the 
fragmented nature of politics in BiH.  Additional reform 
needed in the sector is sure to face further challenges, as 
vested interests are made to give up more and more control of 
a valuable resource.  The most significant upcoming 
challenges are outlined below. 
 
SARAJEVO 00001634  002.2 OF 004 
 
 
 
The Road to a Unified Market 
---------------------------- 
 
¶6.  BiH does not have a unified energy market.  The EP for 
the Republika Srpska ("EPRS") covers only the territory of 
the RS and is not required to meet domestic demand in the 
Federation.  Within the Federation, the two EPs also cover 
distinct territories, with "EPHZHB" principally covering 
Herzegovina (a predominantly Croat region) and "EPBiH" 
covering the rest of the Federation.  These two EPs are not 
required to meet any domestic demand in the RS.  Within the 
Federation, there is a constant conflict over energy supply 
between EPBiH and EPHZHB.  EPHZHB has lower generation costs 
because its generation facilities are mostly hydropower, 
while EPBiH has a larger proportion of more costly thermal 
power plants.  However, EPHZHB is not able to meet the demand 
within its territory, due to the presence of Aluminij Mostar, 
a large aluminum factory with significant power demands.  As 
a result of a conflict between Aluminij and EPBiH over power 
sale arrangements, in December 2003 the Office of the High 
Representative (OHR) imposed a decision that required both 
Federation EPs to meet the power demands of strategically 
important domestic companies in the Federation.  (Refs E and 
F)  Given EPBiH,s higher costs, the price at which it sells 
power to EPHZHB continues to be a sensitive issue, given that 
Aluminij has demanded power below cost, without providing any 
evidence of economic need for subsidies.  The price between 
the companies is now set by the new Federation regulatory 
commission. 
 
¶7.  The result of this fractured market is that once EPRS 
meets domestic demand in the RS, it then exports its excess 
power, even when domestic demand in the Federation has not 
been met.  If EPRS sells power to the Federation, it does so 
at market rates as though it were exporting to another 
country.  In the Federation, EPBiH is pressured to supply 
electricity to EPHZHB below its costs. 
 
¶8.  The vertically-integrated structure of the EPs compounds 
the problem by adding a lack of transparency that facilitates 
corruption and higher costs.  As a result, the unbundling of 
the EPs into separate generation, transmission, and 
distribution operations is the precursor to a unified market. 
 Plans for unbundling of the EPs have been approved in both 
entities, known as the "Action Plans" for restructuring the 
electricity sector.  All of the EPs have already separated 
out their transmission functions in order to transfer those 
assets to the State-level Transco.  (Problems with completion 
of this process are discussed below.)  All three EPs are now 
proceeding with separation of accounting and assets into 
generation and distribution functions, with the goal of 
setting up new and independent joint stock companies. 
Notionally, the final corporatized companies could then be 
privatized, but that final step has not yet been accepted or 
defined. 
 
¶9.  Approval and implementation of the Action Plans has been 
extremely slow and has been met with resistance from many 
sides.  The Federation Action Plan was originally passed by 
the Federation Parliament in October 2003, with a timeline of 
completion by mid-2005.  The plan was then challenged in 
court by the Croat nationalist party HDZ, with the result 
that the Federation Action Plan did not go into effect until 
June 2005.  (Refs A and D)  The RS slowed compliance with its 
own Action Plan until the Federation Action Plan controversy 
was resolved.  The main problem for the Federation Action 
Plan was that the HDZ did not want to lose its control over 
EPHZHB, which it considers to be part of its financing and 
power base.  All of the EPs are subject to this political 
identification to a greater and lesser extent, so political 
problems are sure to continue to crop up as the Action Plan 
implementation proceeds. 
 
¶10.  Even when the Action Plans are completed and the new 
generation and distribution companies are functional, the 
entities still have to make an agreement to unify the market 
(the new companies will not combine assets from the 
Federation and RS EPs).  In the Republika Srpska, the goal of 
a unified market is not recognized or discussed.  As a 
result, the larger concept of whether and how to achieve a 
unified BiH electricity market has yet to be resolved. 
 
A Single Regulator 
------------------ 
 
¶11.  When the entities agreed to set up an independent 
 
SARAJEVO 00001634  003.2 OF 004 
 
 
regulatory system, they agreed to a State-level regulator for 
Transco and ISO tariffs, but kept the regulators for 
generation and distribution at the entity level.  As a 
result, there now exists a State Electricity Regulatory 
Commission (SERC), a Federation Electricity Regulatory 
Commission (FERC), and an RS Electricity Regulatory 
Commission (RSERC).  All of the Commissions began issuing 
tariff decisions in 2006.  The establishment of the 
regulators is a significant step forward, and they should be 
able to fulfill their role of protecting consumers from price 
manipulation, fraud, and poor management. 
 
¶12.  The immediate challenge for these new regulators is 
public acceptance and maintaining independence in the face of 
political pressures.  The first challenge has been to the 
FERC.  The FERC issued its first tariff rulings in April 
2006, and included a 6.58 percent increase in household 
tariffs.  Federation electricity prices had already been 
subjected to a 7 percent increase at the beginning of 2006 as 
a result of the introduction of a value-added tax in BiH. 
The additional increase by the FERC caused a public outcry 
that resulted in attempts by the Federation Parliament to 
diminish the FERC,s independence.  These challenges for the 
FERC will continue, particularly given that 2006 is an 
election year. 
 
¶13.  The larger challenge for the regulatory environment is 
the need to consolidate all of the regulators into one 
State-level regulator for all electricity functions.  The 
existence of multiple regulators will not be compatible with 
BiH,s obligations under the Energy Community Treaty for 
Southeast Europe signed in October 2005.  Although it has not 
yet been officially stated, European Commission counterparts 
have said that the establishment of a single regulator will 
be a requirement under the energy market conditions included 
in BiH,s negotiations for a Stabilization and Association 
Agreement with the EU.  Like the concept of a unified market 
in general, the entities, particularly the RS, have not 
agreed to a single regulatory body.  Reaching this agreement 
will be the next step for regulatory reform. 
 
Transco and ISO 
--------------- 
 
¶14.  Although the State-level Transco and ISO have been 
formed, serious problems have emerged in terms of the 
Transco,s management.  The Transco General Director, Dusan 
Mijatovic, was formerly the General Director of 
EPRS-Elektroprenos, the transmission daughter company of 
EPRS.  According to a report done by the OHR Special Auditor 
in January 2005, under Mijatovic,s management 
EPRS-Elektroprenos was involved in corrupt practices 
concerning the misuse of materials purchased under the "Power 
III" electricity reconstruction project. (Ref B)  His 
subsequent appointment as the General Director of the new 
State-level Transco was a matter of some concern. 
 
¶15.  Since his appointment, he has taken actions to lock in 
RS control of the Transco, and undermine the independence and 
functioning of the ISO.  As a result, the perception is that 
Mijatovic is attempting to consolidate control of the Transco 
and ISO function in Banja Luka, and ignore the previous 
agreements that were reached with the Federation.  Because of 
this concern, the Federation EPs have stalled transfer of the 
EPs, assets to the Transco.  In a worst-case scenario, the 
Federation could pull out of the Transco to avoid an RS 
takeover of the assets.  The Federation government has so far 
failed to assert its rights as the majority shareholder in 
the Transco.  As a result, an even more serious worst-case 
scenario is a Transco locked in the control of a potentially 
corrupt General Director aligned with one entity. 
Non-discriminatory access to the transmission lines is 
crucial to the functioning of the electricity sector, so this 
problem must be resolved. 
 
State-level Capacity 
-------------------- 
 
¶16.  Like many other areas of BiH government, the country is 
hampered by the lack of State-level capacity in the energy 
sector.  Currently, the State,s energy issues are covered 
under MOFTER, whose capacity and authority to handle energy 
matters is low.  This hinders the sector, since there are 
unavoidable instances where State-level participation is 
necessary. 
 
¶17.  BiH recently signed the Energy Community Treaty for 
 
SARAJEVO 00001634  004 OF 004 
 
 
Southeast Europe in October 2005.  The Treaty commits BiH to 
become part of a regional energy market, which would require 
many reforms in the BiH energy sector.  The negotiations of 
this treaty were conducted by MOFTER.  Given that most energy 
competencies are still under the control of the entity 
governments, an agreement by the State government to reforms 
in the energy sector will not necessarily be complied with as 
promised.  If the Treaty goes into effect as expected in 
August 2006, BiH will be completely out of compliance in 
terms of the gas sector.  Other obligations will be affected 
by the Federation,s delay in unbundling the EPs.  It is not 
clear to what extent this obligation entered into by the 
State government will serve as a motivation for the entity 
governments to press forward with reforms. 
 
Corruption 
---------- 
 
¶18.  In February 2003 the OHR Special Auditor published a set 
of audits of the three EPs.  The audits revealed a high level 
of mismanagement, serious corruption, and improper 
procurement procedures.  The situation in EPRS was judged to 
be particularly egregious, with estimated losses of 100 
million KM per year due to corruption.  Since then, there 
have been improvements in management in all three companies, 
with EPBiH currently considered to be the best run and most 
progressive of the three.  However, while the EP managers 
have improved, the control of political parties and 
corruption are still a problem. 
 
Conclusion 
---------- 
 
¶19.  Much progress has already been achieved in electricity 
sector reform.  The U.S. government, through its USAID 
projects, has devoted extensive attention and developmental 
resources to the energy sector because of its high potential 
to contribute to BiH,s economic development.  BiH has a real 
comparative advantage in electricity, particularly because of 
its natural hydropower resources.  With investment in new 
hydropower generation, BiH could double its current power 
production levels.  If BiH can maintain its status as an 
energy exporter, it can become a key supplier in the new 
regional energy market.  However, BiH is less likely to 
attract the investment necessary to expand capacity in the 
sector if it does not follow through on the needed reforms 
that will make the power sector more efficient, transparent, 
independently regulated, and free from the corruption that 
still permeates the system. 
 
¶20.  Although the remaining challenges for the sector are 
significant, continued momentum on the reforms discussed 
above will help achieve these goals.  The unbundling of the 
EPs and the creation of a unified market will increase 
efficiency and transparency.  It will provide customer 
choice, which will create more pressure for further gains in 
cost efficiencies and reliability.  It will help break the 
hold that political parties still have in the EPs, which will 
eliminate a corrupt source of financing for nationalist 
political activities.  The consolidation of the electricity 
regulators into one State-level regulator will allow BiH to 
fulfill its international obligations to the EU and the 
Southeast Europe Energy Community, as well as provide a 
stronger protection for consumers.  Solidifying the viability 
of the new Transco and ISO companies will ensure 
non-discriminatory access to the transmission lines and 
operation of the electricity market, which will be necessary 
for future competition and customer choice. 
CEFKIN