June Elections Could Jeopardize Recent Reforms of

UNCLAS ULAANBAATAR 000340


STATE FOR EAP/CM AND EB/IEC
STATE PASS USTR, EXIM, OPIC, AND EPA
STATE PASS AID/ANE D. WINSTON
MILLENNIUM CHALLENGE CORP WASHDC FOR F. REID
TREASURY PASS USEDS TO IMF, WORLD BANK
MANILA AND LONDON FOR USEDS TO ADB, EBRD

E.O. 12958: N/A
TAGS: ENRG ECON EFIN PGOV EPET MG
SUBJECT: June Elections Could Jeopardize Recent Reforms of
Mongolia's Creaking Energy Sector

REF: A) ULAANBAATAR 0169, B) 07 ULAANBAATAR 0426 AND 0427


SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET DISTRIBUTION

1.(SBU) SUMMARY: In what amounts to a major breakthrough for
donor-agency efforts to promote reform of Mongolia's deteriorated
energy sector, Government of Mongolian (GOM) reps have for the first
time publicly conceded that the sector is financially bankrupt and
in wretched shape. The impetus for these statements and for the
organization was provided by USAID and the Economic Policy Reform
and Competitiveness Project (EPRC) starting in April 2007. Since
that time, eight monthly meetings of the GOM/donor Energy Working
Group (EWG) have been held and discussions of critical issues and
problems facing the sector have been handled openly and candidly.
The new Minister of Fuel and Energy (MoFE) has expressed support for
the reform initiatives outlined and promoted by USAID/EPRC starting
about two years ago and the EWG is in concurrence. The Energy
Working Group (EWG) is a coalition of donor reps (USAID, ADB, World
Bank, EBRD and GTZ) and GOM stockholders and stakeholders including
the MoFE, the State Property Committee (SPC),the Ministry of
Finance (MoF) and Energy Regulatory Authority (ERA). The EWG has
continually encouraged closer cooperation between the EWG and the
various GOM organizations on such issues as the need for an increase
in coal prices and the methodology to determine appropriate prices;
the need for a significant and immediate increase in both
electricity and heat tariffs; the need for the MoFE to encourage the
execution of Performance Agreements, a form of incentive regulation,
between the ERA and the three largest energy enterprises; increased
collaboration and integration of the ERA and MoFE; and the first
steps toward building a new and badly needed large Combined Heat and
Power Plant (CHP). The momentum gained in recent months slowed when
politicians abandoned Ulaanbaatar to campaign in their districts
ahead of the June 29 Parliamentary elections. Continuation (or
possible curtailment) of the process depends heavily on the
yet-to-be-announced results of the June 29 parliamentary election.
END SUMMARY.

The Energy Sector is Bankrupt
--------------


2. (SBU) Since April 2006 the Energy Working Group of donor
organizations and GOM energy sector stakeholders, brought to life
thanks primarily to the efforts of USAID Mongolia, has been pushing
the GOM to implement desperately needed reforms to prevent the
sector from certain electricity and heat shortfalls within the next
one to two years. (See reftels for the state of the crisis.) Yet as
late as December 2007 politicians have blocked all attempts by the
ERA to significantly increase tariffs and EWG entreaties to fund
large sectoral subsidies from the state budget rather than placing
the burden on the energy companies, as is now the case has been
ignored. The former Minister of Fuel and Energy (February to
December 2007) saw no (self-) interest in increasing energy tariffs
and in fact made outrageous and false statements on radio, TV and in
the print media that tariffs would be going down.

FIRST STEP: ADMITTING YOU HAVE A PROBLEM
--------------


3. (SBU) Things began to change in December 2007 when Ch.
Khurelbaatar, former State Secretary in the Ministry of Finance and
former Director of Mongolia's Millennium Challenge Account National
Council, became Minister of Fuel and Energy in Prime Minister S.
Bayar's government. Khurelbaatar immediately recognized the decrepit
state of Mongolia's energy sector and signaled his desire to
implement USAID/EPRC and EWG recommendations. In January, he
publicly announced that the energy sector, so vital to Mongolia's
economic development and national security, was bankrupt. The
Minister of Finance and the former Prime Minister followed suit at
the very same meeting. On January 29 the MoFE and the ERA signed a
memorandum of understanding, based on language from the USAID
contractor EPRC, which laid out common strategies and objectives.
For the very first time in the energy sector, the Ministry and the
ERA were collaborating on energy matters, and continue to do so.

First steps taken for Tariff Reform
--------------


4. (SBU) The EPRC, a key member and driving force in the EWG,
presented its retail tariff reform plan to the ERA and received
their concurrence. The Plan will be distributed to other
stakeholders, including the EWG, in mid June for review, comment and
discussion. First proposed to the ERA in 2006, the two-part
generation tariff methodology, separating tariffs on the fixed
(capacity) and variable (energy) costs involved in energy
generation, became effective on May 1. Next steps include the
introduction of incentive-based regulation and economic dispatching
of electricity and heat (a process of allocating the required load
demand between the available generation units based on the lowest
operating costs first),so that the cost of operation is minimized,
less coal is consumed again reducing costs and also air pollution
and creating the incentive for higher cost producers to reduce their
costs. Consequently, system efficiency will be improved.
Transmission and distribution tariffs will also be subject to
incentive regulation.

Performance Agreements gaining momentum
--------------


5. (SBU) With EPRC guidance first, and later with EWG guidance, the
ERA established Performance Agreements (PA) with three of the 18
Central Energy System licensees. PA's create incentives for
licensees to improve efficiency and lower costs with the prospect of
obtaining monetary rewards for good performance. The ERA uses
financial ratios, and in some cases technical and operational
benchmarks, to track and reward the performance of licensees.
Examples of financial ratios used include: liquidity ratios;
profitability ratios and capital structure ratios. In a sign that
the ERA's strategy appears to be working, the ERA finalized terms of
a third PA for 2008 with the Erdenet-Bulgan Electricity Distribution
Network. Negotiations continue with CHP #4 and other major energy
companies.

Coal Prices and CHP #5
--------------


6. (SBU) Effective December 1st, 2007, the government sanctioned
price at which the privately-owned Sharyn Gol Coal Mine (SG) must
sell coal to Mongolian power plants increased from 13,600 to 16,600
Tugruks (about $11 to $15) per ton. Coal prices of the two other
coal mines supplying the energy sector, where the GoM is the
principal owner, were also increased but the increase was far less
than SG. The move was crucial to keeping the coal mine solvent.
Following long-standing recommendations of the EPRC and later the
EWG, Minister Khurelbaatar has made building a fourth combined
heating and power (CHP) plant in Ulaanbaatar (CHP #5) a top
priority. The tender announcement was scheduled for May 20th, with
bid submittals required 90 days thereafter. Unfortunately, the date
has passed without an announcement and upcoming elections
effectively guarantee that no further actions will take place until
at least late summer.

Public Information/Public Education (PI/PE) Campaign
-------------- --------------


7. (SBU) Energy sector reform efforts have suffered from a
traditional lack of public discussion and awareness of the subject,
and the negative public reaction towards proposed tariff increases
has not helped. Since mid-2007 EPRC has been engaging journalists
and the media with energy sector entities such as power plants, an
electricity distribution company, the heat distribution and supply
company and a coal mine and has made great strides distributing
information in the past six months. There has been at least one
television slot, one radio show, and numerous print articles aired
after each of the six workshops held so far, with more to come. The
campaign has educated the media and increased public awareness of
the problems facing the energy sector. The EWG is fully briefed on
the PI/PE campaign status, progress and plans at every EWG meeting.

Uncertainty amid summer elections
--------------


8. (SBU) While some positive steps have been taken towards much
needed reforms in the energy sector, more remains to be done.
Upcoming June elections have the potential to threaten to jeopardize
the EWG's new-found momentum, but the situation could also improve
even further. There will be one more EWG meeting in late June and
then all meetings will be suspended until the new government is
formed. There is some concern that election results could yield a
new political landscape less accepting of EWG initiatives. Already
some politicians are suggesting that the MoFE (along with the
Ministry of Roads, Transport and Tourism, among others) be rolled
into an all encompassing Ministry of Infrastructure. This move has
the potential to diminish the MoFE's and the EWG's influence on
energy matters and add yet another layer of bureaucracy to a sector
already burdened by excessive government involvement. On the other
hand, if the new head of the energy sector (in whatever form) has
the desire to continue to tackle the critical issues and problems
facing the sector that will be yet another breath of fresh air, such
as Minister Khurelbaatar provided when he was appointed.

Minton