Designing energy subsidy reform strategy for emerging economies

Many countries have incorporated specific measures into their subsidy reform strategies to overcome the barriers of energy improvement. Country reform experiences suggests the following key elements can increase the likelihood of successful subsidy reform:

1. A comprehensive reform plan;
2. A far-reaching communications strategy, aided by improvements in transparency;
3. Appropriately phased energy price increases, which can be sequenced differently across energy products;
4. Improving the efficiency of SOEs to reduce producer subsidies;
5. Targeted mitigating measures to protect the poor; and
6. Depoliticizing energy pricing to avoid the recurrence of subsidies.

Comprehensive Reform Plan

Most of the successful reforms must be well planned with a clear reform strategy. Any fuel subsidy reform should incorporate clear objectives, compensating measures, and a timetable for reform, preceded by an extensive public relations campaign. The public information campaign must emphasize that the main objective of the reform was to replace price subsidies with cash transfers to reduce incentives for excessive energy consumption and smuggling. The authorities must undertake comprehensive planning, with broad consultation with civil society and a well-crafted plan that includes the introduction of a fuel price adjustment mechanism and a targeted subsidy for those living in remote areas. A clear medium-term reform strategy backed by careful planning should also be a major factor behind any successful electricity price liberalisation reforms.

A comprehensive reform plan requires establishing clear long-term objectives, assessing the impact of reforms, and consulting with stakeholders.

• Clear long-term objectives.
  • Subsidy reforms are more likely to be successful and durable if they are embedded within a broader reform agenda. In particular, reforms should incorporate both a sustainable approach to energy pricing and a plan to improve the efficiency of energy consumption and supply.
  • Full price liberalisation and structural reform of the energy sector, for both fuel and electricity, could be articulated as the ultimate goals of reform. This will contribute to the eventual success of reform as the public and governments are able to focus on and adhere to long-term goals, without being distracted by setbacks at intermediate stages.
  • This comprehensive strategy is especially important for electricity reforms. There is a strong inverse correlation between the size of electricity subsidies and the quality of service, reflecting the dampening effect of subsidies on investment. Yet the public is often unwilling to pay higher prices in the absence of quality improvements. Reforms in this sector should not only seek to improve access and service quality but also tackle operational inefficiencies (such as high distribution losses and inadequate bill collection and metering). The need to accompany tariff increases with service improvements can constrain the speed of reform, since improving services often requires up-front investment.
• Assessing the impact of reforms.
• Designing a comprehensive subsidy reform strategy requires information on the likely impact of reforms on various stakeholders and the identification of measures to mitigate adverse impacts. This involves assessing the fiscal and macroeconomic effects of subsidies and identifying the winners and losers from reform. Hence, undertaking an independent poverty and social impact analysis to assess the winners and losers from fuel subsidies and subsidy removal; will be an important foundation for persuasively communicating the necessity for reform and for designing policies to reduce the impact of higher fuel prices on the poor.
• Consultation with stakeholders.
• Stakeholders should be invited to participate in the formulation of the subsidy reform strategy. This stakeholder approach has proven successful in a number of countries (Gupta et al. 2000).
• In Kenya, electricity tariff increases faced significant difficulties early in the reform process. These were overcome after intense negotiations with stakeholders, particularly with large consumers, and efforts to communicate the objectives and benefits of the reform.
• In Namibia, the National Energy Council, chaired by the Minister of Mines and Energy, established the National Deregulation Task Force to examine fuel price deregulation through a consultative process.
• In Niger, the authorities established the Comité du Différé to discuss the best way to approach the fuel subsidy reforms and their subsequent consultation with all relevant stakeholders.

Communications Strategy

• A far-reaching communications campaign can help generate broad political and public support and should be undertaken throughout the reform process. A review of subsidy reform experiences found that the likelihood of success almost tripled with strong public support and proactive public communications (International Monetary Fund 2011). The information campaign should explain the magnitude of energy subsidies and their implications for other parts of the budget. The benefits of removing subsidies, including on a post-tax basis, should be underscored, in particular the scope for using part of the budgetary savings or additional revenues to finance high-priority spending on education, health, infrastructure, and social protection.
• A public communication campaign should begin at an early stage and include a nationwide roadshow to inform the public of the problems of petroleum price subsidies.
• The government should effectively communicate the cost of the electricity subsidy and its incidence to the public. This may be considered the raising of tariffs to be a pro-poor measure.
• Ensuring transparency is a key component of a successful communications strategy. Useful information to be disseminated includes:

1. The magnitude of subsidies and how they are funded, including in oil-exporting countries where subsidies are provided implicitly and not shown in the budget or recorded as tax expenditures. To the extent that subsidies are off budget, they could be reported as a memorandum item in budget documents. Data on subsidies should also cover producer subsidies, which may necessitate better reporting of the accounts of state-owned enterprises (SOEs) in the energy sector and reporting on SOEs in budget documents;
2. The distribution of subsidy benefits across income groups;

• Changes in subsidy spending over time; and

1. The potential environmental and health benefits from subsidy reform.

Making such information public allows for an independent assessment of the costs and benefits of subsidy policies. It is particularly important for determining whether subsidies are the most effective way to achieve desired outcomes, such as social protection for the poor. Subsidy expenditures should be compared to spending on priority areas and planned increases in these outlays as a consequence of the enlarged fiscal space from subsidy reform. Governments should also disclose as much information as possible about how prices are formulated and the factors behind planned price increases.

Appropriately phased and sequenced price increases

Phasing-in price increases and sequencing them differently across energy products may be desirable. The appropriate phasing-in and sequencing of price increases will depend on a range of factors, including the magnitude of the price increases required to eliminate subsidies, the fiscal position, the political and social context in which reforms are being undertaken, and the time needed to develop an effective communications strategy and social safety nets.

• Pace and timing of energy price increases.

Too sharp an increase in energy prices can generate intense opposition to reforms, as happened with fuel subsidy reforms. A phased approach to reforms permits both households and enterprises time to adjust and permits the country time to build credibility by showing that subsidy savings are being put to good use. It also helps reduce the impact of subsidy reform on inflation and creates room for governments to establish supporting social safety nets. The timing of energy price increases should also be considered carefully. Tariff increases that coincide with price increases for other socially sensitive products, such as food and fuels, may meet strong resistance.

• Sequencing of reform.

Price increases can also be sequenced differently across energy products. For example, petroleum price increases can initially be larger for products that are consumed more by higher-income groups and by industry, such as gasoline and jet kerosene. As the safety net is strengthened, subsequent rounds of reform can include larger increases in prices for fuel products that are more important in the budgets of poor households and part of the budgetary savings can be used to finance targeted transfers to poor households. For electricity, tariff increases can initially focus on large residential users and commercial users.

However, gradual reform can create additional reform challenges. First, a slower pace of reform reduces budgetary savings in the short term. There is thus a trade-off between the objectives of achieving budgetary savings and softening the impact of reforms on households. Second, sequencing of reforms can severely distort consumption patterns. Third, a gradual reform runs the risk that opposition may build up over time. To address this concern, gradual reforms must be accompanied by the government’s long-term commitment to follow-through on planned price increases, possibly over several successive administrations. This challenge can be overcome by building up a broad support base for reforms. Effective planning and communication promoted broad consensus on the need for petroleum and electricity sector reforms will enable the government to successfully implement its reform strategy gradually.

Improving the efficiency of SOEs to reduce producer subsidies

Improving the efficiency of state-owned enterprises (SOEs) can reduce the fiscal burden of the energy sector. Energy producers often receive substantial budgetary resources—both in terms of current and capital transfers—to compensate for inefficiencies in production and revenue collection. Improvements in efficiency can strengthen the financial position of these enterprises and reduce the need for such transfers.

• Governance of SOEs can be strengthened by improving the reporting of information on operations and costs. This can help identify system inefficiencies (e.g., overstaffing) and vulnerabilities (e.g., major loss points and bottlenecks in energy flows). A second step is to set performance targets and incentives on the basis of this information. Introducing competition, including from the private sector, can strengthen performance. This option will be more viable for countries with larger markets, where there is scope to ―unbundled activities in both the petroleum and electricity sectors. Notwithstanding these limitations, the private sector’s role in the electricity sector is growing in many emerging and low-income countries. Many of these countries have permitted competition among private generation companies and some of them have invited the private sector to manage electricity distribution, primarily to address operational inefficiencies.
• Improved demand management (by charging higher prices during peak periods) has proven effective in shifting demand to periods where marginal costs of provision are lower (Antmann 2009).
• Efficiency can be improved by exploiting regional trade in electricity (Foster and Briceño-Garmendia 2010).

Targeted mitigating measures

• Well-targeted measures to mitigate the impact of energy price increases on the poor are critical for building public support for subsidy reforms. The first step in this regard is to assess the capacity to expand existing (or implement new) social programs in the short term. Implementing or expanding targeted programs immediately prior to price reforms can help demonstrate the government’s commitment to protecting the poor. Untargeted cash transfers to compensate the population following a subsidy reform could be limited to the amount consumed by the poorest. This can generate fiscal savings, since poor households typically consume substantially lower quantities of energy than the rich. Further fiscal savings would be generated by targeted cash transfers to compensate only lower income groups. In some oil-exporting countries, where subsidies are often seen as a form of wealth sharing, uniform per capita transfers can be both more efficient and more equitable than untargeted energy subsidies. However, wealth sharing may be better achieved through targeted and productive public spending aimed at building physical and human capital. The degree to which compensation should be targeted is a strategic decision that involves trade-offs between fiscal savings, capacity to target, and the need to achieve broad acceptance of the reform.

Depoliticize energy pricing

• Successful and durable reforms require a depoliticized mechanism for setting energy prices. Many countries have successfully implemented reforms only to see subsidies reappear when international oil prices increase.
• Automatic pricing mechanisms can help reduce the chances of reform reversal. Establishing an automatic pricing formula for fuel products can help distance the government from pricing of energy and make it clearer that domestic price changes reflect changes in international prices which are outside the control of the government. Reliance on a formula can reassure the public that price increases would not lead to windfall profits for suppliers.
• However, adoption of such a mechanism is not a panacea for achieving a sustained reform of energy subsidies. A number of countries have abandoned such mechanisms shortly after adopting them, partly due to an unwillingness to pass through sharp international price increase to consumers. The sustainability of these mechanisms can be enhanced if they are packaged and communicated as part of broader structural reforms, including expansion of targeted social safety net and social spending programs. Using price smoothing rules can also help to avoid large price increases.
• Responsibility for implementing the automatic mechanism can be given to an independent body. Technical decisions on pricing can be delegated to an independent institution to ensure that subsidy reform proceeds as planned. The institution can also have the responsibility for implementing the automatic mechanism once subsidies are eliminated.
• A smoothing rule can be incorporated into the automatic pricing mechanism to avoid sharp increases in domestic prices (Coady et al. 2012). Countries often abandon automatic pricing mechanisms when international prices increase sharply. Smoothing mechanisms can also help contain inflationary expectations if supported by appropriate macroeconomic policies. They can help dampen the effects of international price and exchange rate volatility. With a smoothing mechanism, periods of sharp increases in international prices would only gradually be transmitted to domestic prices.
• To protect the budget over the medium term, smoothing must be applied both to price increases (when subsidies increase or taxes fall) and to price decreases (when subsidies decrease or taxes increase). How much smoothing the government chooses to implement; will depend on its preference between lower price and higher fiscal volatility. When prices fall outside this price band, the cost (if above) or benefit (if below) will be absorbed by the budget. While stabilisation funds have also been used to smooth price increases, experience with such funds has been mixed, with funds exhausting their reserves during periods of sharp increases in international prices or incurring large contingent liabilities for the budget (Chile, Namibia, Peru, the Philippines, and Thailand).
• Over the longer term, subsidy reforms for petroleum products should aim to fully liberalise pricing. More liberalised regimes – where prices are determined by private sector suppliers and move freely with international prices – tend to be more robust to the reintroduction of subsidies than automatic pricing mechanisms (Baig et al. 2007). Under a liberalised regime, the role of the government is to ensure that fuel markets are competitive and there is free entry and exit from the sector. A well-functioning social safety net should be in place before countries liberalise to ensure that low-income groups can be protected from future price increases and thus avoid public pressure to reintroduce subsidies. Successful implementation of an automatic pricing mechanism can facilitate the transition to a liberalised pricing regime by getting the public used to frequent changes in domestic energy prices. It can also build up the confidence of private suppliers that the government will not return to subsidised pricing.