Reforming local energy subsidy and competitiveness

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Energy subsidies are pervasive and impose substantial fiscal and economic costs in most countries. On a – pre-tax basis, subsidies for petroleum products, electricity and natural gas are high, when compared to Gross Domestic Product (GDP) and total government revenues. The cost of subsidies is especially acute in oil exporters, which account for about two-thirds of the total. On a post-tax basis – which also factors in the negative externalities from energy consumption – subsidies are much higher, when taking as a proportion of GDP and total government revenues.  Country experiences suggest there are six key elements for subsidy reform. These are:

  1. a comprehensive energy sector reform plan entailing clear long-term objectives, analysis of the impact of reforms, and consultation with stakeholders;
  2. an extensive communications strategy, supported by improvements in transparency, such as the dissemination of information on the magnitude of subsidies and the recording of subsidies in the budget;
  • appropriately phased price increases, which can be sequenced differently across energy products;
  1. improving the efficiency of state-owned enterprises to reduce producer subsidies;
  2. targeted measures to protect the poor; and
  3. institutional reforms that depoliticize energy pricing, such as the introduction of automatic pricing mechanisms.

Energy Subsidy Reform and Competitiveness

The short-run effects of higher energy prices on competitiveness depend on the energy intensity of traded sectors and developments in energy prices in competing countries. Increases in energy prices to reduce subsidies – or avoid the emergence of subsidies in periods of rising international prices – increase production costs. The effects on costs will vary by sector, depending on both their direct use of energy (e.g., fuel products) and indirect use (e.g., the higher costs of intermediate inputs that use fuel) (Dick et al. 1984). Higher fuel prices, for example, can lead to higher electricity prices, which in turn will affect costs and output in manufacturing (Gupta 2007). The use of input-output tables can often be helpful to trace the direct and indirect effects of higher energy prices on costs and competitiveness and to quantify which sectors will be most affected. The effect of higher energy prices on competitiveness depends on developments in energy prices in countries competing for the same markets. If all countries pass on the increase in international prices to domestic prices, for example, the effects on production costs may be similar across countries.

The adverse effects on competitiveness, at the aggregate level, can be reduced if appropriate macroeconomic policies are in place. The extent to which higher energy costs result in a persistently higher price level and an adverse effect on competitiveness will depend on the strength of ―second round effects on wages and the prices of other inputs (Fofana, Chitiga and Mabugu 2009). If prices rise relative to those in trading partners, the real exchange rate will appreciate, reducing competitiveness. These second-round effects can be contained with appropriate monetary and fiscal policies that help anchor inflationary expectations (International Monetary Fund 2012a). Subsidy reform helps support an appropriate fiscal policy response by reducing budget deficits and helping contain demand pressures on prices. Flexible exchange rate regimes also mitigate the impact of volatile international prices on economic growth (IMF 2008b).

The resources freed from subsidy reform can boost competitiveness over the longer term. Subsidy reform can contribute to lower budget deficits and interest rates, thus stimulating private investment. Furthermore, if part of the freed resources is invested in productivity-enhancing public spending, growth dividends can be high (Breisinger, Engelke and Ecker 2011). By removing distortions in price signals, subsidy reform can help reallocate resources toward their best use and improve incentives to adopt energy-saving technologies. Not all sectors will benefit from subsidy reform over the longer term, because those that cannot adapt to higher energy prices will suffer a loss of competitiveness. Yet in the aggregate, the effects on competitiveness are positive. Empirical estimates suggest that higher investment in more efficient and energy-saving technologies could boost growth by up to 1 percent over the long term (Ellis 2010).

Eliminating energy subsidies would generate substantial environmental and health benefits. The over-consumption of energy products due to subsidies can also have effects on local energy demand and prices. The multilateral removal of pre-tax fuel subsidies in countries such as Guyana, under a gradual phasing-out, would reduce prices. The reduction would be substantially larger if prices were raised to levels that eliminated subsidies on a post-tax basis. These spill over effects suggest that non-subsidizers would share the gains from subsidy reform, as well as extending the availability of scarce natural resources.

Equity Implications

Energy subsidies are highly inequitable because they mostly benefit upper-income groups. Energy subsidies benefit households both through lower prices for energy used for cooking, heating, lighting and personal transport, but also through lower prices for other goods and services that use energy as an input. On average, the richest 20 percent of households in low- and middle-income countries capture six times more in total fuel product subsidies (43 percent) than the poorest 20 percent of households (7 percent). The distributional effects of subsidies vary markedly by product, with gasoline being the most regressive (i.e., subsidy benefits increase as income increases) and kerosene being progressive. Subsidies to natural gas and electricity have also been found to be badly targeted, with the poorest 20 percent of households receiving 10 percent of natural gas subsidies and 9 percent of electricity subsidies (International Energy Agency 2011).

While subsidies primarily benefit upper-income groups, a sharp increase in energy prices can nevertheless have a significant impact on the budgets of poor households, both directly through the removal of the subsidies and indirectly through the reduction in real income because of higher consumer prices. For example, a $0.25 per litre increase in fuel prices can reduce real consumption of the poorest 20 percent of households by about 5½ percent (Arze del Granado, Coady and Gillingham 2012). This underscores the need for mitigating measures to ensure that fuel subsidy reform does not result in increased poverty (Sterner 2012). In the case of electricity, the ability to differentiate tariff levels according to consumption levels (e.g., a lifeline tariff) can help protect low-income groups during electricity subsidy reforms. Nevertheless, such subsidies do not reach poor households who have no access to electricity, which limits their progressivity.

Energy subsidies divert public resources away from spending that is more pro-poor. In many subsidising countries, equity could be improved by reallocating outlays toward better-targeted programs in health, education, and social protection. Over the longer term, the removal of subsidies, accompanied by a well-designed safety net and an increase in pro-poor spending, could yield significant improvements in the well-being of low-income groups. In oil-exporting countries, subsidies are often used as a tool for sharing oil wealth with its citizens. But given the high share of benefits that accrues to upper-income groups, the inefficiencies that subsidies create in resource allocation, and in some countries the large share of the expatriate population, energy subsidies are a much less effective policy instrument for distributing wealth than other public spending programs.

Barriers to Reform

Country reform experiences suggest a number of barriers to successful subsidy reform. While there is no single recipe for success, addressing these barriers, which vary from country to country, can increase the likelihood of reforms achieving their objectives and help avoid policy reversals.

Lack of information regarding the magnitude and shortcomings of subsidies. The full fiscal cost of energy subsidies—including both producer and consumer subsidies—are rarely reflected in the budget. This is especially the case for oil exporters, since the subsidies provided by low energy prices are often implicit, i.e., not explicitly recorded in the budget. Populations are also often unaware of how domestic energy prices compare with international market prices, the consequences of low energy prices for both the budget and economic efficiency, and the benefit distribution of energy subsidies. As a result, the public is unable to make a connection between subsidies, constraints on expanding high-priority public spending, and the adverse effects of subsidies on economic growth and poverty reduction. This is especially important for oil exporters, where subsidies are very large. Most countries that successfully reformed energy subsidies undertook an evaluation of the magnitude of energy subsidies prior to implementing subsidy reforms.

Lack of government credibility and administrative capacity. Even where the public recognizes the magnitude and shortcomings of energy subsidies, it often has little confidence that the government will use savings from subsidy reform wisely. This is especially true in countries with a history of widespread corruption, lack of transparency in the conduct of public policy, and perceived inefficiencies in public spending. The middle class may fiercely resist the removal of these subsidies because they are viewed as one of the few concrete benefits they receive from the state. This is especially the case for oil exporters that have ample fiscal resources yet lack the administrative capacity to implement cash transfer programmes.

Concerns regarding the adverse impact on the poor. Although most of the benefits from energy subsidies are captured by higher-income groups, as noted earlier, energy price increases can still have a substantial adverse impact on the real incomes of the poor, both through higher energy costs of cooking, heating, lighting, and personal transport, as well as higher prices for other goods and services, including food. This is an important consideration for countries that do not have a well-functioning social safety net that is capable of effectively protecting the poor from the adverse impact of higher energy prices.

Concerns regarding the adverse impact on inflation, international competitiveness, and volatility of domestic energy prices. Increases in energy prices will have short-term effects on inflation, which may give rise to expectations of further increases in prices and wages unless appropriate macroeconomic policies are in place. This may especially be a concern for countries that have difficulty in anchoring inflation expectations. Higher energy prices may also lead to concerns about the international competitiveness of energy-intensive sectors. In addition, countries are hesitant to liberalize energy prices in order to avoid high volatility in domestic prices arising from international price developments.

Opposition from specific interest groups benefiting from the status quo. Politically vocal groups that benefit from subsidies can be powerful and well organised and can block reforms. For example, in some countries the urban middle class and industrial sector (which also benefits from subsidies) can be an obstacle to reform. On the other hand, those benefitting from reform are often dispersed and less organised. Reform strategies therefore need to address the concerns of the losers. An important stumbling block to reform in many countries is often state-owned enterprises (SOEs) in the energy sector, which can resist efforts to strengthen governance and performance.

Weak macroeconomic conditions. Public resistance to subsidy reform is lower when economic growth is relatively high, and inflation is low—although subsidy reform cannot always be postponed and is often required as part of efforts to constrain inflation and stimulate growth. Rising household incomes can help households better afford the increases in energy prices entailed by subsidy reform. The implementation of subsidy reforms during a period of stable prices and strong economic growth could help make the reform politically more palatable. High inflation is also an obstacle to reform. When inflation is high, frequent large changes in controlled prices are needed to avoid the emergence of fuel subsidies.