Why is reforming fuel subsidies so hard?

With the recent dramatic fall in the price of oil, the issue of fuel subsidies comes to the fore again. Alan Beattie writes a good article in the Financial Times about fuel subsidy reform, how subsidies affect our economies and also why it is so hard to remove them. He also shows that there are some reforms underway that give hope. Do you have views on fuel subsidy reform?

 

Getting rid of fuel subsidies

There are very few things on which economists overwhelmingly agree: free trade and apple pie are about it. But almost all of them will say that across-the-board subsidies for households and companies to lower the price of fuel are a terrible idea.

While advanced economies in general tax fossil fuels – or the carbon emissions that emanate from its use – emerging markets are still big users of subsidies and price caps. The IMF estimates that consumption of petroleum, electricity, natural gas and coal were subsidised by about 2 per cent of total government revenue in 2011 – and much more if compared to a hypothetical efficient tax system. Hydrocarbon exporters accounted for about two-thirds of the total. The subsidy of fossil fuels by oil producers and particularly within the Middle East and North Africa is extreme.

In theory the current conjuncture would be an excellent time to remove them. The fall in oil prices means that subsidies can be abolished without the cost to consumers and businesses rising in absolute terms. With policymakers’ attention starting to focus on climate change talks in Paris later this year, emerging markets can win themselves some global governance points – and possibly cheap money for their renewables sector.

The emerging market world’s two most promising reformers, Narendra Modi in India and Joko Widodo in Indonesia, have made subsidy reform a centrepiece of their respective legislative programmes, and both have started successfully. Yet replicating that around the developing world involves overcoming concentrated interest groups that can pose a serious threat to public popularity. While low oil prices are an opportunity for net fuel importers like India and Indonesia, the fact that most subsidies are in oil-exporting countries means the falling cost of crude may make it harder to reform.

The multiple drawbacks of fuel subsidies are obvious. Any artificially-lowered price will tend to distort usage, encouraging over-dependence on energy-intensive production and lifestyle. Subsidies or tax breaks give up valuable government revenue that could have been spent on social services. Energy consumption has clear externalities in the form of carbon emissions and other costs of fuel extraction. And they fail to achieve what they are supposed to – acting as a form of income support for the poor. The top 20 per cent of households in developing countries gain six times as much in absolute terms as the poorest.

So why is reforming them so hard? Frequently, subsidised fuel (and food) are part of an implicit compact between governments and their populations. For poorer countries, sudden rises in energy costs can cut immediately and substantially into living standards. If those countries also have undemocratic or at least shaky regimes whose policymaking is opaque, fuel and food prices can act as a simple proxy for the quality of government policy. Higher fuel prices spill very quickly into public unrest. Often, subsidies are abolished and then re-imposed after public demonstrations, such as in a succession of oil exporters: Venezuela in 1989, Yemen in 2005, Cameroon in 2008, Bolivia in 2010 and Nigeria in 2012.

Neither the protests nor the response are confined to emerging markets. The UK was brought almost to a halt in 2000 because of hauliers protesting against high petrol prices, and the government announced a range of tax cuts for motorists a couple of months later, and desisted from sharp rises in fuel duties for years afterwards.

Accordingly, it is usually the fiscal cost of subsidies in countries with weak public finances, rather than any outbreak of liberalising zeal or global carbon citizenship, that forces governments into reform. This explains why the locus of most of the emerging world’s energy subsidies, the MENA region, has seen a distinct split between net oil importers and net exporters over the past few years.

Net fuel importers whose balance of payments difficulties were exacerbated by years of high oil prices have been making some effort to cut subsidies: Jordan, Morocco, Egypt, Tunisia and Yemen. (Yemen has swung from being a net oil exporter to an importer in recent years.) And all undertook reform in return for IMF loans rather than entirely of their own volition.

The reaction to those subsidy cuts shows the risks of change. Waves of protests have swept several of the countries, and governments are vulnerable to the accusation that the changes are being pulled out of an IMF-World Bank playbook and implemented without a social safety net to protect the poor.

It is hardly surprising that those countries’ oil-exporting MENA neighbours have been increasing rather than decreasing general subsidies over the past few years. Since the Arab spring in 2011, understandably fearing for their future, the rulers of many MENA states, especially the Gulf oil producers, have increased a range of direct subsidies and state employment to try to buy public support.

In theory, the falling oil price over the last few months should give oil exporters an incentive to reform fuel handouts: their erstwhile healthy public finances will take a severe hit from the reduction in export revenues. But if the falling cost of crude is hurting the economy in any case, it would be a brave ruling house that exacerbated the problem by taking money out of the pockets of households. For the likes of Saudi Arabia, running down its considerable foreign exchange reserves for a couple of years is almost certainly preferable to hitting its citizens with a sudden hike in fuel prices.

Those who bemoan the prevalence of energy subsidies in the emerging market world do at least have something to cheer. India and Indonesia, countries that are liberalising through choice rather than immediate necessity, are setting examples in the emerging market world. Yet it takes a clear political mandate, confidence in having enough time and political space and a benign external environment in order to get reform done. In the region where most of the emerging market subsidies are handed out, MENA, reform still seems either to depend on fiscal exigency or not to happen at all.

4 thoughts on “Why is reforming fuel subsidies so hard?

  1. Or it could just be that the fossil fuel industry runs an enormous lobby to retain its tax breaks… Witness the call by North Sea oil and gas producers,given lower fuel prices, for tax reductions – a call which the UK government seems poised to endorse. Will we ever learn?

    1. We know the fossil fuel industry runs an enormous lobby, as does the nuclear industry. Unfortunately, I believe the UK government will endorse the call. This will mean less revenue for the Treasury. I wonder how the Chancellor of the Exchequer plans to compensate for that. Well, we know he has a plan . . .

      1. Rod

        It is depressing how little ever changes..

        Incidentally I had thought you might have been prepared to give some prominence to my latest eibi column, which basically says that the EU ETS is a busted flush. I have been really gratified at how many Commission officials have responded to it so already so positively (albeit writing on their private email addresses!). You can find an electronic link on the ACE website (eibi tends not to place on line until the next month’s issue is out)

        Regards

        Andrew

        On 26 January 2015 at 10:04, Energy in Demand – Sustainable Energy – Rod

      2. Hi Andrew
        I have to apologise for not giving your article any prominence. The start of this year has been quite overwhelming. That said, I hope I can do this week. I am pleased to hear about the comments you have received from Commission officials. Yes, they know what is going on — or what isn’t going on. I will be attending a Commission event Thursday for the Energy Efficiency Financial Institutions Group. The final report will be discussed and it is to be published in March. Ristori is to open the meeting.

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