Part II of IV: Why economics, not politics, should steer energy subsidies

Part II of IV: Why economics, not politics, should steer energy subsidies

The first part in this series examined why energy subsidies still widely exist, despite a growing consensus arguing for their removal. This section will look at their economic cost and why emerging economies attempting to reform subsidies in a credible way could prove to be a smart long-term investment.

Energy subsidies have proven economically inefficient, exacting substantial fiscal costs, discouraging investment, and depressing economic growth. They act as a regressive force in society, disproportionately benefiting upper income households. Subsidy reform can counteract this, unlocking higher potential growth and a more equitable wealth distribution.

Fiscal and societal costs

As energy prices increase, the fiscal cost for governments can quickly rise as maintaining price caps becomes more expensive. In 2008, Mauritania felt increased fiscal pressure as energy costs spiked, leading to a failed attempt to remove price freezes.

When the cost of subsidies propels fiscal deficits, countries become more exposed to shifts in global interest rates. As rates look set to rise worldwide, those countries will face higher borrowing costs, further exacerbating fiscal pressure.

Reforms can lower budget deficits, fueling private investments and reinforcing growth in all aspects of the economy. Data by the IMF suggests that subsidy reform coupled with higher investments in efficient energy technologies could “boost growth by one per cent over the long-term.”

Energy subsidies also act as a regressive force in societies. In its research, the IMF found that, on average, the wealthiest quintile of households received 43 percent of the benefit of fuel subsidies, while the bottom quintile saw only 7 percent. This makes sense, as the wealthy are more likely to drive cars and live in energy-demanding homes. While subsidies help the poor the least, the poor also bear the majority of the cost when energy prices rise.

Displacing investment

Subsidized prices for energy often result in low profits or outright losses for state-owned energy companies, making it difficult for them to expand energy production, enhance their infrastructure, and invest in forms of alternative energy.

In Sub-Saharan Africa, losses incurred by energy suppliers have left many utility companies unable to invest in new electricity capacity. As a result, installed per capita generation capacity is less than one-tenth of that in Latin America, where energy subsidies are not as prevalent. A lack of modern energy infrastructure creates a dangerous cycle where inefficient systems spur higher domestic costs, causing the amount spent on subsidies to rise, and government budgets to constrict even further.

Subsidies also pose a real risk to growth and investment in the private sector. Subsidy reform will raise domestic energy prices and increase production costs in the short-term, but government resources can be reallocated in the long-term. This could free up room for private firms, spurring domestic investment.

High fiscal spending on energy subsidies also represents an opportunity cost, diverting resources away from crucial investments and public services. In a speech last year, the IMF’s deputy director David Lipton noted “subsidies remain a stumbling block to higher growth by squeezing out much-needed health, education, and infrastructure spending.”

A way out

Despite the convincing case for removing subsidies, they have proved to be a persistent policy challenge. A lack of information on the true cost of the subsidies — along with low trust in government oversight — has led to public backlash over removing subsidies.

In one recent case, Sudan saw widespread unrest and protests last fall following President Bashir’s decision to remove subsidies over budget concerns. In countries with poorly run governments, people often think it unlikely the economic gain will be appropriately reallocated to aid them.

The IMF recommends clear communication as part of a comprehensive and slowly phased-in plan to reduce subsidies. Governments need to convey how energy subsidies hurt the public and engage with stakeholders to assure them that costs will be offset.

In Iran, the 2010 fuel subsidy reform was preceded by an extensive public information campaign, which emphasized the benefits that reform will bring to the Iranian standard of living. Similar steps were taken in successful recent reform campaigns in Turkey, Namibia, and the Philippines.

Cash transfers and vouchers have proven most effective, but governments can also provide relief for families by lowering fees, or assisting with healthcare and education costs. Sharp increases in fuel prices tend to cause the most disruption, so transitioning slowly helps quell potential unrest.

As energy demand grows in emerging economies over the next twenty years, efficient energy policy will be crucial to ensuring equitable growth. Following the financial crisis, these countries were an important driver of global growth.

Reforming energy subsidies would go a long way towards bolstering that trend. Investors will continue to look at emerging economies for higher returns. A nation attempting to reform subsidies in a credible way could prove to be a smart long-term investment.

Categories: Economics, International

About Author

Rami Ayyub

Rami is an analyst with a US Defense and Space firm, where he works in strategic planning and finance for Civil and Defense programs. He holds Bachelor degrees in Finance and Classical Music from the University of Maryland, College Park.