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Commentary Climate Change

Energy Subsidy Reform: Lessons and Implications

With energy inextricably linked to economic growth, many countries subsidize energy costs in varying forms and magnitude. It is estimated that total energy subsidies globally may add up to a staggering $2 trillion, larger than the GDP of most nations. The distortive impacts of these subsidies can aggravate budget deficits, not only through direct spending but also through forgone revenues if energy taxes are set below efficient levels; depress growth, by making energy sector investments unattractive; and crowd out critical growth in areas of public spending such as education and healthcare. Subsidies may also widen the gap between the rich and the poor, with the richest 20 percent of households in low-and middle-income countries consuming the most energy and accruing 40 percent of the actual benefits from the energy subsidies.

Understanding the impact of energy subsidies—and how the impacts might change in the evolving global energy landscape—is necessary if decision makers are to successfully navigate the complex world of energy policy. Benedict Clements, an International Monetary Fund (IMF) official, presented on these exact issues at the Center on Global Energy Policy on November 18. Clements is co-author of a recent IMF report that details the consequences of energy subsidies.

In the report, Clements and his co-authors categorize subsidies into three forms:

  • “Pre-tax” subsidies, which occur when consumers pay a price below the supply cost of energy, including transportation and distribution.  For example, Nigeria spends about $8 billion a year on fuel subsidies, while Mexico subsidizes gasoline prices for their populations. These “pre-tax” subsidies total $492 billion worldwide.  Nearly half of this lost revenue subsidizes petroleum products.

Source: IMF

  • Tax subsidies are found when taxes on the consumption of energy are too low, that is to say when the production price does not account for the full social cost. Benedict argues that energy should be taxed similarly to other consumer products and that the additional taxes should account for any adverse effects (i.e., negative externalities) of energy consumption not captured in the pre-tax price.

Source: IMF

  • “Post-tax” subsidies—or the total subsidy level—are calculated by adding up the pre-tax and tax subsidies. These post-tax subsidies are four times larger than pre-tax subsidies, totaling ~$2 trillion.  Almost a third of these dollars go toward subsidies for coal.

Source: IMF

To estimate the environmental implications of energy subsides, Clements tests the impact of raising energy prices to levels that would eliminate subsidies for petroleum products, natural gas, and coal. He concludes that this reform would reduce global carbon emissions by 4.5 billion tons and generate significant health benefits by reducing local pollution emitted by power plants in the form of SO2. Clements has found that underpricing for externalities (pollutants) accounts for a large charge of post-tax subsidies across all regions.

Removing these subsidies is expected to affect consumer prices by increasing production costs and raising energy prices. In isolation, the removal of these subsidies could result in a de facto regressive tax regime. Benedict argues that these increased costs will, over the long-term, reallocate resources to less energy and capital intensive activities. Economist Komal Sri-Kumar recently echoed these assertions in a piece about this phenomenon in India.  Besides the direct cost burdens that consumers must bear, the relative economic competitiveness of countries that increase energy prices to reduce subsidies may also be affected.  Benedict writes that these outcomes can be mitigated if countries competing for the same markets all enact subsidy reform.  However, as we have seen in recent attempts at global governance to mitigate global climate change, many nations are weary of risking short-term competitiveness for longer-term gain.

After illustrating the ubiquity of energy subsidies, Clements presented six “ingredients” for reform, using country case studies.  These include:

  • A comprehensive reform plan with clear long-term objectives, assessment of the impact of reforms, and consultation with stakeholders.
  • A far-reaching communications strategy that informs the public of the size of subsidies and the benefits of reform, in addition to strengthening transparency in subsidy reporting.
  • Appropriately phased and sequenced price increases that permit households and enterprises time to adjust and governments to build social safety nets.
  • Improvements in the efficiency of state-owned enterprises (SOEs) to reduce their fiscal burden by improving information disclosure on their costs, setting performance targets and incentives, and introducing competition where appropriate.
  • Targeted efforts that would protect the poor from potential cost increases, including targeted cash transfers and other programs such as job training.
  • Depoliticize energy price-setting by implementing an automatic price mechanism with price smoothing and establishing an autonomous body to oversee price setting.

The energy subsidy policy challenge is not going to disappear anytime soon.  As long as energy is so strongly linked with economic and geopolitical success, governments will have an incentive to subsidize its usage and distribution. We do have, however, some examples of success upon which to draw. Maria Vagliasindi, a World Bank economist, authored Implementing Energy Subsidy Reforms, a 2012 report that described lessons learned from 20 developing nations that attempted to implement energy subsidy reforms.  Vagliasindi has found that net energy importers such as Armenia, Jordan, India, Chile, Peru, and Turkey have had the most success with their phase-out of subsidies. The work of Clements and Vagliasindi illustrate the complexity of energy subsidy reform in any country.  Many countries, including the Untied States, are grappling with this challenge and are attempting to determine the economic costs and benefits of reform.  The reasons for these reforms are clear, but the process and politics that must be navigated to successfully implement these changes can be difficult.

Author: Seth Levey is a first year SIPA student in the energy and environment concentration


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Commentary Climate Change

Energy Subsidy Reform: Lessons and Implications