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Appendix 2 Good Practices in Retail Fuel Price-Setting Mechanisms32

Author(s):
Trevor Alleyne, and Mumtaz Hussain
Published Date:
August 2013
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The most sustainable schemes for domestic pricing of petroleum products would be either full liberalization or transparent and simple automatic adjustment mechanisms for administered prices. Coady and others (2010) provide an excellent overview of international policies in this area. A fully liberalized regime would require adequate regulation to ensure the prevalence of competitive practices, which might be difficult in the case of low-income countries where regulatory capacity is weak and the size of the market is small. In general, a prerequisite for a successful liberalization of domestic prices is to strengthen regulatory frameworks to inhibit anticompetitive behavior that would be harmful to consumers. Therefore, although full liberalization is the first best option, a country’s history and institutional context might make it reasonable to have a simple automatic mechanism in place to administer prices over the short and medium terms. The discussion below focuses on that option.

A simple, transparent, and automatic pricing mechanism would ease the administrative burden of price regulations. Price adjustment formulas should be based on actual costs of supply, including transport, storage, and other costs incurred assuming efficient operations (for a discussion see, for example, Coady and Karpowicz, 2009). Cost estimates should be updated at regular intervals to reflect changes in market prices for inputs. The use of smoothing mechanisms can make the implementation of an automatic pricing mechanism more palatable for both consumers and policymakers by avoiding sharp price adjustments.

Price adjustment mechanisms should also include a desired level of taxes on petroleum products. Several factors can determine the level of taxes, including overall revenue requirements of the government and efficiency and equity considerations (Coady and others, 2010; Gillingham, Lacoche, and Manning, 2008). Fuel taxation is considered a relatively efficient source of revenue because the price elasticity of fuel demand is low. Furthermore, fuel consumption entails negative externalities, such as traffic congestion and environmental pollution, providing an additional rationale for taxation. There might also be equity concerns when setting a desired level of taxation, such that taxes should be lower on products that represent a relatively high share in total consumption of the poorest households (typically kerosene is seen as relatively more important for poorer households).

Price adjustments to changes in international prices should be automatic and frequent to limit distortions and fiscal costs. Pass-through of changes in international prices is important to avoid distortions in relative prices, provide adequate incentives for fuel consumption, and avoid cross-border spillovers (David, El-Harak, Mills, and Ocampos, 2012). Incorporating a smoothing rule in the automatic pricing mechanism can help to avoid large price variations deemed undesirable by policymakers. Commonly used smoothing mechanisms include the following:

  • Pricing based on a moving average of past international/import prices;
  • Price bands imposing a cap on maximum price adjustments allowed at any given time (for example +/− 5 percent of the prevailing price in a given month); and
  • Price adjustment triggers (e.g., the retail price is adjusted whenever the price given by the adjustment mechanism exceeds the prevailing price by 5 percent).

Important trade-offs should be considered when choosing an appropriate price smoothing mechanism. Most notably, excessive smoothing leading to low pass-through (by, for example, implementing adjustments based on long moving averages) increases the volatility of net fiscal revenue linked to petroleum products and may lead to the build-up of liabilities to oil importers and distributors. Simulations performed by the IMF’s Fiscal Affairs Department for 2006 through 2011 show that narrower price bands (+/- 3 percent) provide the best results (relative to other smoothing mechanisms) in terms of reducing retail price volatility while stabilizing fiscal revenue and mitigating fiscal costs (see Tuladhar and Eyraud, 2010, for an application to Togo; and Figure A6 for Mali). Nevertheless, in a context of prolonged increases in international fuel prices, all smoothing mechanisms will have adverse effects on net revenue.

Figure A6.Mali: Simulations of the Impact of Alternative Pricing Mechanisms, 2006–2011

Source: Belhocine (2012).

In practice, automatic price adjustment mechanisms are subject to significant implementation risks. Several African countries have adopted, at some point, automatic formulas for adjusting petroleum product prices, but these mechanisms are frequently suspended or not fully implemented for extended periods, particularly as international prices increase. Recent examples of countries that suspended automatic price adjustment mechanisms include Mozambique, Togo, and Zambia.

The governance structure of the institutions in charge of implementing the price formula is also an important element of the pricing policy. The pricing formula should be insulated from political influence, perhaps by delegating its implementation to an independent body that includes representatives from the different stakeholders (importers, distributors, transporters, among others) and with appropriate disclosure to the public. South Africa has adopted an institutional setting that contains some (but not all) of these features (Kojima, Matthews, and Sexsmith, 2010).

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