Chapter

Appendix 1. Reforming Energy Subsidies

Author(s):
International Monetary Fund. Fiscal Affairs Dept.
Published Date:
April 2013
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Energy subsidies are high in many emerging market economies and low-income countries because of limited pass-through of recent increases in international energy prices to domestic consumers. But inadequate pricing of energy products is also common in advanced economies, in which energy taxes are often below levels needed to fully capture the negative externalities of energy consumption in regard to the environment, public health, and traffic congestion. These developments have led to renewed calls to phase out energy subsidies. For instance, the Group of Twenty (G-20) Pittsburgh Communiqué of September 2009 called for a phase-out of inefficient fossil fuel subsidies in all countries, and this commitment was reaffirmed at the 2012 Los Cabos G-20 meeting. This appendix summarizes the findings of IMF (2013a), which presents estimates of energy subsidies for 176 countries. It also discusses how to undertake energy subsidy reform, drawing on insights from 22 country case studies.

Pretax and posttax subsidies

A pretax consumer subsidy arises for a certain good when the price paid by consumers (households and enterprises) is below its supply cost (including transportation and distribution costs). For internationally traded goods, such as petroleum products, the supply cost is the international price adjusted for distribution and transportation costs. In the case of nontraded goods—such as electricity, in most countries—the relevant price is the cost recovery price for the domestic producer, including a normal return to capital and distribution costs.

A posttax subsidy arises when the price paid by the consumer does not cover the supply cost plus an efficient level of consumption taxation to meet revenue requirements and correct for negative environmental and other externalities. Therefore, when there is a pretax subsidy, the posttax subsidy is equal to the efficient tax plus the pretax subsidy. When there is no pretax subsidy, the posttax subsidy is equal to the difference between efficient and actual taxation. A producer subsidy arises when a domestic producer suffers losses at pretax supply prices.

Implications of energy subsidies

Energy subsidies have wide-ranging economic consequences. Though aimed at protecting consumers, subsidies aggravate fiscal imbalances (or alternatively crowd out priority public spending) and depress private investment. International evidence further shows that energy subsidies exacerbate macroeconomic imbalances. By diluting incentives to reduce domestic energy consumption, incomplete pass-through of increasing international energy prices to domestic consumers worsens the adverse balance of payments impact in oil-importing economies and reduces the beneficial balance of payments impact in oil-exporting countries. In the latter, the failure to fully adjust domestic prices during periods of rising international prices can make demand management more difficult when higher oil prices boost incomes in the oil sector and lead to higher domestic demand. Subsidies also distort resource allocation and lead to negative externalities by encouraging excessive energy consumption and pollution, artificially promoting capital-intensive industries, reducing incentives for investment in renewable energy, and accelerating the depletion of natural resources. Subsidies are typically highly inequitable, as they are largely captured by higher-income households and divert public resources away from spending that is more pro-poor. On average, the richest 20 percent of households in low- and middle-income countries capture about six times more in energy subsidies than the poorest 20 percent of households.

Magnitude of energy subsidies

Energy subsidies are pervasive and impose substantial fiscal costs in most regions (Figures A1.1, A1.2, and A1.3). Pretax subsidies for petroleum products, electricity, natural gas, and coal reached US$480 billion in 2011 (0.7 percent of global GDP or 2 percent of total government revenues). Petroleum product subsidies and electricity account for about three-quarters of total pretax subsidies. These subsidies are concentrated in the Middle East and North Africa region, which accounts for about 50 percent of global subsidies (more than 8½ percent of regional GDP or 22 percent of total government revenues). Oil exporters, most of which are developing and emerging market economies, account for about two-thirds of total subsidies.

Figure A.1.1.Composition of Subsidy Costs by Product

(Percent)

Source: IMF (2013a).

Figure A.1.2.Composition of Subsidy Costs by Region

(Percent)

Source: IMF (2013a).

Posttax subsidies amount to US$1.9 trillion (2½ percent of global GDP or 8 percent of total government revenues). Subsidies to petroleum products and coal account for about three-quarters of global posttax subsidies. Advanced economies account for about 40 percent of these subsidies, and oil exporters account for about one-third. However, as a percentage of GDP and government revenues, these subsidies are highest in the Middle East and North Africa, at about 13 and 33 percent, respectively.

Figure A.1.3.Magnitude of Energy Subsidies by Region

Source: IMF (2013a).

Note: Advanced: advanced economies; CEE-CIS: Central and Eastern Europe and Commonwealth of Independent States; ED Asia: emerging and developing Asia; LAC: Latin America and the Caribbean; MENA: Middle East and North Africa; SSA: sub-Saharan Africa.

Implementing subsidy reform

Despite the potential gains, many countries have found energy subsidy reform difficult. Price adjustments have often led to widespread public protests, with a subsequent complete or partial reversal of price increases. The absence of public support for subsidy reform partly reflects a lack of confidence in governments’ ability to reallocate the resulting budgetary savings to benefit the broader population, as well as concerns that vulnerable groups will not be protected. This problem is particularly challenging in oil-exporting countries, where subsidies are seen as a mechanism to distribute the benefits of natural resource endowments to their populations and where the capacity to administer targeted social programs is typically limited. Governments are also often concerned about the inflationary effects of higher energy prices and their adverse impact on competitiveness. Furthermore, subsidy reform can be complex when it involves efforts to reduce inefficiencies and production costs, as is often the case for the electricity sector.

Although there is no single recipe for successful subsidy reform, country experiences suggest that the following ingredients can facilitate success and help avoid policy reversals:

  • a comprehensive energy sector reform plan with clear long-term objectives, a detailed analysis of the impact of reforms, and consultation with stakeholders;
  • an extensive communication 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 and take into account the capacity to implement mitigating measures;
  • improvements in the efficiency of state-owned enterprises to reduce producer subsidies;
  • measures to protect the poor through targeted cash or near-cash transfers or, if this option is not feasible, a focus on existing targeted programs that can be expanded quickly; and
  • institutional reforms that depoliticize energy pricing, such as the introduction of automatic pricing mechanisms.

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