Curtail oil subsidies in favour of big bang reforms

This article appeared originally in Gulf News: link to original article

In previous reports on the oil markets, I briefly touched on now is the best opportunity available for governments to reduce or completely eliminate their energy subsidies.

Subsidies in their different forms were introduced to support citizens against outrageous spikes in fuel prices, which if passed on to consumers would have limited their purchasing power and curbed consumption, led to limited savings, and probably encouraged debt through personal loans and financing. And so subsidies were increased as oil prices went up as governments tried to limit the expenses that would be incurred by consumers if governments didn’t elevate their subsidy.

Then, once subsidies were in place and then increased, it turned into a self-sustaining policy which stayed on in almost all countries where these exit, with a couple of exceptions that would be highlighted towards the end of the report. According to the International Institute for Sustainable Development; Indonesia’s government spent $18 billion (Dh66 billion) on petroleum subsidies and $9 billion on electricity subsidies in the fiscal year 2013, equivalent ‘to 2.5 per cent of GDP and 25 per cent of total government expenditure’.

The report herewith will focus on energy subsidies, their effects and how lower oil prices is providing a clear way to introduce a plan to gradually rid economies of energy subsidies.

The assumption here is that energy subsidies lead to excessive and inefficient consumption, with a great share of it anyway assumed to benefit those whom they were not meant to benefit when introduced. The best way to understand the relationship between energy subsidies and consumption, and the best way to prove it as well, is to see what correlations may exist, if any, between energy subsidy rates and energy consumption.

Consumption will be assessed separately based on two factors — the first is the percentage of fossil fuel energy consumption of overall energy consumption for each country analysed, with the remaining consumption being from renewable and clean energy sources. The second is the electric power consumed (kWh) per capita.

Data for both factors has been obtained from World Bank’s data portal. The average subsidy rates of fossil fuel consumption in countries was obtained from data provided by the International Energy Agency (IEA). The data from both sources is that of 2011 as it is the only year with no missing data for all the countries being studied. Now to analyse the relationship, I ran two regressions.

The first regression analysed the relationship between average subsidisation rate and the percentage of fossil fuel consumption from the total. The model included 34 countries, with subsidisation rates ranging from 0.2 per cent in South Korea, the lowest rate, to 92.70 per cent in Venezuela, which is the highest among the 34 countries.

The model shows that the relationship is a high positive correlation with 95 per cent level of confidence, and that a 1 per cent increase in the percentage of fossil fuel consumption from total energy consumption is connected to a subsequent increase in average subsidisation rate of fossil fuels’ consumption by 0.46 per cent.

The second regression proved that there is a strong positive correlation between electric power consumed (kWh) per capita and average subsidisation rate in a country, with a 95 per cent level of confidence. The regression showed that an increase of 1 per cent average subsidisation rate in a country resulted in an increase of 2.39 kWh of energy consumed per capita, noting here that the average per capita consumption per country is 3,847 kWh.

Please keep in mind here that many countries from the 34 used in both models were the ones that have energy subsidy rates in place and that the limitation of both models is due to a small sample. Yet, the correlation’s significance in each model is extremely high.

After proving the relationship between energy subsidies and inefficient consumption, let’s look into subsidy bills paid by governments. The IEA reported that total ‘spending on subsidies reached $532 billion in 2011, 30 per cent growth when compared to 2010’.

Do you know much money is needed per year to end poverty in 20 years? In his book, ‘The End of Poverty’, Jeffrey Sachs estimates that amount to ‘be about $175 billion’. So, basically if energy subsidies’ money was fully allocated towards that, we could end worldwide poverty as we know it in less than seven years.

I am only stating this to show a better use of money spent on energy subsidies. So, why the topic of energy subsidies and their inefficiencies now? Because oil prices have dropped by more than 40 per cent since last year, and there is a link to be exploited.

The two are associated due to different reasons: first, lower oil prices have enabled oil consumers to witness significant savings, like Egypt is expected to save around 30 per cent because of lower oil prices. Secondly, countries that are oil producers, and got very high energy subsidy rates could pass a great portion of subsidy costs to consumers, like Venezuela could do with its extremely high 92.7 per cent subsidisation rate, amounting to $21.4 billion in 2011.

The third and final point is that the 34 countries had percentages of fossil fuel consumption from total energy consumption ranging from 39.27 per cent for Angola, the lowest percentage, to 99.9 per cent for the GCC, Algeria, and Brunei, with these countries maintaining the highest fossil fuel consumption percentages from total energy consumption.

Therefore, and as the GCC and Algeria are major oil producers; directing part of money spent on subsidies towards developing clean and renewable sources of energy would be of great future benefit. The UAE has already started doing so via solar energy projects and nuclear reactors with the first to be up and running by 2017.

Countries reduced or attempted to reduce subsidies in the past, with the pro argument being the realisation of how expensive subsidies can be, especially with populations that are increasing in size. For instance, subsidies cost Russia $324.7 per person per year for a population exceeding 140 million, with the amount being $323 in Argentina for a population exceeding 40 million.

For the UAE, the subsidy cost per capita for the year 2013 was estimated by IEA at $2,378, with the total cost of subsidising electric power being $4.3 billion in 2013 too. The same costs amounted to $14 billion for Saudi Arabia with subsidy cost at $2,155.1 per capita.

With all of the above explained, what should countries do? A paper by the World Economic Forum (WEF), titled ‘Lessons Drawn from Reforms of Energy Subsidies’, lists a few examples of what countries have previously attempted. Bolivia, with a current subsidisation rate of 44.10 per cent, removed energy subsidies in 2010 as the government believed a great portion ends up benefiting smugglers and foreigners.

Fuel prices increased by 80 per cent, leading to public riots which then led to subsidies being reinstated. Oil prices (Brent) averaged back then around $80 per barrel, which is significantly higher than today’s average. If anything, this provides plenty of maneuvering space for governments willing to take the bold step of introducing a plan to gradually eliminate subsidies.

In 2005, and according to the same WEF’s paper, Ghana’s government ‘commissioned a study to assess the winners and losers from the subsidy and its removal’. The study concluded that most subsidies benefit the rich. Ghana reduced its subsidy rate, which hoovers now at 8.5 per cent with cost per capita being $14.1.

The money saved from reducing subsidies was directed to spending on social programmes which benefited the poor more efficiently. Chile has done what I personally hope other countries will end up doing. It introduced a tax on transport fuel, while maintaining a price band of the last five years’ average oil price (WEF).

When oil price increases above the five-year average price, tax is reduced to support consumers. When oil price drop below the five-year average, tax is increased. The net result is a constant stream of government revenues and electric power consumption per capita of 3,568 kWh, lower than the average of the 34 countries studied in the two models.

To further emphasise Chile’s success, it must be pointed out that the average consumption per capita for the 34 countries has been reduced by countries with low electric power consumption due to infrastructure constraints. The thought that I want to leave you with is — what should be done knowing that the UAE’s electric power consumption (kWh) per capita is more than 2.5 times that of Chile?