Part I of IV: Why energy subsidies still exist despite inefficiencies

Source: Andrew Taylor via Flickr

GRI Series on energy subsidies: Despite resolve to remove them, governments around the world continue to subsidize energy production and consumption. This series explores why.

At the G20 Leader’s summit in 2009, member countries shifted their focus from containing the global financial crisis to rebuilding global growth. Among the measures taken, the G20 committed to phasing out inefficient fossil fuel subsidies. Energy subsidies have long been a target of multilateral institutions, like the International Monetary Fund (IMF), who wish to remove them to correct the economic distortions they create.

While they are politically popular and appear to insulate citizens from global price shocks, energy subsidies exacerbate fiscal imbalances, increase economic inequality and crowd out other investments. Their removal, however, presents governments around the world with a unique set of challenges. Government commitment to reform must be credible, and the institutional capacity to carry out those reforms needs to be high. Otherwise, a country may have to choose between an inefficient, inequitable status quo and economic disruption from a poorly executed transition to a liberalized energy market.

Large amounts of government funds 

Energy subsidies represent the difference between the actual price paid for energy and the price that should be paid to cover production costs and taxes. The IMF estimates that energy subsidies cost the world $1.9 trillion in 2011, or around 8% of global government revenues. This number combines pre-tax subsidies, such as price caps, and post-tax subsidies, where energy is taxed at lower rates than other goods.

Yet, even after removing the opportunity cost of post-tax subsidies, the world still collectively spent $480 billion (or 0.7% global GDP) on energy subsidies in 2011. The independent International Energy Agency puts the 2012 cost even higher, at $544 billion. Developing countries, especially those that are commodity rich, account for almost all of these pre-tax subsidies. Saudi Arabia, for example, spends 14% of its government revenue on petroleum subsidies.

Lingering appeal of subsidies

The argument for subsidizing various forms of energy is quite simple: artificial price caps can prevent oil companies from charging too much at the pump, shielding citizens from shocks in global energy markets. Subsidies are often implemented at the producer-level, as well, in the form of tax breaks. Energy companies can then, in theory, pass these savings on to the consumer.

While low prices on fuel can be politically popular, rising global demand for energy has forced governments around the world to increase their annual subsidy outlays to keep domestic prices stable. In 2011, Uzbekistan spent 47% of government revenue on pre-tax natural gas subsidies. Failing to fully tax fuel also hurts. In that same year, major petroleum-producer Iraq forewent revenue equivalent to nearly 10% of GDP by keeping fuel taxes low.

Even amid growing budgetary constraints, domestic support for energy subsidies has been strong in recent years. In Indonesia, a nation known for its past attempts at subsidy reform, Presidential candidate Joko Widodo opposed fuel subsidy cuts due to pressure from opposition groups and labor unions. In Argentina, where government spending on energy subsidies rose over 70% in just the first half of 2013, President Christina Kirchner has refused to increase rates for the majority of the population.

In countries with large energy reserves, subsidies are often seen as a way to share the nation’s natural wealth. This spurs opposition to their removal and offers a compelling political reason for governments to maintain their subsidy regimes. The harm from energy subsidies, however, outweighs any short-term political gain. The next piece in this series discusses the economic cost of energy subsidies and ways to mitigate the political risk associated with reform.

This GRI Series will first introduce the mechanics and appeal of energy subsidies. It will then address the economic dislocation caused by subsidies as well as the political risk tied to reform. The final pieces examine two countries, Indonesia and Nigeria, poised to be increasingly important on the global stage.

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Categories: Economics, International

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  1. Part II of IV: Why economics, not politics, should steer energy subsidies | Global Risk Insights - April 3, 2014

    […] first part in this series examined why energy subsidies still widely exist, despite a growing consensus […]

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