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Time to End Fuel Subsidies?

Subsidies distort markets and discourage development of substitutes. Subsidies for fuel are especially problematic, because energy is a backbone of any economy. In terms of energy production and consumption, the world is an uneven playing field in terms of reserves, taxes, regulations, public versus private ownership and income availability. An abrupt end to fuel subsidies would crush the poorest. With few ready alternatives, fossil fuels are highly inelastic products in economic terms – as prices rise, consumption of such necessities do not decline by much. Wealthy countries purchasing oil often set contract terms that benefit a few, and developing countries that are oil rich arrange subsidies as one benefit for the middle class and poor. Subsidies, even in countries lacking energy resources, contribute to political and economic stability. Ending subsidies – without putting alternative support programs into place – only adds to the ranks of the poor and threatens global security. – YaleGlobal

Time to End Fuel Subsidies?

Budgetary balance and need to develop alternatives, are reasons to end fuel subsidies
Will Hickey
YaleGlobal, 7 June 2012
To subsidize or not: As two photos from Nigeria show, world opinion is divided on the merits of fuel subsidies - a women's group supports ending subsidies (top) while others want to maintain them

DAEJEON: Developing countries of Asia and Africa are coming under increasing pressure to balance their budgets by cutting fuel subsidies. Resource-rich countries, too, are pressed to end subsidies as they distort markets. Proponents of alternate energies blame fuel subsidies for discouraging development of new products.

Many in developing countries are living on a subsistence level of US$2 a day. About half of the world’s more than 7 billion people are in that category. For these, a rise in petrol prices of, say 75 cents, could be catastrophic, triggering riots like recent ones in Indonesia and Nigeria. For middle-income people, such a rise is not a severe problem. They can afford it. Yet, ending subsidies has an alarming effect on the poorest in developing countries – affecting every facet of life. Society today is so dependent on fuel that even the poor cannot simply abstain from use. They need it for heating, cooking, generators, crop transport and motorbikes. Fuel is an absolute necessity for economic survival of the poorest.

Theoretically, taking away fuel subsidies would heighten prices on fuel and consumption will go down. A vital economic argument against fuel subsidies is that they inflict a heavy burden on government budgets, add to global warming, pollution and wasteful consumption in general.This, in turn, diverts much-needed resources from more pressing needs, such as health and education.

Fuel subsidies burden government budgets, adding to global warming, pollution and wasteful consumption.

Practically, however, price elasticity on fuel is very small so that higher prices won’t mean a decline in consumption. For the poorest, fuel is a necessity they can’t be spared.  Rich people can compensate for higher fuel prices with saving less or changing consumption patterns, but they’ll probably consume the same amount of fuel overall. The subsidies are the only tangible benefit the poor can get in normal economies, especially in resource-rich developing countries.

Subsidies are essentially the government buying energy at market prices and reselling it back to citizens at lower prices. Fuel subsidies are generally only possible when a country has windfall revenue in either resources, such as oil in Nigeria, or in trade surpluses, such as China’s.

Countries having scant resources and trade imbalances, such as India, Vietnam and Sri Lanka, however, run persistent budget deficits, reflected in consistently weakening currencies. They do this, of course, for political reasons. China successfully uses fuel subsidies to keep its export machine humming, and continues to do so to ensure growth. In India today, groaning under fuel subsidy of rupees 200,000 crore, US$40 billion, enormous coal reserves in Bihar and Orissa States lie in the hands of the few. India recently took the highly unpopular step of raising gas price in order to reduce its subsidy. Fossil fuel resources are fungible, existent reserves of minerals and should be utilized to address India’s endemic poverty issues.

In all, it’s estimated the developing world spends more than US$400 billion a year on fuel subsidies, according to the International Energy Agency in 2010. 

In Western countries, energy costs are passed directly to the consumer, usually with considerable taxes added on, as in the case of the European Union, the United States and Australia. These countries have higher GDPs than the developing world, and residents can absorb costs without seriously disrupting buying power.

The International Energy Agency has estimated developing nations spend over US$400 billion a year on fuel subsidies.

In resource-rich countries, governments often grant foreign investors rights to exploit resources under production-sharing contracts, or PSCs, in oil or work contracts in mining. Briefly written, the production-sharing contracts are made by the investors, typically oil companies, specifying that the sellers, typically developing countries, pay for expenses incurred by the investors in developing the oil fields. The effect of this is that the sellers are not interested in making big payments for other expenses unrelated to direct extraction, for example, education and training of employees.  

PSCs today are largely banned in developed countries as an abuse of bargaining power by international oil companies against unsophisticated government officials. Iran, for example, with the second largest proven oil reserves in the Middle East, refuses to use PSCs.  In some places, such as post-war Angola or Kurdistan, oil interests dictate, via largesse to public officials, how new “investment” rules will be written.

Mining contracts require knowledge of ores and calorie content to be equitably enforced. Of course, mining companies know the legal requirements and their own operations capabilities, thus easily outmaneuvering officials and, in countries where China invests, paying off bureaucrats to look the other way. Corruption and patronage flourish with citizens shortchanged.

Countries facing burgeoning, youthful populations with scant job opportunities, but sitting atop minerals or fossil fuels, simply cannot afford these colonial era economic models. Libya and Nigeria have met with political unrest due to enforcing the PSC model over their unemployed citizenry. Indonesia has recently endured mining strikes in Papua over subsistence wages.

Fuel subsidies work like indirect payments to the citizens as sovereign owners. Under this reasoning, and with no faith in central governments to deliver on employment and growth, as seen in Nigeria, maintaining the subsidy is justified. Sudden removal, as many Western economists and the International Monetary Fund call for, would be too severe a shock for the most vulnerable.

There are alternatives to fuel subsidies, but cash distribution plans require political reform and transparency.

In absence of leadership that will empower, or develop its people, such distribution schemes should be maintained. If governments insist on ending subsidies, they must first discard punitive PSCs and mining contracts that generously provide for foreign investors and leaders that approved them. Existing economic models need be changed to promote a new paradigm: burden sharing.

Unfortunately many economists don’t appreciate the role fuel subsidies play for the poor. Yes, there are alternatives to fuel subsidies, but these require political reform and transparency initiatives. For example, the State of Alaska takes the legal position their citizens effectively own the resources under their borders – namely oil and minerals – and generates a cash windfall each year that’s divided among its residents, about $1000 yearly. This is money from the oil exports freely given to residents to improve their living standards. Also note that in Alaska, oil companies originally fought hard against these reforms. Of course, while Alaska is part of a developed country, the possibility does exist.

The fossil fuel model is alive and well; without innovative alternatives, this will doom the planet and cause more strife in both resource-rich developing countries and countries with scant resources. The world is quickly changing, yet old economic paradigms of rewarding shareholders in the oil industry have failed to connect and empower countries with booming, hungry populations and dwindling resources.

 

Will Hickey, twice a Fulbright professor of energy and human resources, is an associate professor of management at Solbridge International School of Business in Daejeon, South Korea. He can be reached at whickey@solbridge.ac.kr.

Rights:Copyright © 2012 Yale Center for the Study of Globalization

Comments on this Article

14 June 2012
Fuel subsidies may discourage the pace of the development of alternative energy sources relative to what might occur in their absence, but given the utility (one might even say necessity) of fuel subsidies to the poorest individuals of the relevant developing countries' societies, the abrupt termination of these subsidies could have a strong humanitarian fallout in the forms of health deterioration, diminished economic productivity, and political unrest. I would personally favor the continuation of fuel subsidies and let alternative energy sources develop as fast as they are able under such conditions or at the very least gently phase out the subsidies so that the individuals most reliant on them are not exposed to an utterly brutal economic shock. When the government throws out a rope to pull its citizens to safety, it needs to be sure they have something to grab on to before it lets go of the rope. The abrupt termination of fuel subsidies is a bad idea.
Shawn Hadwiger
Political Science, B.S. from Oklahoma State University
-Shawn Hadwiger , Stillwater, OK
14 June 2012
Very good analysis. Yes. Subsidies on conventional energy like coal,kerosene are not reflected when comparing conventional energy sources with Renewable Energy. A transition has to be from conventional to non-conventional energy. Renewables offer as a decentralised energy generation systems especially in developing countries.
Dr.A.Jagadeesh Nellore(AP),India
E-mail: anumakonda.jagadeesh@gmail.com
-Anumakonda , Nellore(AP),India
13 June 2012
A good analysis. Yes, subsidies will have to be phased out gradually in all countries, especially in those countries that do not own natural resources nor generate trade surplus earnings. If the left hand is taking away (subsidies) the right hand has to replenish it (tax revenues or surplus earnings). You cannot have the cake and eat it too. I firmly believe that there must be a user cost for every scarce economic resource. Nothing should be costless and there should be no free riders.Only when we pay for something do we realize its value, else it is deemed to be considered an "Individual Right" and hence to be provided free of cost. There is no free lunch in reality since someone pays the price- in this case the tax payers or by deficit financing/borrowing, which could have an inflationary cost effect on the society. This is my take on this issue.I want all the end users to pay something- if not the full cost (market price). This can later be gradually raised to the level of the market price. Essential goods are price inelastic and hence demand for such goods will not necessarily decline with the rise in price. Stop politicising this issue for short term gains at the expense of long term benefits.
-Jacob Kurien , Johns-Hopkins-Nanjing Center, China
12 June 2012
I am really appreciate with Fuel Subsidies topic that Dr. Will Hickey wrote. Indonesia is one of the biggest crude oil exporter and probably the biggest Fuel Subsidies in the world.
Since Indonesia has very far differentiation between the poor and rich people, the issue of Fuel Subsidies is very very critical and political.
The most important is how to persuade people to believe that the elimination of Fuel Subsidies will not corrupted.
That's ' the key issue about Fuel Subsidies in Indonesia.
-Ford , Jakarta Indonesia
12 June 2012
The article was written as a concept opposed to conventional economic thought and focuses more on the ownership perspective of natural resources. Western countries are largely transparent with their resources in regards to rights. Even when oil or mining is found for example, offshore, countries like the UK, Norway, and US State of Alaska have enshrined resources as utilization of a public good that is mandated in jobs programs, social services and education and in Alaska's case, DIRECT payouts to residents. (As is on the record, the leaders in populist Alaska had to fight long and hard against BP for this ideal to even bear fruition in the late 1970's, when the effectively told BP that the oil in situ belonged to the citizens of ALASKA, not to the oil company). This is theme of my work. In the absence of transparency and good guality institutions, the fuel subsidy is the ONLY tangible benefit most realize from their own countries in situ vast resources. Due to spotty governance policy beforehand (and perhaps an indicator of the riots and upheaval) removal of the subsidy will not lead to better governance and a 'redirect of public spending' in many of these countries. (Why should their citizens trust their leaders now?) Removal of the benefit will reduce govt. spending but any income realized will soon enough end up in singular or elite pockets, or in the case of India and Nigeria, in the hands of foreign investors who are very shrewd in protecting their outlays. So again the conceptual is to break out of traditional economic beliefs and search for a new method when corruption and rent seeking are endemic. Peter Senge at MIT has researched much about systems thinking. This current economic thinking is badly broken, and based on 19th century colonial models that do not reflect building social capital or the ideal of burden sharing. The world has 7 billion people, the Friedman model of 'markets' is failing to deliver for the many. Having lived in India and in Indonesia, the grinding poverty in the former and mismanagement of resources in the latter necessitates thinking outside the box. The ownership perspective is not really considered as foundational in orthodox economics as it is assumed. Yet, it could be part of an endogenous growth model if citizens are given a tangible ownership part of the resource pie. Ownership is a key.
-Will Hickey , Daejeon, ROK
9 June 2012
In India Fuel is also highly taxed.But this subsidy bogey is raised to favour the only Private player in India who has enormous Political and Monetary clout. As this is a commodity which cannot one go without, it is easily taxed to raise revenue.The Governments will not reduce the taxes but harp about subsidy which only makes the private crony capitalist to fatten himself
-captainjohann, Bangalore, INDIA , bangalore,India
8 June 2012
While "the poor" get some crumbs from energy subsidies, the middle classes and rich use much more energy per capita and get the vast majority of fuel and electricity subsidies. I work on energy subsidies in Myanmar and Indonesia, and in both cases it would be MUCH better for the poor to charge about what it costs for electricity and extend the grid than to keep power cheap for the fortunate few (in Myanmar) and mainly urban (in Indonesia) who do get power. The higher charges would also allow the reductions of costly blackouts and lower connection charges. I can see a "lifeline" rate for very low quantity users but these tend to creep to include those well above that line. It is true that any movement is better to be gradual, especially for fuels like kerosene used for cooking, though Indonesia has wisely shifted to subsidized small gas canisters that cut the cost of subsidies and reduce "unintended" industrial use. Cutting fuel subsidies would also reduce fuel smuggling. Reduced subsidies can also be used for health and education, spending which can and often does benefit the poor. Overall, the thrust of the article is misleading (in my view) and misses an opportunity to redirect public spending to much more productive and equitable uses.
-David Dapice , Tufts University