Fuel subsidy cuts need not come at the poor's expense

Many Asian governments are reluctant to reduce fossil fuel subsidies out of concern for poor communities. But the money freed up from subsidies could fully offset their expenditures when energy prices rise, says ADB economist Rupa Jha.

Many Asian governments have subsidized coal, oil and gas as well as electricity for decades with the goal of making energy more affordable to the public and to domestic industry.

Oil has traditionally absorbed the largest share of subsidies. A few years ago, when crude oil shot past $100 per barrel, developing Asia accounted for as much as a third of total global subsidies for fuel consumption, most of which was spent on petroleum products.

At about 2.5 per cent of gross domestic product, these expenses held back governments from spending on other development priorities such as education, health and infrastructure. But do such subsidies at least reach the poor?

In a region where more than 425 million people have no access to electricity and 2 billion get by burning firewood, charcoal or crop waste for cooking and heating, the benefits of fossil fuel subsidies for the poor are surprisingly difficult to see.

In India and Indonesia, where the authorities have subsidized petroleum fuels for decades, biomass remains the cooking fuel of choice among the rural poor, ahead of even subsidized kerosene and liquefied petroleum gas. For lighting and heating, low-income families typically use kerosene or electricity.

Their purchases of petroleum products are limited as most cannot afford to own vehicles. The indirect needs of the poor for diesel and electricity are small, mainly for transport services and as inputs for agriculture, fishing vehicles, freight and small-scale generators.

When energy is discounted for the entire population, it typically benefits well-off residents more than it does the poor. Cheap gasoline encourages the wealthy to drive inefficient sport utility vehicles. Underpriced electricity and diesel embolden well-off farmers to overrun irrigation pumps and waste water.

In many low- and middle-income countries, the richest 20 per cent of households capture, on average, fossil fuel consumer subsidies worth more than six times as much as those enjoyed by the poorest 20 per cent.

It’s no wonder that such widespread availability of underpriced fuels creates a sense of entitlement to cheap energy. Artificially low prices also encourage illegal resale in parallel markets and smuggling into neighboring countries where fuel is more expensive.

The current period of low oil prices offers a favorable moment for removing the subsidies and leaving energy prices to be determined by the market. Indeed, in part enabled by lower oil prices and in part reflecting political commitments, many countries in Asia have recently attempted to reform subsidies, including Bangladesh, China, India, Indonesia, Malaysia, Myanmar, Nepal, Thailand, Turkmenistan and Uzbekistan.

The present bottoming-out of oil prices means subsidies could be reformed with little risk of adverse economic consequences or political disruption.

But progress on reforms has been uneven and many other governments have been reluctant to move further for fear of paying a political price. History has shown that consumers protest against higher energy prices while powerful interest groups that benefit most from subsidies strongly oppose reform.

The present bottoming-out of oil prices means subsidies could be reformed with little risk of adverse economic consequences or political disruption. A fraction of the money freed up from subsidies could be used to fully offset poor people’s additional household expenditures when energy prices rise.

Trade-off

The Asian Development Bank estimated in a recent study of India, Indonesia and Thailand that less than 10 per cent of potential savings from the removal of subsidies would be enough to compensate for the direct and indirect impact of higher energy prices on the bottom 40 per cent of the population.

With just half of the savings from fuel subsidies, all households could be fully compensated. This shows that energy subsidy reform can release substantial funds for other development needs.

Rather than lowering market prices, governments frequently try to customize subsidies for the poor. In practice, it can be highly challenging to enforce different energy prices for different users. Instead, non-subsidy alternatives like cash transfers can be more cost-effective and can be expanded quickly to achieve better outcomes in relation to poverty and equity.  

Cost is an important factor to be considered. For example, public works programs, while effective in targeting benefits, are a costly way to deliver assistance. The choice of specific programs will vary by country and should be made in consultation with stakeholders, particularly local governments with responsibility for social protection.

In Indonesia, for instance, a cash transfer program was developed in six months and subsequently used to assist households during energy subsidy reforms in 2008 and 2013. The transfer program, which accounted for about half of social assistance expenditures, fully neutralized the effects of energy price increases.

These examples show that with the right timing and the right alternatives, budget-busting subsidy programs can be reformed. The trick is not only striking while the iron is hot, but also for governments to adopt systems that allow domestic prices to adjust to market rates.

If this is not done, the same costly subsidies will return the moment international prices swell to pre-trough levels.
 
Shikha Jha is principal economist in the Asian Development Bank’s department of economic research and regional cooperation. This article is republished from the Asian Development Bank.

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