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Azerbaijan Republic: Selected Issues

Author(s):
International Monetary Fund
Published Date:
January 2005
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I. Domestic Energy Product Pricing in an Oil-Exporting Country: The Case of Azerbaijan

A. Introduction 1

1. Azerbaijan is endowed with large oil and gas resources, estimated at 7.0 billion barrels (0.6 percent of proven world oil reserves) and 48.4 trillion cubic feet (0.8 percent of proven world gas reserves), respectively. After a long period of decline in oil production, oil output started to increase in mid-1990s, to reach 0.3 million barrels per day in 2003, and is expected to increase sharply in 2005, reaching a maximum of 1.3 million barrels per day in 2010. This boost to oil production capacity is attributable to substantial investments implemented in cooperation with international oil companies during the last five years. As in many other developing oil-producing countries, domestic energy prices are heavily subsidized in Azerbaijan.

2. Governments of oil-producing developing countries often keep prices of domestic energy products below their world market levels. Inherently unstable world market prices of energy products provide a rationale for these governments to step in to protect the welfare of domestic consumers, especially the poor, from excessive price changes. Another argument often employed by governments of oil–producing countries is that the country is rich in exhaustible natural resources, and cheap provision of energy products is the state’s social obligation. The economic literature provides a number of counter-arguments to this reasoning. Selling energy products domestically at a lower price than could have been obtained by exporting these products results in implicit subsidization of energy consumption, a loss of valuable revenues for the government, allocation inefficiencies, and negative externalities.

3. During the last three years, the government of Azerbaijan has made substantial progress in dealing with energy-related subsidies. Indeed, the latter were reduced from an estimated 22 percent of GDP in 2000 to around 10 percent of GDP in 2003 (Table 1.1).2 The elimination of remaining energy subsidies will represent an important challenge for the Azeri authorities, in particular if world market oil prices were to remain at current levels, which are substantially higher than the averages for the last 10 years. A recently approved Long-Term Strategy of Oil Revenue Management and the government’s commitment to revise energy prices annually in the context of annual budgets are key steps to intensify reform efforts in this area.

Table 1.1.Azerbaijan: Estimated Fiscal and Quasi-Fiscal Energy-Related Subsidies, 2003
 2003
Total fiscal and quasi-fiscal subsidies (bln. manats)3,418
Fiscal subsidies 1/1,895
Azerenergy1,753
Azerigas142
Quasi-fiscal subsidies 2/1,524
Total fiscal and quasi-fiscal subsidies (in percent of GDP)9.8
Fiscal subsidies 1/5.4
Azerenergy5.0
Azerigas0.4
Quasi-fiscal subsidies 2/4.3
Source: Ministry of Finance of Azerbaijan; and Fund staff estimates.

4. The paper reviews the current scope and consequences of underpricing of domestic energy products and explores options for further energy price reforms in Azerbaijan. Together with the oil and gas sectors, the electrical power sector is also considered to the extent it uses underpriced energy products as inputs for electricity generation. The extent of underpricing is estimated relative to international reference prices, which could be based on import or export parities. This paper relies on import parity reference prices for petroleum products for the following reasons: (i) for petroleum resources, which are non-renewable, import parity prices represent a measure of the opportunity cost; and (ii) import parity promotes more efficient outcomes, as imported products would be able to compete with domestically refined products. For natural gas, since Azerbaijan is currently a net gas importer, import parity is also the proper reference price to use. In 2004, Azerbaijan was importing gas from Russia at a price of US$52 per thousand cubic meters.

5. The paper is organized as follows. Section B provides a summary of current domestic energy product pricing policies and describes inefficiencies arising from underpricing of energy products in Azerbaijan. Section C makes a case for a two-stage approach to energy price reform. In the first stage, domestic energy prices need to be aligned with world market levels, and the paper presents a number of illustrative scenarios incorporating various assumptions on the pace of adjustment, reference world market prices, and price and volume elasticities. Once the gap between domestic and world energy prices has been eliminated, the authorities will need to proceed to the second stage of price reform and consider options for energy price adjustment mechanisms, aiming at preventing price gaps from re-emerging. Section D concludes and recommends moving toward world market energy prices in 1–3 years and adopting a rules-based smoothing mechanism for energy price adjustment thereafter.

B. Current Domestic Energy Product Pricing Policies and Their Consequences in Azerbaijan

Energy prices in Azerbaijan

6. The domestic market for oil products has been tightly regulated by the government since Azerbaijan gained independence. Azerbaijan is largely self-sufficient in oil products because of its substantial endowment of exhaustible mineral deposits and existing refining capacity. In the period September 1993–November 2004, the Cabinet of Ministers adjusted oil product prices 15 times to reduce gaps between domestic and world market prices that had widened because of movements in world oil product prices and exchange rate depreciation. Despite these adjustments, both wholesale and retail prices of most oil products were well below world market prices for the most part of this period.

7. The last adjustment in energy products prices took place in November 2004 as a part of the government’s broader strategy to gradually raise domestic petroleum products prices toward world market levels. The government increased both wholesale and retail prices of most oil products by 10–12 percent, reducing a large price gap with import reference prices,3 which has widened since the previous adjustment to retail prices undertaken in February 2003. The November 2004 price increases were implemented mainly through increased indirect taxes, as the ex-refinery prices of petroleum products were left unchanged. Despite these increases, wholesale prices for key refined oil products, including taxes, are still 19 to 69 percent below the import reference prices (Table 1.2).

Table 1.2.Azerbaijan: Domestic Prices of Selected Petroleum Products, 2004 1/
 Gasoline 92Diesel fuelFuel oil (Mazut)Jet fuelKeroseneNaphtha
 /2/3/2/3/2/3/2/3/2/3/2/3
 (In thousand manats per ton)
Ex-refinery price952952645645300300652622538538661661
Excise tax6178390970007815120053
Delivery cost (including VAT)474737413535035414100
Wholesale price (including VAT)4/1,8992,162797916389389769861694818780842
Retail Prices (including VAT)2,0962,3589521,071868992
 (In U.S. dollars per ton)
Ex-refinery price1941941311316161133127110110135135
Excise tax12617102000016324011
Delivery cost (including VAT)10108877078800
Wholesale price (including VAT) 4/3874401621867979157175141167159171
Retail Prices (including VAT)427480194218177202
FOB (Mediterranean) price412412352352168168387387371371356356
Price at Baku’s port 5/454454390390207207426426410410397397
Delivery cost887766667700
Reference wholesale price (including taxes)—import parity545545468468251251510510492492468468
Reference wholesale price (including taxes)—export parity 6/457457392392153153386386
Domestic wholesale price (including taxes)3874401621867979157175141167159171
As percentage of import parity reference price718135403131313429343437
As percentage of export parity reference price8596414751514144
Source: Cabinet of Ministers Decrees No. 20 and No. 165, and Fund staff estimates.

8. While Azerbaijan is self-sufficient in oil products, it needs to import about 3 billion cubic meters (bcm) of natural gas annually to meet its domestic consumption demand of 7 bcm.4 As in the case of oil products, currently both wholesale and retail prices of natural gas are regulated by the state. There are separate tariffs for residential and business consumers. The Cabinet of Ministers implemented four adjustments to natural gas prices in the period September 1993–November 2004.

9. Together with oil product prices, in November 2004 the government also increased domestic gas prices for residential consumers and unified them for businesses. This was motivated by the large financial losses of the State Oil Company of Azerbaijan Republic (SOCAR)—the single producer, importer, and provider of natural gas to the domestic market—and Azerigas—the national gas company. These losses arose because of the low domestic price for residential consumers (US$7.26 per thousand cubic meters (tcm)), which, before the increase, was substantially below the import price of US$52 per tcm (which is the marginal cost), as well as the average cost of gas of US$32 per tcm (World Bank, 2004). The new tariff for residential consumers at US$16.50 per tcm and the unified business tariff at US$46 per tcm are now closer to cost recovery. This price increase, together with the intensification of the program to install gas meters for households, will in due course help reduce waste of gas. The other important issue facing the gas sector is low collection of tariffs due, which is currently estimated at about 50 percent.

10. The electrical power sector benefits from the underpricing of domestic energy inputs. Azerenergy—the national electricity generating company—receives underpriced fuel oil and gas from SOCAR. Not only are current electricity tariffs insufficient to cover operating, maintenance, and underpriced input costs and provide funds for necessary investments in the sector, a low level of collection on payments due, estimated at 34 percent in 2002, compounds the plight of the electricity sector.

Inefficiencies Arising from Underpricing

11. Energy product prices that are substantially below world market prices lead to a loss of allocation efficiencies in both production and consumption. Productive inefficiency arises as energy prices do not reflect the true resource cost and create incentives for producers to adopt energy-intensive technologies over and above the socially optimal level. This is, for example, true for electricity production in Azerbaijan, where, according to World Bank (2004), fuel input to electrical output compares relatively unfavorably with Baltics, Russia, and other countries of the former Soviet Union (BRO), putting Azerbaijan second only to Kazakhstan, another oil-producing country in the region (Table 1.3). While there are no reliable data on the petrochemical industry in Azerbaijan, it is clear that underpricing of inputs does not provide incentives for using efficient technologies in this sector.

Table 1.3.Selected BRO Countries: Fuel Input and Electrical Output, 2003
 grams per kilowatt hour
Armenia375
Azerbaijan410
Kazakhstan466
Latvia233
Tajikistan365
Ukraine373

12. Similarly, as prices do not reflect the true opportunity costs of consumption, consumers over-utilize energy-intensive products. According to World Bank (2004), while electricity consumption relative to GDP is high in all BRO countries, Azerbaijan is one of the highest consumers of electricity (Table 1.4). Oil intensity per unit of purchasing power parity adjusted GDP is also quite high in Azerbaijan compared to some BRO and other developing countries (Table 1.5).

Table 1.4.BRO Countries: Annual Electricity Consumption Per Capita Relative to GDP Per Capita, 2001
 Kilowatt hour

Electricity

Consumption

Per Capita
US$ GDP

Per Capita
Ratio
Armenia1,1277001.6
Azerbaijan1,8466602.8
Belarus2,6761,3002.1
Estonia3,7643,9301.0
Georgia7186001.2
Kazakhstan2,8501,3502.1
Kyrgyz Republic1,3512804.8
Latvia1,9433,2600.6
Lithuania1,8513,3400.6
Moldova7854002.0
Russia4,2971,8002.4
Tajikistan2,15117012.7
Turkmenistán1,2311,0901.1
Ukraine2,2177203.1
Uzbekistan1,6343205.1
Table 1.5.Selected Countries: Oil Consumption Intensity Per Unit of GDP, 2002 1/
 barrel/US$ GDP
Azerbaijan0.102
Belarus0.069
Kazakhstan0.084
Lithuania0.054
Poland0.038
Turkey0.055
Ukraine0.038
Uzbekistan0.119
Source: World Bank data and BP Statistical Review of World Energy.

13. Subsidization of energy product prices also raises environmental concerns. Given that the use of many energy products is associated with negative effects on the environment, especially where there is a weak environmental regulatory framework (such as in Azerbaijan), economic theory suggests that energy product prices should be higher than those set by the market alone. Gupta et al. (2003) recommends using the cost of $0.1 per liter of gasoline to capture its externality in developing countries. Given 457 thousand tons of gasoline consumption in Azerbaijan, the externality cost is estimated at US$54.7 million or 0.6 percent of GDP in 2003. As data in Table 1.6 show, the emission of environmentally harmful carbon dioxide (CO2), which is the result of fossil fuel combustion for power generation, transport, industry, and domestic use, is very high in Azerbaijan compared to other BRO countries.

Table 1.6.BRO Countries: Carbon Dioxide Emissions(average, 1995-2000)
CountryIn kg per US$1 of GDP 1/
Armenia1.91
Azerbaijan8.82
Belarus3.78
Estonia3.83
Georgia1.35
Kazakhstan6.28
Kyrgyz Republ2.72
Latvia1.47
Lithuania1.79
Moldova5.74
Russia3.69
Tajikistan4.50
Turkmenistan13.30
Ukraine8.64
Uzbekistan7.47
Source: World Development Indicators.

14. Subsidization of energy products through underpricing results in significant fiscal costs. The extent of the loss is a function of the price differential and the magnitudes of cross-border smuggling and officially tolerated price arbitrage by domestic companies, as well as amounts of undercollection on tariffs charged. The Azeri authorities have explicitly reflected some energy-related subsidies in the budget since 2002, including (i) the cost of electricity and gas utilities’ underpayments stemming from poor collection; and (ii) the compensation for the provision of sufficient fuel and gas for electricity generation (Table 1.1). These subsidies are offset by tax credits granted to SOCAR against its clearance of tax arrears and current tax liabilities. However, the quasi-fiscal subsidies related to underpricing are not presented in budget documents nor is information on their size widely disseminated. This stands in contrast with good fiscal management, which requires explicit accounting of all government activities in the economy and the associated costs. As a result, it is difficult to have a public debate on the validity of subsidy policies and accurately assess the opportunity cost of underpricing energy products to society.

15. Even if explicitly accounted for, underpricing of energy products is effectively a non-targeted subsidy. It disproportionately benefits higher income households since they consume larger quantities of petroleum products and electricity and, therefore, benefit relatively more from subsidies (Gupta et al., 2003). This argument applies to Azerbaijan, where on average the richest 20 percent of population of the capital city Baku consumed 5 percent more electricity per month than the poorest 20 percent in 2002 (Azerbaijan, Poverty and Social Impact Analysis, 2004). The difference in consumption in regions outside Baku is presumably higher but no accurate data are available.

16. There is also a welfare cost of underpricing. Deadweight welfare cost is the difference between foregone government revenue because of subsidization and the increase in consumer’s surplus due to subsidized prices. The consumer surplus represents the difference between what a person is willing to pay for a product and the amount at which this product can be bought. In Azerbaijan, the deadweight cost is projected at about 1 percent of GDP in 2005.5

C. Reform Options for Domestic Energy Product Pricing

Moving Toward World Market Prices

17. In Azerbaijan, first, energy prices will need to increase to the levels of world market prices, and, subsequently, a mechanism for their adjustment should be chosen to prevent a re-emergence of price gaps. The government of Azerbaijan has chosen to bring domestic energy prices to world levels through annual step adjustments in the context of annual budget approval. While this decision in part reflects difficulties to undertake unpopular measures, it also accounts for the fact that the implementation of supporting structural reforms might take time. In particular, lack of targeted social assistance and structural problems with collection of energy tariff payments, as well as high energy intensity in production, are legitimate concerns justifying a gradual adjustment to catch up with import reference prices. Moreover, provided that increases in tariffs are accompanied by improvements in the quality of service, including uninterrupted access to power and natural gas, and a more widespread use of gas meters rather than the current system of normative consumption, there can be expected a greater willingness by consumers to pay higher tariffs for energy supplies. No matter how difficult supporting reforms are, it should be borne in mind that an overly long adjustment period may dilute the political will to deal with energy underpricing, perpetuate the distortions and their effects, and hamper the speedy implementation of other reforms that are inter-related to it (Fetini and Bacon, 1999).

18. The price adjustment undertaken in November 2004 is an important step on the way toward eliminating energy product underpricing. The net direct impact of this measure on the 2005 budget is estimated to be positive—about 1.5 percent of non-oil GDP. The main impact is expected to come from an increase in revenue of 0.9 percent of non-oil GDP, on account of higher excise revenue on petroleum products (0.7 percent of non-oil GDP), as well as VAT and royalty.6

19. Expenditure is projected to decline by 0.7 percent of non-oil GDP on account of energy price adjustments. In particular, the subsidy to Azerigas is projected to decline (Table 1.7), as weighted average gas prices increased to US$27 per tcm in November 2004, though they are still below the level (US$32 per tcm) required to cover production and import costs (World Bank, 2004). Since the price of fuel oil (mazut) was left unchanged, the subsidy to Azerenergy, the other main recipient of budgetary subsidies and the main consumer of domestically produced fuel oil (as it is an input into its production of electricity) will not be affected by the petroleum price increases. At the same time, some expenditure items will increase on account of higher transportation and heating costs of ministries and budgetary agencies, and some very limited direct compensation for the poor (less than 0.1 percent of GDP). Given that there is no appropriate social assistance targeting mechanism, the government instead decided to increase both the minimum wage and the minimum pension in 2005, which is not reflected in the net impact of the November energy price adjustment on the budget. While this measure provides a short-term patch to the issue of social protection, it should not be used in the future in place of targeted mechanisms.

Table 1.7.Azerbaijan: Effects on the 2005 Budget of Increasing Domestic Petroleum Product and Gas Prices in November 2004(In percent of 2005 non-oil GDP).
 2005
Revenue0.9
VAT0.1
Excises0.7
Royalty0.0
Expenditure−0.7
Energy subsidies−0.8
Direct compensations0.1
Memorandum items:
Total revenue and grants44.1
Total expenditure40.6
Source: Fund staff projections.

20. Keeping energy prices unchanged in the medium term (2005-08) would represent a large fiscal cost (Table 1.8). If the current import reference prices remained unchanged in the medium term, the present value of foregone revenue would amount to US$2.9 billion or 33 percent of 2004 GDP (Table 1.8, Scenario I). If import reference prices declined in the medium term, as projected in the fall 2004 World Economic Outlook (WEO), the present value of foregone revenue would be slightly lower at US$2.6 billion or 30 percent of 2004 GDP (Table 1.8, Scenario II).

Table 1.8.Azerbaijan: Scenarios of Energy Price Reform, 2005-08 1/
 No domestic price adjustmentDomestic price reform
 Unchanged world market prices Scenario IWEO forecast Scenario IIAll prices adjusted in 1 year Scenario IIIGradual adjustment in 3 years Scenario IV
Present value of foregone revenue for 2005-2008 (as a percent of 2004 GDP)    
20057.87.84.46.5
20068.17.50.04.2
20078.47.40.02.0
20088.67.40.00.0
Total32.930.14.412.7
Loss of annual revenue (as a percent of non-oil GDP)    
200510.210.25.78.4
20069.58.80.04.9
20078.97.80.02.2
20088.37.20.00.0
Source: Fund staff estimates and projections.

21. The quicker the adjustment is, the lower the cost in terms of foregone revenue is. Two additional illustrative scenarios assess the orders of magnitude of the fiscal impact stemming from bringing domestic prices to import reference prices consistent with the WEO assumptions. Scenario III (Table 1.8) assumes that the domestic/import reference price gap will be eliminated in one year. In this case, the present value of foregone revenue is estimated at US$0.4 billion or 4 percent of 2004 GDP. Given that the import reference prices are projected to decline during 2006-08, domestic prices for energy products will need to decline as well.

22. Scenario IV (Table 1.8) assumes a longer period of energy price adjustment with a pace differentiation by product. Increases for those oil products that are used predominantly by the private sector, already paid for mainly in cash (e.g., gasoline), and not affecting the poor directly could be implemented faster. At the same time, increases for those products that are used predominantly by industries that are characterized by serious payments problems (e.g., fuel oil) or that will have a significant impact on vulnerable groups and the agricultural sector (e.g., diesel, kerosene, and natural gas) could be implemented more slowly. Assuming that gasoline prices catch up with import reference prices in one year, while other energy prices increase over three years, the present value of foregone revenue amounts to US$1.1 billion or 13 percent of 2004 GDP.

23. The sensitivity analysis (Table 1.9) varied key elasticity parameters.7 As shown, varying these parameters over a broad range of values does not materially affect the conclusion. The averages of estimates over these various scenarios are close to the baseline scenario, and the standard deviation for each scenario is relatively small.

Table 1.9.Azerbaijan: Sensitivity Analysis - Total Cost/Loss of Revenues, 2005-08(In present value terms as share of 2004 GDP)
  Scenario IScenario IIScenario IIIScenario IV
Baseline scenario 1/ 32.930.14.412.7
GDP elasticity     
 0.633.530.64.413.0
 0.734.031.14.513.3
 0.834.631.64.613.5
 0.935.232.14.613.8
Price elasticity     
 −0.1032.930.14.212.3
 −0.2532.930.13.611.3
 −0.5032.930.12.79.6
 −0.7532.930.11.78.1
Coefficient of adjustment 2/     
 0.1032.932.34.112.6
 0.2532.931.54.212.6
 0.7532.928.74.512.7
 1.0032.927.44.712.7
Average 33.330.44.012.2
Standard deviation 0.81.40.91.6
Source: Fund staff estimates and projections.

24. While increasing domestic energy prices to the level of import reference prices will raise substantial additional fiscal revenue and improve allocation efficiency, the government will need to address the issues of the macroeconomic and distributional impact of energy price increases. Sound fiscal management is key to maintaining macroeconomic stability during the price reform process. The government should continue to focus on the non-oil fiscal deficit as a measure of the fiscal stance as required under the Long-Term Oil Revenue Management Strategy approved by the President in 2004, and the annual limits on increases in the non-oil fiscal deficit should account for the chosen pace of energy price adjustment, which de facto will have a contractionary effect equivalent to a cut in expenditure. A portion of the targeted increase in explicit expenditure will need to be channeled to financing targeted social assistance, which is planned to be developed by 2006 with World Bank assistance.

Rationale for and Alternative Forms of Price Smoothing

25. Once the gap between domestic and import reference prices has been eliminated, it is essential to have a mechanism in place ensuring that this gap does not re-emerge. There might be two options to consider for such a mechanism. First, a full adjustment of domestic prices to reference prices could be implemented. Second, a smoothing mechanism reducing volatility of energy prices could be put in place.

26. In developing countries, smoothing volatility of oil prices might be superior to a full adjustment provided certain conditions are in place. Volatile energy prices negatively affect the budget constraints of consumers and producers. In the presence of risk aversion and substantial sunk costs of adjustment to changes in oil prices, smoothing volatility in oil prices is welfare-enhancing. In developed countries, such smoothing is mainly achieved through oil price hedging, insurance, and credit markets, which help reduce direct exposure of consumers’ and producers’ budgets to oil price fluctuations. In developing countries, these three possibilities are missing or very limited, creating a rationale for a government-sponsored mechanism of energy price smoothing. While such a mechanism involves domestic product price regulation by the government, domestic energy product prices should be in line with international reference prices on average during a certain period of time. This will ensure that domestic consumers are not subsidized and the government does not systematically forego hydrocarbon revenue (Giulio et al.,2003).

27. Countries smoothing retail energy product prices can adopt a discretionary or rules-based adjustment mechanism. A discretionary approach almost inevitably means that price smoothing will be used for political purposes, and may prevent the desirable adjustment to retail prices, both when international prices rise and when they fall. As a result, governments implementing price adjustments in a discretionary manner are more inclined to adjust prices rarely and only when they are forced to do so by circumstances. Furthermore, in case of a discretionary approach, prices, in practice, need to be adjusted by large amounts due to the likely long lag between any consecutive two price adjustments.

28. Rules-based or automatic price adjustment mechanisms rely on a formula, which determines the level of domestic product prices at regular intervals, taking into account import reference prices. One of the important advantages of this approach is that it minimizes political interference in price setting, as it does not require approval of executive authorities or legislative bodies. It also enables the government to distance itself from unpopular price changes and allows for more regular and modest price adjustments, which are easier for the economy to respond to. On these grounds, a rules-based price adjustment mechanism seems superior to a discretionary approach. Most common rules-based mechanisms are Moving Average Rules 8, Trigger Rules 9 or a combination of both.

29. Governments in developing countries, including Azerbaijan, are often concerned about rules-based smoothing because it might be conducive to speculative hoarding. Individuals and firms with a capacity to hoard may engage in building up stocks before the new—higher—prices are announced. Such hoarding, for the purpose of either speculation or a reduction of adjustment costs, can arguably lead to artificial shortages of the products in the domestic market. The larger the gap between the current domestic and world market prices is, the higher incentives to hoard are. Thus, it is important to reduce periods between adjustments and avoid large trigger limits on price changes.

30. Speculative hoarding by producers, which in developing countries are usually represented by a few large state companies, could also be potentially limited by controlling their propensity to attain extra profits through monitoring their inventory. Producers should be required to report the balance of inventories on the last day of each month, thus establishing the inventory level on the day the price initially increases. This initial inventory level later should be compared to the inventory level in effect at the time of the next price movement. If the inventory is higher, the producer will be subject to an extra profit tax payment on the incremental portion of inventory based on the differential between the adjusted and previous prices. Conversely, if the inventories are lower, the producer will be entitled to a tax credit. Not only is this procedure expected to reduce incentives to hoard oil products, it is also likely to encourage producers to minimize inventory levels. If used, this procedure should be transparent to prevent rent-seeking.

31. Frequent adjustments in prices will reduce the likelihood of large adjustments and, on average, maintain relatively small gaps between current domestic and import reference prices even in case of large price increases in the world market. Figure 1.1 shows how various automatic price adjustment mechanisms would have worked, had they been applied to the international spot price of crude oil for the last 12 years. As can be seen, less frequent adjustments and shorter periods of averaging past prices under Moving Average Rules would lead to greater average deviations of domestic prices from reference prices (Figure 1.1). As for the adjustments with the use of Trigger Rules, higher triggers result in less frequent adjustments and larger deviations from reference prices (Figure 1.1).

Figure 1.1.International Spot Crude Oil Prices: Various Automatic Adjustment Mechanisms, 1991-2003

Source: Fund staff estimates.

32. Price smoothing should affect all domestic energy product prices. Governments often adjust only prices of some domestic energy products and leave others, such as, for example, fuel for cooking or heating, still below import reference prices due to their wide usage by households. This is likely to lead to a substitution of the expensive energy resource by the subsidized one, and, consequently, an inefficient consumption mix.10 Also, this mechanism will not be effective to protect the poor because it is not targeted.

33. The choice of a mechanism for energy price adjustment should reflect current economic and political factors in Azerbaijan. A price smoothing mechanism might have some advantages in Azerbaijan compared to a full pass-through because of underdeveloped financial markets, a low degree of monetization of the economy, and limited access to credit. These deficiencies will make it difficult for consumers and producers to shield their budgets from large fluctuations of oil prices if they are fully passed on to domestic prices. If a price smoothing option is chosen, adoption of a transparent rules-based mechanism for all energy products, which does not involve a need for approval from executive bodies and is fully enforced, would ensure the transparency of the process and reduce the likelihood of price gap re-emergence for prolonged periods. In particular, a smoothing mechanism with quarterly adjustments based on semi-annual moving averages or trigger bands of 2 to 5 percent are likely to strike the right balance between the need to smooth price fluctuations and minimize the risk of prolonged gaps with import reference prices. Figure 1.2 illustrates how such mechanisms could work, should the government decide to implement one of them beginning in 2006, consistent with Scenario III.

Figure 1.2.Azerbaijan: Automatic Price Adjustment Mechanisms, 2006-08

Source: Fund staff estimates and projections.

D. Conclusion

34. Although the November 2004 increases in oil product and natural gas prices have reduced the extent of underpricing of energy products in Azerbaijan, substantial gaps between world market reference and domestic prices remain in selected product categories, especially fuel oil, jet fuel, diesel, kerosene, and natural gas. The continuation of energy product underpricing will result in substantial fiscal costs and the aggravation of problems related to excessive use of energy products in production and consumption.

35. The government’s adherence to its commitment to review energy prices at least once a year in the context of the annual budget preparation process will be crucial at the first stage of energy price reform. The government still needs to make a decision on how quickly to eliminate the existing gap between the world market reference and domestic energy product prices. The paper recommends increasing domestic energy prices to import reference price levels in 1–3 years, to have sufficient time to resolve outstanding structural issues, including the need to establish targeted social assistance and restructure enterprises which could be adversely affected by higher energy prices. Once domestic and import reference prices are at parity, at least quarterly adjustments of domestic energy products prices could be considered, using a number of smoothing options.

The primary authors are Koba Gvenetadze and Eric Le Borgne.

For details of assessing implicit quasi-fiscal subsidies see IMF (2002).

The reference price corresponds to the refinery price of the Mediterranean market in Italy plus transportation and delivery costs, as well as VAT. The latter is included as there is no reason to exclude energy products from VAT imposition.

By 2006, natural gas produced from the Azeri-Chirag-Guneshli oil field will be delivered free of charge under the associated Production Sharing Agreement, and the production from the Shah-Deniz gas field will begin. However, based on the current projection of domestic demand, even these deliveries are unlikely to be sufficient to eliminate the need for gas imports.

The deadweight cost is calculated using constant compensated elasticity of demand function given in Gupta et al. (2003).

The (small) increase in royalty taxes stems from the increase in the wholesale price of gas.

Scenarios III and IV, as well as the sensitivity analysis, imply efficiency gains from price increases, as volumes are expected to adjust to price changes through assumed demand elasticities.

Under these rules, current retail prices are based on a moving average of past spot prices, starting from the current month and moving backwards. The longer the time horizon of the moving average is, the more price smoothing this rule achieves.

Under these rules, a price band is initially determined (e.g., plus or minus 10 percent of the current spot prices), and retail prices are updated to reflect the current spot price only when spot prices reach a level which is outside the band. When prices are changed, the price band shifts up or down, taking the current spot price as the new central point of the band. This pricing rule reduces fluctuations in domestic retail prices, but passes on relatively large changes in international prices.

As noted in IMF (1991), although in the short run, the elasticity of substitution between fuels are low, over the medium and long terms, such pricing policies are likely to have a considerable negative impact on the structure of fuel use throughout the economy.

References

    Azerbaijan, Poverty and Social Impact Analysis, 2004, World Bank.

    British Petroleum Statistical Review of World Energy, 2004, available on Internet at: http://www.bp.com

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