4. Reforming Energy Subsidies
- International Monetary Fund. African Dept.
- Published Date:
- May 2013
Energy subsidy reform1 has been a long-standing policy challenge for both advanced and developing countries. In sub-Saharan Africa, the fiscal cost of subsidising energy is estimated at about 3 percent of GDP, equivalent to total public spending on health care. For many countries, explicit and implicit subsidies continue to crowd out more efficient spending on much-needed social and infrastructure projects. Moreover, energy subsidies are often poorly targeted, with the bulk of the benefits accruing to the better-off. Finally, pervasive energy subsidies have discouraged investment and maintenance in the energy sector in many countries in sub-Saharan Africa, leading to costly and inadequate energy supply that is increasingly a bottleneck for economic growth. This note explores why policymakers have found energy subsidy reform so difficult and draws lessons from global experience in designing a successful energy reform strategy.
Energy Subsidies In Sub-Saharan Africa: Costly, Poorly Targeted, and Inefficient
Energy subsidies are costly to the budget and crowd out other spending, including on much-needed infrastructure and social services. An analysis of available evidence for sub-Saharan Africa shows that:
- The fiscal cost of fuel subsidies, taking into account both direct subsidies and foregone taxes, amounted to 1.4 percent of the region’s GDP in 2012.2 For oil exporters, the fiscal cost was 3.2 percent of their GDP.
- In the electricity sector, substantial fiscal costs are incurred in sub-Saharan Africa by fixing power tariffs below the costs of production. The fiscal and quasi-fiscal costs of electricity provision in sub-Saharan Africa amounted to 1.4 percent of the region’s GDP in 2009—reflecting both problems with tariff policies and poor cost control by utility companies.
Energy subsidies in sub-Sahara are poorly targeted. Fuel and electricity consumption in countries is typically skewed toward higher income households and, as a result, energy subsidies benefit mostly the better-off. Household survey evidence from nine African countries suggests that the richest 20 percent of households spent, on average, nearly 20 times more on fuel and electricity than the poorest 20 percent of households (Arze del Granado and others, 2010). In sub-Saharan Africa, on average, households in the highest 20 percent of consumers capture about 45 percent of fuel subsidies, while households in the lowest 40 percent receive about 20 percent of the fuel subsidy benefits. Access to electricity is below 10 percent for the poorest 40 percent of households, whereas it rises to close to 80 percent for the richest 20 percent of households (Eberhard and others, 2011).
Energy subsidies discourage investment in the energy sector, leading to persistent shortages and lower service quality. Tellingly, per capita electricity generation in sub-Saharan Africa has not increased since the 1980s, leaving the region to fall farther and farther behind the rest of the world (Figure 4.1). Power supply bottlenecks have serious consequences: Calderon (2009) uses simulations based on panel data to show that if the quantity and quality of power infrastructure in all sub-Saharan African countries were similar to that of a strong performer (such as Mauritius), long-term per capita growth rates would be 2 percentage points higher.
Figure 4.1.Selected Regions: Electricity Production, 1975–2009
Sources: World Bank, World Development Indicators; and IMF staff estimates.
Challenges to Energy Subsidy Reform
Several considerations often lead to the emergence of energy subsidies:
- A desire to avoid the transmission of price spikes to the domestic economy. This can be an understandable response to sharp rises in world petroleum prices deemed to be temporary. However, the empirical evidence suggests that shocks to petroleum and petroleum products can be quite persistent, making it difficult to identify temporary spikes. Too often, temporary subsidies become permanent.
- The goal of expanding the population’s access to energy products. Cheaper energy is deemed to be more affordable, notably for the poor. But when low prices lead to underinvestment, for example in rural electrification, they can actually reduce rather than increase access to energy.
- The appeal of a highly visible and readily available fiscal tool, requiring little administrative capacity. Low-income countries, in particular, often feel that they lack other mechanisms to provide benefits to the population. But increasingly, countries in sub-Saharan Africa have been developing more targeted means of reaching the poor, which reduces the need for general price subsidies, including on energy.
- The difficulty of controlling the financial performance of energy companies, particularly state-owned ones. Structural and governance problems in electricity companies and fuel refineries take time to be tackled, making it possible to rationalize the presence of temporary transfers from the government; but this easy fix becomes permanent in many cases.
In addition, there are several implementation problems inherent in subsidy reforms:
- Impact on the poor. Although benefits are skewed mainly to the rich, the poor also receive significant benefits. Indeed, as a percent of their total expenditure, the poor spend as much on energy as rich households (Arze del Granado and others, 2010). Thus, the removal of energy subsidies must be accompanied by alternative social safety net programs to mitigate the adverse effect on the poor.
- Potential loss of competitiveness. Concerns about a possible loss of competitiveness in the short run tend to be particularly relevant for electricity users. Electricity prices are already quite high in sub-Saharan Africa, elevating the costs of domestic production relative to imported products. But high prices often reflect high costs. Thus, subsidy reform need not primarily focus on raising tariffs, but rather first on ensuring that supply and quality of service are improved, so that firms may actually reduce energy costs, including by reducing their reliance on costly self-generation.
- Impact on inflation. The extent to which higher energy costs result in a persistently higher price level will depend on the strength of second-round effects on wages and the prices of other inputs. These second-round effects can be contained with appropriate monetary and fiscal policies that help anchor inflationary expectations.
Elements of A Successful Reform Strategy
Despite the difficulties encountered, the experiences of various sub-Saharan African countries point to key elements of a successful reform strategy (Box 4.1). At the design stage of successful reform strategies, careful preparation, early consultation with stakeholders, and a well-planned public communications campaign have proven crucial. At the implementation stage, appropriate timing, well-targeted mitigating measures (Box 4.2), and reform of associated state-owned enterprises have facilitated public acceptance of reforms. Finally, a number of actions and reforms have been implemented to help to ensure the durability of energy reforms, including depoliticizing the energy pricing process.
Availability of information on size, distributional incidence, and economic impact of energy subsidies has an impact on the reform strategy. Ghana’s 2005 reform was supported by an independent poverty and social impact analysis (PSIA) to assess the winners and losers from subsidies and subsidy removal. This was an important foundation for persuasively communicating the necessity for reform and for designing policies to reduce the impact of higher fuel prices on the poor. By contrast, in Nigeria, the National Assembly did not support the removal of the gasoline subsidy in December 2011, claiming a lack of firm data underpinning the size and incidence of subsidies.
Early consultation with stakeholders
In planning a reform, it is important to identify main stakeholders and interest groups, and develop strategies to address their concerns. In Kenya, consultation with unions allowed the electricity reform process to proceed without the retrenchment of staff in the utilities. In addition, early in the reform process, the support of large consumers for tariff increases was secured only with a commitment to use extra revenue to expand electricity supply. In Namibia, the National Deregulation Task Force in 1996 examined fuel price deregulation through a broadly consultative process, culminating in a White Paper on Energy Policy in 1998.
Well-planned public communications campaign
A comprehensive public information campaign ahead of the removal of energy subsidies is crucial to explain the reform’s rationale and objectives. Beyond detailing the cost and beneficiaries of existing subsidies and the narrow fiscal implications of subsidy reform, the broader positive impacts of reform on growth, productivity, and increased public resources for physical and human capital formation should be emphasized. In Ghana, the 2005 communication campaign included an address to parliament, radio broadcasts, advertisements in national papers comparing Ghanaian prices with its West African neighbors, interviews with government and trade-union officials, and posting the PSIA on the Internet. In Uganda, the government pointed out that it could no longer afford costs of over 1 percent of GDP to subsidize electricity to which only 12 percent of the country had access.
When possible, energy subsidy reforms should be phased in gradually. This is especially true if subsidies are large or have been in place for a long time. A gradual approach will allow time for energy consumers to adapt and will prevent sharp price increases that could undermine support.
Box 4.1.Energy Reforms Payoff in Kenya and Uganda
In the early 2000s, both Kenya and Uganda implemented a multitude of reforms aimed at improving performance of the power sector:
- In Kenya, reform efforts culminated in a new energy policy in 2004, which substantially increased power tariffs to reflect long-run marginal costs, introduced an automatic pass-through mechanism to adjust tariffs for changes in fuel costs, and reconstituted the Electricity Regulatory Commission.
- In Uganda, electricity sector reform included the passage of a new Electricity Act (1999); the establishment of a regulatory agency (2000); and the unbundling of the power utility (2001) and concessioning of its parts (2003–05). In 2006, power tariffs were almost doubled to reflect the long-run marginal costs of power.
In both countries, the reforms led to improvements in the electricity sector:
- Power supply increased. The private sector’s involvement in power generation combined with increased tariffs led to a substantial boost in power supply. In the post-tariff increase period, the average annual increase in power supply in Kenya was over 5 percent and in Uganda over 9 percent. This growth in power supply is significant given that these countries rely heavily on hydropower, which was adversely affected by drought in 2008–09.
- Distribution losses of power fell and bill collection rates improved. In Kenya, line losses declined from 18 percent in 2005 to 16 percent in 2011, and collection rates increased from 85 percent of total power bills in 2005 to 99 percent in 2011. Efficiency gains were even stronger in Uganda: distribution losses declined from 38 percent in 2005 to about 27 percent in 2011; and collection rates increased from 80 percent of total power bills in 2005 to 95 percent in 2011.
- Access to grid-supplied power expanded. After limited progress early on, the number of customers with access to grid-supplied power in Kenya increased by nearly 140 percent in 2005–11 (with similar developments in Uganda).
Progress on reducing quasi-fiscal costs was mixed:
- In Kenya, tariff increases in the mid-2000s combined with the automatic price adjustment mechanism and improved efficiency helped reduce quasi-fiscal costs from 1.4 percent of GDP in 2001 to almost zero by 2009.
- In Uganda, notwithstanding efficiency gains, quasi-fiscal costs increased steadily until 2011 because of higher fuel costs and lack of adjustments in power tariffs. In early 2012, however, tariffs were raised to cost-recovery levels, and a pass-through mechanism to adjust tariffs in response to changes in generation costs is being developed.
A gradual approach is particularly helpful if there are only a limited number of available instruments for delivering mitigating measures to the most needy, and when time is needed to improve the government’s track record on spending quality. In Kenya, electricity subsidies were eliminated over the course of seven to eight years through a combination of tariff increases, improvements in collections, and reductions in technical losses. In Nigeria, where there was a large credibility gap, the attempted one-step fuel price deregulation, raising prices by 115 percent, had to be scaled back following widespread protests. Subsequently, to build consensus for the future elimination of fuel subsidies, the authorities launched a program to demonstrate that subsidy savings are being used for high-priority projects.
Well-targeted mitigating measures
Measures to mitigate the impact of energy price increases on the poor are critical to building support for subsidy reform. A conditional cash transfer targeted to the most needy income groups can work well, as was done in Gabon (2007) and Mozambique (2008) at the time of fuel subsidy reductions in those countries. For electricity, better targeting of lifeline and volume differentiated tariffs, and mechanisms to assist lower-income customers to finance connection costs, are possible options (for example, Kenya and Uganda).
Reform of state-owned energy enterprises
While price changes grab headlines, increasing the efficiency of enterprises is necessary to obtain durable benefits from reform. For state-owned companies this requires strengthening governance, improving revenue collection, and enhancing exploitation of scale economies. Performance targets and incentives (for example, improved revenue collection, reduced power outages) should be set to increase accountability of managers of state enterprises. In Cape Verde, the electricity power company is allowed to keep resources from overperformance, which can then be used for investment. Introducing competition by permitting independent private producers to be involved in electricity generation can strengthen sector performance.
Opportunities for trade
The costs of energy supply can also be reduced by promoting regional trade in power. This can allow producer countries to exploit their comparative advantage and potential economies of scale. The potential for trade in sub-Saharan Africa is large because resources for energy generation are unevenly distributed. For example, oil and gas reserves are in the Gulf of Guinea, Mozambique, and Sudan; hydropower is mostly in the Democratic Republic of the Congo, Ethiopia, and Mozambique; and geothermal energy is in Kenya and Ethiopia. While regional power pools exist in sub-Saharan Africa, power trade is quite limited except within the Southern African Power Pool. With increased power trade, power-importing countries could reduce their marginal cost of power by $0.02-$0.07 per kWh (Foster and Briceño-Garmendia, 2010) Smaller countries (for example, Burundi, and Guinea-Bissau) and countries heavily reliant on thermal power (for example, Angola, Chad, and Niger) stand to gain most from such cross-border trade.
Box 4.2.Mitigating Measures to Protect the Poor
In Niger, following negotiations with civil society organizations and the transport sector, the government provided a direct subsidy to the transport sector in 2010 to mitigate the impact of fuel price increases on the poor, at a fraction (0.1 percent of GDP) of the cost of the fuel subsidies (0.7 percent of GDP).
In Ghana, fuel price increases in 2005 caused much less social tensions than previous increases thanks to mitigating measures, including cross subsidies in favor of kerosene and LPG, the fuels consumed most by the poorest income groups; an increase in the daily minimum wage; a price ceiling on public transport fares; elimination of school fees for primary and secondary education; and other measures.
In Nigeria, the government kept the price of kerosene unchanged when it increased fuel prices in January 2012. It also committed to use the subsidy savings to expand several social safety net programs, such as maternal and child health services, women and youth job programs, vocational training, and support for urban mass transit.
Kenya and Uganda both maintained “life-line” tariffs when other tariffs were raised. Kenya also introduced measures to expand access, such as a rural electrification program and a revolving fund for deferred connection fee payments (financed by donor funds).
Development of strong institutions and entrenchment of good practices
While unwavering political will is the key to sustaining reforms, the entrenchment of good practices can substantially improve their likely durability:
- Being transparent in accounting for subsidy costs. In Niger, Mali, and Mozambique the authorities have introduced an explicit accounting of fuel subsidies in the budget.
- Implementing an automatic and transparent price adjustment mechanism. If full deregulation of prices is not feasible, then energy prices should be determined by transparent price formulas and an adjustment mechanism (with some smoothing) to changes in international fuel prices. Ghana published the price formula for determining fuel prices, including the weights of the individual components (for example, cost of crude, refiner’s margin, excise duty, etc.).
- Depoliticizing the price-setting framework by establishing an independent authority to manage energy pricing. In Tanzania, the creation of a specialized regulatory entity, not only to issue licenses and technical regulations, but also to keep the public constantly informed about prices and price structure and to review the proper functioning of the market (for example, to investigate concerns about potential price collusion practices) seems to have played an important role in sustaining fuel subsidy reforms.
This measure is clearly sensitive to the methodology and benchmarks chosen. Here, the fiscal cost of subsidies and taxes foregone is calculated using an adjusted cost-recovery price that includes the average effective tax rate on fuel in sub-Saharan Africa. In IMF (2012f), the fiscal cost of subsidies and taxes foregone in sub-Saharan Africa at end-2011 was estimated using actual effective sub-Saharan African tax rates at end-2008 as the comparator. In IMF (2013a), the fiscal cost of subsidies and taxes foregone in 2011 was calculated using an adjusted cost-recovery price that included the national value-added tax rate and an estimate for the cost of externalities, such as CO2 emissions.