Azerbaijan: The Size of Quasi-Fiscal Subsidies Implicit in Current Domestic Energy Policies

A. Introduction

1. After ten years of independence and transition, Azerbaijan continues to suffer from an extensive circuit of non-payments and arrears, with the energy sector at its heart. Electricity and gas users hardly pay for their consumption, causing the state electricity company, Azerenergy, and the state gas company, Azerigas, to fail to pay their creditors, of which the State Oil Company of Azerbaijan Republic (SOCAR) and the tax service are the most prominent. SOCAR, as a direct result, also has large arrears to the tax authorities. Thus, at the expense of the budget, large implicit subsidies are provided to end-users of gas and electricity. This policy leads to wasteful use of energy resources and poses a threat to medium term macroeconomic stability and growth.

2. This paper estimates the size of quasi-fiscal subsidies implicit in domestic energy policies in Azerbaijan. For the purpose of this paper, quasi-fiscal subsidies are defined as off-budget transfers of value from the public sector to a public or private sector entity. From a consolidated public sector perspective, quasi fiscal subsidies are no cheaper than fiscal or on-budget subsidies. Eventually, the budget bears the cost of the quasi-fiscal activity via reduced tax or dividend payments. The only difference between the quasi-fiscal subsidy and the on-budget subsidy is transparency. On-budget subsidies are clearly visible to policy makers, parliament and the public at large. Conversely, quasi-fiscal subsidies remain implicit and therefore tend to be underestimated and ignored. Parliament does not debate or vote on the “expenditure” and the official budget underestimates the true level of government expenditures.

B. Domestic Energy Policy in Azerbaijan

3. Current domestic energy policies in Azerbaijan can be characterized as follows:

• The government sets the domestic prices of oil, oil products, gas and electricity below the market value. Under pricing occurs both in fuel deliveries from SOCAR to Azerenergy and Azerigas, and in transactions between the power and gas companies and their customers. For example, in 2000, the domestic gas price charged by SOCAR to Azerigas was about US$15 per thousand cubic meters (tcm), and the price charged by Azerigas to households was about US$8 per tcm. Both prices are much lower than the true value of the gas; Azerbaijan imported gas in 2000 at US$48 per tcm.

• Even at these low prices, non-payment does not lead to an interruption of supply. Again, this non-payment occurs on two levels. In 2000, Azerenergy collection rate was just 16 percent, and Azerigas collection rate over the first nine months of that year was 13 percent. Combined with the fact that tariffs are set lower than wholesale price levels, it is not surprising that these companies were not able to pay SOCAR for fuel deliveries - SOCAR’s 2000 collection rate for deliveries to Azerigas and Azerenergy was 0 percent. As all three companies are fully state-owned, allowing uninterrupted supply in the face of non-payment is clearly government policy. Rather than instructing state owned utility companies to stop supplying non-paying customers, the government apparently views providing cheap or free gas and electricity as a way of supporting troubled industries and poor segments of the population.¹ This conclusion is supported by the specification of tariffs charged and payments made by category of consumer provided in Appendix 1, which makes it clear that only private companies in the category trade and services generally pay their electricity bills.

4. Preliminary calculations, detailed below, suggest that in 2000, the total value of these subsidies amounted to 6.4 trillion man at, or 27 percent of GDP.² For comparison, the size of the consolidated government state budget in 2000 was 4.9 trillion manat, so in this year Azerbaijan implicit spending on energy subsidies exceeded the total of all expenditures of the consolidated government budget. As SOCAR, Azerigas and Azerenergy are all 100 percent state owned enterprises, all of these subsidies entail transfers of value from the public sector to end users of energy. In the end, the budget fully bears the cost of the subsidies via reduced tax payments and profit transfers by SOCAR, Azerigas and Azerenergy to the budget.

C. Estimating Methodology

5. The size of the value transfer from the energy sector to end-users of energy can be assessed by estimating the cost of producing and distributing the electricity, gas and oil products provided, and subtracting actual collections from end users, in the following way:

• Calculate the true value of SOCAR oil and gas deliveries to the domestic market. This is done by valuing the oil and gas supplied by SOCAR to the domestic market at world market prices. For oil, the average price in 2000 as reported in the IMF World Economic Outlook (WEO) minus transport costs is used.³ For gas, the price that Azerbaijan paid to import gas in 2000 is used. The gas imported by SOCAR as well as the associated gas produced by Azerbaijan International Operating Company (AIOC) and handed over to SOCAR for domestic distribution are both included in the assessment of the quantity delivered to the domestic market.

• Add to this the production and distribution costs of Azerigas and Azerenergy, as well as the cost of SOCAR’s refining activities. Payments by end-users of electricity, gas and oil products should not cover just the value of the fuel inputs in the end products, but also all other costs that must be incurred to generate and distribute the products, including labor costs, capital costs, maintenance, and tax payments that power and gas generating and distributing companies should pay on their economic activities. An estimate of the full size of the quasi-fiscal subsidy to end users of electricity, gas and oil products must therefore add these costs to the costs of the fuel used. Production and distribution costs should be assessed on the basis of what should be paid by Azerenergy, Azerigas and SOCAR according to the law of the country and to keep the infrastructure intact, rather than actual payments made. For a good estimate of production and distribution costs, not all the data needed are presently available, but a reasonable estimate can nevertheless be made -see the exercise for 2000 below.

• Calculate how much end users actually pay for the electricity, gas and oil products that find their way to the domestic market. This includes payments by customers of Azerenergy and Azerigas, and by consumers of SOCAR oil products (excluding the fuel oil delivered to Azerenergy and used by Azerenergy to generate electricity).

• The difference is an estimate of the size of the quasi-fiscal subsidies implicit in current domestic energy policies.

D. Applying the Methodology to the Year 2000

6. In 2000, SOCAR delivered 42.7 million barrels of oil to the domestic market (in various forms), and SOCAR produced 4.6 billion cubic meters (bcm) of natural gas for the domestic market. In addition, SOCAR imported 0.3 bcm of gas to be used by Azerenergy for electricity generation, and Azerbaijan International Operating Company (AIOC) produced 1.0 bcm of gas that was delivered to the domestic market ⁴. The market value of this supply of fuel to the domestic market can be calculated as shown in Table 1. It shows that the true value of the oil and gas supplied by SOCAR and AIOC to the domestic market is 6307 billion manat. At a GDP of 23, 565 billion manat, that is 26.8 percent of GDP.

Table 1.

Market Value of SOCAR’s and AIOC’s Domestic Oil and Gas Supplies, 2000

Source: IMF staff calculations.

Table 1.

Market Value of SOCAR’s and AIOC’s Domestic Oil and Gas Supplies, 2000

	Quantity	Price In US$	Transport	Domestic value In million US$	Domestic value In billion manat
SOCAR oil	42.7 mln	28.3/barrel	US$1.9/barrel	1127	5041
	barrel
SOCAR gas	4.6 bcm	48/tcm		221	987
production
SOCAR gas	0.3 bcm	48/tcm		14	64
import
AIOC gas	1.0 bcm	48/tcm		48	215
Total				1410	6307

Source: IMF staff calculations.

View Table

Table 1.

Market Value of SOCAR’s and AIOC’s Domestic Oil and Gas Supplies, 2000

	Quantity	Price In US$	Transport	Domestic value In million US$	Domestic value In billion manat
SOCAR oil	42.7 mln	28.3/barrel	US$1.9/barrel	1127	5041
	barrel
SOCAR gas	4.6 bcm	48/tcm		221	987
production
SOCAR gas	0.3 bcm	48/tcm		14	64
import
AIOC gas	1.0 bcm	48/tcm		48	215
Total				1410	6307

Source: IMF staff calculations.

7. To this amount, we add estimates of the cost of producing and distributing electricity (Azerenergy costs), of distributing gas (Azerigas cost) and of refining crude oil into fuel oil and other oil products and distributing those products (SOCAR refining costs). Estimates provided by the Macro-Economic Policy Group at the Ministry of Finance in Baku of Azerenergy’s 2000 expenditures, excluding fuel costs and repayments on foreign debt, and of Azerigas 2000 expenditures excluding fuel costs and repayments on foreign debt, are 285 billion manat and 87 billion manat respectively. SOCAR reports refining expenditures in 2000 of 1, 145 billion manat. A breakdown of these expenditures is presented in Table 2.

Table 2.

Azerenergy, Azerigas and SOCAR Expenditures, 2000

(In billion manat)

Sources: Macro-Economic Policy Group, Ministry of Finance, SOCAR, and IMF staff estimates.

^1/The amounts included for essential maintenance are rough approximations supplied by the Macro-Economic Policy Group (for Azerenergy and Azerigas) an SOCAR.

Table 2.

Azerenergy, Azerigas and SOCAR Expenditures, 2000

(In billion manat)

	Azerenergy expenditures	Azerigas expenditures	SOCAR refining expenditures
Wages	74	16	33
Taxes	85	45	643
Social contributions	26	6	11
Essential maintenance 1/	100	20	458
Total	285	87	1145

Sources: Macro-Economic Policy Group, Ministry of Finance, SOCAR, and IMF staff estimates.

^1/The amounts included for essential maintenance are rough approximations supplied by the Macro-Economic Policy Group (for Azerenergy and Azerigas) an SOCAR.

View Table

Table 2.

Azerenergy, Azerigas and SOCAR Expenditures, 2000

(In billion manat)

	Azerenergy expenditures	Azerigas expenditures	SOCAR refining expenditures
Wages	74	16	33
Taxes	85	45	643
Social contributions	26	6	11
Essential maintenance 1/	100	20	458
Total	285	87	1145

Sources: Macro-Economic Policy Group, Ministry of Finance, SOCAR, and IMF staff estimates.

^1/The amounts included for essential maintenance are rough approximations supplied by the Macro-Economic Policy Group (for Azerenergy and Azerigas) an SOCAR.

8. From this amount, the 2000 actual receipts by Azerenergy and Azerigas for its deliveries and by SOCAR for its deliveries to end-users should be subtracted. In 2000, Azerenergy collected a total of 236 billion manat, and Azerigas collected 50 billion manat. SOCAR reports receipts of 1164 billion manat on all domestic oil product sales, including its sales of fuel oil to Azerenergy (Table 3). However, since SOCAR also reports that Azerenergy did not pay at all for 2000 fuel deliveries, we can assume that this amount is fully collected from oil product sales other than sales of fuel oil to Azerenergy. Table 4. presents the overall calculation of the subsidies implicit in current domestic energy policies.

Table 3.

Azerenergy, Azerigas, SOCAR: Actual Domestic Receipts, 2000

Sources: Marco-Economic Policy Group, Azerenergy, and SOCAR.

Table 3.

Azerenergy, Azerigas, SOCAR: Actual Domestic Receipts, 2000

	2000 Receipts, domestic sales, billion manat
Azerigas	50
Azerenergy	236
SOCAR	1164
Total	1450

Sources: Marco-Economic Policy Group, Azerenergy, and SOCAR.

View Table

Table 3.

Azerenergy, Azerigas, SOCAR: Actual Domestic Receipts, 2000

	2000 Receipts, domestic sales, billion manat
Azerigas	50
Azerenergy	236
SOCAR	1164
Total	1450

Sources: Marco-Economic Policy Group, Azerenergy, and SOCAR.

Table 4.

Azerbaijan: Subsidies Due to Domestic Energy Sector Policies, 2000

Source: IMF staff calculations.

Table 4.

Azerbaijan: Subsidies Due to Domestic Energy Sector Policies, 2000

	Billion manat
Market value of SOCAR’s and AIOC’s domestic oil	6307
and gas deliveries (Table 1)
Plus: expenditures of Azerenergy and Azerigas	1517
operations, and of SOCAR’s refining activities,
excluding the cost of fuel inputs (Table 2)
Minus: receipts from domestic sales (Table 3)	1450
Total	6374
In per cent of GDP (2000 GDP: 23, 565 bin manat)	27.0

Source: IMF staff calculations.

View Table

Table 4.

Azerbaijan: Subsidies Due to Domestic Energy Sector Policies, 2000

	Billion manat
Market value of SOCAR’s and AIOC’s domestic oil	6307
and gas deliveries (Table 1)
Plus: expenditures of Azerenergy and Azerigas	1517
operations, and of SOCAR’s refining activities,
excluding the cost of fuel inputs (Table 2)
Minus: receipts from domestic sales (Table 3)	1450
Total	6374
In per cent of GDP (2000 GDP: 23, 565 bin manat)	27.0

Source: IMF staff calculations.

9. The data needed to perform a similar exercise for the year 2001 are not available at this point. An assessment of 2001 quasi-fiscal subsidies would probably show a lower total, for two reasons. First, on average, 2001 world market prices for oil were lower than 2000 prices. Second, the government intensified its program of importing gas to replace fuel oil deliveries to Azerenergy, using the reduced demand for fuel oil to increase exports of crude oil. Nevertheless, quasi-fiscal subsidies implicit in domestic energy sector policies remained very large in 2001.

E. A Breakdown of Quasi Fiscal Subsidies into its Components

10. Are quasi-fiscal subsidies in Azerbaijan mainly driven by non-payment or by under pricing? For the gas sector (excluding the gas imports that were used for electricity generation), Table 5 provides a breakdown.⁵ SOCAR 2000 production of 4.6 bcm, as well as AIOC 2000 production of 1.0 bcm, was fully handed over to Azerigas, without any payment. The market value of this gas at the import price of US$48 per tcm is 1, 202 billion manat. At the domestic wholesale price of US$15.5 per tcm, the value of the gas was 388 billion manat. Hence, about two-thirds of the value of the gas provided to Azerigas was lost due to under pricing, and the remaining one third because of non-payment by Azerigas. However, this distribution between under pricing and non-payment is rather arbitrary. The domestic wholesale price of gas does not have any economic meaning if there is not a single transaction that is actually settled using this price - it is simply an accounting price. If the domestic wholesale price of gas as set by the Ministry of Economic Development was doubled, we would find less under pricing but more non-payment, and Azerigas payments would still be zero. A more meaningful breakdown can be obtained by looking at the prices charged to end-users. In the transactions between Azerigas and its customers, non-payment is a bigger problem than under pricing, as is evident from Table 5. The bottom rows of Table 5 make clear that for the gas sector taken as a whole, under pricing accounts for almost two thirds of the quasi-fiscal subsidies, with the balance due to non-payment ⁶.

Table 5.

Gas in Azerbaijan: Under pricing and Non-payments, 2000

Sources: Macro-Economic Policy Group, and IMF staff

Table 5.

Gas in Azerbaijan: Under pricing and Non-payments, 2000

	billion manat
a. Total value of SOCAR and AIOC gas production for the domestic	1202
market, world market prices
b. Total value of SOCAR and AIOC gas production, domestic wholesale	388
prices
c. Azerigas payment	0
d. Azerigas non-fuel costs (Table 2)	87
e. Azerigas total costs at current wholesale gas prices (*= b + d)	475
f. Azerigas revenue assuming full collection	521
g. Azerigas actual revenue (Table 3)	50
h. Total quasi-fiscal subsidy, gas sector (= a + d - g)	1239
i. o/w Non-payments by Azerigas customers (= f - g)	471
j. o/w Under pricing (a + d - f)	768

Sources: Macro-Economic Policy Group, and IMF staff

View Table

Table 5.

Gas in Azerbaijan: Under pricing and Non-payments, 2000

	billion manat
a. Total value of SOCAR and AIOC gas production for the domestic	1202
market, world market prices
b. Total value of SOCAR and AIOC gas production, domestic wholesale	388
prices
c. Azerigas payment	0
d. Azerigas non-fuel costs (Table 2)	87
e. Azerigas total costs at current wholesale gas prices (*= b + d)	475
f. Azerigas revenue assuming full collection	521
g. Azerigas actual revenue (Table 3)	50
h. Total quasi-fiscal subsidy, gas sector (= a + d - g)	1239
i. o/w Non-payments by Azerigas customers (= f - g)	471
j. o/w Under pricing (a + d - f)	768

Sources: Macro-Economic Policy Group, and IMF staff

11. For oil production and electricity generation, the picture is slightly more complicated. Let us first look at the oil supplied to Azerenergy in the form of fuel oil, and the gas imported by SOCAR and provided directly to Azerenergy for electricity generation. In 2000, of SOCAR’s 42.7 million barrels of oil delivered to the domestic market, 29.7 million barrels were delivered to Azerenergy in the form of fuel oil. In addition, Azerenergy received 0.3 bcm of imported gas from SOCAR for electricity generation. Taking the prices used in Table 1, the market value at world market prices of the crude oil that was used for producing the fuel oil was 3511 billion manat, and the value of the gas at US$48 per tcm was 64 billion manat. At domestic wholesale prices, the value of the fuel oil was 1092 billion manat, and the value of the gas at domestic wholesale prices was 21 billion manat. In actual fact, no payments were made. As in the case of gas sector above, this would lead to a conclusion that SOCAR loses the value of its fuel deliveries to Azerenergy mainly due to under pricing. Also, as in the case of gas sector, however, this breakdown is arbitrary, given the fact that domestic wholesale fuel prices are purely accounting prices.

12. In estimating the overall quasi-fiscal subsidy provided to electricity users, we must also take into account that converting crude into fuel oil is not without costs. The available financial data on SOCAR do not allow for a direct assessment of these costs. However, as about 70 percent of SOCAR’s crude that found its way to the domestic market was refined into fuel oil, we can, as an approximation, take 70 percent of SOCAR’s total refining costs, or manat 801 billion, as a working assumption for SOCAR’s cost of producing fuel oil ⁷. Table 6 shows that as in the case of the gas sector, in the electricity sector end users are subsidized primarily by undercharging them (over 60 percent of the total subsidy), and to a lesser (although still substantial) extent by allowing non-payment at the current prices.⁸

Table 6.

Electricity: Underpricing and Nonpayments, 2000

Sources: Macro-Economic Policy Group, and IMF staff

Table 6.

Electricity: Underpricing and Nonpayments, 2000

	billion manat
a. Total value of crude content in SOCAR fuel oil delivery to Azerenergy,	3511
world market prices
b. Estimated SOCAR refining costs for fuel oil production	801
c. Value of gas imported by SOCAR for Azerenergy, world market prices	64
d. Total value of SOCAR fuel delivery to Azerenergy, domestic wholesale	1113
prices
e. Azerenergy payment	0
f. Azerenergy non-fuel costs ((Table 2)	285
g. Azerenergy total costs at current wholesale oil prices (= d + f)	1398
h. Azerenergy revenue assuming full collection	1972
i. Azerenergy actual revenue (Table 3)	236
j. Total quasi-fiscal subsidy, electricity sector (=a + b + c + f-i)	4425
k. o/w Non-payments by Azerigas customers (= h - i)	1736
l. o/w Under pricing (a + b + c + f-h)	2689

Sources: Macro-Economic Policy Group, and IMF staff

View Table

Table 6.

Electricity: Underpricing and Nonpayments, 2000

	billion manat
a. Total value of crude content in SOCAR fuel oil delivery to Azerenergy,	3511
world market prices
b. Estimated SOCAR refining costs for fuel oil production	801
c. Value of gas imported by SOCAR for Azerenergy, world market prices	64
d. Total value of SOCAR fuel delivery to Azerenergy, domestic wholesale	1113
prices
e. Azerenergy payment	0
f. Azerenergy non-fuel costs ((Table 2)	285
g. Azerenergy total costs at current wholesale oil prices (= d + f)	1398
h. Azerenergy revenue assuming full collection	1972
i. Azerenergy actual revenue (Table 3)	236
j. Total quasi-fiscal subsidy, electricity sector (=a + b + c + f-i)	4425
k. o/w Non-payments by Azerigas customers (= h - i)	1736
l. o/w Under pricing (a + b + c + f-h)	2689

Sources: Macro-Economic Policy Group, and IMF staff

13. The third and final element in this breakdown concerns subsidies implicit in pricing of and non-payments for the remaining part of SOCAR’s domestic market oil deliveries, i.e. supplies of oil products other than in the form of fuel oil to Azerenergy. These deliveries contain a relatively small part of quasi-fiscal subsidies in Azerbaijan. For these 13 million barrels of oil, SOCAR received 1164 billion manat, or about US$20 per barrel. The available information does not allow for a breakdown of these subsidies into under pricing and non-payment.

Table 7.

Oil Products Other Than Fuel Oil: Total Quasi-Fiscal Subsidies

Source: IMF staff

Table 7.

Oil Products Other Than Fuel Oil: Total Quasi-Fiscal Subsidies

	billion manat
a. Total value of crude content in SOCAR oil products except fuel oil,	1530
world market prices
b. Refining costs	344
c. Payments	1164
d. Total quasi-fiscal subsidy, oil products except fuel oil (= a + b - c)	710

Source: IMF staff

View Table

Table 7.

Oil Products Other Than Fuel Oil: Total Quasi-Fiscal Subsidies

	billion manat
a. Total value of crude content in SOCAR oil products except fuel oil,	1530
world market prices
b. Refining costs	344
c. Payments	1164
d. Total quasi-fiscal subsidy, oil products except fuel oil (= a + b - c)	710

Source: IMF staff

F. Policy Implications

14. This note has made it clear that at present, a large proportion of Azerbaijan’s natural wealth is used in untargeted subsidies to supply energy below cost or free of charge to end-users. Reform of domestic energy sector policies could greatly enhance the availability of energy sector receipts for targeted government spending aimed at reducing poverty. Recognizing this, the government of Azerbaijan is now committed to implementing a program to strengthen financial discipline in the energy sector. Some of the most important elements of that program are discussed below.

15. The visibility of energy sector subsidies in Azerbaijan has been greatly enhanced by the authorities’ decision to convert quasi-fiscal subsidies into on-budget subsidies. Formal incorporation into the budget at domestic market prices will take place in 2003. During 2002, the subsidies will be included in quarterly public reports on the execution of the 2002 consolidated budget, and SOCAR will be granted a tax credit for any unpaid fuel deliveries. By publicly acknowledging the quasi-fiscal subsidies and bringing these subsidies on-budget, the massive size of subsidies to electricity and gas users is made transparent, which may lead policy makers and parliamentarians to reconsider the desirability of this allocation of resources. Putting the subsidies on-budget may also help create the necessary political momentum to revise energy prices and tariffs and enforce strict cut-off policies.

16. Next, payments discipline must be improved. This paper has made clear that non-payments account for a substantial share of quasi-fiscal subsidies in Azerbaijan. The fact that energy bills are allowed to remain unpaid means that users do not receive proper incentives to economize on the use of scarce energy resources. The government’s comprehensive plan to improve financial discipline in the energy sector contains various measures to improve collection rates. First, consumption ceilings for budgetary organizations have been identified, and utility companies have been instructed to disconnect service after the ceiling has been reached. The authorities have also committed to cut off all state owned enterprises that do not pay their utility bills from January 2002 onward, and to monitor and publish Azerigas and Azerenergy collection rates by category of end-users from the first quarter of 2002 onwards. Moreover, a plan for improved metering of energy use will be developed.

17. In addition, the gap between domestic and world market prices must be reduced. This paper has shown that over sixty percent of total quasi-fiscal subsidies related to domestic energy sector policies are due to under pricing of electricity, gas and oil products. Again, by supplying energy to domestic users below the opportunity cost, domestic users do not receive adequate incentives to economize on the use of energy. Rather than subsidizing all energy users via low energy prices, the government should focus social assistance on those who truly need it. The authorities have now committed to develop a plan for the gradual unification of domestic and world market energy prices that will establish full unification of domestic and world prices by end 2004.

18. Finally, measures to improve the efficiency of state owned enterprises in the energy sector, including restructuring and privatization are needed. The ongoing privatization of non-core activities of SOCAR has already helped to reduce costs at the oil company. In the second half of 2001, a long term management contract for the Baku Electricity Distribution. Network was signed, and in 2002 the three remaining electricity distribution companies will be prepared for privatization. As a result, Azerenergy activities will become more focused and concentrate on electricity generation. Privatization of gas distribution is also planned for 2002.

G. Conclusion

19. Non-payments and arrears in the energy and utility sectors constitute the major economic problem that Azerbaijan faces today. This paper has outlined a method for estimating energy-related quasi fiscal subsidies. For the year 2000, the subsidies were estimated at 6.4 trillion manat, or 27 percent of GDP. Energy-related quasi fiscal subsidies were significantly larger than the 4.9 trillion manat total expenditures included in the consolidated government budget in 2000. The authorities have now taken a number of steps to improve financial discipline in the energy and utility sector. Importantly, it has been decided to bring quasi-fiscal subsidies on-budget in 2003, and to include them in quarterly public reports on the execution of the 2002 consolidated budget. However, establishing full payments at prices that reflect true economic value will require a concerted and committed effort over several years.