This Selected Issues paper analyzes energy price reform in Kuwait. It emphasizes that Kuwait should take advantage of current low global energy prices to strengthen efforts to reform domestic energy prices. In the longer term, this would benefit growth by increasing efficiency in the economy and creating space for higher public and private investment. In the short-term, one-off effects on inflation should be manageable. Productive activities more sensitive to energy costs, particularly the transport sector, would be able to adjust to higher energy prices more easily if the reform is gradual.

Abstract

This Selected Issues paper analyzes energy price reform in Kuwait. It emphasizes that Kuwait should take advantage of current low global energy prices to strengthen efforts to reform domestic energy prices. In the longer term, this would benefit growth by increasing efficiency in the economy and creating space for higher public and private investment. In the short-term, one-off effects on inflation should be manageable. Productive activities more sensitive to energy costs, particularly the transport sector, would be able to adjust to higher energy prices more easily if the reform is gradual.

Energy Price Reform in Kuwait – What can be Learned From International Experience1,2

Kuwait should take advantage of current low global energy prices to strengthen efforts to reform domestic energy prices. In the longer term, this would benefit growth by increasing efficiency in the economy and creating space for higher public and private investment. In the short-term, one-off effects on inflation should be manageable. Productive activities more sensitive to energy costs, particularly the transport sector, would be able to adjust to higher energy prices more easily if the reform is gradual.

A. Introduction

1. Energy prices in Kuwait are low compared with international and regional benchmarks. Kuwait should take advantage of the current environment of global low oil prices to adopt a comprehensive energy price reform that gradually increases domestic energy prices up to a global benchmark and depoliticizes the mechanism for adjusting energy prices once the benchmark is reached. Energy price reform would create budget space to protect social spending and public investment during a medium-term fiscal adjustment process, and would create incentives for reducing energy consumption and contribute to a better environment.

B. Energy Efficiency in Kuwait

2. Kuwait faces significant challenges on domestic energy prices, consumption, and production. A policy of tight regulation to keep domestic energy prices low, combined with economic growth, has supported expansion in domestic consumption of energy products, particularly refined petroleum products, electricity, and gas. Low domestic prices have also promoted energy intensive industries. This policy crowds out social spending and redistributes resources in favor of higher-income groups. Higher energy consumption also reduces resources available for future generations, besides creating environmental challenges for the country.

Domestic energy prices and energy consumption

3. Energy products in Kuwait are sold at prices well below international references. Gasoline and diesel prices in Kuwait were 66 percent and 41 percent, respectively, below U.S. prices before taxes at end-July 2015. They were also below average prices in the GCC by 20 percent and 6 percent, respectively (Table 1). Electricity tariffs are very low at two fils per kilowatt compared with production costs of 41.43 fils per kilowatt. To cover the cost threshold electricity tariffs would need to increase about 20 times. Average electricity pre-tax tariffs in OECD Europe were about $0.17 in 2014, compared with $0.006 in Kuwait.3

Table 1.

Retail Prices of Gasoline and Diesel, August 2015

(In US$ per liter)

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Sources: EIA, GlobalPetrolPrices.com; and country authorities.

Price includes taxes

Gasoline and diesel retail prices exclude taxes of 17 percent and 18 percent, respectively.

4. Low domestic energy prices represent a significant cost for the Kuwaiti economy. Kuwait’s on-budget costs of low energy prices (including water) were about KD3.7 billion (7.6 percent of GDP) in 2014; 35 percent of which corresponds to petroleum products subsidies. The government budget for 2015 estimates subsidies on energy products (including water) at about KD2.3 billion—37 percent less than in 2014, but still amounting to 6.5 percent of GDP (Table 2). Budget costs reflect payments made to energy producing companies to compensate for the difference between the production cost and domestic selling price. Budget costs, however, do not include the loss of potential revenue or opportunity cost. A more comprehensive measure of the opportunity cost of low energy prices could be estimated using the difference between a benchmark price—often the U.S. price—and the domestic energy price, scaled by consumption volumes.4 The opportunity cost for selling energy products (gasoline, diesel, natural gas, and electricity) at prices below international prices is estimated at $12.7 billion (7.4 percent of GDP) in 2014; lower energy prices in 2015 reduce the estimated cost to $9.3 billion (7.2 percent of GDP).5

Table 2.

Kuwait: Budget Government Subsidies, 2012–15

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Source: Ministry of Finance, Kuwait.

Budget

5. Per capita energy consumption in Kuwait is among the highest in the world. Kuwait consumed 10 tonnes of oil equivalent (TOEs) per capita in 2014, which compares with a world average of 4 TOEs per capita. Kuwait is the sixth largest consumer on a per capita basis in a sample of 67 countries, below only Qatar, Trinidad and Tobago, Singapore, the UAE, and Bahrain and ranking above Canada, Norway, Saudi Arabia, the United States, and Oman (Figure 1).6 Kuwait’s energy consumption is not only high, it has also been growing faster than consumption in countries with similar, or higher, income per capita. Energy consumption in Kuwait grew on average 0.9 percent per year during the past 40 years, compared with negative growth in the United Kingdom, Germany, the United States, and Denmark, and growth below 0.9 percent per year in New Zealand, France, Belgium, Finland, Canada, Austria, and Ireland. Energy consumption growth in Kuwait, however, is lower than that in Korea (5 percent), Hong Kong (3 percent), the United Arab Emirates (2.5 percent), and Saudi Arabia (1.9 percent).

Figure 1.
Figure 1.

Primary Energy Consumption Per Capita, 2014

(Tonnes of oil equivalent, TOEs, per person; average in sample is 4 TOEs per person)

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Sources: British Petroleum Statistical Review of World Energy; and IMF staff calculations.

6. Relatively cheap energy has contributed to energy consumption in Kuwait that appears high when compared with other countries. While energy consumption is determined by many variables, including income and climate, there is a clear negative association between energy prices and energy consumption. The correlation between primary energy consumption per dollar of income produced and the price of gasoline and/or diesel (a proxy for the price of energy) is about 57 percent (Figure 2), suggesting that after controlling for income, countries with lower energy prices tend to consume more energy. For instance, Kuwait consumed about 250 TOEs per dollar produced in 2014, with the price of gasoline at $0.22 per liter; however, our analysis show that energy consumption per dollar produced could be halved if gasoline price were increased to $0.62 (US pre-tax).7

Figure 2.
Figure 2.

Energy Consumption to GDP and Price of Energy, 2014

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Sources: British Petroleum Statistical Review of World Energy, Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH; and IMF staff calculations.

Other consequences of low energy prices

7. Higher income households tend to be the main beneficiaries of low domestic energy prices. International experience shows that generalized support programs for energy products do not always reach the most vulnerable segments of the population and are not particularly effective at redistributing income. The World Bank reports that the poorest 25 percent of the population in countries like Egypt, Jordan, Mauritania, Morocco, and Yemen received only 1 – 7 percent of the resources used to support diesel consumption. In Egypt, the poorest 40 percent of the population received only a modest amount of the resources used to support consumption of energy products (3 percent for gasoline, 7 percent for natural gas, and 10 percent for diesel). IMF (2014) reports that in Jordan, the amount of resources to support energy consumption that went to the richest quintile was about 20 percentage points higher than that which went to the poorest quintile. IMF (2013) indicates that this disparity between rich and poor households was most pronounced in the cases of gasoline and diesel, where the richest quintile received nearly 20 (6) times more resources when consuming gasoline (diesel) than the poorest quintile. The IEA (2011) reports that the poorest 20 percent of households received only about one-tenth of the resources to keep prices low for natural gas and electricity.

8. The opportunity cost of low energy prices has been lower social spending. Low energy prices lead to high fiscal or quasi-fiscal costs and crowd out budgetary space for productive spending, including social spending and public investment. In Kuwait the implicit opportunity costs of low energy prices (using the price gap approach) is larger than public capital spending in 2014, 7 percent of GDP and 4 percent of GDP, respectively; other things equal, this would suggests that higher domestic energy prices could support higher public investment. From a sample of 109 countries, Ebeke and Lonkeng (2015) assess whether countries more prone to having low domestic energy prices also tend to have less public social spending. They find that public spending on education and health was, on average, 0.6 percentage point of GDP lower in countries where the opportunity cost of low energy prices was one percentage point of GDP higher; the crowding out increases to 0.8 percentage point of GDP when debt-to-GDP reaches 70 percent or for oil importers; the crowding out is almost one-to-one for countries with weak domestic institutions (countries above the 75th percentile in indicators of corruption and government ineffectiveness, proxy for weak domestic institutions).

9. High-energy consumption makes Kuwait one of the largest emitters of carbon dioxide per capita. Data from British Petroleum indicate that the world average of carbon dioxide emissions per capita was about 10 tonnes in 2014; emissions per capita in Kuwait were 28 tonnes—the fifth largest emitter in the sample (Figure 3). When compared with its GCC peers, and on a per capita basis, Kuwait pollutes less than Qatar (56 tonnes, the largest emitter) and the United Arab Emirates (29 tonnes), but more than Bahrain (22 tonnes), Saudi Arabia (22 tonnes), and Oman (20 tonnes). The magnitude of carbon dioxide emissions per capita points to the existence of significant environmental distortions, which could be reduced through adjustments in domestic energy prices.

Figure 3.
Figure 3.

Carbon Dioxide Emissions Per Capita, 2014 1/

(Tonnes per person; average in sample is 10 tonnes per person)

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Sources: British Petroleum Statistical Review of World Energy; and IMF staff calculations.1/ For Bahrain and Oman data is for 2012 from CEm2 Emissions Statistics (IEA).

C. International Experience with Energy Price Reform: Lessons for Kuwait

10. A number of countries in the GCC and the MENA region have initiated energy price reforms. Several GCC countries have increased some energy prices. Qatar has increased gasoline prices, Bahrain and Saudi Arabia have increased electricity tariffs for industries, Kuwait has increased diesel and kerosene prices and is considering an increase in electricity prices, and Bahrain and Oman have increased natural gas prices for industrial users. Most recently the United Arab Emirates introduced a pricing mechanism for setting fuel prices against an international benchmark. Among non-GCC energy exporters, Iran and Yemen, and among oil importers, Egypt, Jordan, Mauritania, Morocco, Sudan, and Tunisia, have initiated subsidy reforms. Among energy exporting countries outside the MENA region, Malaysia, Nigeria, and Indonesia are successful cases of energy price reforms.

11. International experience has helped to identify the main elements for successful energy price reforms.8 Country case studies suggest that the elements below can increase the likelihood of energy price reform being a success.

  • a) A comprehensive energy sector reform plan: the reform strategy should be formulated in consultation with stakeholders, establish clear long-term objectives—including a sustainable approach to energy pricing—assess the likely impact of the reform on various stakeholders, and identify measures to mitigate adverse reform impact.

  • b) An extensive communication strategy: a well-planned communications campaign is essential to help generate broad political and public support, and should be undertaken throughout the reform process. The campaign should inform the public of the cost of current policies and the benefits of the reform, including the budgetary savings generated to finance high-priority spending on education, health care, infrastructure, and social protection, or to reduce debt. Another key component of the communications strategy should involve strengthening transparency in reporting the costs of low energy prices in the budget and how they are financed.

  • c) Appropriately phased and sequenced price increases: the appropriate phasing-in and sequencing of price increases across energy products will depend on a number of factors, including the magnitude of the price increase to bring domestic prices to the relevant global benchmark, the fiscal position, the political and social context in which the reform is taking place, and the time needed to develop an effective communications strategy and social safety nets. A phased approach to reform provides time to households and firms to adjust and helps reduce the impact of the reform on inflation, whereas a large increase in energy prices can generate intense opposition to reform. However, a gradual reform reduces budgetary savings in the short term and runs the risk of providing space to build up opposition to the reform.

  • d) Targeted mitigating measures: well-targeted measures to mitigate the impact of energy price increases on the poor are critical for building support for reforms. Targeted cash transfers or vouchers are the preferred approach in terms of consumption flexibility for households and lower program costs for the government. When cash transfers are not feasible because of limited administrative capacity, other initiatives, such as public works programs, can be expanded while capacity is developed. The degree to which compensation should be targeted is a strategic decision that involves trade-offs between fiscal savings, the capacity to target, and the need to achieve broad acceptance of the reform.

  • e) Depoliticize energy pricing: successful and durable reforms require a depoliticized mechanism for setting energy prices, which range between full price liberalization (prices are aligned and move freely with international prices) and automatic pricing mechanisms through a pricing formula that reflects international prices. The price mechanisms can include smoothing rules to avoid sharp increases in domestic prices, with technical decisions on pricing delegated to an independent institution (Box 1). Automatic price mechanisms can help reduce the chances of reform being reversed, but are not a panacea for achieving a sustained reform of energy prices. Over the longer term, price reform for energy products should aim to fully liberalize pricing, a regime that tends to be more robust to the reintroduction of price distortions than automatic price mechanisms.

  • f) Improve efficiency of state-owned energy producers: energy producers often receive substantial budgetary resources to compensate for inefficiencies in production and revenue collection. Strengthening the financial position and operational performance of these enterprises can reduce the need for budget transfers. For improving the efficiency of State Owned Enterprises (SOEs), country experiences suggest to strengthen governance, improve demand management and revenue collection, and better exploit scale economies.

D. What to Expect from Energy Price Reform in Kuwait

12. Energy price reforms will impact inflation and the productive sector, particularly in the near term. In the longer term, energy price reform would be positive for growth by increasing efficiency in the economy, creating space for higher public investment, and enhancing incentives for higher private investment. Energy price reform could also increase export revenues and improve equity, across both households and generations. In the short term, however, it will increase prices for consumers and cost of inputs for firms; therefore, subsequently lower real income for households and lower profits for firms may weigh on economic activity. The impact on aggregate demand would depend on the net budget impact of the reform and fiscal multipliers.

Automatic Price Setting Mechanisms 1/

Mechanisms for setting energy prices range between full price liberalization and automatic pricing. Over the longer term, energy pricing reform should aim to fully liberalize the pricing regime, a policy that tends to be more robust to the reintroduction of pricing distortions than other pricing policies, including automatic price setting mechanisms. However, automatic price setting mechanisms could pave the way for a fully liberalized pricing and supply regime.

Automatic pricing mechanisms are intended to fully transmit price fluctuations in the international prices to domestic retail prices and avoid an ad hoc approach to fuel pricing where governments change prices at irregular intervals, and could incorporate smoothing rules to avoid excessive price volatility.

Implementing an automatic pricing mechanism requires specifying the price structure (pricing formula) to link international and domestic prices, the timeline for updating the components of the price structure, and a rule determining when retail prices are changed and by how much.

The most common types of smoothing mechanisms include:

Moving Average Mechanisms (MA): Retail price adjustments are based on changes in the average of historical international prices, where the period to calculate averages could be set in days, weeks, or even months. Longer averaging periods tend to reduce the magnitude of prices changes.

Price Band Mechanisms (PB): A maximum limit is set on the retail price variation (a cap). If the required retail price increase is larger than the cap, the maximum allowed increase is implemented. If the implied price increase is below the cap, then the full adjustment is allowed.

A number of countries have adopted automatic price mechanisms. Jordan resumed a monthly fuel price adjustment mechanism in January 2013; Tunisia increased fuel prices on an ad hoc basis in 2012-13 and re-introduced an automatic price formula for gasoline in January 2014 to allow for future convergence to international prices over time; Mauritania adopted a new automatic diesel price formula in May 2012; Morocco started implementation of a partial indexation mechanism for certain petroleum products in September 2013, eliminated regulating gasoline and industrial fuel prices in January 2014, and introduced bimonthly reviews of these prices; and Cote d’Ivoire, which used to have fixed prices for fuel products, adopted an automatic pricing mechanism with smoothing in 2013.

1/ See Baig and others (2007), Bridel and others (2014), Coady and others (2012), and IMF (2014).

Inflationary pressures

13. The pass-through of higher energy prices to overall inflation is determined by the share of energy products in the consumption basket, how well inflation expectations are anchored, and by the magnitude of increase in energy prices. For a given increase in energy prices, the higher the share of energy products in the consumption basket—typically captured by their weight in the consumer price index (CPI), the higher the first-round effects on headline inflation. If inflation expectations are well anchored, they should respond little to higher energy prices, and second-round impact on inflation should also be limited.9 However, the larger the adjustment in energy prices, the larger the first round effects on inflation and the chances that inflationary expectations may be affected by the energy price reform. If conditions are permissible, a gradual adjustment in energy prices would be preferred to help keep inflation under control and also, as discussed later, to provide time for the productive sector to adjust to the new relative prices in the economy.

14. Cross-country experience suggests that the pass-through of price shocks to headline inflation could be relatively small. While there is limited evidence on the propagation of domestic energy price shocks to headline inflation, the empirical work that assesses the inflationary impact of global energy and food price shocks on the CPI suggests that the impact is relatively small. In particular, the evidence shows that food price shocks have greater second-round effects on inflation than energy price shocks, including after taking into account the relatively higher weight of food in the CPI.10 In particular, estimation results indicate that a 10 percent increase in global oil prices increases headline inflation between 0.5 and 1.4 percentage points; a 10 percent increase in global food prices increases headline inflation between 1.3 and 2.5 percentage points; IMF (2011) reports that the median pass-through of an oil price shock to transportation prices is 0.13 percent for advanced economies and 0.17 percent for emerging and developing economies (Table 3).

Table 3.

Evidence on Impact of Global Price Shocks to Headline Inflation

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Source: Papers in references.

15. First-round effects from energy price reform on inflation are likely to be low given the weight of energy products in Kuwait’s Consumer Price Index (CPI). Disaggregated data for Kuwait indicates that the importance of energy products in the CPI is relatively low (Table 4). For instance, a 10 percent increase in the price of gasoline and diesel would increase inflation by 17.9 basis points (the weight of gasoline and diesel is 1.79 percent in the CPI; in other words, current household spending on diesel is relatively minor). If electricity tariffs were increased 10 percent, CPI will increase 35 basis points. For reference, Table 4 also reports other CPI items relatively intensive in the use of energy, particularly transportation services.

Table 4.

Kuwait: Weights in Consumer Price Index (`CPI) 1/

(In percent)

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Source: HAVER.

CPI base 2007

16. The inflation response to previous domestic price shocks also anticipates a modest impact on domestic inflation if energy prices were raised in Kuwait. In particular, monthly inflation shocks to the CPI sub-indices do not seem to translate into higher headline monthly inflation during the 12 months after the shock occurred, particularly with shocks to housing and transport—sub-indices that include energy products. Figures 4 and 5 display domestic monthly inflation shocks to CPI sub-indices during 2005–15, and depicts monthly headline and sub-index inflation during the 12 months before and after the shock occurred.11 The charts indicate that, for instance, when an inflation shock to transport services occurs, headline inflation remains broadly similar before and after the shock; a similar finding emerges in the case of housing services. The story is slightly different for food products, where a shock appears to increase monthly inflation, particularly when compared with monthly inflation 10–12 months before the shock occurred.

Figure 4.
Figure 4.

Impact of Domestic Inflation Shocks to Headline Inflation

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Source: IMF staff calculations.Note: Inflation shock defined as the 10 percent largest monthly inflation in each component of the CPI observed during 2005-2015. Chart displays average of 10 percent largest values.
Figure 5.
Figure 5.

Impact of Domestic Inflation Shocks to Headline Inflation

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Source: IMF staff calculations.Note: Inflation shock defined as the 10 percent largest monthly inflation in each component of the CPI observed during 2005-2015. Chart displays average of 10 percent largest values.

17. The increase in diesel prices since January 2015 did not have a noticeable impact on headline inflation. Kuwait initiated diesel price reform in early 2015; a committee determines on a monthly basis the price of diesel based on Kuwait’s diesel export price. The reform has been implemented gradually, with reformed prices attached mainly to retail sales while (most) wholesales still carry subsidized prices. While assessing the pass-through of diesel prices to headline inflation requires a more detailed and technical analysis, data as of July 2015 seems to suggest that the 100 percent diesel price increase in January 2015 has not had any significant impact on inflation so far (Figure 6). Transport prices did not increase in January, fell in March, then increased slightly in May (0.16 percent). Headline inflation during 2015 appears to follow the pattern observed during the second half of 2014.

Figure 6.
Figure 6.

Kuwait: Headline and Transport Monthly Inflation, 2014–July 2015

(In percent)

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

Source: IMF staff calculations.

Impact on economic growth

18. In the longer term, energy price reform has a positive effect on growth. Lower distortions, higher efficiency of available resource in the economy, rationalization of energy use, increase in export revenues and/or reduction in the import bill, and stronger budget structures create an environment conducive to economic growth. In the short term, energy price reform may be equivalent to a reduction in current spending, which could adversely affect economic activity. The impact on growth could be minimized—or even more than offset—if part of the savings is redirected to other public spending, such as transfers to the poor and/or investment.12 Governments could also use the budgetary savings to redeem government debt, which would improve the country’s fiscal profile and free resources that could be used by the private sector, enhancing the country’s growth prospects.

19. In the near and medium term, an increase in domestic energy prices would represent a negative shock to the productive sector. The increase in energy prices would increase production costs, particularly in energy intensive sectors such as aluminum, chemicals, metals, mining, plastics, petroleum refining, and steel.13 Firms in export-oriented sectors, which are price takers in global markets, are likely to be particularly affected since they would find it challenging to pass on to consumer the increase in costs. Affected firms would have to reduce profits and/or increase the efficiency in their production process to compensate for higher energy costs. Overall the increase in relative energy prices would lead to a shift in the production mix away from energy-intensive goods. At the same time, though, lower consumption of energy domestically would permit increased exports of energy products, so overall exports (energy plus non-energy) could increase even in the short and medium term.

20. The transport sector, particularly air and water, would be the most heavily impacted sectors if energy prices were increased. The transport sector is the largest consumer of fuel and oil products. For instance, if fuel and oil product prices were to increase 10 percent, the increment in energy cost would be about 30 percent of value added for sea transport and 10 percent of value added for air transport. Other activities that could be classified as most affected include: renting of construction equipment, manufacturing of basic metals, nonmetallic products, and food and beverages (Table 5). These findings also favor adopting a gradual approach for raising energy prices and give time for the productive sector to adjust to a new set of relative prices.

Table 5.

Productive Sector: Consumption of Electricity and Fuel Products, 2011

(KD millions)

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Source: World Bank.

21. Preliminary estimates suggest that in the long-term Kuwait could generate net permanent savings in the range of 1.6–2.2 percent of GDP. Estimated net savings represent the deadweight loss (DW)—the loss for the society, from selling products in the domestic market at prices (Pd) lower than world prices (Pw), which lead to consumption levels (Qd) that are higher than what would be at world prices (Qw) in the context of a demand that responds negatively to prices (Box 2, Figure 7).14 The estimated net gain assumes that consumers are fully compensated from losses coming from higher prices.15 The estimate reflects opportunity costs of 7.4 percent of GDP for gasoline, diesel, electricity, and natural gas, and price elasticity for energy consumption in the range of (-0.3, -0.5).16 The estimate assumes that energy prices are aligned with U.S. pre-tax gasoline prices; due to data constraints, electricity tariffs are inclusive of taxes (but still below pre-tax tariffs in OECD Europe); for natural gas Henry Hub prices are used as reference.

Figure 7.
Figure 7.

Efficiency Costs from Domestic Prices Lower than International Prices

Citation: IMF Staff Country Reports 2015, 328; 10.5089/9781513512266.002.A001

22. If net savings from reforms were invested, Kuwait’s GDP could further increase between 0.06 percent of GDP and 0.08 percent of GDP. 17 The return on equity for the corporate sector was about 3.7 percent (average 2013–14).18 If the estimated net savings from the reform (between 1.6–2.3 percent of GDP) were invested at such rates of return, GDP could increase further between 0.06 and 0.08 percent of GDP, equivalent to about $105 million and $140 million, respectively, using 2014 GDP as reference.

Efficiency Costs of Price Distortions: Estimating the Deadweight Loss

The three basic postulates for applied welfare economics are the pillars for assessing efficiency costs and calculating the deadweight loss. The postulates are:1

  • a) The demand price for a given unit measures the value of that unit to the demander;

  • b) The supply price for a given unit measures the value of that unit to the supplier;

  • c) When evaluating the net benefits or costs of a given action (program, project, or policy), the costs and benefits accruing to each member of the relevant group should be added.

Assuming a supply curve perfectly elastic—for example, the country is a price taker in global markets, at world prices Pw (international benchmark prices). Market equilibrium is reached when consumers buy Qw (Figure 5). Postulate a) indicates that consumers’ valuation for Qw is given by the area below the demand curve (A+B+C); however, from postulate b) we know that for getting Qw individuals pay Pw*Qw equivalent to area B+C. From postulate c), the net gain for the economy is given by A, which in this case (perfectly elastic supply curve) is equal to the consumer surplus.

If the government decides to sell Q in the domestic market (such as energy products) at a price below international prices Pd, then the amount consumed will increase to Qd. The per unit opportunity cost of this policy is given by the price gap Pw – Pd, i.e. the difference between the international price Pw – the price at which the economy could sell in the international market, and the domestic price Pd –the price the government receives for Q given the price policy; the opportunity cost for the government is given by areas B, E, and DW, commonly referred as “implicit subsidy.”

However, higher consumption increases consumer welfare in an amount given by the increase in the area below the demand curve (areas B and E). The difference between the extra benefits for the consumers and the costs for the government provide the net gain or loss for the economy; in this case, the economy as a whole loses DW, also called deadweight lost or excess burden from the policy of relatively lower domestic prices.2

DW could be estimated using data on international and domestic prices (Pw and Pd), amounts consumed (Qd), and estimates on the price elasticity of demand.3 In particular:

DW=12(PwPd)(QdQw)(0.1)
DW=12(PwPd)Qd(QdQw)Qd(0.2)
OpportunityCost=(PwPd)Qd(0.3)
PercentChangeinQuantityConsumed=(QwQd)Qd(0.4)

For a Cobb-Douglas type demand for Q: 4/

QwQd=(PwPd)β;βistheelasticityofdemand(0.5)
1Harberger, A. C. (1971). ȌThree Basic Postulates for Applied Welfare Economics: An Interpretative Essay.” Journal of Economic Literature. September, 9:3, pp. 785–97.2 Estimation of areas below and above the demand and supply curve is a routine exercise in Cost – Benefit Analysis. Applications of this methodology for assessing efficiency costs in output and input markets, including for labor, capital, and foreign exchange are discussed in Jenkins, G.P., Kuo, C., and Harberger, A.C. (2011) Cost Benefit Analysis for Investment Decisions.3 For a discussion on the estimation of efficiency costs arising from price distortions see Hines, J. R. (1999). “Three Sides of Harberger Triangles.” Journal of Economic Perspectives. Volume 13, Number 2, pages 167–188. In particular, note the discussion on general equilibrium consideration:“Harberger’s papers do not take explicit account of all possible general equilibrium price interactions between markets, relying instead on the assumption that the effects of any unaccounted price changes are unlikely to overturn the qualitative conclusions of his analysis. The general equilibrium work of numerous writers—for example, Shoven and Whalley (1972, 1977), Shoven (1976), Ballard, Shoven and Whalley (1985) and Ballard et al. (1985)—largely supports this assumption.”4/Charap and others (2013) estimate the price elasticity of the demand for energy products between −0.3 and −0.5.

References

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1

Prepared by Sergio Rodriguez.

2

The Note uses “energy products” generically to refer to fuel products—including natural gas, and electricity.

3

The Kuwaiti dinar is subdivided into 1,000 fils; 1 KD = US$ 3.3035 (average for July 2015).

4

See Koplow (2009) and IMF (2013a) for a discussion of the price gap approach, including the attributes that the benchmark price should have. In general, when the energy product is traded internationally the benchmark prices is given by an international price; when the product is not traded internationally, the appropriate benchmark is the cost-recovery price for the domestic producer, with inputs valued at their opportunity costs, including raw materials, labor, capital, and distribution costs.

5

The estimated opportunity cost uses as reference, gasoline and diesel US pre-tax prices published by the IEA, Henry Hub gas prices, and average electricity tariff for all sectors published by the US EIA.

6

Calculations based on energy data included in British Petroleum Statistical Review of World Energy, June 2015.

7

In fact, regressing energy consumption per income against the price of gasoline (in natural logarithms) produces an estimated price elasticity of minus 0.5, with confidence interval of (-0.62, -0.28) –in line with other estimates in the literature. Note that this estimate imposes income elasticity equal to one, and does not take into account other variables, such as climate. See Charap and others (2013) for a more comprehensive analysis of the elasticities of energy consumption. Data on prices comes from International Fuel Prices 2014 - Data Preview, published by Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH.

9

See WEO September 2011, Chapter 3 and Subsidy Reform in the Middle East and North Africa, Chapter 5.

10

Ghezzi and others (2011) indicate that for countries in their study, the average weights of food and energy in the CPI were 15 percent and 9 percent, respectively (a ratio of 1.7). The estimated response of headline inflation to food and energy price shocks was 2 percentage points and 0.5 percentage points, respectively (a ratio of 4).

11

Domestic inflation shocks were selected as follows: monthly headline and sub-index inflation were calculated for the sample period—132 observations per sub-index. Domestic inflation shocks were selected as follows: for each CPI sub-index monthly inflation was calculated during the sample period, which varies between 11 and 6 years, depending on data availability for each country. For each sub-index (e.g. Transport) the 10 percent largest monthly price changes were defined as “shocks”. Each shock was compared with monthly headline inflation during the 12 months after and before the price shock occurred. For instance, let’s assume that one of the largest monthly price changes in Transport prices occurred in March 2008. To assess whether the shock to Transport prices in Mach 2008 had an impact on headline inflation, the exercise looks at headline monthly inflation between March 2007 – February 2008 (12 months before the price shock) and between April 2008 – March 2009 (12 months after the price shock). If monthly headline inflation is broadly the same before and after the identified shock to transport prices, then the finding would suggest that the shock to transport prices did not propagate into headline inflation.

12

See IMF (2014), Chapter 5.

13

The US office of Energy Efficiency and Renewable Energy reports that for producing aluminum, energy costs account for about 30 percent of total costs, although they vary from about 12 percent in Canada to 33 percent in the USA. For producing steel energy costs account for between 15 and 20 percent of total costs. Energy costs in mining represent about 17 percent of supply costs, while energy cost for producing chemicals could amount up to 85 percent of total production costs. Within the chemicals industry, energy cost in terms of raw material costs are about 73 percent for plastics, 54 percent of cyclic crude, 61 percent for industrial organic chemicals, and 67 percent for nitrogenous fertilizers. http://energy.gov/eere/office-energy-efficiency-renewable-energy

14

The exercise assumes that the country is a price taker in global energy markets and faces an infinitely elastic supply curve. If supply were upward slopped, the net gain would be (Pw-Pd)*(energy exports before the change in prices) plus (½)*(Pw-Pd)*(change in exports).

15

The policy of lower energy prices generates costs for sellers of (Pw-Pd)*Qd (equivalent to areas B, E and DW) and gains for consumers equivalent to areas B and E; if prices were increased consumers’ lose A and B, but sellers win A, B, and DW. The net gain for the economy as a whole is DW.

16

Elasticity estimates come from Charap and others (2013).

17

The impact of reforms should be assessed in terms of its effect on the level of income, since the impact measured in terms of growth may be misguided given the subtleties involved. For instance, assume initial GDP is $100 at t=0, an energy price reform occurs at t=1, efficiency gains from the reform amount to $10, the rate of return on investments is 10 percent, and the depreciation rate is 10 per cent. Under these assumptions the economy grows with the reform 10 percent in year t =1—income increases from $100 in year t=0 to $110 in year t=1. If the extra income is used for consumption, then the economy will have a once-and-for-all increase in income from $100 to $110 only. If the economy invests the income gain ($10), the investment will produce $1 extra of income in year t=2. The income path for the economy would be $100, $110, and $111, with the growth path being 10 percent, and 0.9 percent in t=1 and t=2, respectively; if returns continue to be reinvested, income will continue to grow to reach $159 after 50 years, but the growth rate would have fallen to 0.6 percent per year by then. In other words, over the longer term the reform increased income form $100 at t=0 to 159 at t=50, with the larger impact occurring at t=1 when income increases to $110; the impact on growth is more difficult to assess, with the average impact declining as the period considered increases. If investments depreciate, for instance at 10 percent per year, income after 50 years would reach about $119.9 and the growth rate would have fallen to zero percent per year.

18

The return on equity for the non-financial corporate sector has been about 7 percent (average 2009–14)

Kuwait: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
  • View in gallery

    Primary Energy Consumption Per Capita, 2014

    (Tonnes of oil equivalent, TOEs, per person; average in sample is 4 TOEs per person)

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    Energy Consumption to GDP and Price of Energy, 2014

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    Carbon Dioxide Emissions Per Capita, 2014 1/

    (Tonnes per person; average in sample is 10 tonnes per person)

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    Impact of Domestic Inflation Shocks to Headline Inflation

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    Impact of Domestic Inflation Shocks to Headline Inflation

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    Kuwait: Headline and Transport Monthly Inflation, 2014–July 2015

    (In percent)

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    Efficiency Costs from Domestic Prices Lower than International Prices