A. Introduction

1. There is broad consensus that subsidies are often costly, inequitable and unsustainable, and yet subsidy reform is one of the most difficult tasks a government can undertake. Subsidy reform is often difficult because those who stand to lose from the reform may be in a position to exert substantial political pressure. Nevertheless, a reform of the fuel import system and of fuel subsidies is necessary in Mozambique because the current system is costly, inefficient, and poorly targeted, with the most vulnerable segments of the population benefitting little from the subsidies.

2. The fuel subsidy system is costly, though the cost has been declining as a result of the recent decline in international prices. While international oil prices declined from $108 to around $50 per barrel from June 2014 to mid-October 2015, retail prices in Mozambique have not changed, which allowed the government to offset part of the fiscal cost associated with past subsidies. However, in May 2015, despite the decline in international prices, the government had to securitize about $100 million (0.7 percent of GDP) of debt due to fuel distributors to pay off part of the subsidies accrued in 2014, due in large part to inefficiencies in the import system. These resources seem difficult to justify in a context of declining international prices and they could have been used more effectively to finance better targeted subsidies, either through social transfers, transportation subsidies, or by expanding access to basic health and education.

3. The cost of importing fuel to Mozambique is higher than in most other countries in the region due to a series of inefficiencies in the import system, especially since April 2014.² This generates pressures on the budget and on international reserves. A higher fuel import bill creates balance of payment pressures given that the central bank has agreed since 2009 to provide up to 100 percent of the foreign exchange needed for fuel imports. On average, fuel imports account for the majority of the foreign exchange sales by the central bank.

4. This annex reviews briefly the system of fuel imports and subsidies in Mozambique and makes some suggestions for reform. Successful reform would contribute to achieving three interrelated objectives: (i) budgetary savings that could generate fiscal space for social programs, (ii) greater transparency and efficiency, and (iii) a reduction in balance of payment pressures.

B. Current Challenges

5. Fuel imports in Mozambique are centralized through a consortium of fuel distributors (Imopetro). Imopetro prepares the tender to select a trader authorized to import fuel for six months and coordinates the mobilization of foreign exchange through a bank syndicate to finance the related imports. Membership in Imopetro is compulsory and no operator is authorized to import fuel outside this system. Petromoc, the public sector fuel distributor has de facto control of Imopetro given its 51 percent stake. The signature of the contract is supposed to follow an international tender process which is supervised by an ad-hoc inter-ministerial commission (CACL).³ This commission was created to ensure transparency and competitiveness in the procurement of fuel products, but there were complaints in 2014 about possible irregularities.

6. The current system for fuel imports, fuel pricing and fuel subsidies is affected by several problems:

• Transparency. While the last contract for fuel imports was attributed in May 2015 following stronger tendering procedures, the relatively transparency in the tendering of previous contracts was a source of concern. The principle of the lowest price was, in particular, not followed with the contract extensions awarded in 2013 and 2014 without a clear explanation of why this was the case. Inefficiencies in the import system are likely to have resulted in a higher cost of imports and, therefore, a need for a higher fuel subsidy.⁴

• Fuel Import System inefficiencies.⁵ First, there is weak supervision and control of the key parameters that affect fuel prices.⁶ Second, Imopetro has limited capacity to monitor the execution of the fuel import contract and impose penalties for non-compliance. Similarly, CALC focuses on supervision activities around the procurement process, and has no dedicated technical staff, or ability to impose sanctions. Finally, imports are financed by a bank syndicate that helps mobilize foreign currency (typically by requesting US dollars from the Central Bank) on behalf of Imopetro. Forcing private sector fuel distributors to mobilize financing through Imopetro and the bank syndicate increases costs and generates a direct link between fuel imports and international reserves given that the central bank gives an implicit guarantee to provide foreign exchange and, in practice, offered until November 2015 a more favorable rate than available through the interbank market.

• Fuel Pricing. While there is a formula that should set retail prices transparently, with monthly adjustments, this formula has not been implemented since July 2011. In fact, the formula is currently used only to calculate the size of fuel subsidies. The current fuel pricing structure is complex and does not adequately reflect actual costs associated with fuel imports, distribution and retail. The main problems include (i) a lack of clarity on the calculation of the subsidy component, which should be the difference between the retail price and the formula price; (ii) the use of CIF prices inflated by inefficiencies in the fuel import structure and with no detailed breakdown; (iii) higher direct import costs than efficient levels; (iv) a poorly understood price correction factor; and (v) distribution and retail margins that are not regularly updated.

• Cost-effectiveness of fuel subsidies. In 2014 fuel subsidies reached 1.1 percent of GDP on an accrual basis. An estimated 50 percent of this subsidy ($73 million dollars) was due to inefficiencies in the system of imports that resulted in unusually large gaps between the formula CIF price and the international FOB price without any benefit for the population. In practice, part of the fuel subsidy is used to compensate the public sector fuel distributor (Petromoc) for its quasi-fiscal losses. This fuel subsidy could be included in the budget (as an explicit subsidy to Petromoc).⁷ The rest of the subsidy was captured disproportionately by the top income quintile of the population in urban areas, which received about 48 percent of the subsidy.

C. Policy Recommendations

7. Reforms should aim at generating fiscal savings, reducing pressures on international reserves and achieving greater transparency and efficiency in the sector. Fuel subsidies paid by the State could have been lower (especially in 2014) through a more efficient import system. This would have reduced the amount of fuel imports and the volume of FX sales by the central bank. Three specific steps could help improve the system:

8. First, fuel product distributors and large natural resource companies (known as megaprojects in Mozambique) should be allowed to import fuel and mobilize financing directly, in line with their market needs.

• The current centralization of the import system implies that the company with the weakest balance sheet (Petromoc) in practice controls the process through its majority stake in the monopoly importer (Imopetro). This generates reluctance on the part of the banks to provide dollar liquidity to Imopetro as they see that exposure risks to Imopetro are affected by the financial position of Petromoc. In a decentralized system, each company would be able to mobilize its own foreign exchange independently. Petromoc’s balance sheet would also be strengthened if the Treasury provided timely compensation for its quasi-fiscal activities (see above).

• Until November 2015, the Central Bank sold foreign exchange at a more favorable rate than the effective interbank rate to help reduce the import bill and offset some of the system inefficiencies. In a liberalized system, the main fuel importers (especially for megaprojects in the coal sector) and fuel distributors could try to mobilize financing to pay for their fuel shipments directly out of their export proceeds, through offshore loans (subject to central bank authorization), or financing from their parent companies.

• In addition, the domestic banking system has enough deposits in dollars in the form of customers’ deposits (about $1.8 billion in October 2015) to be able finance the fuel imports. This would require that banks buy dollar deposits from their customers at a sufficiently attractive foreign exchange rate. They, however, have little incentive to mobilize these dollars as long as the Central Bank is willing to sell dollars at a discount.

• The companies would also have a greater incentive to supervise the shipments and audit the quantities received. Imopetro should then be dismantled or transformed into an organization where participation by the fuel distributors is voluntary.⁸

9. Second, certain institutional changes would be required to support the new system:

• Use a reference price. This should help to align incentives for Imopetro and other fuel importers and distributors to seek the lowest import cost possible. The CIF price in the formula should be based on a benchmark international reference price increased by a standardized margin reflecting an efficient importer, rather than on actual import costs.

• Regular application of the price-setting formula. Freezing retail prices for a long period of time makes the use of the formula unmanageable and leaves the system vulnerable to manipulation and mismanagement, which adds to the cost of the subsidy. To ensure transparency and efficiency, consideration should be given to the establishment of an independent institution responsible for data collection, implementation of the automatic pricing mechanism, verification of the tender process and execution of the fuel imports contract.

• Reinforce government regulation and supervision to avoid market collusion and ensure quality, safety and regular access to fuel products in all areas of the country.

10. The reactivation of the fuel price-setting mechanism would also generate several important benefits. First, it would permanently eliminate the need for a fuel subsidy, which could generate savings of around $65 million per year, on average, if we consider the annual average subsidy disbursed over the last five years.⁹ Second, it would help activate a market adjustment mechanism as rising prices would help reduce import volumes. The use of the formula and elimination of the subsidy would also help reduce the possible problem of “leakage” or “smuggling” of fuel imports to neighboring countries. Finally, some compensatory measures may be needed to adjust to the new system. A fuel price increase of 20 percent is estimated to decrease income by 20 percent in the two lowest quintiles of the income distribution. The government could study targeted subsidies to the public transportation system and/or and expansion of the existing social safety net programs.