Allow Price Pass-through

Countries should aim at allowing domestic prices to follow international prices. Price signals are crucial for inducing demand responses. For energy, the demand response can be sizable. Short-term price elasticity of demand in the empirical literature has been estimated at –0.2, with the highest elasticity for gasoline (–0.29) followed by natural gas (–0.18) and diesel (–0.15) (Labandeira and others 2017).⁷ Long-term price elasticities of demand are even greater. In contrast, food is a basic good that takes a higher fraction of incomes of the poor and may be less price-elastic. Ensuring affordable access to basic staples, especially where food security is a concern, therefore, should be prioritized. Higher prices on energy should encourage more efficient use of energy and investments in renewables, while higher food prices should encourage more agricultural production. Measures aimed at preventing domestic prices to adjust are costly, crowd out productive spending, and reduce producer incentives. At the same time, it is possible to appropriately design measures to protect the vulnerable households.

Protect the Most Vulnerable

The ability of countries to effectively protect vulnerable households from energy and food price shocks depends on the strength of their SSNs. Strong SSNs allow governments to identify eligible households to better target and efficiently deliver such assistance. Strong SSNs can be defined as a set of benefit programs that have high coverage of the poor, adequate benefit levels, good benefit incidence,⁸ are effective at reducing poverty, and have good infrastructure to scale up transfers in response to shocks. The scalability of SSNs depends on the availability of strong information systems, such as universal and robust identification that is effectively linked to databases with socio-economic information (household characteristics, employment, and income), on the adequate implementation capacity to deliver benefits to the intended beneficiaries in a reliable and timely manner and on strong medium-term fiscal frameworks that ensure flexible and sustainable financing.

Countries with strong SSNs could use targeted and temporary cash transfers to mitigate the impact on low-income and vulnerable groups. Transfers that are independent of the consumption of energy or food are preferred as they do not distort relative prices. Tax systems can also be used to provide relief to vulnerable households, for example, using refundable tax credits.⁹ With energy prices, if existing SSN programs cannot be scaled up immediately, then other temporary measures that rely on utility service providers could be considered. For example, by combining household income information with utility bill information governments can provide lump-sum discounts to those who fall below a certain income threshold. Such lump-sum benefits are preferred over benefits that are proportional to utility bills as they are more progressive and less distortive. Additionally, smoothing energy consumption bills over time could be considered. While the immediate relief should be temporary (time-bound), more permanent support through existing SSNs should be provided by indexing the benefits to inflation.

Countries without strong enough SSNs to provide support to the most vulnerable can expand existing programs. When feasible, the existing most efficient SSN programs (for example, school feeding programs) can be expanded to provide some relief to low-income and vulnerable households by increasing benefit levels and coverage as needed. Alternative approaches to targeting, such as geographic, categorical, self-selection, community-based, or proxy-means testing, can be used. Ad-hoc measures, such as those introduced in response to COVID-19, can be considered.¹⁰ In this respect, digital tools can be leveraged, for instance for beneficiary intake and registration through online applications complemented with information on individual situations from non-standard sources, such as telecom metadata. Benefits can be delivered through Government-to-Person (G2P) mobile payment platforms. During the pandemic, some governments, such as Brazil and Thailand, implemented registration processes through dedicated websites. In Togo, the government was able to quickly identify and enroll the vulnerable with the help of biometric voter IDs and satellite and phone record data. Cash transfers through a digital G2P platform. Nigeria used a new targeting method based on census data and high-resolution satellite imagery to map the poorest urban areas and target benefits. However, these technology-based approaches can lead to the exclusion of low-income households that may not have access to digital tools and/or may be difficult to reach through digital mechanisms. Governments could also consider reducing education, health, or public transportation fees if they help in reaching the targeted groups and can be effectively implemented. All these imply that countries with weak SSNs must rely on a combination of measures to reach the desired target groups.

Countries with existing energy or food subsidies should gradually pass through international prices to retail prices while committing to eliminate subsidies over the medium term. The pace of pass-through should be carefully calibrated based on the gap between retail and international prices, the available fiscal space, and the ability to put measures in place to mitigate the impact on vulnerable households.¹¹

• Fuels. Countries with fuel subsidies could consider differentiating adjustment paths of domestic prices by type of fuel based on their relative weights in the consumption of different income groups. For example, in some countries, liquefied petroleum gas and kerosene are more important for low-income households—which use these fuels for cooking or heating, and hence could have a slower adjustment path than prices for gasoline and diesel. Once the domestic price is increased in line with the international price, countries could adopt an automatic energy pricing mechanism with smoothing that prevents sharp adjustments in fuel prices as a transition to liberalized pricing. The expansion of fuel subsidies could also impose a risk to fuel security as incomplete compensation of fuel suppliers is often associated with supply shortages.¹²

• Utilities. Countries with utility subsidies can adjust prices gradually in line with changes in costs. To mitigate the impact of higher prices, some temporary measures, such as uniform lump-sum bill discounts could be considered. In addition, smoothing of energy bills throughout the year can help households avoid falling into arrears during the months when more energy is needed for heating or cooling. While lifeline tariffs will continue to play a role in cushioning the impact of high prices on low-income households, they may need to be redesigned to make them fiscally affordable.¹³ Moreover, lifeline tariffs are generally inferior to other alternative measures, such as lump-sum discounts for several reasons: the consumption level of poor households is not always lower (Komives and others 2005), the measure reduces the average tariff for the utility and distorts prices, and poor households who do not have access to the power network are not likely to benefit from it.

• Food. In countries with food subsidies, rationed food prices can be increased gradually. Targeting of existing programs can be improved to reduce leakages to higher income groups and in the supply chain of food subsidies. This could reduce the fiscal burden of food subsidies while not impacting the most vulnerable benefitting from food subsidies. Food security should be prioritized within the existing fiscal envelope. If food security is a concern and all previously-mentioned options have been exhausted, governments can consider other temporary measures, such as providing price subsidies or lowering consumption/import taxes with clear sunset clauses for basic food staples. Efforts should also be made to increase the food supply by supporting production and avoiding hoarding behaviors¹⁴ by using food reserves¹⁵ when available and prioritizing human consumption over other uses of food crops.

Cut Taxes on Affected Goods Only as the Last Resort

In general, reducing taxes on energy and food are not advisable. Given the prevalence of ad valorem taxes (such as VAT or ad valorem excises), higher prices and relatively lower price elasticity of demand implies that in many countries tax revenues will go up when energy and food prices rise. This additional tax revenue can be used to provide targeted support to vulnerable households. On the other hand, a general reduction in taxes implies providing relief to all including the most affluent households and results in the loss of significant revenues when these are most needed.¹⁶ For fuel taxes, such as excises, there are several additional considerations. Externalities that fuel excises address remain valid to mitigate climate change, therefore higher fuel taxes are still needed. Even in the absence of an explicit tax cut, a specific excise tax falls as a share of the consumer price when the pretax price rises. Leaving aside environmental considerations, there could be a case for some rebalancing by cutting the equivalent ad valorem tax while increasing the specific tax. In countries with weak SSNs where the expansion of existing programs does not provide sufficient protection and where food security concerns are particularly severe, governments can consider temporary reductions in taxes with clear sunset clauses for staple foods. Import tariff cuts on necessities, which are less distortionary, would then be preferable.

Permanent excess profit taxes that target economic rents are preferred over ad hoc tax surcharges on windfall profits. The surge in energy prices and the profits of some energy companies has led to renewed calls for the imposition of taxes on windfall profits. However, such taxes could discourage investments and thus be counterproductive (Baunsgaard and Vernon, forthcoming). Instead, a tax on excess profits—economic rents in excess of the return required by investors—is preferred (Hebous and others, forthcoming). Excess profit taxes would support social cohesion by enabling contributions from businesses that prosper during the crisis rather than those companies (and their workers) that are hit hard and earning normal profits or even incurring losses. Such taxes could become a source of significant revenue while causing little distortion.

Manage the Rationing Efficiently

In extreme cases, countries can use quantitative controls in combination with price mechanisms. Rationing can be an option if prices are too high and raise concerns about food security or access to energy. Food rationing can be implemented through ration shops (for example, the public distribution system in India, see Gadenne 2018), vouchers, or direct food distribution. With respect to energy rationing, maintaining price signals to entertain demand response and providing clear targets to the population through a communication campaign are important. For example, in the early 2000s, Brazil designed an effective quota system with price signals and achieved a more than 20 percent reduction in consumption in one year (Maurer and others 2005). Implementing quotas without prices is less efficient. After the March 2011 earthquake and the subsequent shutdown of nuclear power plants, Japan set consumption targets for enterprises and reduced demand for air conditioning. Electricity demand decreased by 15 percent (Kimura and Nishio 2016). Blackouts should only be used as a last resort. Although easy to implement, such an indiscriminate form of rationing, which does not distinguish between essential from non-essential users, results in larger economic losses (Maurer and others 2005).

Strengthen International Cooperation

International cooperation is key for ensuring an adequate and affordable supply of energy and food on the global market. Low-income countries, where food inflation is running high, have little fiscal space for an effective policy response. Those heavily dependent on food imports from Russia and Ukraine (countries in the Middle East and North Africa, Central Asia, and sub-Saharan Africa) are particularly vulnerable in the short run. Vulnerable countries would need external assistance, which should include the provision of emergency food supplies, financial support, and increased agricultural and fertilizer production. Moreover, the recently adopted Doha Program of Action calls for exploring the feasibility of a system of stockholding for the least developed countries on a regional and subregional basis. Export restrictions, which have already been announced by several countries, can be harmful to global food security and add to further price pressures, especially when imposed by countries with a sizable share of the global market. Lessons from the previous food price peaks in 1973 and 2008 have shown that trade barriers are ineffective in stabilizing domestic prices, on average, while increasing further world prices.¹⁷ In the long run, export bans may also hurt countries imposing restrictions as they reduce production incentives and encourage smuggling to countries with higher prices.

Accelerate the Climate Agenda

The crisis offers an opportunity to galvanize support for diversifying energy supplies away from fossil fuels and for achieving more sustainable, inclusive, and efficient food systems. Diversification of energy supplies can help accelerate a transition to green economies and strengthen energy security. Countries should aim to increase investments in the production of renewables and reduce their dependence on fossil fuels. However, in the short run, as economies grapple with supply shortages, alternative supply sources of nonrenewable energy, including, for example, enhancing markets for liquefied natural gas, and expanding production of shale oil and gas may be needed. This should be done in a way that is consistent with climate change goals and avoids investing in long-duration and capital-intensive fossil fuel projects. Consideration could be given as to whether excessive incentives are in place to use corn for biofuel production rather than the food supply (Glauber and Laborde 2022). Governments should also promote measures to improve energy efficiency by encouraging thermostat adjustments and accelerating energy efficiency improvements. In addition, governments need to incentivize the shift towards more environmentally and socially responsible food production and consumption.