79283 Drawing a Roadmap for Reforming Oil Pricing Policy Masami Kojima Sustainable Energy Department 2013 World Bank 2 Challenges of High Oil Prices Between 2003 and 2012 the average annual world prices of gasoline, diesel, and kerosene in 160 countries more than doubled, while the prices of liquefied petroleum gas (LPG) used for cooking and heating increased by two-thirds (with prices converted to local currency units and adjusted for domestic inflation). Rising world oil prices affect all countries by increasing either import costs or government revenues from oil exports. This has important policy implications for developing countries, the oil demand of which is expected to overtake that in developed countries shortly. Against the backdrop of high oil prices, many countries have not passed through the oil price increases to consumers, instead instituting government policies to keep domestic prices low. The retail prices of oil products converted to U.S. dollars in developing countries in January 2013 showed large variations: a factor of 190 between the lowest and highest prices for gasoline, 250 for diesel, and 75 for LPG. If a handful of countries with very low prices are excluded, the differences are reduced to a factor of about 10 for gasoline, diesel, kerosene, and LPG. By region, the Middle East and North Africa had the lowest median prices. Between January 2009 and January 2013, many countries did not pass through increases in world oil product prices to domestic consumers. The median pass-through for gasoline and diesel increased with income and was less than two-thirds in low-income countries. High-income countries had larger median pass-through coefficients than any other income group. For kerosene, the median pass-through was full in upper-middle-income countries, but half in low and lower-middle-income countries. Among developing countries, the median pass-through for LPG was highest in low-income countries. Continuing price controls The less-than full median pass-through coefficients in developing countries signal continued government influence on domestic fuel prices. Governments use a range of policies to keep domestic prices low, including setting prices or price ceilings, providing universal or targeted price subsidies, establishing a fund or mechanism for smoothing prices across time or freight cost equalization across the country, reducing taxes, requiring oil companies to bear some or all subsidy costs, and imposing export restrictions. Combinations of these measures have resulted in two-fifths of 65 countries studied freezing the retail prices of gasoline, diesel, or both, for months or even years during the past three years. More generally, about two-thirds of the study countries have kept domestic prices below market-based levels for one or more fuels in the past three years, subsidizing consumers. In every case the government pays directly—or indirectly through budgetary transfers, tax expenditures, or lower corporate tax collection due to financial losses suffered by oil companies. By compensating one or more consumer categories through price adjustments rather than cash transfers and other forms of assistance, these pricing policies also distort the downstream oil sector. Many countries have universal price subsidies, widely acknowledged to be regressive. Quite a few have subsidies targeting certain consumer categories, most notably kerosene and LPG for households. Price subsidies targeting the poor are rare. On paper, a price smoothing scheme can be self-financing: in times of low world prices, 3 consumers pay more and the savings are put aside, and in times of high world prices, the savings are drawn down to reimburse the oil marketers to keep prices low. In practice, however, most price smoothing schemes build up deficits over time, eventually requiring budgetary transfers or large loans. These budgetary transfers can run into billions of dollars, as in Colombia and Peru. Unintended consequences of price controls Targeted subsidies for oil products have large leakages (such as diversion and smuggling) because, unlike electricity or natural gas, liquid fuels are easy to store and transport. Differentiating prices for the same oil product by user category creates powerful financial incentives to divert lower-priced fuels to users ineligible for the price discounts. Typical recipients of such targeted price subsidies are households (kerosene or LPG for cooking, lighting, and heating), transport operators, farmers, and fishermen. Although prices of kerosene and diesel are close on the world market, many governments price kerosene below diesel in the name of protecting non-electrified households that use kerosene for cooking, lighting, and heating. Kerosene, however, is well suited for adulterating diesel. The larger the price difference, the greater the financial incentive to divert kerosene to the automotive diesel sector. Chemical marking, color dyes, and other detection measures can curb diversion to a degree, but these can be subverted. Also common is the diversion to commercial establishments—such as restaurants—of subsidized LPG sold in small cylinders for households. In most cases, the intended beneficiaries are not engaged in diversion on any meaningful scale. One possible exception is subsidized fuel for fishing boats: boat owners may be involved in diversion because boats can smuggle large quantities of fuel. These criminal activities worsen governance in the downstream oil sector, making sector reforms difficult. Fuel shortages—and flourishing black markets with high prices—are common in markets with low official prices. Shortages occur because of diversion and smuggling and because of the government’s inability or unwillingness to reimburse oil companies for subsidies. Cash-strapped oil companies may cut back on refining and imports, and even shut down filling stations if losses become unsustainably large. Subsidies may be channeled through state-owned oil companies, granting them monopoly or near- monopoly status. Not having to face competition, they become opaque and inefficient, raising costs. Toward Market-Based Pricing Given the weight of the evidence, governments should pursue policies to make the downstream oil sector competitive and to deregulate it. Price controls are inefficient and unsustainable means of protecting the poor, curbing inflation, and achieving other objectives cited by governments that keep prices low. To help the poor cope with high oil prices, the long-term goal should be to replace fuel price subsidies with effective social service delivery. The most efficient and least distorting approach is arguably to transfer cash as part of an integrated, comprehensive poverty alleviation program; government interventions using sectoral subsidies to keep prices low for each good and service are generally suboptimal. In parallel, to reduce vulnerability to oil price volatility, governments should promote energy conservation measures throughout the economy and facilitate fuel diversification to reduce overreliance on oil where it makes economic sense. 4 Starting conditions The path to market-based pricing depends on the starting conditions. Considerations include the size of the gap between current and market-based price levels, the level of public awareness about the extent of departure from market prices, the degree of market concentration and competition in downstream oil, the subsidy delivery mechanism where subsidies are provided, the robustness of social service delivery, and the perceived credibility of the government. International experience makes clear that it is far more difficult to move to market-based pricing if the government has little credibility because of a poor record of service delivery or worse, or if the legitimacy of the government is being challenged. If the oil sector is perceived to be corrupt―and this occurs particularly in countries with significant oil production―then the public may falsely come to believe that corruption is what makes subsidies unaffordable, and that subsidies can be made affordable if corruption is stamped out and subsidy delivery is made more efficient. If a national oil company dominates the sector, steps should be taken to introduce competition; options include breaking up the company, mandating third-party access to its infrastructure as a transition measure, and taking other steps to facilitate new entry. For healthy and fair competition, it is essential to establish clear and sound regulations and enforce them. All these steps should lower costs of supply over the long run. Strengthening social safety nets and making the oil sector transparent and accountable are essential for lasting price reforms. Communication and consultation In the immediate term, governments can develop a communication strategy to inform the public effectively about— • the magnitude of the combined under-recoveries covered by the government and oil companies; • captured subsidies broken down by income and by sector, and the winners and losers of the price reform, including likely effects on different income groups, as well as opposition likely to be mounted by powerful groups benefiting from the subsidies legally and illegally; • evidence on diversion and smuggling; • nonfiscal costs of under-recoveries, such as acute fuel shortages and deteriorating infrastructure in the oil sector, leading to inefficient operations and rising costs; • alternative ways of achieving the social and economic goals of current pricing policies; and • a proposal or menu of options suited to the country circumstances to move away from a price- setting policy in the oil sector to market-based pricing complemented by broader social protection and compensation mechanisms outside the oil sector. Consultation is an important element of communication. The variety of current media, including electronic media, makes a national conversation about price reform possible. 5 Continuous process of adjustment Government transparency is important regarding the agency in charge of pricing, the scope of its regulatory power, how prices are set, the criteria for price adjustments, the price breakdown, the magnitude of under- or over-recoveries, and the stakeholders being consulted. Informing the public frequently about cumulative under-recoveries is important because, even when fuels are subsidized, news headlines about falling world oil prices can prompt the public to clamor for immediate price reductions in line with those declines. If current prices are very low, they may need to be raised several-fold to reach market levels. In the case of universal price subsidies, bridging the price gap in one-off, very large price increases is likely to be too disruptive and invite a public backlash. The question for the government is how long it should take to raise prices and how large each price increase should be. In considering the reform strategy, it is important to look at the likely effects on consumers, which depend on the prices actually paid rather than the official prices. If fuel shortages are widespread and consumers are paying several times the official prices, making large adjustments to official prices and eliminating fuel shortages may have much smaller adverse effects than the theoretical impact of the large price adjustments. Once prices are within a few tens of percent (such as 20 percent) of market levels, adopting automatic price adjustment rules linked to world oil prices and based on a formula should be a near-term goal. Doing so should largely depoliticize pricing. Adoption is easier in times of low international oil prices. Absent such an opportunity, prices should continue to be raised, with adoption of formula-based pricing in the last price increase. The timing of price deregulation―whereby the government ceases to be active in price-setting―depends on whether there is sufficient competition in the market. It is easier to gauge the degree of price competition if the government is setting price ceilings rather than price levels themselves; departure from price ceilings and measurable price variation across companies are signs of emerging competition. Recent international experience suggests that pricing reform often does not have a clear end and should instead be viewed as a continuous process of adjustment and search for mechanisms that take into account the country’s institutions and political system, and the oil sector’s market structure, infrastructure, and history. The table below shows specific issues that may need to be considered for pricing reform. CONSIDERATIONS FOR DRAWING A ROADMAP FOR PRICING REFORM Consideration Specific issues Starting conditions in the oil sector Gap between current price Is the gap becoming an important fiscal concern? If the gap is large, what time period and market-based price for bridging the gap is likely to find public acceptance, and how large a price increase levels could be taken at a time? If the gap is relatively small, how soon could a formula- based market pricing mechanism be adopted or resumed? How prices are set and who Price levels or price ceilings? At retail, wholesale, refinery gate, or elsewhere? Pan- sets them territorial pricing or geographical variation? Is there a formula for setting prices? Is 6 Consideration Specific issues the formula being followed, or has it been suspended in practice? Is there an agency in charge of setting prices, or is the decision to change prices made by different political groups depending on the state of politics at the time? Who determines under- Is the size of under-recoveries based on self-reporting of costs by oil companies, or recoveries, who pays for some international benchmarks? Does the government reimburse oil companies fully them, and how or partially, and in a timely manner or often with long delays? Is the downstream oil infrastructure languishing for lack of investment because of price controls? Are reimbursements for under-recoveries channeled through state-owned oil companies? Is the government’s share of subsidies clearly shown in the budget, or are there off-budget transfers of funds, obscuring the magnitude of the subsidies? Are tax expenditures used to cover under-recoveries? Subsidies should be made transparent and easy to track. Competition in the market How concentrated is the market at refining/import, wholesale, and retail levels? Does a national oil company dominate the market? Are inefficient refineries or state- owned oil companies protected by tariffs, subsidy delivery mechanisms, or other means? Is hospitality or third-party access encouraged to facilitate new entry and avoid duplication of infrastructure? Subsidies in place Are these universal or targeted subsidies? Who is targeted and how? Are subsidized fuels rationed, and if so, how? Who uses which fuel and for Is there widespread use of gasoline or diesel for standby electricity generation? If so, what purpose higher fuel prices could threaten access to electricity. Is gasoline used primarily by the better-off, or is there widespread use of gasoline in motorbikes by small businesses and lower-middle class families so that gasoline is not fuel only of the rich? Is kerosene or LPG widely used for cooking? There is more resistance to raising cooking fuel prices that affect a majority of households. Is there widespread use of kerosene for lighting? If so, pro-poor arguments could be used to argue against raising kerosene prices without compensation. Commercial malpractice Are there flourishing black markets? Are actual prices paid by consumers markedly higher than official prices? If so, raising official prices would have much less adverse impact. Is short-selling routine? If so, enforcing rules against short-selling would lower the effective price increases when official prices are raised. Is there smuggling? Is there diversion of subsidized fuels to consumers who are not eligible? Is there adulteration of higher-priced fuels with subsidized fuels? Perception of the oil sector Is it considered opaque, corrupt, politically well-connected, or a state within a state? Are there scandals to do with large leakages in subsidy delivery? If so, raising prices could be difficult if the public is angry about corruption; on the other hand, it might be possible to persuade the public that higher prices get to the source of the corruption and help stamp it out. If the state is a large oil producer, is the country a member of the Extractive Industries Transparency Initiative (eiti.org)? Social protection Safety nets Is there an up-to-date database of beneficiaries? Is there an administrative system in place to deliver benefits? Does the government have a national identity and smart card system for cash transfer to the needy? Does the government have safety nets that can be scaled up in terms of benefits, coverage, or both, to compensate the vulnerable for higher oil prices in a way that would be consistent with medium- and long-term goals for social protection? Or will deployment of sound social safety nets require considerable preparatory work and development? Delivery of essential social What is the state of primary education, primary health, access to safe water, access services to sanitation? Is the track record of delivery such that the public would consider 7 Consideration Specific issues credible the government’s promises of putting the savings from subsidy reduction to better uses? Reform steps Sector structure and Is the market sufficiently large to become competitive over time, making price regulation deregulation a realistic goal? If there is market concentration, what are the physical assets that protect the market power of the incumbents—import terminals, refineries, depot terminals, pipelines? How can their market power be broken? Are there laws or regulations on supply that need to be amended? Do regulations and standards reflect current international good practice, or do they need to be updated? Is there monitoring and enforcement, and, if so, how can they be strengthened? How is commercial malpractice tackled and is there a plan to reduce it further? Who will set prices and how Will there be an independent regulatory agency in charge of setting prices? Are there laws or regulations on pricing that need to be amended? If there are large price subsidies, what transition steps are needed before an automatic, formula-based pricing mechanism can be adopted or prices deregulated? Timing Are there events outside the oil sector that could affect timing—national elections, natural disasters, food crisis, large-scale agricultural crop failure, domestic or international financial crisis, soaring unemployment, or collapsing prices of other commodities, such as coffee or minerals, that the economy depends on? Most of these would call for greater social protection measures in response to price reforms. Is there a time when fuel consumption is higher—major national holidays, winter in cold-climate areas, summer travel period—that should be avoided for raising official fuel prices? Analysis of winners and Is there a reasonable understanding of effects of price reforms on different segments losers of society and income groups, including likely effects on inflation and which sectors would be particularly affected? What are the relative effects of higher food prices, higher transport fares, and higher energy prices on the poor? If food prices are more important because of the expenditure patterns of the poor, that would argue even more for moving away from sectoral approaches and combining safety nets for all risks under one umbrella. Does the financial viability of some businesses depend on oil price subsidies? If so, they will lobby to oppose subsidy reforms through industry associations, trade unions, and other groups. Is there a need for managed closure of these businesses and retraining of staff? Would it be possible to make small, regular, incremental price increases that minimize adverse effects? Would it make sense to provide support for fuel switching or fuel efficiency improvement? Does the electricity sector rely on diesel, fuel oil, or both? Can electricity utilities pass on oil price increases to consumers, or will the utilities have to bear financial losses until the next round of tariff adjustments? Is underpricing a problem in the electricity sector? If oil product price increases will significantly increase electricity tariffs, affect the financial viability of electricity utilities, or do both, careful consideration needs to be given to coordination between the oil and electricity sectors, and to the political economy of electricity tariff reforms. Are there powerful groups benefiting from subsidies and can they exercise their influence to block price reforms? Are some groups benefiting illegally from subsidies by engaging in smuggling, black marketing, diversion, and fuel adulteration? Do they include high-level government officials and high-level oil-company officers? If so, building a broad-based coalition of supporters for price reforms would be all the 8 Consideration Specific issues more important. Immediate, tangible benefits Would it be possible to deliver immediate benefits of the price reform? In the oil sector, such benefits could be no more queues, much less fuel adulteration, much lower black market prices, and a crackdown on short-selling. Outside the oil sector, are there existing administrative systems in place that can deliver compensation immediately and is visible to the public? If not, is there something that could be set up quickly, and could the start of any large price adjustments be postponed until that setup is nearly, if not fully, operational? Longer-term assistance Aside from initial compensation to help adjust to higher prices, is there a need for longer-term compensation or assistance, such as energy efficiency fund or tax expenditures for acquisition of more efficient equipment and appliances to reduce oil consumption, increases in food assistance, and long-term cash compensation to the poor for higher fuel prices? Communication About the current state Is the public aware of the size of under-recoveries, who is benefiting, the distortions caused by keeping prices low, and the opportunity costs of the under-recoveries? Can the public easily find out past and present price gaps? Is there a national dialogue on the pros and cons of the current pricing policy? About future options or plan Are options or a proposal for price reform being communicated effectively and accurately? Or are rumors causing panic buying and hoarding? Is there a mechanism to consult different stakeholders and include them in deliberation and decision- making to the extent possible? Is communication about compensation plans undertaken far in advance of the implementation of the price reform, so that the public is well prepared? Means of communication Are all forms of communication being exploited? Is consideration being given to a Web-based national conversation, giving many people an opportunity to be heard? Are all segments of society being reached, including those without access to the internet or TV? Is electronic communication being complemented by face-to-face stakeholder meetings? Communication about the oil Is there a plan to make price, production, and consumption information available sector regularly and in a timely manner so that consumers and potential investors can take informed decisions? As competition begins to emerge, could the government make price information readily available to further promote price competition? Is there a mechanism for registering complaints? Are companies found in violation of rules named with specific charges outlined? Are all regulations and rules, announcements about pricing policy, calculations of controlled prices, the magnitude of the remaining subsidies and how they are channeled, and any other information related to prices consolidated in one place so that they can be easily found? Is information provided in plain language and comprehensible to many, if not most, people in the country?