83946 A briefing of good practices and lessons learned from the ECA region November 2013 > Volume 66 Managing the Balancing Act: Energy Subsidies & Energy Affordability Authors: Caterina Ruggeri Laderchi, Anne Olivier and Chris Trimble Many Europe and Central Asia (ECA) countries are faced with a difficult balancing act of cutting subsidies to the energy sector while protecting affordability for consumers. This study assesses at the micro-level the distributional impact of raising energy prices to cost recovery levels, while recommending a transition to more effective social assistance measures and demand management interventions. Introduction Sheltering consumers from the high cost of energy through subsidies to the energy sector is becoming increasingly unaf- fordable for many countries in ECA. At a time when fiscal and environmental concerns are calling for increasing tariffs to cost- recovery levels, questions on energy affordability challenge the political feasibility of reforms. Governments are faced with a balancing act of cutting subsidies while protecting affordability. Relying on the ECAPOV database,2 a new World Bank study, Balancing Act: Cutting Energy Subsidies while Protecting Affordabil- ity, assesses at the micro-level the distributional impact of rais- ing energy prices to cost-recovery levels. The analysis focuses on electricity and gas, which account for 4.5 and 1.6 percent of KEY MESSAGES household spending3 in the region, respectively, and adopts a • Sheltering consumers from the high cost of energy by broad country grouping to address commonalities across the subsidizing the energy sector is increasingly unaffordable for following subregions: most countries in ECA, which face growing pressure to raise • European Union (EU) member states energy tariffs to cost-recovery levels. • EU candidate and potential candidate (CPC) countries, in- • Since household consumption patterns reflect past infrastructure investments and are unlikely to change in the cluding Croatia,4 Turkey, and the Western Balkans short term, energy tariff increases would negatively affect large • The Eastern Partnership and Other Commonwealth of Inde- segments of the population in the region. The shock of higher pendent States countries (EPOC), which include the mem- energy tariffs is likely to be significant, particularly for the bers of the Commonwealth of Independent States (CIS) and poorest households. Georgia • A new World Bank study1 has found that helping households cope and adapt to more expensive energy requires an The report estimates that higher tariffs would increase house- integrated policy agenda of more effective social assistance hold expenditures on energy by 14 percent for the EU member measures as well as demand management interventions such as energy-efficiency incentives. 1 Caterina Ruggeri Laderchi, Anne Olivier and Chris Trimble, Balancing Act: Cutting Energy Subsi- dies while Protecting Affordability (Washington, DC: World Bank, 2013). • The cost of these interventions is largely outweighed by the 2 ECAPOV is a unique database of standardized household surveys that covers the majority of savings from removing the subsidized tariffs. The study reveals countries in the region. that in almost half of ECA countries, reducing subsidies while 3 The average share of electricity spending ranges from 1.6 to 7.3 percent, and the average share of gas spending ranges from 0.2 to 5.1 percent of the household budget. protecting affordability could lead to fiscal savings of over 1 4 Croatia joined the European Union on July 1, 2013. percent of GDP. EUROPE AND CENTRAL ASIA KNOWLEDGE &LEARNING states,5 13 percent for the CPC countries, and 28 percent for Figure 2. “Balancing Act” Framework the EPOC countries. As a result, poverty could increase by 5–30 percent, while even larger shares of the population could face severe energy poverty. Energy Affordability in a Broader Context Higher electricity prices are associated with higher burdens on household budgets, as illustrated by Figure 1. Households appear to have limited ways of keeping their energy expendi- tures in check. Indeed, country evidence over time shows that energy price increases often compel households to cope by cutting down on other types of basic consumption, such as food or health spending. However, the past decade also shows that increasing energy efficiency can help households manage Source: World Bank staff their energy spending. A companion report6 to the new study offers an overview of the energy-efficiency policies that were From Costs to Tariffs: The Role of Subsidies implemented in countries that have successfully decreased their Most ECA countries fix their tariffs at levels below cost recov- energy intensity.7 ery, thus subsidizing the price households pay for energy. For Figure 1. Electricity Price & Electricity Share of Total Household Expenditures the sake of comparability, the report adopts a common cost- recovery standard equal to 12.5 U.S. cents per kilowatt hour (kWh) for electricity to cover technical costs (and 16 U.S. cents per kWh for the EU10,9 accounting for the social costs of energy production). For gas, a common threshold of US$560 per 1,000 cubic meters (m3) (that is, US$16.70 per gigajoule [GJ]) is used. Subsidies through the tariff system are currently pervasive and absorb an estimated 2.3 percent of GDP on average, ranging from 0 in Latvia to 12 percent in Tajikistan. The most common way of implementing these subsidies is through lifeline tariffs, or block tariffs designed to keep the price for the bottom block of consumption at levels significantly below the average tariff. While lifeline tariffs have played an important role in cushioning Source: ECAPOV, World Bank estimates the impact of the shift to higher residential tariffs over the past decade, the magnitude of subsidies they absorb appears unsus- Balancing Act adopts a simple framework to characterize the challenge countries face in balancing affordability with fiscal tainable at a time of heightened fiscal pressures. prudence and environmental concerns. The framework distin- Universal subsidies are also an expensive and inefficient way of guishes the factors that determine the technical cost of energy protecting consumers because they represent recurrent costs from those that affect energy affordability for households, as and because they reach everybody, including households that do illustrated in Figure 2. not need support in paying their bills. Figure 3 presents esti- In the framework, predetermined elements are identified that re- mates of how implicit benefits are distributed via subsidized gas flect country endowments. These include past policies (in blue) and electricity tariffs. As shown in the study’s simplifying frame- that determine the current technical cost of energy, and current work, households benefit from the subsidy in proportion to their policy variables (in green) that affect household demand and consumption, so that in most countries, wealthier households energy affordability. The current technical cost is determined tend to be the main beneficiaries of electricity and gas subsidies. by: (i) prices; (ii) regulations that govern tariff settings, such as EU regulations to internalize the social costs of energy produc- Developments in the energy markets, concerns about the envi- tion or reforms to enhance network operational transparency; ronmental sustainability of current energy consumption levels, and (iii) investment to upgrade the capital base of the sector.8 Subsidies, social protection, and sectoral policies are the current 5 This accounts also for environmental costs. policy variables that affect energy demand and affordability for 6 Gary Stuggins, Alexander Sharabaroff, and Yadviga Semikolenova, Energy Efficiency in ECA: households—or conversely, their vulnerability to tariff increases. Lessons Learned from Success Stories (Washington, DC: World Bank, 2013). These policy variables drive: (i) how technical costs are translat- 7 Energy intensity is defined as total energy consumption per unit of GDP. ed into tariffs; (ii) how sectoral policies shape demand patterns; 8 Recent estimates suggest that for the region as a whole, these costs might amount to as much as US$3.3 trillion if a lights-out scenario is to be averted. See World Bank, Lights Out: The Out- and (iii) the social protection measures available to support look for Energy in Eastern Europe and Central Asia (Washington, DC: World Bank, 2010). energy affordability. 9 The EU10 refers to the 10 countries that joined the EU in 2004 (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia) and 2007 (Bulgaria and Romania). KNOWLEDGE BRIEF > www.worldbank.org/eca and the need to start planning for significant investment in the the poorest, because eligibility is not linked to income. sector all suggest that energy costs will continue to increase. To There are two main challenges to the expansion of ESA through- avoid passing this rising cost along to households, even greater out the region. The first has to do with delivery mechanisms, subsidies would be required. Yet, continuing to shelter consum- which might not yet be in place in some countries, despite high ers through subsidies to the sector might be a vanishing luxury poverty incidence. As these systems are put in place, transitory for most countries. solutions such as vouchers or well designed lifeline tariffs might Figure 3. Distribution of Benefits for the Implicit Subsidy on Electricty and be needed. The second challenge is cost. Even restricting the Gas, by Quintile compensation to the poor only—an option that might not be wise given the burden faced also by the middle class in many countries—could require more than 1 percent of GDP for energy programs alone in the poorest countries in the region. Neverthe- less, experience from the past decade does offer examples of how existing programs can be made more effective, including measures to reach those most in need by strengthening the targeting of benefits and consolidating multiple programs in a common and enhanced delivery mechanism. Source: ECAPOV, World Bank estimates Yet, transfers alone cannot be used to guarantee energy afford- Note: Countries with non-regressive patterns are highly reliant on district heating. Once all types of ability, even if only to some subset of the population. Since these subsidies are accounted for, the pattern would be regressive across all countries. recurrent expenditures do not help address the problem at its If tariffs were made equal to the regional cost-recovery stand- root, they should be complemented with more extensive secto- ards, households across the region would experience price ral policies supporting energy efficiency. shocks of different magnitudes. In most countries, the shocks would be significant, with an average increase in the share of Sectoral Policies: Improving Energy Efficiency household budgets spent on energy of 1.5 percentage points A subset of policies in the energy sector, particularly invest- (among EU members), 1.2 percentage points (CPC countries), ment in infrastructure and housing, would allow households to and 2.1 percentage points (EPOC countries), resulting in energy diversify their energy consumption and increase their energy expenditures that amount to a respective 14, 13 and 30 percent efficiency so as to adapt to a higher tariff environment. of household budgets. Overall, the increases would range from 1.3 to 51.9 percent across all countries in the region. Transitioning households to lower consumption behavior has important distributional implications. Poor households tend to While poorer groups would not be the most seriously affected allocate higher shares of their energy budgets to electricity, due by the price increases in all countries, poverty incidence overall to their limited access to alternative sources such as district would increase significantly across the board. The report esti- heating or gas. While the rural poor might be able to rely on mates that across EU member states, poverty could increase by wood or lower grade fuels to keep their energy budget in check, 5–30 percent. In addition, energy poverty—defined as the share poor households in urban areas might be the most vulnerable to of households that spend 10 percent or more of their budgets on energy increases. Evidence also suggests that energy consump- energy—would rise substantially. tion patterns can remain stable even if tariffs increase, as was the case, for example, in Armenia over the past decade. Social Protection: Helping Vulnerable Households Pay their Bills Given that household tariffs would have to increase significantly to attain cost recovery, more effective policy solutions than those currently in place will be needed to address the social impact of further tariff increases. In addition to generalized tariff subsidies, countries typically have social protection programs aimed at helping vulnerable households pay their energy bills. These programs are common- ly referred to as energy-related social assistance (ESA). Means- tested programs tend to have a higher share of their budgets reaching poorer groups, but lower coverage than other types of programs. Categorically targeted programs, in contrast, gener- ally have much higher coverage, especially if the list of eligible groups is extensive; however, they are often weak at targeting Electrical power lines connecting towns in Southeast Europe KNOWLEDGE BRIEF > www.worldbank.org/eca More comprehensive and sustainable measures are needed to help households adapt to this ABOUT THE AUTHORS higher tariff environment, particularly in a context such as ECA, where many households still use energy inefficiently. One example is the white certificate programs, implemented in France, Italy, the United King- dom, and Australia, which impose specific energy savings obligations on energy suppliers or CATERINA RUGGERI distributors.10 LADERCHI is a Senior Economist in Moving Toward Implementation of an Integrated Policy Agenda the Europe and Central Asia Poverty Reduction and The fiscal costs of maintaining current tariff structures in the face of upward pressures on the Economic Management Unit. costs of energy are clearly unsustainable. Countries will need to move toward higher energy tariffs while simultaneously improving energy social assistance programs and demand-manage- ANNE OLIVIER is a Consultant in the Europe ment tools. Yet, different segments of the population can be covered by different tools. Targeted and Central Asia Poverty social assistance measures can cater to the needs of poor households, for example, while incen- Reduction and Economic tives to increase efficiency can help all households manage their energy demands. The efforts Management Unit. required will vary across the region and some countries may require more transitional measures before being able to effectively implement such an agenda, as not all have targeted social as- CHRIS TRIMBLE sistance programs in place that cover the poor effectively. is an Energy Specialist in the Africa Sustainable Would such an agenda be feasible? Given the large amount of resources that are currently ab- Development Unit. sorbed by energy subsidies, the report shows that most countries would eventually realize fiscal savings by focusing on both targeted energy-related social subsidies and investments in energy efficiency for all households. The result would be savings of over 1 percent of GDP for almost half of the countries in the region, though the estimates vary significantly across countries and are clearly approximations (Figure 4).11 Figure 4. Estimated Net Gains from Removing Subsidies, Compensating Poor Households, and Implementing a Basic Energy-Efficiency Program The findings, interpretations, and conclusions expressed herein are those of the author(s), and do not necessarily reflect the views of the International Bank for Reconstruction and Development /The World Bank and its affiliated organizations, or those of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Conclusion Countries in the ECA region face a difficult balancing act between addressing fiscal and environ- mental concerns that call for raising energy tariffs to lower fiscal burdens and curb household consumption on the one hand, and coping with concerns about energy affordability and the political economy of unpopular reforms on the other. Balancing Act, the new World Bank report, recommends a well-planned transition from tariff-based subsidies to better-targeted social assistance programs and improved demand management tools to increase energy efficiency as part of an affordable policy reform agenda. Specific policy recommendations would need to be tailored to the circumstances of each country. To access the full report, please visit: http://imagebank.worldbank.org/servlet/WDSContentServer/IW3P/IB/2013/06/24/000333037_20130624101834/Rendered/PDF/768200Rev ised00rt0REVISED0JUNE02013.pdf 10 World Bank, 2012 Overall, these are rather conservative estimates, as they do not factor in the energy-saving effects of the energy-efficiency measures discussed 11 above. In other words, savings could be realized even if the protracted investment in energy efficiency that would be required to bring down con- sumption took time to materialize. “ECA Knowledge Brief” is a regular series of notes highlighting recent analyses, good practices, and lessons learned from the development work program of the World Bank’s Europe and Central Asia Region http:/ /www.worldbank.org/eca KNOWLEDGE BRIEF > www.worldbank.org/eca