37199 310 privatesector P U B L I C P O L I C Y F O R T H E NUMBER NOTE 2006 Phasing Out Subsidies AUGUST Robert Bacon and Recent Experiences with Fuel in Developing Countries Masami Kojima Many developing countries subsidize petroleum products. The doubling PRESIDENCY Robert Bacon of world oil prices since January 2004 has had very high fiscal costs (rbacon@worldbank.org) VICE is a consultant, and for these countries, increasing public debt and squeezing other Masami Kojima government spending. The subsidies have also had unintended (mkojima@worldbank.org) a lead energy specialist, consequences: fuel adulteration, smuggling, and benefits that go in the World Bank's Oil, mostly to the better-off. But phasing out subsidies is politically DEVELOPMENT Gas, and Mining Policy challenging. This Note reviews some successful strategies for removing Division. or reducing subsidies while protecting the poorest consumers. SECTOR The large and sustained increase in interna- The government of Thailand introduced price PRIVATE tional oil prices since late 2003 has led many ceilings on petroleum products in January 2004. developing countries to adopt pricing policies Expecting that the price increase would be AND to protect users from the full impact. In a world- short-lived, the government initially estimated wide sample of 38 developing countries during that the price control would last no more than the period January 2004­May 2006, 14 coun- two months and that the fiscal cost would be at FINANCIAL tries suspended market-based pricing that most US$128 million. By the time it removed linked domestic to international prices (for one the subsidies--in October 2004 for gasoline and or more fuels).1 They joined 12 others that had in July 2005 for diesel--the bill had reached already controlled prices, keeping them at lev- US$2.2 billion. In the Arab Republic of Egypt els that, by 2005, were below the international the estimated cost of the subsidy on petroleum GROUP equivalent. In addition, 23 countries reduced products during the fiscal year ending June taxes on petroleum products to help offset the 2006 was revised upward to US$7.1 billion in BANK higher costs (ESMAP 2006). February. And in Indonesia the government's Many of the subsidy schemes were prompted cost in 2005 was close to US$10 billion. in part by incorrect assumptions about how By mid-2006, with world oil prices having large the price increase would be and how long more than doubled since the beginning of WORLD it would last. So while the fiscal effects of the 2004, net oil importers had all concluded that policies have varied, for some governments they large fuel subsidies were unsustainable. So had THE have been unexpectedly large and protracted. some major oil exporters that were having to P H A S I N G O U T S U B S I D I E S R E C E N T E X P E R I E N C E S W I T H F U E L I N D E V E L O P I N G C O U N T R I E S import refined products because years of subsi- ing it with kerosene. This leads to a substantial dies had led to undercapitalization of their leakage of the kerosene subsidy. refining sector. A study of household surveys conducted in 1993/94 and 1999/2000 in India suggests that as Unintended consequences much as half of subsidized diesel was diverted to Subsidizing fuels has high costs. Moreover, uni- the automotive diesel and other sectors. This versal price subsidies almost always benefit high- leakage cost the government close to US$1 bil- income households more than the poor, because lion in fiscal 2000 (ESMAP 2003). These lucra- richer households consume more energy. Other tive but illegal activities enable criminal elements 2 adverse consequences include rampant abuses in to flourish. Some become extremely powerful, as fuel markets (Kojima and Bacon 2001) and an recent events in Iraq illustrate. inefficient downstream petroleum sector lan- Because petroleum products are easy to store guishing for need of reform. and transport, another problem arises where a To provide a subsidy, a government must neighboring country charges higher prices. Fuel increase its borrowing, raise additional revenue price subsidies then create a strong incentive to elsewhere, or reduce spending on other public smuggle out the subsidized fuel for resale at these goods. If the subsidy is used to stabilize or lower higher prices, as governments of Argentina, the final prices, it frees consumers from having to Islamic Republic of Iran, Iraq, Kazakhstan, adjust their purchasing behavior to the costs of Malaysia, Nigeria, República Bolivariana de supply, instead giving them financial incentives Venezuela, and Vietnam can attest. This results in to overconsume the subsidized commodity. The higher apparent demand and the transfer of ben- result is the well-known deadweight loss. efits to inhabitants of the neighboring states. Using a reduction in taxes to lower final Another adverse consequence is suffered by prices, because it leads to a loss of revenue, sim- the downstream oil sector. An essential part of ilarly requires a government to raise additional improving sector efficiency is the introduction of revenue or reduce other public spending. If tax relentless but fair competition. Subsidies deter rates were set near the optimal level overall firms from entering the market--as in Nigeria before the price rise, this policy also results in a and Sri Lanka, for example. Without new loss of welfare. entrants and the infusion of capital, the sector The relative sizes of subsidies for different becomes increasingly inefficient, undercapital- petroleum products also matter. Many govern- ized, and, in some cases, corrupt. In the long run ments provide larger subsidies for diesel and, governments and consumers pay a high price. even more so, for kerosene than for gasoline. The rationale is that diesel is used economywide--in Policies to remove or reduce subsidies goods, public transport, agriculture, fishing, and Historically, in countries where fuel prices are in some cases electricity generation--while controlled and subsidized by the government, kerosene is used for lighting and cooking by poor price increases have often met with broad oppo- households. By contrast, gasoline tends to be con- sition from civil society and trade unions. sumed by better-off households. Consider the violent demonstrations against This approach helps target the subsidies in fuel price hikes in Indonesia, Nigeria, and theory and can reduce the overall costs. But Venezuela. Since the end of 2003 several gov- diesel is primarily a transport fuel and con- ernments have attempted to reduce subsidies. A sumed more (directly and indirectly) by middle- few have been able to do so without much oppo- and high-income households than by the poor sition. Some have felt that their political posi- in many developing countries. The result is a tion was too weak to risk opposition and have leakage of the diesel subsidy to higher-income kept fuel prices frozen or increased them very groups. In addition, where the subsidy for little. kerosene is substantially larger than that for This experience points to the need for gov- diesel--as it is in many developing countries-- ernments to find a way of defusing potential there is an incentive to adulterate diesel by mix- opposition to removing or reducing subsidies. Two policy measures have been used to do so: Table Average retail price ratios for fuels I Providing targeted subsidies or compensation. 1 I Using an effective publicity campaign. Fuels Price ratio Providing a larger subsidy or lower tax rate Diesel/kerosene 1.3 for kerosene than for other fuels is the most Gasoline/diesel 1.3 common way to target subsidies to lower-income Gasoline/kerosene 1.6 households. The international market prices (net of taxes and transport costs) for diesel, Note: The table reflects the most recent price information for 27 developing countries for which data were available. kerosene, and gasoline are very similar. In the Source: ESMAP 2006. 3 sample of developing countries, however, many governments, through taxation (and subsidy) US$1.24­2.48 a month to offset the rising costs policy, ensure that kerosene is sold at a discount of liquefied petroleum gas. And in October relative to diesel and at a sizable discount rela- 2005 the government of Indonesia launched an tive to gasoline (table 1). Maintaining markedly ambitious cash transfer scheme to compensate different price levels for similar fuels results in for raising product prices by an average of 114 significant adulteration. percent, though the final level was still below Another way to target subsidies is to issue international market prices (box 1). vouchers or smart cards that permit users to buy Indonesia shows how an effective public rela- a limited amount of certain fuels at a reduced tions campaign, coupled with general trust in price. The smart card can be limited to certain the government, can help achieve public accept- classes of users, for differing amounts of fuel. ance of large price increases. In January 2003 Malaysia recently began using smart card systems the previous administration had attempted to for public transport vehicles and fishing boats. increase prices amid widespread public dis- A different approach to protecting lower- satisfaction with the government and with the income households involves removing subsidies corruption and inefficiency perceived to be per- while providing targeted compensation, through meating the political life and bureaucracy. A a cash transfer or benefit in kind, to protect these public outcry led the government to roll back households from the impact. If targeting is rea- much of the diesel price increase. By contrast, sonably accurate and administrative costs rela- in 2005 the current administration more than tively low, this approach is likely to be the most doubled gasoline and diesel prices and nearly efficient in nearly all circumstances. But that tripled the kerosene price with no substantial requires two things. First, there must be a rea- sonably accurate list of low-income households to Box Launching a cash transfer scheme in Indonesia ensure that only the needy, and most of the 1 needy, are compensated. Second, there must be Before raising fuel prices in October 2005, the government of Indonesia put into place a cash transfer a low-cost mechanism for transferring the cash or scheme targeting 15.5 million poor and near-poor households (some 28 percent of the population). benefits to these households, or administrative The transfers, quarterly payments of about US$30 per household, are to be continued for one year. costs could outweigh the benefits of targeting The scheme was widely publicized--through newspapers, village notice boards, television talk shows, compensation. and pamphlets with answers to frequently asked questions. Several countries have used some variation of Though prepared quickly, the program has performed well. The rapid rollout was followed by many media reports about initial problems, including mistargeting and leakage. The government responded this approach. In 2005 Chile made a one-time quickly, commissioning an early assessment of the program. The assessment pointed to satisfactory payment of US$28 to low-income households to results overall, with transfers on time and beneficiaries expressing satisfaction. compensate for higher fuel prices and provided For poor recipients the cash transfers more than compensate for the fuel price increase. Even with extra cash compensation to 1.4 million house- moderate mistargeting--with cash benefits randomly distributed to the poorest 40 percent rather holds consuming less than 150 kilowatt-hours of than the targeted 28 percent--the program is expected to prevent an increase in poverty due to the electricity a month. In 2006 it announced price increase. another round of cash transfers, US$35 to 1.25 Thanks to the government's efforts, the sharp rise in fuel prices passed without major public million families living on less than US$350 a protest. month. For a short period in early 2006 some provinces in China gave poor residents Source: ESMAP 2006. P H A S I N G O U T S U B S I D I E S R E C E N T E X P E R I E N C E S W I T H F U E L I N D E V E L O P I N G C O U N T R I E S opposition, thanks to a cash compensation Conclusion scheme coupled with the government's greater Fuel price subsidies help the poor, but at a large popularity and its public relations campaign. cost to society and to governments. Governments Some governments considering removing should look for opportunities to move away from or reducing subsidies have promised to fuel price subsidies as rapidly as possible and viewpoint increase social spending as compensation, par- replace them with targeted assistance to the poor. ticularly where the spending might support Preparatory work to identify beneficiaries and lower-income households. Two actions can design efficient ways to deliver assistance should is an open forum to increase the effectiveness of this strategy. First, be given high priority, especially since high oil encourage dissemination of demonstrating to civil society that the present prices are likely to continue in the coming years. public policy innovations for subsidies benefit mainly the better-off. And sec- private sector­led and ond, improving social spending in a way that is market-based solutions for transparent, immediate, effective, and pro- development. The views poor. Ghana provides an instructive example: Note published are those of the it combined prior analysis of which groups 1. The 38 countries are Argentina, Bangladesh, authors and should not be were benefiting most from the subsidies with a Brazil, Cambodia, Cameroon, Chile, China, the Arab attributed to the World campaign publicizing the measures that would Republic of Egypt, Ethiopia, Ghana, Guatemala, Bank or any other affiliated be used to compensate for removing the subsi- Honduras, India, Indonesia, Kazakhstan, Kenya, the organizations. Nor do any of dies (box 2). Kyrgyz Republic, the Lao People's Democratic Republic, the conclusions represent Madagascar, Malawi, Malaysia, Mexico, Morocco, official policy of the World Mozambique, Nicaragua, Nigeria, Pakistan, the Bank or of its Executive Box Removing subsidies in Ghana Philippines, Rwanda, Senegal, Sri Lanka, Tanzania, Directors or the countries 2 In 2004, when it became apparent that world oil Thailand, Tunisia, Uganda, República Bolivariana de they represent. prices were unlikely to come down much and that Venezuela, Vietnam, and Zambia. Ghana could not maintain for long its policy of subsi- To order additional copies dizing petroleum products, the government launched a References contact Suzanne Smith, poverty and social impact assessment (PSIA) for fuel. ESMAP (Energy Sector Management Assistance managing editor, Guided by a steering committee of stakeholders from Room F 4K-206, Programme). 2003. "India: Access of the Poor to Clean ministries, academia, and the national oil company, the The World Bank, Household Fuels." Report 263/03. Washington, D.C. PSIA was completed in less than a year. By the time 1818 H Street, NW, ------. 2006. "Coping with Higher Fuel Prices." the government announced the 50 percent price Washington, DC 20433. Report 323/06. Washington, D.C. increases in February 2005, it could use the PSIA find- ings to make its case for liberalizing fuel prices to the Kojima, Masami, and Robert Bacon. 2001. "Abuses in Telephone: public--including the fact that the price subsidies Fuel Markets: How to Protect Consumers and Public 001 202 458 7281 most benefited the better-off. Health." Viewpoint series, Note 237. World Bank Group, Fax: The minister of finance launched the public relations Private Sector Development Vice Presidency, Washington, 001 202 522 3480 campaign with a broadcast explaining the need for the D.C. Email: price increases and announcing measures to mitigate ssmith7@worldbank.org their impact. A series of interviews with government officials and trade union representatives followed. The Produced by Grammarians, Energy Ministry used newspaper advertisements with Inc. charts to show that Ghana's fuel prices were the lowest in West Africa after Nigeria's. The mitigation measures, transparent and easily Printed on recycled paper monitored by society, included an immediate elimina- tion of fees at government-run primary and junior sec- ondary schools and a program to improve public transport. While the trade unions remained opposed to the price increases, the public generally accepted them, and no large-scale demonstrations occurred. Source: ESMAP 2006. T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l