Economic Research Forum (ERF)

Energy subsidy reform: progress and challenges

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Despite a growing global consensus about the need for reform of costly and environmentally damaging energy price subsidies, many countries remain resistant. This column takes stock of recent developments in the context of a database of diesel prices. Environmental concerns seem to play a role in driving reform, but most reforming countries have been facing large fiscal imbalances.

In a nutshell

The sharp drop in international energy prices provides an opportunity for energy importers to remove their subsidies, while putting pressure on energy exporters to reform their subsidies.

Energy subsidy reforms that are driven by long-term factors, such as environmental concerns, are likely to endure.

Reforms that are mainly driven by fiscal imbalances may not last unless they are accompanied by deeper reform measures.

Energy subsidies are fiscally costly; they crowd out productive public spending; they damage the environment; and they are a highly inefficient way of distributing income. Yet despite their widely recognised negative consequences, energy subsidies have proved difficult to reform in many countries.

But several recent developments have opened up a window of opportunity for reform. Sluggish global growth has put continued fiscal pressure on many economies. The sharp drop in international energy prices since mid-2014 provides a unique opportunity for energy importers to remove their subsidies, while putting pressure on energy exporters to reform their subsidies as energy revenues fall.

The fact that over 190 countries submitted proposals for reducing greenhouse gas emissions for the Paris Agreement on climate change creates an additional impetus for change. And there is a growing consensus on how best to reform energy subsidies in a way that can help to mitigate the social and political impacts.

To take stock of recent developments in energy subsidy reform, we have examined an energy price database for diesel, a fuel that is often the central focus of reform and the prices of which are readily available.

International diesel prices have experienced increased volatility since the end of 2006, with the most recent sharp decline starting around mid-2014. Measures of ‘pass-through’ – the ratio of changes in domestic prices divided by changes in international prices – can help us to understand how countries around the world have responded to changes in international prices.

Pass-through has varied substantially across regions, largely reflecting differences in energy pricing regimes. In the Middle East, North Africa, Afghanistan and Pakistan, pass-through has been lower than anywhere else. Many countries in the region administratively set energy prices, often at levels substantially below international prices, and rarely change them much in response to international price movements. Since many countries have not fully passed through the drop in international prices, energy subsidies – that is, the extent to which domestic energy prices are below international supply costs – have declined.

Country-specific experiences provide additional insights on the impetus for energy subsidy reforms. While pass-through measures provide information on the evolution of energy prices, they may mask important developments in energy subsidy reforms. A large number of countries have actively reformed their subsidies since mid-2014 by raising energy prices – in contrast to the passive partial pass-through of falling international prices – and also by introducing automatic pricing mechanisms or by liberalising their energy markets.

Several important themes emerge from the details of the subsidy reforms in these countries. The first is that recent reform efforts have been concentrated in oil-exporting countries, including some that have traditionally been stalwart energy subsidisers. This is mainly driven by declines in oil revenues, which force oil-exporting countries to consider broad fiscal reforms including energy subsidy reform. While some of these exporters initiated small fuel price increases prior to 2014, they have intensified their efforts in response to lower oil prices.

A second theme is that most of the countries that implemented reforms faced large fiscal imbalances. While almost all countries that initiated energy subsidy reform had a fiscal deficit at the start of the reform, fiscal deficits in recent reform countries tend to be particularly larger and more concentrated in oil-exporting countries. This suggests that fiscal imbalances are likely to be one of the main reasons for energy subsidy reform and could have important implications for the durability of reforms.

The third theme is that environmental concerns are an important driver of energy subsidy reform in some countries. This includes countries that recently introduced a carbon tax, raised carbon prices on top of the European Union’s emissions trading system or introduced their own emissions trading systems.

The final theme is that recent reforms tend to be better designed, drawing on lessons from past reforms and best practices. Many of these reforms have built on the key ingredients for successful energy subsidy reform and very few reforms involve only simple, one-time price increases.

A comprehensive communication campaign has been widely adopted as part of the reform strategy; some countries implemented automatic pricing mechanisms or liberalised energy prices to prevent the return of energy subsidies; gradual and phased price increases were adopted by many countries; and many introduced measures to mitigate the impact on the poor, strengthen the social safety net and/or invest in health and education spending. In addition, some oil-exporting countries have considered energy subsidy reform as part of a broader economic reform to reduce their oil dependency.

A key concern is whether subsidies will re-emerge once international prices start to increase. There are some encouraging signs, but questions remain over the extent to which these reforms can be sustained. Not all the declines in international energy prices have been passed through to domestic prices in many developing economies and, as a result, energy subsidies have declined.

Reforms that are driven by long-term factors – such as environmental concerns – are likely to endure since these factors will not disappear in the near future. In addition, many recent reforms have been better designed to address their social and economic impacts and therefore are less likely to be reversed.

On the other hand, reforms that are mainly driven by fiscal imbalances may not last as these conditions are temporary unless they are accompanied by deeper reform measures, such as adoption of an automatic fuel pricing mechanism or even liberalisation.

Authors’ note: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

A longer version of this summary is available at VoxEU.

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