Time to End Fuel Subsidies?

Subsidies distort markets and discourage development of substitutes. Subsidies for fuel are especially problematic, because energy is a backbone of any economy. In terms of energy production and consumption, the world is an uneven playing field in terms of reserves, taxes, regulations, public versus private ownership and income availability. An abrupt end to fuel subsidies would crush the poorest. With few ready alternatives, fossil fuels are highly inelastic products in economic terms – as prices rise, consumption of such necessities do not decline by much. Wealthy countries purchasing oil often set contract terms that benefit a few, and developing countries that are oil rich arrange subsidies as one benefit for the middle class and poor. Subsidies, even in countries lacking energy resources, contribute to political and economic stability. Ending subsidies – without putting alternative support programs into place – only adds to the ranks of the poor and threatens global security. – YaleGlobal

Time to End Fuel Subsidies?

Budgetary balance and need to develop alternatives, are reasons to end fuel subsidies
Will Hickey
Thursday, June 7, 2012

To subsidize or not: As two photos from Nigeria show, world opinion is divided on the merits of fuel subsidies - a women's group supports ending subsidies (top) while others want to maintain them

DAEJEON: Developing countries of Asia and Africa are coming under increasing pressure to balance their budgets by cutting fuel subsidies. Resource-rich countries, too, are pressed to end subsidies as they distort markets. Proponents of alternate energies blame fuel subsidies for discouraging development of new products.

Many in developing countries are living on a subsistence level of US$2 a day. About half of the world’s more than 7 billion people are in that category. For these, a rise in petrol prices of, say 75 cents, could be catastrophic, triggering riots like recent ones in Indonesia and Nigeria. For middle-income people, such a rise is not a severe problem. They can afford it. Yet, ending subsidies has an alarming effect on the poorest in developing countries – affecting every facet of life. Society today is so dependent on fuel that even the poor cannot simply abstain from use. They need it for heating, cooking, generators, crop transport and motorbikes. Fuel is an absolute necessity for economic survival of the poorest.

Theoretically, taking away fuel subsidies would heighten prices on fuel and consumption will go down. A vital economic argument against fuel subsidies is that they inflict a heavy burden on government budgets, add to global warming, pollution and wasteful consumption in general.This, in turn, diverts much-needed resources from more pressing needs, such as health and education.

Practically, however, price elasticity on fuel is very small so that higher prices won’t mean a decline in consumption. For the poorest, fuel is a necessity they can’t be spared.  Rich people can compensate for higher fuel prices with saving less or changing consumption patterns, but they’ll probably consume the same amount of fuel overall. The subsidies are the only tangible benefit the poor can get in normal economies, especially in resource-rich developing countries.

Subsidies are essentially the government buying energy at market prices and reselling it back to citizens at lower prices. Fuel subsidies are generally only possible when a country has windfall revenue in either resources, such as oil in Nigeria, or in trade surpluses, such as China’s.

Countries having scant resources and trade imbalances, such as India, Vietnam and Sri Lanka, however, run persistent budget deficits, reflected in consistently weakening currencies. They do this, of course, for political reasons. China successfully uses fuel subsidies to keep its export machine humming, and continues to do so to ensure growth. In India today, groaning under fuel subsidy of rupees 200,000 crore, US$40 billion, enormous coal reserves in Bihar and Orissa States lie in the hands of the few. India recently took the highly unpopular step of raising gas price in order to reduce its subsidy. Fossil fuel resources are fungible, existent reserves of minerals and should be utilized to address India’s endemic poverty issues.

In all, it’s estimated the developing world spends more than US$400 billion a year on fuel subsidies, according to the International Energy Agency in 2010. 

In Western countries, energy costs are passed directly to the consumer, usually with considerable taxes added on, as in the case of the European Union, the United States and Australia. These countries have higher GDPs than the developing world, and residents can absorb costs without seriously disrupting buying power.

In resource-rich countries, governments often grant foreign investors rights to exploit resources under production-sharing contracts, or PSCs, in oil or work contracts in mining. Briefly written, the production-sharing contracts are made by the investors, typically oil companies, specifying that the sellers, typically developing countries, pay for expenses incurred by the investors in developing the oil fields. The effect of this is that the sellers are not interested in making big payments for other expenses unrelated to direct extraction, for example, education and training of employees.  

PSCs today are largely banned in developed countries as an abuse of bargaining power by international oil companies against unsophisticated government officials. Iran, for example, with the second largest proven oil reserves in the Middle East, refuses to use PSCs.  In some places, such as post-war Angola or Kurdistan, oil interests dictate, via largesse to public officials, how new “investment” rules will be written.

Mining contracts require knowledge of ores and calorie content to be equitably enforced. Of course, mining companies know the legal requirements and their own operations capabilities, thus easily outmaneuvering officials and, in countries where China invests, paying off bureaucrats to look the other way. Corruption and patronage flourish with citizens shortchanged.

Countries facing burgeoning, youthful populations with scant job opportunities, but sitting atop minerals or fossil fuels, simply cannot afford these colonial era economic models. Libya and Nigeria have met with political unrest due to enforcing the PSC model over their unemployed citizenry. Indonesia has recently endured mining strikes in Papua over subsistence wages.

Fuel subsidies work like indirect payments to the citizens as sovereign owners. Under this reasoning, and with no faith in central governments to deliver on employment and growth, as seen in Nigeria, maintaining the subsidy is justified. Sudden removal, as many Western economists and the International Monetary Fund call for, would be too severe a shock for the most vulnerable.

In absence of leadership that will empower, or develop its people, such distribution schemes should be maintained. If governments insist on ending subsidies, they must first discard punitive PSCs and mining contracts that generously provide for foreign investors and leaders that approved them. Existing economic models need be changed to promote a new paradigm: burden sharing.

Unfortunately many economists don’t appreciate the role fuel subsidies play for the poor. Yes, there are alternatives to fuel subsidies, but these require political reform and transparency initiatives. For example, the State of Alaska takes the legal position their citizens effectively own the resources under their borders – namely oil and minerals – and generates a cash windfall each year that’s divided among its residents, about $1000 yearly. This is money from the oil exports freely given to residents to improve their living standards. Also note that in Alaska, oil companies originally fought hard against these reforms. Of course, while Alaska is part of a developed country, the possibility does exist.

The fossil fuel model is alive and well; without innovative alternatives, this will doom the planet and cause more strife in both resource-rich developing countries and countries with scant resources. The world is quickly changing, yet old economic paradigms of rewarding shareholders in the oil industry have failed to connect and empower countries with booming, hungry populations and dwindling resources.


Will Hickey, twice a Fulbright professor of energy and human resources, is an associate professor of management at Solbridge International School of Business in Daejeon, South Korea. He can be reached at whickey@solbridge.ac.kr.

Copyright © 2012 Yale Center for the Study of Globalization