The Fuel Subsidy Debate:

Placing all the cards on the table

By Oluwole O. Adesina, PhD

As the news broke that the Nigerian government has decided to remove the oil subsidy effective January first, I wondered how I could simply explain the word “SUBSIDY” to my mother and some elders in my community. All they know is that government took away subsidy on petroleum products and that caused an increase in price from N65 to N142. How this can help or hinder growth of the country is not completely known or clarified.

Some other words for subsidy can be: Aid, Grant, Funding, Support, and Discount. I decided to use the word “discount” to explain subsidy to my mother and some elders in my community so that they can understand the concept completely. Thus this work is just to shed more light on the pros and cons of fuel subsidy, I am totally neutral on the subject however, I just want to share what recent research says on fuel subsidies, its economic and social impact and let readers decide on which side to swing either to the left or to the right.

Nigeria has over 159 million inhabitants. It covers an area of 924,000 square kilometers. Abuja, the Federal capital since 1991, has a population of more than one million. English is Nigeria’s official language, although many local languages such as Hausa, Yoruba, Igbo and Ijaw are also spoken. Major resources in Nigeria include petroleum, natural gas, tin, iron ore, coal, limestone, niobium, lead, zinc and arable land. The capital-intensive oil sector provides 20 per cent of our country's gross domestic product, 95 per cent of foreign exchange earnings, and about 65 per cent of budgetary revenues.

Oil was first discovered in Nigeria in 1956 at Oloibiri, in Nigeria’s Bayelsa State and since then Nigeria has been able to join world leaders in oil production and eventually became a member of Organization of Oil Exporting Countries since 1971. Other members include: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. The secretariat or headquarters of OPEC has been located in Vienna Austria since September 1965.

The Secretary General is the legally authorized representative of the Organization and Chief Executive of the Secretariat. In this capacity, he administers the affairs of the Organization in accordance with the directions of the Board of Governors. The current holder of that office is Abdalla Salem El-Badri. The Nigerian representatives in this organization are: Mrs. Diezani Alison-Madueke; Minister of Petroleum Resources, Eng. Goni Musa Sheikh as the governor for OPEC/Chairman of the Board of Governors, and Mr. Suleman Ademola Raji as National Representatives (OPEC 2012)

There have been many researches on subsidy reform and how it affects a country; the economic, environmental, and social impact of removing subsidy at a global level (Burniaux et al., 2009; Koplow, 2009). In developed and developing countries, subsidies to the production and consumption of fossil fuels exist in a wide variety of forms including direct budgetary transfers, tax exemptions and price controls.

Subsidies can be justified in theory if they promote an overall increase in social welfare. However, the consensus of expert opinion is that fossil-fuel subsidies have a net negative effect, both in individual countries and on a global scale (Von Moltke et al., 2004).

According to Jenifer Ellis 2010, removing fossil-fuel subsidies is considered by many to be a win-win policy measure that would benefit both the global economy and the environment and therefore a “no regret” option for climate-change mitigation (Burniaux et al., 2009). In theory, eliminating fossil-fuel subsidies would result in higher fossil-fuel prices in countries that currently subsidize consumer prices, which would reduce consumption and thereby Green House Gas (GHG) emissions. At the same time, removing subsidies would remove a costly drain on the government budget. Consequently, eliminating subsidies to fossil fuels may be one of the most cost effective and least distortionary options available to governments for reducing their GHG emissions.

However, governments contemplating fossil-fuel subsidy reform should carefully evaluate the environmental and economic benefits of doing so. It is possible that reforms could provoke some unintended negative environmental effects. In some poorer countries, for example, the sudden removal of subsidies for cooking fuels could lead to a reliance on biomass for cooking and heat in some areas, increasing pressure on forests and negatively affecting indoor air quality (Von Moltke et al., 2004). And at a global level, subsidy removal could result in downward pressure on international prices of fossil fuels, resulting in increases in consumption in regions not subject to a cap on GHG emissions.

In addition, there is concern that subsidy removal could have adverse social impacts, or that the social benefits may not be fairly distributed. Pearce and von Finckenstein (2000) observe that, by their very nature, subsidies redirect economic rents to certain stakeholders. Thus subsidy removal could, in the short-term, create some economic losers.

The International Energy Agency (IEA, 1999) notes that even if there are some losers from subsidy reform, solutions that increase overall net economic and environmental well-being should still be implemented, and measures to compensate the losers considered. The money saved from subsidies could, in theory, be redirected to transfers or social programs that are better targeted for the poor.

The timing and speed of reform is also critical. Many countries that have eliminated food or fuel subsidies in recent years have experienced large-scale civil unrest (Coady et al., 2006). For example, when the Government of Indonesia dramatically raised fuel prices twice in 2005—thereby escalating the prices of food and commodities—demonstrators took to the streets throughout the country, with mobs burning tires and effigies, and throwing stones in protest.

According to recent study conducted by Jennifer Ellis (2010), the major economic, and social and impact of fuel subsidy reform are:

Economic Impact

The precise economic impacts of fossil-fuel subsidies are in part related to whether they take the form of:

a) producer supports that lower prices for consumers by lowering production costs for producers;

b) consumer supports that lower prices for consumers but also reduce returns for producers; or,

c) price support, which increases revenues for producers but increases prices for consumers.
 

For example, subsidies that lower the cost of fossil fuels generally increase the consumption of fossil fuels and sometimes demand (if the fuels are not available to consume), which in turn generates a whole range of additional economic impacts. The level of subsidies for each type of fossil fuel also distorts interfuel substitution decisions. For example, in the 1990s, subsidies for coal fostered excessive production in many developed countries, and excessive consumption of coal in many developing countries (Anderson and McKibben, 1997).

1.    Subsidies can increase energy consumption and reduce incentives for energy efficiency. Subsidies that reduce prices for consumers promote higher consumption of energy, and reduce incentives to use energy efficiently. Subsidies that reduce production costs for producers reduce producer incentives to minimize costs and increase efficiency (Morgan, 2007).

2.    Subsidies can decrease foreign exchange revenues. Subsidies that encourage greater consumption reduce export opportunities for fossil-fuel-producing nations and revenues from those lost exports (Birol et al., 1995; de Moor, 2001).

3.    Subsidies are a drain on government finances through direct financial transfers from government budgets, government expenditures on infrastructure or research and development or reduced government income from taxation. This can lead to fiscal deficits and debt accumulation

4.    Subsidies can increase countries dependence on imports. Subsidies that increase fossil-fuel consumption in non-fossil-fuel-producing countries increase those countries’ dependence on imports.

5.    Subsidies undermine investment in alternative energy sources and alternative energy technologies. By increasing consumer demand for fossil fuels, or decreasing production costs for producers, subsidies distort the market and reduce investment in alternative energy sources or alternative energy technologies that are potentially more efficient or less environmentally harmful (Varangu and Morgan, 2002).

6.    Subsidized fuels are used for purpose for which they were not intended. By lowering prices for certain fuels, subsidies can result in misuse of those fuels for purposes that were not intended. For example, in India and Indonesia subsidized kerosene intended for household cooking has been used illegally or as a cheap addition to transport fuel (Committee on Pricing and Taxation of Petroleum Products, 2006).

7.    Subsidies can promote smuggling and corruption. Subsidies that lower prices for consumers but also lower returns to producers can encourage smuggling of the fuels to countries where prices are higher. This has occurred in Africa and Indonesia and benefits those selling the fuels while having negative economic impacts for the country as a whole (Clements et al., 2003). Corruption is another common consequence when fuels are subsidized and scarce as attempts are made to control distribution channels, in the case of LPG and kerosene.

Social Impact

Subsidies to fossil fuels, particularly those that keep down the price of liquid fuels, natural gas or electricity, are often justified in non-OECD countries on the basis that they benefit the poor and reduce the cost of living (IEA, 1999). There is an argument to be made for subsidies of this kind, particularly with respect to electricity, which is considered key for reducing poverty and indoor air pollution (Varangu and Morgan, 2002). However subsidies do not always accomplish this, and may not be the most efficient mechanism for poverty alleviation. Subsidies may be regressive, benefiting middle- and upper-income groups more than lower-income groups. Direct transfers to target groups rather than general subsidies may be more effective in reducing poverty.

1.      Subsidies may benefit the rich more than the poor, who spend more money on energy and have greater access to energy than the poor (Clements et al., 2007; UNEP, 2008). A study by the World Bank (2008) found that the bottom 40 per cent of the income distribution receive only 15 to 20 per cent of fossil-fuel subsidies. Even when the rate of energy consumption by the poorest quintiles increases as a result of subsidies, the wealthy derive larger absolute benefits from lower energy prices (World Bank, 2008).

2.      Subsidies may reduce energy available to the poor because in an artificial low price environment, producers may have little incentive to produce or supply more, and a higher percentage of what is produced may be consumed by the rich (UNEP, 2008).

3.      Subsidies often do not target types of energy that would be more beneficial to the poor.  Subsidies may favor larger capital-intensive projects, such as dams or power plants, at the expense of local labor intensive means of providing energy services (IEA, 1999). Power plant and dam construction can displace or create negative environmental impacts that primarily affect poor communities, while not improving their access to energy.

4.      Subsidies may divert government money that could be more effectively directed to social program such as healthcare, free education, food coupons or targeted cash transfers.

5.      Fossil-fuel consumption and production produce local emission that cause many health effects that impact the poor in particular, due to their more limited choices regarding where they live (Von Moltke et al., 2004).

References

Anderson, K. and McKibben, W.J. (1997). “Reducing Coal Subsidies and Trade Barriers: Their Contribution to Greenhouse Gas Abatement.” Seminar Paper 97-07. Centre for International Economic Studies, University of Adelaide: Adelaide, Australia.

Birol, F., Aleagha, A.V. and Ferrouki, R. (1995). “The economic impact of subsidy phase out in oil exporting developing countries: a case study of Algeria, Iran and Nigeria.” Energy Policy . 23(3):209-215.

Burniaux, J.-M., Chanteau, J., Dellink, R., Duval, R. and Jamet, S. (2009). “The economics of climate change mitigation: How to build the necessary global action in a cost-effective manner.” Economics Department Working Papers No. 701.

Clements, B., Jung, H.-S. and Gupta, S. (2007). “Real and Distributive Effects of Petroleum Price Liberalization: The Case of Indonesia.” Developing Economies. 45(2): 220-237.

Coady, D., El-Said, M., Gillingham, R., Kpodar, K., Medas, P. and Newhouse, D. (2006). “The Magnitude and Distribution of Fuel Subsidies: Evidence from Bolivia, Ghana, Jordan, Mali and Sri Lanka.” IMF Working Paper.

Committee on Pricing and Taxation of Petroleum Products. (2006). Report of the Committee on Pricing and Taxation of Petroleum Products . India.

de Moor, A. (2001). “Towards a Grand Deal on subsidies and climate change.” Natural Resources Forum , 25(2):167-176.

International Energy Agency (IEA). (1999). World Energy Outlook 1999: Looking at Energy Subsidies –Getting the Prices Right . International Energy Agency: Paris.

Jeniifer Ellis (2010). The Effects of Fossil-Fuel Subsidy Reform: A review of modeling and empirical studies.

Koplow, D. (2009). Measuring Energy Subsidies Using the Price-Gap Approach: What does it leave out?

Morgan, T. (2007). Energy Subsidies: Their Magnitude, How they Affect Energy Investment and Greenhouse Gas Emissions, and Prospect for Reform . Menecon Consulting.

OPEC (2012). Nigeria membership. Retrieved on January 2^nd 2012http://www.opec.org/opec_web/en/about_us/167.htm

Pearce, D. and von Fincklestein, F. (2000). “Advancing Subsidy Reform: Towards a Viable Policy Package.” Finance for Sustainable Development: Testing New Policy Approaches , Background Paper 15, UN CSD 8th Session (24 April – 5 May 2000).

United Nations Environment Program (UNEP). (2008). Reforming Energy Subsidies: Opportunities to Contribute to the Climate Change Agenda.

Varangu, K. and Morgan, T. (2002). Defining and Measuring Environmentally-Harmful Subsidies in the Energy Sector. OECD.

Von Moltke, A., McKee, C. and Morgan, T. (2004). Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms. Sheffield: Greenleaf Publishing.

World Bank. (2008). Climate Change and the World Bank Group: Phase I: An Evaluation of World Bank Win-Win Energy Policy Reforms.  World Bank: Washington, DC.