Time is of the essence: can Indonesia phase out energy subsidies without hurting the poor?

Subsidies were not reaching the poorest
Subsidies were not reaching the poorest

Today’s post is by Maroussia Klep of the OECD Environment Directorate

Indonesia enacted a major reform recently. On 1 January, President Joko Widodo followed through with his electoral promise to cut decades-long subsidies for energy products. Many leaders had tried before him, but retreated in the face of fierce resistance from the people. Thanks in part to low oil prices, the newly-elected President got the reform through without much trouble. The true challenge will be how to support poor households when prices start rising again.

If the President holds strong on this reform, benefits can be great for Indonesia. Fossil-fuel subsidies introduced by the government in the 1970s recently hit nearly $20 billion a year. This amount, which represents 20% of the public budget, could be used for development and poverty alleviation if the reform succeeds. Removing the subsidies was even more justified as they were not reaching the poorest households who can neither afford electricity, nor consume products such as gasoline.

A new OECD publication supports these claims. The study highlights notable economic and environmental benefits of phasing out fossil-fuel subsidies in Indonesia. Interestingly, the study is based on the context that pertained until mid-2014, when international oil prices where high and before the recent phase-out of subsidies by the government. With a total removal of subsidies, it is estimated that up to 0.7% GDP growth and 1.6% welfare gains for consumers could be generated by 2020 through a more efficient allocation of resources.

The report also highlighted potential environmental benefits from such reforms, which would incentivise a decrease in energy consumption and thereby a reduction in greenhouse gas (GHG) emissions and local air pollution. Other uncertain environmental impacts may follow, which could be positive such as the development of new renewable solutions, or less desirable such as an increase in deforestation coming from substituting wood for kerosene.

But next to the overall impacts for the country as a whole, a sudden increase in energy prices due to the removal of subsidies may have significant effects on households. As highlighted by OECD Secretary General Angel Gurria: “for this [the removal of fossil-fuel subsidies] to succeed, we need well-targeted, transparent and time-bound programmes to assist poor households and energy workers who might be adversely affected in the short-term.”

The new report aims to answer this key question: what redistribution scheme could be put in place in order to make sure that the reform favours low-income households? Three possible scenarios are explored.

Under a first scenario, the reform is compensated by unconditional cash payments paid by the government to every household. This type of programme is not easy to implement but could help reduce relative inequalities.

A second possibility for the government would be to provide payments to households in proportion to their labour income. However, in Indonesia, poor people often work in the informal sector and would therefore not be eligible for the transfers. Thus such a policy could mostly benefit the wealthy.

Finally, a third option would be to translate savings from the reform into new subsidies, for example for food products. This policy would primarily benefit the poor given their proportionally higher spending on food. However, at the economic level, this option appears less efficient.

As often in OECD reports, no single policy recommendation can be drawn. This is because several compensation policies should probably be combined together for achieving best results. Besides, while the three scenarios identified are common options, there are of course other ways to ensure a fair and efficient subsidy phase-out. The government may for example decide to use savings from the subsidy cuts for expanding public services and investments in education or health care.

Time is now of the essence for the President. When the government reflects on how to best reallocate resources, external events may well play a decisive role in the success of recent reforms. If a new surge arises in international oil prices, the shock will be much harder to bear for poor households in the absence of solid and sustainable compensation programmes. Today, Indonesia has the opportunity to demonstrate that economic welfare and environmental protection can also benefit the poor.

Useful links

OECD work on fossil fuel subsidies

The IEA’s interactive fossil fuel subsidy world map

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