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

Fossil fuel subsidies: billions up in smoke?

Click to read the report online
Click to read the report online

On a visit to Scotland in 1435, Aeneas Sylvius, the future Pope Pius II, saw many marvellous things, but as he wrote in his journal, the most astonishing was how “the poor, who almost in a state of nakedness begged at the church door, depart with joy in their faces on receiving stones as alms!” Like most Europeans at the time, the pre-Pope didn’t know what coal was, but once he heard the explanation, he saw that the monks were doing a good deed by helping the poor to heat their hovels.

These days, he may have been astonished to learn that often it’s the other way round. German taxpayers for instance gave 2 billion euros to coal producers in 2011. Poland’s coal producers got 7 billion euros over 1999-2011. These are just a couple of examples of the 550 measures that support fossil-fuel production or use in the OECD’s 34 member countries.  These measures had an overall value of $55 to $90 billion a year in 2005-2011 according to a new OECD report, Inventory of Estimated Budgetary Support and Tax Expenditures for Fossil Fuels 2013.

Despite the many benefits for the environment and public finances of reforming fossil-fuel subsidies, lack of information regarding the amount and type of support measures in place makes it difficult to design and apply policy efficiently. Usually, lack of data is associated with developing counties, but in this case the culprits include OECD members. The International Energy Agency (IEA) has been producing data on fossil-fuel consumer subsidies in emerging and developing countries for several years using an estimation approach known as the “price-gap” method. This measures the extent to which a policy keeps domestic fuel prices below an international reference price. According to the IEA’s 2012 World Energy Outlook, fossil fuel subsidies amounted to $523 billion in 2011, up almost 30% on 2010 and six times more than subsidies to renewables.

However, the IEA approach does not capture support to producers and tax concessions to producers and consumers. The new report does, and you can download the data for each country or consult a country overview here.

Lack of data isn’t the only difficulty facing reform. There is a problem of political economy you’ll find in many other cases too. Those who stand to lose from the reform may be significantly worse off and feel the impact immediately. Benefits on the other hand may be more long term and not amount to much when spread over the whole population. Moreover, those seeking to block reform are often better informed and better organised than the reformers.

That said, there are a number of examples of successful reform. The figure of 2 billion euros to the German coal industry actually represents a significant drop from the 5 billion the industry got in 1999. Much of the money Poland is now paying is associated with historical liabilities, and since 2011 the country has to follow EU regulations that only authorise state aid for the purpose of closing mines, treating damage to miners’ health, and addressing environmental problems from past mining.

The OECD report cites a number of other examples of successful reforms, and identifies a number of common characteristics of programmes that work. First, improve the availability and transparency of support data. Apart from informing the debate, this helps to identify where support is helpful and where it’s not. (The report itself insists that  it “does not analyse the impact of specific measures or pass judgement on which ones might be usefully kept in place, and which ones a country might wish to consider for possible reform or removal.)

Second, some people are going to suffer from subsidy removal, so provide them with financial if needed.

Third, where possible, integrate the subsidy reforms into a package that includes broader structural reforms.

And finally: “Ensuring credibility of the government’s commitment to compensate vulnerable groups and, more generally, to use the freed public funds in a beneficial way.” So announcing that you’re cutting pensioners’ heating allowance to help pay bankers’ bonuses may not rally the support you need.

Useful links

Taxing Energy Use: A Graphical Analysis provides the first systematic statistics of effective tax rates – on a comparable basis – for each OECD country, together with “maps” that illustrate graphically the wide variations in tax rates per unit of energy or per tonne of CO2 emissions.

Joint report by IEA, OPEC, OECD and World Bank on fossil-fuel and other energy subsidies: An update of the G20 Pittsburgh and Toronto Commitments” prepared for the G20 Meeting of Finance Ministers and Central Bank Governors (Paris, 14-15 October 2011) and the G20 Summit (Cannes, 3-4 November 2011)