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Ending fuel subsidies

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 seven 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 $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.

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.

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. 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. The fuel subsidy is the only real claim to ownership or bona fide shared interest most people have on resources in their own country.

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

© 2012 Yale Center for the Study of 
Globalisation