The politics of fossil fuel subsidy reform

I have just posted the following as a guest on Duncan Green’s From Poverty to Power blog:

In recent years up to $500 billion a year or more has been spent globally on making high-carbon fuels cheap, with around 40% of that in developing countries, including some of the big emerging economies such as China, India, Indonesia and South Africa.

From a policy perspective, reducing fossil fuel subsidies is a no-brainer. To begin with, they are a kind of negative carbon pricing (i.e. a carbon subsidy). Moreover, most of the benefits by far are captured by the middle classes rather than the poor. The IEA estimates that of $22.5 billion spent by India on fossil fuel subsidies in 2010, less than $2 billion benefitted the poorest 20% of the population. Such patterns are fairly typical – ratios for Indonesia, Thailand, Pakistan and South Africa were similar, and only slightly better for China. As a form of social protection, subsidies are very poorly targeted.

 Subsidies also take up fiscal resources that could be spent on public services or better targeted social protection. In some Indian states in the mid-2000s, as much as 50% of the state budget went on subsidies to (largely coal-fired) electricity. Up until 2009, Indonesia spent more on energy subsidies than on health, education, social security and defence combined.

 Small wonder then that in the run up to this year’s G20 and Rio+20 summits on-line campaigning group Avaaz called for an end to “black subsidies”. The group wanted to see a “climate spring”, launching a petition that would persuade world leaders to phase out fossil fuel subsidies once and for all. Simples.

 Or not so simples. Reform of subsidies has in fact been on the G20 agenda since the Pittsburgh Summit in 2009, but has proved difficult to achieve in practice, despite the fact that large rises in oil prices in recent years have ratcheted up the fiscal costs of maintaining subsidies.

 Where attempts at subsidy reduction or removal have taken place, they have often been reversed within a few years (e.g. Ghana in 2008) or even within a few days (Nigeria in 2012), postponed (Indonesia in 2012), or at best been highly partial (India since the 1990s). Fuel price rises often provoke violent street protests – the most recent example is Sudan, which follows a series of riots this year sparked off by reform attempts in Nigeria in January and Indonesia in March.

 David Victor, a Stanford political scientist working with the Geneva-based Global Subsidies Initiative (GSI) of the International Institute for Sustainable Development, argues that governments give subsidies as part of a political bargain – they are “a visible way to deliver benefits in exchange for political support”, and administratively cheap and easy to deliver compared to alternatives. Once a subsidy is there, it gets locked-in and often increased, as it becomes a key symbol of populist action by successive politicians.

The political role played by subsidies is then key to understanding how a reform package might be more successful. Victor suggests several lessons for reformers. One is that any reform strategy must begin with the political logic that led governments to create the subsidy – powerful interests that currently benefit have to be compensated or reform has to be inoculated from their opposition. A second is that transparency about the costs and purpose of subsidies usually aids reform. Another is that it is very helpful to have available or to develop better administrative tools for redistribution, to replace broad spectrum subsidies, which are a blunt instrument.

 Thus, for example, Ghana’s 2005 reform of fuel subsidy reductions succeeded where previous efforts failed partly because good information about the costs and the incidence of subsidies was widely shared with key stakeholder groups like trade unions. In Indonesia in 2008, a new alternative form of compensation for poor households was introduced in the form of a means tested safety net which allowed subsidy reduction without major protests. The GSI has started to propose reform packages for specific countries based on this explicitly political approach.

 But perhaps one of the most difficult issues in the politics of subsidy reform concerns the compensating measures that are widely seen as necessary to legitimise reform. Even though poor households capture only a small part of the direct benefits of subsidies, the effects of subsidy removal on their incomes is proportionately higher than for better off households. This is partly because of the indirect effects of subsidy reduction or removal – higher fuel costs increases the price of everything that is moved by road, including food. As a result, a key component of reforms is now the introduction of better targeted social protection for the poor. For example, in Indonesia in 2008, following unsuccessful attempts at subsidy reduction in 1998 that led to protests that ultimately toppled the government, a reform programme included a cash transfer scheme called Bantuan Langsung Tunai (BLT) to compensate for the fuel price increase. This was an ambitious scheme designed to reach about a third of the population. Current plans for further subsidy reform, due to be renewed in the autumn, include an updated version of BLT called BLSM. However, the BLT has proven controversial, in large part because the targeting process left the door open to corruption and politicisation of the benefit. Unlike a fuel price, which people can monitor easily, a non-universal benefit is inherently more open to discretion. Unhappiness about the history of BLT is now a big factor in resistance to the current round of reform.

 A possible explanation of what is going on here comes from new institutional economics in the form of a “commitment problem”. If corruption is a major problem, promises to compensate people for the loss of fuel subsidies with a targeted benefit face a big credibility problem. People see that there is no incentive for ruling regimes to eliminate corruption and distribute resources fairly, and there is no impartial third party which can enforce the promise. This partly explains why Nigerian demonstrators held placards saying “Remove corruption, not subsidy”.

 Thus in some situations, while there may be a set of ideal, or “first-best” designs for reforms, these may not be possible, and second-best responses will be more realistic. For example, if compensating targeted benefits are not a credible element of a reform package, then alternatives will have to be considered. These may include consumer food subsidies, which do often have drawbacks, but may not be as damaging as fossil fuel subsidies.

 There is a real need for more research to look at the dynamics of reform from these perspectives. As oil prices rise, as the climate challenge grows, the pressure to resolve the fuel subsidy issue will only increase. It is of course a laughable cliché for an academic to say that “more research is needed”, but this really is an area where a better understanding of the political economy of reform could help bring about practical change that benefits poor people and the environment in a major way.

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One response to “The politics of fossil fuel subsidy reform

  1. The power play of fossil fuel subsidies!

    It seems counterproductive why governments are giving fossil fuel subsidies when the impacts of climate change are more real than ever. Instead of cutting back on the subsidies and then using that money to then intensify more research for greener energy.

    However, the reality is that many countries are addicted to fossil fuel. To the extent when the production of the oil is affected,it has a tremendous effect on the prices of most goods and services. Unfortunately, the worst part is that the poor are the most affect by this.

    On the other hand, the rich are the ones who benefit from the fuel subsidies. Of whom constitute a very small proportion of the economy.

    So,having said this,how do we go about on actually changing the fact that goverments are giving fuel subsidies for fossil fuels? and to actually make them more committed to green energy? when in actually reality is that fossil fuels are easily available?

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