Why Energy Subsidies Distort Markets and Hurt Consumers
Normally, you would receive the next OEI tomorrow.
However, something important happened today, and it requires I take an unexpected trip. As soon as our sessions conclude here in Frankfurt by the mid-afternoon, I am boarding a flight to Dubai.
Our conversations in Germany have taken an unexpected turn. Usually, the 600-pound gorilla in the room – the great restraint on a genuine market – remains off the table for discussion. Everyone knows it is there and that it greatly distorts energy prices.
Nobody tends to comment on it, especially when German energy ministers attend our meetings.
That forbidden issue is government subsidies.
Though we typically avoid the issue, something unusual happened yesterday. Subsidies became the focus of a very spirited debate after a recent report released by the International Monetary Fund (IMF) staff indicated that the global price tag for subsidies had risen again.
It now totals more than $1.9 trillion. That’s trillion with a T.
Continued government involvement in the market through support of either energy production (through tax incentives) or consumer prices (through grants) becomes a very visible issue when central budgets are strained by the cost and availability of energy.
And it’s going on right now.
As governments continue to confront strained budgets and rising energy costs, a great shake-up could be in the works for energy investors.
Subsidies Help Rich, Hurt Poor Energy Consumers
As I noted on Monday, German consumers are facing a rise in energy costs, despite already paying the highest per unit prices in Europe. That is in spite of some programs meant to lower both the cost of renewable production and reduce the rise in effective market prices for end users.
As the IMF report observed, the sheer weight of government involvement is counterproductive. It concludes that subsidies for consumption both discourage private investment (by lowering the expected rate of return) and run contrary to the assumption for using them to begin with.
Contrary to the common view, the primary benefits accrue to wealthy, not poor, countries.
That means, rather than assisting those areas of the world where need and demand potential are greatest, subsidies actually provide the most help to those already able to pay the costs of energy.
German and other European consumers may disagree with this assessment. And consumers from a number of countries are certainly not going to like the primary conclusion of the report. The IMF staff argues that taxes on energy should be increased, a move that would certainly raise end prices even more.
Carlo Cottarelli, the director of fiscal affairs at the IMF, puts it this way. “Energy subsidies are large and they’re harmful,” he said during a conference call on Wednesday. “They lead to excessive consumption of energy; they absorb public-sector resources that could be used for more useful purposes. [T]hey benefit the rich more than the poor.”
And the IMF study supports this sentiment. On average throughout the globe, the richest 20% of households in low and middle-income groups capture six times more in total fuel subsidies than the poorest 20% percent, according to this research.
As a result, a range of policy considerations has risen, providing the reason why it was introduced into our meetings. While we were primarily considering natural gas import questions, much of that subject cannot be considered without equating the effective cost of energy in general with resulting market prices.
Subsidies in Wealthy Nations are Booming
It is important to observe that the IMF report is from the staff, not from the Fund itself. For the IMF to release an official statement, that conclusion would have to be approved by the IMF board. That would generate considerable disagreement among member countries.
This is because of another interesting conclusion contained in the report. One might expect that subsidies would be a primary tool for developing countries in their attempt to protect essential domestic industry and allow retail consumers access. It turns out that more than 40% of all government subsidies provided worldwide arises in advanced economies.
In fact, the U.S. provides more subsidies than any other nation on earth (about $502 billion in 2011, the last year for which figures are available). China and Russia come in at the next two top spots.
On the other hand, pre-tax subsidies – essentially the difference between the real cost of energy and the price paid by consumers – remain concentrated in developing economies, especially in those countries where the primary source of central budget revenues comes from the export of crude oil.
The subsidies show a stubborn resistance. Any move to cut them will be met with strong public resistance. Upon occasion, as was the case in Nigeria when President Goodluck Jonathan tried to phase them out, that resistance will turn violent.
Subsidies Distort Pricing, Promote Black Market
The IMF report also pointed to another result. Continuing subsidies, which distorts the pricing dynamics and lowers investment profit, opens the door for smuggling and a vibrant black market. This is what has happened in Iran, where international sanctions have made smuggling oil products like gasoline and heating oil a lucrative practice.
Yet smuggling is hardly restricted to developing countries.
The IMF report notes-somewhat unexpectedly-that profit motives have introduced some interesting variations in unlikely places. In Canada, for example, cross-border subsidy differences with the U.S. have encouraged some “creative” energy moves.
The unusually open discussions over the past 24 hours here in Frankfurt have centered on how to suggest the restructuring of downstream (i.e., closer to the consumer) subsidies to offset another major increase in natural gas prices. Of course, that subject also involves government tax programs and centers on the genuine concern over stifling a necessary industrial expansion.
There is no way to advance any possible policy revisions that far down the line unless there is a clear way to determine (and suggest revisions on) the upstream subsidies.
Well, as noted above, these pre-tax government subsidies, both direct and indirect, are concentrated in oil exporting countries.
For this reason, several of us attending this meeting are set to huddle with colleagues in the United Arab Emirates to assess the nature of-and possible leverage for revisions in-upstream government assistance programs. There is no way to argue for a relaxation of back-loaded subsidies (those introduced downstream) without the potential for a similar cut in parallel front-loaded (production-oriented) programs.
Looks like my Easter meal with the grandkids will be delayed until Monday.