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Why Energy Subsidies Distort Markets and Hurt Consumers

by | published March 28th, 2013

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.

Sincerely,

Kent

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  1. enthusceptic
    March 28th, 2013 at 12:20 | #1

    Subsidising natgas, really? That to me is proof that subsidies are a beast running wild.
    Thank you so much for the invitation to Micro Energy Trader! My Master Card was heating up and ready for action, but I have to try to get in later because of other commitments even if the price will double.

  2. Croploss
    March 28th, 2013 at 14:54 | #2

    The political decision to eliminate nuclear power by the Germans will come back to bite them hard and repeatedly. Real leadership would have been to tell the people that elimination of nuclear power was simply not possible without severe and significant increases in the cost of power and energy. We could use a little leadership in this country regarding nuclear, coal, and the BS in alternate sourcing.

  3. Mary Jane
    March 28th, 2013 at 22:27 | #3

    Dr. Moors, this is my first comment although I read your work regularly.
    This is such a clear, fair and non-political assessment of a politically influenced energy “situation.”
    Thank you so much for it. I wish you all the best in working with global colleagues to change the way energy is priced and therefore allocated.

    appreciatively,
    Mary Jane

  4. charlie
    March 29th, 2013 at 10:24 | #4

    subsidised enrgy infrastructure expansion ( wind & solar) directly depletes the available financing needed for profitable infrastructure developement. Break-even on a wind farm in the us (subsidised) is $37.00 per killowatt unit LOSS!!! when susidies end these losses are unsustainable & the projects will be abandoned, without viable coal, nat gas, or nuclear projects ready to take their place the energy grids’ future becomes questionable at best.

  5. Geoff Thomas
    April 2nd, 2013 at 19:12 | #5

    @charlie it has long been a beef from Wind and Solar in Australia that there is no level playing field, the subsidies to oil and coal are so huge.
    Kent’s article is mainly about the subsidies to Energy, – all energy, Nuclear, Oil, Coal, Solar, Wind, Natural Gas etc.
    With developing technologies, like Wind and Solar were, a case could be made that the subsidies would allow development, and in fact it has, Solar has come down from $8/watt 6 years ago to $1/watt now, and can compete very well against other technologies, so all over the world the subsidies for Solar are disappearing.
    The same could not be said for coal and oil, subsidies are still there that should have disappeared decades ago or longer, what do they achieve except to distort the market?
    A free economy is damaged by these subsidies as true value is lost, when value becomes distorted it opens the way to abuse money as the major banks, Govts etc. now do.
    In regard to the comment about Wind, a wind turbine costs about $2/watt installed, design life is 20 years, and maintenance is conservatively estimated at 2%, – usually works out more like 1%.
    A coal fired power plant is again in that same area of cost to build, although the need to take responsibility for emissions will push that up a bit, – but unlike Wind, which is free, you have to keep throwing coal at it 24/7 for the rest of it’s shorter life.
    Where Charlie gets $37/kilowatt/hour for wind is beyond me.
    Not being American, I don’t know what the tax credit thing for Wind is or whether Coal gets it also, certainly in Australia if one purchases such equipment, it comes off your Tax, – that doesn’t distort the Market, although income tax probably does, – but that is a discussion for another day.
    Subsidies for Nuclear are not so clear, apparently the Govt. provides Insurance, that is a huge cost that should be part of the retail price of Nuclear generated power, and whilst some countries require contributions for waste disposal, it is not at all clear that that contribution will cover the waste disposal, – currently even high level waste is not disposed of and Nuclear power plants all over the world have cooling ponds full of spent fuel rods, some of them since 50 years or so.
    The cost of de-commissioning Nuclear plants should also be part of the retail cost and there is special dispensation given to Nuclear plants that all their power is sold, – in other words they have first bite at the market, due to the extremely high costs of building them, and that most can not be throttled up and down regularly without risk.
    This means that the variability of the market, where there are Peaks many times the minimum load, has to be born by the other generators, – something that Gas generators are very good at doing so Gas is subsidizing Nuclear.
    Nuclear also has absorbed the vast majority of research funds for 60 years or more, it should be a big boy by now and able to compete in the market place without subsidies, whereas I think there is a good case for subsidizing Wave and Tidal power, and Geothermal Hot Rocks especially in tandem with Solar Thermal, as these are barely out of the lab at this stage but have great promise.
    I would call funding them ‘part of Research’ and as soon as they are a viable item or if they don’t have that possibility, then funding should cease as it should long ago have ceased for Energy in general.

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