Energy Subsidies: Lessons Learned in Assessing their Impact - UNEP

Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reforms
A subsidy that reduces the price received by energy suppliers undermines the returns on their
investments and, consequently, their ability and incentive to invest in new infrastructure. As
a result, subsidies may encourage reliance on out-of-date and dirtier technology. There are
many examples of this phenomenon, especially in the developing world. The dire financial
state of the state electricity boards in India is an extreme case. A failure to eliminate subsidies
by raising prices to full-cost levels has severely curtailed the ability of the companies to
finance new investment, which has directly contributed to the poor quality of supply and held
back extending the network to remote villages.
Subsidies to producers, by cushioning them from competitive market pressures, tend to
reduce incentives to minimise costs, resulting in less efficient plant operation and investments
that may otherwise not be economic. The subsidies on coal production in several OECD
countries, described in Chapter 3, have hampered efforts to improve productivity in past
decades. In the United Kingdom, for example, the phasing out of subsidies in the 1980s and
1990s together with the privatisation of the industry led to a huge improvement in
productivity.
Direct subsidies, in the form of grants or tax exemptions, act as a drain on government
finances. For example, the IMF estimates that the Iranian Government’s direct spending on
energy subsidies amounted to $4 billion in 1997 – 8% of its budget. The cost of oil-product
subsidies in Indonesia is even higher, at around 10% of central government spending. The
special low rate of VAT that was applied to the sale of electricity and gas to households by
the Czech and Slovak Governments in the 1990s exacerbated those countries’ budget-deficit
problems. Direct subsidies on oil products can lead to acute pressure on government finances
during periods of rising prices. This has been a major problem in several developing
countries, including Indonesia. Indonesia allocated almost $4 billion to oil subsidies in 2002.
If left unchanged, the bill for those subsidies would soar to around $36 billion between 2000
and 2005 due to higher oil prices. In the long run, indirect subsidies that reduce economic
growth also lead to lower tax government revenues.
Subsidies always have an impact on international trade. Consumption subsidies that increase
energy use boost demand for imports or reduce the amount of energy available for export.
This harms the balance of payments by increasing the country’s dependence on imports. For
example, the massive increase in LPG use in Senegal that resulted largely from subsidies has
led to a huge increase in imports. The Indonesian Government estimates that energy subsidies
in total will cost the country $16 billion in lost export earnings over the five years to 2005 if
they are left as they are. Iran’s exports of crude oil will decline rapidly if subsidies are not
removed soon, since production will be unable to keep pace with soaring domestic
consumption. Subsidies in major energy-producing countries such as Indonesia and Iran also
undermine global energy security to the extent that they reduce those countries’ capacity to
export. The removal of subsidies to oil products would lower domestic demand in Indonesia
and free up more oil for export, thereby reducing the share of the dominant OPEC countries
in international oil trade and reducing those countries’ ability to push for higher prices.
Subsidies can also encourage cross-border smuggling of oil products and other tradable forms
of energy to neighbouring countries with higher prices. This has been a major problem in
some African countries, Iran and Indonesia.
Price caps or ceilings below market-clearing levels can lead to physical shortages and a need
for administratively costly rationing arrangements. This is the case in India, where the state
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