New rules needed for setting energy prices in the Middle East

Published in Financial Times, May 30, 2013

Of all the regions in the world, the Middle East and north Africa stands out as the one that relies most on universal energy subsidies.

For decades, governments in oil-rich and oil-importing countries have provided subsidies to their populations as a way of sharing their natural resources and offering people some relief from high commodity prices.

But this well-intended form of social protection is not an efficient way to channel aid to the most vulnerable and is weighing on already stretched public finances in several countries across the region.

Energy subsidies come at a high cost. Our estimates at the IMF suggest that, for the Middle East region as a whole, pre-tax energy subsidies – subsidies measured as the difference between the value of consumption at world and domestic prices – cost close to $240bn in 2011. This amount is equivalent to about 8.5 per cent of regional GDP, or 22 per cent of government revenue, and accounts for about half of global energy subsidies.

Although energy subsidies provide some support to consumers, they are highly inequitable as their benefits accrue mainly to the better-off. In Egypt, for example, one-third of energy subsidies benefit the wealthiest 20 per cent of the population.

Energy subsidies also divert government resources away from investments in healthcare, education and infrastructure, and encourage overconsumption, which aggravates pollution and leaves fewer resources for future generations.

They also tend to encourage capital-intensive industries to the detriment of employment-intensive activities and create incentives for waste and smuggling. And, they can lower profits, or even cause losses, for energy companies, making it less likely that they will invest in the energy sector, potentially leading to energy shortages, as we have seen in a number of countries in the region.

For many, maintaining current levels of spending on subsidies is becoming increasingly difficult. With oil-importing countries facing, on average, fiscal deficits of more than 8 per cent of GDP and public debt of more than 75 per cent of GDP, there is a growing urgency for governments to rein in budget deficits. Some oil-importing countries cannot realistically achieve fiscal sustainability without slashing energy subsidies.

Subsidy reform is not easy. To succeed, it needs to be done right. In a number of countries, attempts to phase out subsidies have been reversed after meeting resistance from the general public and vested interests.

The full cost of subsidies is rarely reflected in government budgets and, as a result, people do not make the connection between subsidies and constraints on high-priority public spending. Even where the magnitude and drawbacks of energy subsidies are recognised, lack of confidence on the part of the population that governments will use the savings from subsidy reform wisely, gives rise to resistance to reform.

Experience from countries across the world points to a number of lessons for success. A comprehensive communications campaign that informs the public about how much subsidies really cost and underlines the benefits of reform for society at large is vital for generating broad support.

The timing and pace of price increases need to be carefully planned. A gradual approach to phasing in price increases, one that allows people and businesses to adjust and governments to strengthen social safety nets, is by and large more effective. Most crucial is that those who are hardest hit by the removal of subsidies be compensated from the outset through more targeted social protection, such as cash transfers, lifeline tariffs, or coupon schemes.

For reforms to be durable, energy price setting must be depoliticised and rules based. An automatic pricing mechanism that allows for changes in world prices to be transmitted to domestic prices can reduce the chance of reform reversal. Responsibility for implementing such a mechanism should belong to an independent body, shielded from political pressures.

More generally, improving the operational efficiency of state-owned enterprises, especially in the energy sector, can strengthen their financial position and reduce the need for transfers from government coffers to begin with.

The economic and social challenges facing many Arab countries underscore the widespread desire to shift away from the status quo and to embrace new socioeconomic policies. Shifting from subsidising energy to more productive public spending on healthcare and education and to addressing large infrastructure gaps can have big pay-offs in terms of greater equity, higher growth and more jobs.

Masood Ahmed is director, Middle East and Central Asia department, at the International Monetary Fund