Subsidizing Energy Consumption: Why it’s Wrong and What Can Be Done About it

IMF Blog, March 27, 2013

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Subsidizing Energy Consumption: Why it’s Wrong and What Can Be Done About it

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Bibliographic details

• Authors: Carlo Cottarelli
• Published: March 27, 2013

Summary of the problem

• Energy subsidies are the difference between the price consumers should pay (to cover supply costs and the appropriate consumption tax) and what they actually pay.
• Subsidies are widely used to make energy cheap for households and companies, often justified as protecting the poor or maintaining competitiveness.
• Key negative effects identified:
  • Poor targeting: in emerging and low-income countries, 43 percent of energy subsidies (before taxation) go to the richest 20 percent of the population.
  • Fiscal cost: pre-tax subsidies in 2011 amounted to $480 billion, or 0.7 percent of world GDP and 2 percent of public revenues.
  • Macroeconomic opportunity cost: subsidies preempt public spending on education, infrastructure, or other productive uses; even energy producers forego revenue that could be used productively.
  • Environmental damage: eliminating energy subsidies would reduce CO2 emissions by 4½ billion tons, a 13 percent reduction.
  • Overconsumption: subsidies lead to excessive energy use and associated externalities.

Magnitude and distribution of subsidies (2011 figures)

• Pre-tax subsidies:
  • $480 billion total.
  • 0.7 percent of world GDP.
  • 2 percent of public revenues.
  • Regional example: Middle East and North Africa — 8.6 percent of GDP and 21.8 percent of revenues.
• Post-tax subsidies (accounting for under-taxation to cover externalities, using relatively conservative estimates):
  • $1.9 trillion total.
  • 2.7 percent of world GDP.
  • 8 percent of total government revenues.
  • Advanced economies: every single one is under-taxing energy.
  • The Unites States accounts for about one fourth of all post-tax subsidies.

Why subsidies fail to achieve policy goals

• Poor targeting: benefits skew toward the rich who consume more energy.
• Efficiency costs: subsidized energy supports survival of inefficient firms, harming long-run growth.
• Fiscal and environmental externalities: large fiscal burdens and increased CO2 emissions.

Evidence on reform feasibility

• The IMF study examined subsidy reform in 19 countries, focusing on cases where governments reduced pre-tax subsidies.
• Reforms are feasible and have a body of country experience that provides a roadmap.

Six key elements for successful reform

• A comprehensive reform plan:
  • Preferable to ad hoc decisions.
  • Requires clear long-term objectives, such as achieving full price liberalization and improving the quality of service.
• A far-reaching communications strategy and consultation with stakeholders:
  • People must understand that subsidies involve costs for the economy and society as a whole, not benefits.
• Protecting the poor:
  • With most subsidies benefiting the rich, their elimination allows not only to fully compensate the poor, but also to make resources available for pro-growth, pro-equity public spending.
• Appropriately phased and sequenced price increases:
  • Allow time for households and governments to adjust their energy consumption.
  • Absent large and immediate fiscal pressures, gradual pace is more acceptable if part of a clear comprehensive strategy.
• Improving the efficiency of state-owned enterprises:
  • Helps reduce their fiscal burden.
• Depoliticizing the setting of energy prices:
  • Needed to make reforms durable.

Policy implications and recommendations

• Reform energy subsidies to improve targeting, fiscal space, and environmental outcomes.
• Consider increases in energy taxation as part of fiscal consolidation, especially in advanced economies with high public debt.
• Use savings from subsidy removal to:
  • Compensate and protect the poor.
  • Finance pro-growth and pro-equity public spending (education, infrastructure).
• Adopt comprehensive, communicated, phased reforms with measures to improve state enterprise efficiency and depoliticize pricing.

Source: Carlo Cottarelli, "Subsidizing Energy Consumption: Why it’s Wrong and What Can Be Done About it", March 27, 2013 (IMF Blog).

Content in this bundle

• Energy Subsidy reform--Lessons and Implications; IMF Policy Paper; January 28, 2013
  • Energy Subsidy reform--Lessons and Implications; IMF Policy Paper; January 28, 2013 (Markdown version)
  • Energy Subsidy reform--Lessons and Implications; IMF Policy Paper; January 28, 2013 (PDF)
• 012813a
  • 012813a (Markdown version)
  • 012813a (PDF)