Should we continue subsidizing energy?

Here is an article by Antoinette M. Sayeh that tackles head-on the issue of energy subsidies in sub-Saharan Africa.

For many years, countries in sub-Saharan Africa have spent large amounts on subsidizing fuel and electricity. For both sources of energy combined, this averages around 3 – 4 percent of GDP. That is about the same magnitude as public spending on health in many countries. Now we need to ask some important questions.

Is this a good use of scarce resources? 

Where does this money go?

Is it helping to support the livelihood of the poorest in African economies?

Is it helping to boost the country’s competitiveness?

The answers are largely, no. I believe this money can and must be used better to invest in the critical physical and social infrastructure required to sustain growth in sub-Saharan Africa. A recent IMF paper backs this up.

Tracking who benefits

Most of the fuel products are consumed by higher income groups. The situation is even more acute with electricity subsidies, as a large majority of the poor are not even connected to the grid.
Sometimes, the benefits don’t even stay in the country, given the incentives to smuggle subsidized fuel products to higher price neighbouring countries.  Oil exporters generally have higher subsidies because they are less likely to face the financing constraints that oil importers may encounter when international oil prices are high. In addition, subsidy costs tend to be less transparent—appearing in the form of lower profits of state oil companies rather than explicit costs to the budget.  Sometimes they fall into the trap of looking at their low costs of production instead of the resources forgone if they sold the fuel at world market prices. That said, we need to approach reform in a transparent and carefully planned way. Removing subsidies will affect all income groups, given the poor do receive some of the benefits, including from the impact of lower transport prices on food costs.

Eyes on growth

There are also serious costs from a more medium to longer-term growth perspective.

First, subsidies distort investment decisions by both the public and private sectors. A failure by power companies to recover costs leads to a vicious circle of underinvestment: neglected infrastructure crumbles, leading to frequent power outages that reduce competitiveness and depress potential growth.  Private investors are discouraged from much needed investment to expand supply.

This is indeed the story of sub-Saharan Africa since the mid-1980s, where per-capita energy production and consumption have barely increased, and where today (excluding South Africa) installed capacity for the entire region is still about one-third that of Spain. Without a significant increase in power generation capacity, sub-Saharan Africa will not be able to maintain current economic growth rates for the next two decades.  Simulations done by the World Bank suggest that if electricity infrastructure in all sub-Saharan countries were improved to that of a better performer (such as Mauritius), long-term per capita growth rates would be 2 percentage points higher.  In many countries, small-scale operations and a reliance on expensive thermal systems or emergency power drive up costs. Countries flush with low-cost hydro or natural gas resources need to increase production and build the infrastructure to invigorate regional trading through power pools.

Also, energy subsidies directly crowd out other critical spending, including on much-needed infrastructure and social services. For example, even after recent reductions, Nigeria’s government spends more of their outlays on energy subsidies than on education and health.

Mounting costs

We see other costs too, such as the environmental costs from overconsumption of fuel products relative to other forms of energy. In a continent blessed with considerable sources of renewable energy—hydro and solar for example—subsidies continue to encourage fossil fuel dependency and undermine the competitiveness of these renewable sources.

So if there are large opportunity costs and the poor are not gaining much, why do subsidies continue? How do we go about reforming them?

One reason for their persistence is that energy subsidies are a relatively easy way for governments to transfer resources, especially when compared to undeveloped social safety nets. A second is that politically vocal interest groups who are the main beneficiaries are loath to give up these large handouts and will seek to undermine reform efforts. And third, the population at large is often reluctant to give up these subsidies, not trusting that their government will use the savings for either better social protection or growth-enhancing investment.

A path to reform

Reform is therefore not easy. But the IMF’s detailed review of country experiences across the globe highlights some useful lessons that can increase the chances of success. Let me highlight three that are of particular importance in sub-Saharan Africa. First, careful preparation and sequencing is needed. You need to build public understanding of the status quo—how much is being expended on subsidies and who is benefiting? It takes time to build consensus for reducing energy subsidies among all stakeholders. Both Namibia and Kenya took many years of preparation before successful energy reforms were implemented. Part of careful preparation involves a strong public communications campaign, introducing compensatory measures for those most affected, and demonstrating how the savings will be used.

Second, sustained reform requires strong institutions. Tanzania’s fuel subsidy reform included the establishment of a specialized regulatory entity, not only to issue licenses and technical regulations, but also to keep the public constantly informed about prices and to review the proper functioning of the market.

And third, durable electricity subsidy reduction requires much more than tariff increases. Tariffs in sub-Saharan Africa are already considerably higher than in other regions because of higher costs. Efficiency gains in public utilities are possible through improving governance, lowering distribution and commercial losses and raising revenue collection rates. And low levels of public debt in many sub-Saharan African countries provide an opportunity for significant investment in cheaper sources of energy production.

Energy subsidy reform is a critical policy challenge that is central to the future growth agenda in sub-Saharan Africa. While a gradual approach may be appropriate given the overall difficulties, the payoffs from successful reform are huge. So we now need to approach subsidy reform with renewed vigour—there is no time to waste.