Petrol subsidies stain a developing world

Petrol subsidies ensure the world's majority continue to bear a huge opportunity cost, and the situation looks set to worsen as the resource dries up and more nations develop.

Lowy Interpreter

When G20 leaders met in Pittsburgh in 2009, they committed to "rationalise and phase out over the medium term inefficient fossil fuel subsidies that encourage wasteful consumptio". Subsequent meetings have repeated this commitment.

It's a big issue. One estimate puts the worldwide subsidies at 2.5 per cent of global GDP. But no matter how powerful the economic case for eliminating these subsidies, they are deeply embedded in politics. Not much progress has been made.

The economic argument is open-and-shut. Misdirected budget subsidies shift scarce funds away from high-priority uses such as education and health. Subsidies misallocate resources and thus retard growth. They provide the wrong incentives for environmental objectives such as climate change, pollution and traffic congestion.

Unlike the budget subsidies intended to address income inequality, petroleum subsidies are particularly perverse for distribution. At the global level, only 3 per cent of petrol subsidies are received by the lowest-income quintile (the poorest 20 per cent of the population) while the top quintile receives over 60 per cent. As the IMF's pie charts illustrate (below), the poor do better with subsidies on kerosene (used for lighting and cooking), thus underlining the case for beginning reform at the petrol pump.

Indonesia illustrates the issues. Its energy subsidy, calculated as the difference between the domestic price and the international market price, is now nearly 4 per cent of GDP and accounts for over 20 per cent of budget expenditure, about the same as what's spent on education. Petrol costs less than 50 cents a litre at present and even if the much-delayed increase goes ahead, this will rise to just over 60 cents.

Many oil producers rationalise high subsidy levels by arguing that low petrol prices distribute the nation's own wealth. However, even this misguided argument doesn't fit the reality: Indonesia was a petroleum exporter until 2004 but declining domestic production (now not much more than half of peak production) and the spectacular rise in motor vehicles has changed that, and Indonesia now imports more than 20 per cent of its petroleum needs, with this figure growing quickly. Subsidised petroleum is also used to generate electricity, with consumption growing fast as the middle class turns to air-conditioning.

No matter how compelling the economic case, raising petrol prices is politically traumatic. There is some history here. One element of IMF conditionality during the 1997-8 crisis was the removal of fuel subsidies. The rise in petrol price helped trigger the huge demonstrations which led to President Soeharto's resignation in May 1998. Since then, every attempt to raise petrol prices brings the students onto the streets again.

It can be argued that President Susilo Bambang Yudhoyono is unduly cautious, because the petrol price was raised in 2005 and 2008 without  toppling his government. He is towards the end of his last presidential term, and perhaps has less reason to worry about his personal popularity. But there is substantial parliamentary opposition. The economic case has never won the day.

Indonesia is far from alone in subsidising fuel. At least on 2010 figures, Malaysia, Thailand, Vietnam, Brunei, Pakistan and Bangladesh all have larger subsidies relative to GDP. Moreover, this is not the whole story of just how underpriced petroleum is. The price should really be set high enough to allow for the negative externalities of petroleum consumption (principally the environmental damage).

What can't be disputed is that energy subsidies are a key part of an intractable longer-term global issue. Looking ahead, petroleum seems the scarcest of the energy sources. Thus it is sensible to shift demand to other sources. But if progress is made in reducing petroleum subsidies, more electricity will be produced from coal.

And overshadowing this narrative is the uncomfortable reality that the debate has not yet seriously addressed how the globe will cope with the energy demands of the countries which are now just at the start of the upward demand trajectory. If America's per capita electricity represents where the emerging countries are headed, China has a five-fold increase ahead of it and Indonesia a 20-fold rise.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.

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