Energy subsidies: easy to enact, difficult to retract

Ultimately Opec residents may have to decide to support their long-term well-being by sacrificing a favourite perk, says Jim Krane

Big oil exporters have a complex calculation to make over how much of their own product they can afford to consume.

Overconsumption is bad for two reasons. First, excess consumption causes excess pollution. Second, if growth continues, big exporters may no longer have surplus production to export.

Most of the Opec group of countries are growing wealthier and more populous, which are two big drivers of energy demand. But a big factor – and the easiest to confront – is the low price at which these countries sell energy products such as electricity, fuel and desalinated water.

In the GCC, my calculations show that low prices are responsible for roughly a third of energy demand. Raising prices would have a dramatic effect.

Using a modest estimate for the scale of public reaction to higher prices, rationalised electricity prices in Kuwait would cut long-term demand by something like 60 per cent. An end to petrol subsidies in Saudi Arabia implies a reduction of demand by a third, and in Oman by 20 per cent. Similar reductions would likely occurin the UAE.

While these results are purely hypothetical, they suggest the big role that subsidies play in stimulating demand.

By selling energy too cheap at home, exporters could end up removing themselves from the export business.

Indonesia did just that in 2008. Domestic demand, aided by subsidies, overtook exports and Indonesia dropped out of Opec.

Some projections forecast Saudi Arabia will be in the same boat after 2030 unless it moderates its habits. The kingdom’s oil consumption has risen from about three per cent of production in the 1970s to about a quarter of production now.

The other GCC states exhibit similar symptoms, with Qatar’s oil consumption rising fastest of all.

What about carbon emissions? The IMF calculated that eliminating energy subsidies in major exporters would accomplish about 13 per cent of the carbon emissions reductions required to meet the target associated with the goal of limiting global climate change by 2020. The local public health improvements of such a reduction would also be significant.

Many economists see a clear case for subsidy reform within the Opec group. Let energy prices rise to world levels and market forces will halt waste, they say. Governments would have more revenue, which they can distribute in lieu of energy products if they wished. Smoggy skies would give way to cleaner air. Domestic demand would wisely defer to the export market.

If only things were this easy. It is not for nothing that subsidies are often described as asymmetric: easy to enact, difficult to retract.

This is because government handouts create beneficiary groups who are likely to react strongly if their benefits are removed or restructured.

Given this, can subsidies be cut without attracting widespread criticism?

Many say no. Ending subsidies would look to some citizens like a breach of the social contract between state and society. But energy subsidies are not sacrosanct.

According to the IMF, all but five of 28 substantial attempts to dismantle subsidies over the past two decades met with some success. Even oil exporting countries raised prices: Iran, Indonesia and Mexico among them.

One factor that has been shown to enable action in some settings is external pressure. A vociferous international outcry can provide the requisite cover for governments to introduce unpopular measures.

For example, external pressure stemming from Saudi Arabia’s accession to the WTO in 2005 helped the kingdom draft and enact economic reforms. In Kuwait, IMF director Christine Lagarde’s recent subsidy warning provided cover for voices to demand reform.

External criticism can provide a persuasive reform tool. But ultimately Opec residents may have to decide to support their long-term well-being by sacrificing a favourite perk. Paying more to use less is a tall order, but in energy terms, it might not be a bad thing.

Jim Krane is the Wallace S. Wilson Fellow for Energy Studies at Rice University’s Baker Institute, in Houston. He is the author of the book Dubai: The Story of the World’s Fastest City