Reforming energy subsidy

ARTICLE: In Pakistan, many households are finding it difficult to access affordable and reliable electricity. Families struggle to pay their monthly bills, often cutting spending on other essential household needs. ... As the World Bank's Energy Strategy (2013) emphasizes, ensuring access to affordable and reliable energy is crucial to ending poverty and achieving shared prosperity. ... In 2014-15, the Government of Pakistan spent almost US $2 billion on electricity subsidies, but they are poorly targeted as the majority of the subsidy benefit goes to non-poor households. They also distort incentives to improve service delivery in the sector as they enable suppliers to produce at an inefficient cost. - Energy Sector Management Programme (2017), World Bank Group.

Covid-19 has put most countries in the world on a recessionary path. While this has increased income inequality and people living below poverty line, virtually across the spectrum of countries, the impact of the pandemic has been most severe on developing countries like Pakistan, where vulnerability was already significantly acute even before the current crisis. To make matters further difficult for the people, the fast approaching climate change has all started to show starker signs in terms of its manifestations - unusually severe wildfires, for instance fire tornado in California, and extremely heavy downpours in Karachi in July and August.

While a broad stimulus package is needed, along with much improved service delivery of public institutions, to provide the much needed support to affected households and business, in these recessionary times, in the specific case of Pakistan - like many developing or emerging economies, in particular, which are net importers of oil, and where a significant proportion of electricity generation is oil-based - one such important area of support is in the shape of providing broad-based subsidy programme in the energy sector. Unfortunately, over the years, subsidy programmes overall, and in the specific case of energy sector, have lacked capacity to reach the target group in any effective and meaningful manner.

There is therefore an urgent need to formulate a well-designed subsidy programme for the energy sector. In this regard, the government should rationalize proper and well-targeted subsides in the energy sector in terms of consumer and producer subsidy, respectively, and also how much and where the subsidy should be pre-tax (or pretax), where it should be post-tax (or posttax).

To understand these two areas of intervention for subsidies, the IMF (International Monetary Fund) defines them in its edited book (2013) 'Energy subsidy reform: lessons and implications' as "Energy subsidies comprise both consumer and producer subsidies. Consumer subsidies arise when the price paid by consumers, including both firms (intermediate consumption) and households (final consumption), are below supply costs, including transport and distribution costs. Producer subsidies arise when prices are above this level. ... Consumer subsidies include two components: a pretax subsidy, if the price paid by firms and households is below supply and distribution costs, and a tax subsidy, if taxes are below their efficient level."

Pakistan's cost of doing business has been on the higher side in emerging and developing Asia, and one of the reasons is the high energy costs for businesses, where one of the main reasons is low level of energy subsidies. IMF in the same book indicates that in 2011 energy subsidy on petroleum products - both as percentage of GDP, and government revenue - for Pakistan was well below those of other countries, which were both fast growing overall, and had higher levels of exports and investments, like India, Indonesia, and Malaysia. The table below highlights this.

In correcting the subsidy focus in favour of facilitating consumers and producers, especially in these recessionary times as a result of the pandemic, it is important to build momentum on undoing the main barriers faced in general by countries, especially in developing and emerging economies with relatively weaker economic institutions, when reforming the subsidy programme. The IMF highlights that country experience has brought out the following main barriers in this regard, which include "[1] lack of information regarding subsidies, [2] lack of confidence in the government, [3] concerns over harmful impact on the poor, [4] concerns over general economic impact, [5] opposition from interest groups, and [6] weak macroeconomic conditions." It would make sense that the government should prepare on these fronts to properly create momentum among all the political and economic stakeholders, so that a meaningful reform process can be initiated.

The design of the subsidy reform strategy itself should first of all be one that is comprehensive - well planned and clear. For instance, Iran came up with such a strategy in 2010 to reform its fuel subsidies - something which could provide meaningful guiding principles to Pakistan in initiating energy subsidy reform - where, according to the IMF, the strategy "incorporated clear objectives, compensating measures, and a timetable for reform, preceded by an extensive public relations campaign."

In this regard, while the main purpose of Iran was to rationalize upwards the prices, the reason why it incorporated a compensation strategy with the overall reform programme, the current context of recession in particular calls on countries like Pakistan, which have historically provided lower levels and less-targeted subsidies in the energy sector, yet the design framework principles could be learnt from. In this regard, according to the IMF "a comprehensive reform plan requires (1) establishing clear long-term objectives, (2) assessing the likely impact of reforms, and (3) consulting with stakeholders."

In addition to reform being comprehensive, it should remain cognizant of internalizing such aspects as transparency, appropriate timing and pacing of energy tariff increases, and improving the efficiency of involved State-Owned Enterprises (SOEs) so that production and revenue collection inefficiencies could be minimized; and hence lesser need for subsidies in the first place.

A very important aspect of subsidy reform strategy, and which is generally a very weak link in rollout of subsidies, is their proper targeting. The IMF points out that "targeted cash transfers can reduce opposition to subsidy reform and assist the poor." A World Bank (2016) paper 'Residential electricity subsidies in Pakistan: targeting, welfare impacts, and options for reform' indicated in this regard that 'The analysis finds that targeting could be improved considerably by allocating subsidies according to proxy-means test scores using an existing national proxy-means test database. Providing a flat credit rather than a price subsidy could also alleviate certain governance concerns.'

Moreover, the same paper pointed out the absence of the Government's 2013 National Power Policy, since as against its objectives of better subsidy targeting in protecting the vulnerable section of electricity users "The subsidy scheme continues to fall short of these objectives... with the result that electricity subsidies continue to benefit the richest households disproportionately. Even though recent reforms have made subsidies slightly less regressive, the richest 20 percent of households still receive 40 percent more in subsidies than the poorest 20 percent of households. Moreover, there is a strong seasonality of electricity consumption, with rich and poor consuming more in the summer months. This pushes even the poorest households into higher-tariff slabs, increasing their bills substantially. Conversely, many richer households 'drop' into the more heavily subsidized and lifeline slabs during the winter months."

Energy subsidy reform is one of the most important aspects of business-friendly and welfare-oriented energy pricing in Pakistan, especially in the wake of the pandemic. This should be one of the top priorities of the government, trying to manage the circular debt issue, in addition to the concerns above.

(The writer holds PhD in Economics degree from the University of Barcelona, and previously worked at International Monetary Fund. He tweets @omerjaved7)

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Petroleum Products Subsidy (2011)
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                       % of GDP                 % of Gov. Rev.
                 Pretax        Posttax        Pretax      Posttax
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India              1.25           2.02          6.75        10.91
Indonesia          2.58           3.47         14.51        19.46
Malaysia           1.24           5.38          5.67        24.61
Pakistan           0.13           1.14          1.02         8.93
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(Source: IMF Estimations; 'Energy subsidy reform: lessons and implications')

Copyright Business Recorder, 2020