Published:  12:00 AM, 12 January 2017

Energy subsidy: Its effectiveness

Energy subsidy: Its effectiveness
In the modern era, energy is considered one of the utmost important inputs which is tapped in production of all goods and services in an economy. Thus, its contribution to the economy cannot be denied. In addition, the concept of energy security, whereby a minimum sustainable supply of energy is to be made accessible to a broader segment of the society, and also brought under the lime light. Moreover, clean and affordable energy access across the globe has recently been enlisted in the seventeen Sustainable Development Goals (SDGs) declared by the United Nations. Thus, energy and its sustainability should be a matter of priority when it boils down to adoption of public policies that are in line with economic development of underdeveloped nations in particular. However, provision of energy subsidies may hamper in achieving energy security in countries that are striving to embrace development in the near future.

Energy price is considered a crucial macroeconomic determinant since it attributes to widespread economic activities. Thus, sudden changes in energy prices may affect an economy adversely if adaptive measures are not taken in due time. The effects of changes in energy prices on real economic activities can be understood from both demand and supply side channels.

As per the demand side is concerned, a rise in energy prices is synonymous to a fall in demand of other goods and services by a household. This happens because as price of energy increases and there is less scope for reduction in minimum energy consumption, the household is forced to reallocate its fixed disposable income from non-energy to energy expenditure. On the flip side of the coin, the supply side hinges on the argument that as energy prices goes up, the cost of production of goods and services go up as well. As a result, producers are compelled to cut down on their output levels and operate at below capacities which in turn have a negative impact on supply of goods and services in the economy.

Developing energy-importing countries like Bangladesh are vulnerable to world energy price shocks. For instance, Bangladesh imports oils from developed nations in order to generate electricity, the most important form of energy used in the nation.

 As a result, a surge in world oil prices is likely to raise input costs for industries in Bangladesh which eventually may lead to fall in outputs and a simultaneous rise in domestic price levels. It has been acknowledged worldwide that higher oil price may eventually lower income levels in underdeveloped nations. Thus, in order to protect the economies from such shocks the governments in the less developed countries resort to provision of energy subsidies, artificially keeping energy prices low. Although such measures to combat the atrocity of energy price shocks are required to some extent, provision of subsidies in the energy sector usually generate negative impacts on the economy which in the long run can even outweigh the nominal short run benefits.

Subsidizing energy prices is considered to be a crucial policy tool amongst governments of developing countries and at times such policy moves are also stimulated by political motives. Energy subsidies in Bangladesh are both directly and indirectly extended to producers and consumers whereby the subsidies lower the cost of energy inputs and raises revenues for the producers while it also reduces the price paid by the end consumers as well. In Bangladesh, energy subsidies are specifically provided in the form of direct subsidies, equity injections, artificial fixation of retail energy prices, natural gas purchase, concessional power sector loan financing from national budget, preferential tax treatments, and distribution channel subsidization.

 Government intervention in the energy sector can depress macroeconomic indicators within an economy. Thus, the governments in the developed nations purposively abstain from intervening into the associated markets letting energy prices automatically adjust by responding to the market forces of energy demand and supply. Conversely, in developing countries like Bangladesh, the government intervenes into the market subsidizing energy prices and keeping it below the market price which in turn mitigates competition within the energy sector.

Energy subsidies depress economic growth and development via numerous channels. Firstly, provision of subsidies in the energy market distorts energy equilibrium energy prices whereby the prices set do not reflect the true costs. Due to this absence of cost-reflective price, there is usually inefficient and over-use of energy which is contradictory to economic growth attainment. Moreover, over consumption of imported fuels at subsidized prices may also lead to deterioration in the nation's balance of payments and cannot alleviate the nation's dependence on such imported fuels. For example, following world oil price hike in the 1970s the Bangladesh government decided to reduce the use of imported liquid petroleum products for its electricity generation and to replace it with indigenous natural gas. In order to do so, the government subsidized natural gas price and offered it, at a price that was below the supply cost, for electricity generation.

Although such a step reduced electricity generation costs by one-sixth of the imported oil-fired electricity costs, it ensured adverse consequences on the nation's natural gas reserve. This was because of the absence of cost-reflective price of natural gas whereby excessive amount of gas was used to generate electricity. As a result, the nation is currently facing acute gas shortages and its natural gas reserve, at the current usage and exploration rates, is likely to be exhausted by 2031. Had the market price of natural gas reflected the true cost, its usage would have been efficient which would have ensured a sustainable natural gas supply for a longer period of time. An acute natural gas shortage stifles the power plants and forces them to produce below their installed capacities.

In addition to this, provision of excessive subsidies in the energy market also creates disincentives for investment in the energy sector and also holds back energy infrastructure development goals. This is because low energy prices would mean lower profits for energy producers who are price takers and cannot charge prices higher than that set by the government.

With sustainable energy and its security in focus, investment in the energy sector is the most important macroeconomic tool which requires utmost attention. No stones should ideally be unturned in boosting energy sector investments but provision of subsidies may well work against such an agenda. Moreover, energy subsidies also hamper energy resource diversification drives. Transition from use of non-renewable energy to greater use of renewable energy is a tested solution to attainment of energy security in developing countries like Bangladesh. However, subsidization of prices of traditional energy resources makes sure that the price of renewable energy stays at a relatively higher level compared to the non-renewable energy price. As a result, fuel diversification, etc. are overlooked putting the nation's energy security to the sword. For instance, per unit cost of electricity produced from solar power is way less than that produced by imported oils. However, commercial transition from oil-based electricity generation framework to solar power requires hefty investments especially in the form of R&D. With energy prices being artificially kept low, such investments do not seem to be worthwhile for power producers and as a result energy diversification stays limited only on pen and paper.

An indirect negative impact of energy subsidy is possible crowding out of growth enhancing public spending. In Bangladesh, the total amount government revenue spent on energy subsidies was around 1.9 billion US dollars by the end of the fiscal year 2013 which is almost 1.6% of the nation's GDP. In addition, the shares of energy subsidies on the government's total development expenditure and total tax revenues have also experienced rising trends.

Therefore, if these subsidy payments were channeled to be invested in other growth enhancing sectors like health, education, etc. then the nation would have not only benefitted more in terms of economic growth, but would have also been at a better position in terms of attainment of energy security. Underscoring the necessity of achieving energy security and ensuring a sustainable supply of energy to be accessed by the future generation, it is ideal for the government of all developing countries to gradually reduce and get over the provision of energy subsidies for greater macroeconomic benefits.

An energy subsidy distorts energy prices leading to inefficient resource allocations whereby putting the economy in to jeopardy. Moreover, subsidizing policies aimed at helping the poorer segment of the society and enhancing the overall economic welfare level are ineffective as benefits of such subsidy provisions are enjoyed by the wealthier segment of the society. Thus, it is ideal for the government to refrain from excessive intervention into the energy markets and to adopt appropriate public policies to enhance completion within the aforementioned sector. Prevalence of cost-reflective energy prices could well be a possible step towards achieving energy security in the underdeveloped nations which would in turn complement to the Sustainable Development Goals.  

The writer is a Research Assistant, North South University

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