A QUARTERLY JOURNAL FOR DEBATING ENERGY ISSUES AND POLICIES CONTENTS

Issue 88 May 2012 The Controversy over Energy Subsidies

Energy subsidies have been a core policy in many parts of the world, Laura El-Katiri and typically aimed at achieving broader welfare and development objectives. Bassam Fattouh – page 3 Yet, in recent years a growing number of countries – Indonesia, Nigeria Joerg Spitzy – page 5 Fatih Birol – page 8 and Iran being some examples – have begun to reform their domestic Paul Segal – page 11 energy pricing systems, in particular for fossil fuels and electricity. Part Anupama Sen – page 13 of the reason for this trend lies in the oil market, where higher prices Damian Tobin – page 15 since the early 2000s have rendered energy imports, and the mounting Hamid Tabatabai – page 17 fiscal burden of subsidies that level the gap between international and Shirin Narwani – page 20 domestic prices, ever more expensive for governments. But criticism of James Henderson – subsidies has also sprung from what increasingly many observers see as page 22 the ineffectiveness of many current subsidy systems in achieving their Letter declared policy goals, such as promoting universal energy access and Robert Levin – page 26 industrial value-added growth. Issues such as unequal access, demand growth in emerging economies, and the sustainable long-term use of Asinus Muses – page 28 energy resources additionally feature in this debate – reason enough for this special edition of the Oxford Energy Forum.

The debate is started by Laura El-Kat- rationale for regulating energy prices, iri and Bassam Fattouh, who explore of protecting consumers against in more detail some of the factors that price rises and fluctuations, is today have contributed to the controversy still as valid as ten years ago; this is surrounding energy subsidies. They in view not only of the potentially emphasise the difficulty of providing damaging effect of considerable price a universally accepted definition, and rises on emerging countries’ macro- hence measurement, of subsidies. For economic stability, but also in view this reason, quantifying the size and of an estimated 2.7 billion people in performance of subsidies remains a the developing world who until now controversial task. Assessments of sub- are unable to afford access to non- sidies in place differ widely, while the traditional sources of energy such as reform of subsidies in the eyes of many fossil fuels. Rather than condemning governments remains costly – not least subsidies per se, he argues that the way due to political considerations in view in which subsidies should be assessed of mass protest and industrial action. is to distinguish between efficient and inefficient subsidies. Joerg Spitzy provides a close account of OPEC’s perspective on energy Fatih Birol, Chief Economist at the subsidies. He points out that the IEA and responsible for the IEA’s PAGE 2 | OXFORD ENERGY FORUM | MAY 2012 annual World Energy Outlook, offers an alternative Hamid Tabatabai and Shirin Narwani follow up view. He proposes a general rethink of fossil fuel more closely the Iranian subsidy reform. Tabatabai of- subsidies, which in his view have many unintended fers an overview of the reform process since December consequences that contradict their original rationale. 2010. He concludes that ‘the Iran model of reforming Under his assessment, the removal of fossil fuel the system of energy subsidies is a bold attempt at subsidies could mean a triple-win situation for pursuing the twin objectives of enhancing economic reforming economies: by cutting global primary efficiency and social justice at the same time’ but -ar energy demand, the removal of these subsidies could gues that ‘while the extent of its success so far may be be an integral building block for tackling climate judged differently, its longer-term impact remains to change; contribute towards greater energy security be seen.’ Narwani shares this assessment; in her view, in both importing and exporting countries via the reform has succeeded in cutting energy demand reduced imports and increased availability of fossil beyond expectations, but the long-term viability of fuels for exports; and make consumers globally more the country’s compensatory scheme remains doubtful. responsive to oil price fluctuations, and hence reduce James Henderson discusses the case of Russia, which volatility in international energy markets. underwent a comprehensive, gradual reform of Several authors in this issue look more closely at energy prices since the breakup of the Soviet Union. specific country experience with the use and reform He suggests Russia’s only remaining exception to the of energy subsidies. Paul Segal, Economics Lecturer reform of energy prices, natural gas, has only been made possible by relatively higher netback prices for at Sussex University, calls for the reform of fuel Russian gas exports, but that this factor hasn’t saved subsidies based on his observation of Mexico’s case. the country considerable distortions on its domestic Describing subsidies as ‘both extremely popular and energy market. wholly unjustifiable’, Segal proposes that alternative ways of distributing Mexico’s oil revenues do exist, via a resource dividend, targeted or universal, models of Contributors to this issue which are already in place such as under the Alaska FATIH BIROL is Chief Economist Director at the Permanent Fund or Bolivia’s Renta Dignidad. International Energy Agency, Paris Anupama Sen of Oxford Institute for Energy Stud- LAURA EL-KATIRI is Junior Research Fellow at the ies assesses the reform of energy prices in India. Oxford Institute for Energy Studies BASSAM FATTOUH is Director of the Oil and the Highlighting first steps in the right direction, Sen Middle East Programme at the Oxford Institute for emphasises that India’s energy pricing system is Energy Studies still in transition. While some problems have now JAMES HENDERSON is a Senior Research Fellow at the been displaced from one sector to the other, she also Oxford Institute for Energy Studies points out that the longevity of India’s reforms will ROBERT LEVIN is Managing Director, Commodity still need to be proven following the country’s next Research and Product Development, CME Group general elections in 2014. SHIRIN NARWANI is a Visiting Senior Research Fellow at the Oxford Institute for Energy Studies Damian Tobin focuses on subsidies in the petro- PAUL SEGAL is Lecturer in Economics at the University chemical sector. He shows how in the Chinese case, of Sussex and a Visiting Senior Research Fellow at the economic necessity, mostly as a result of rapid growth Oxford Institute for Energy Studies of manufacturing in China, has forced the state to ANUPAMA SEN is Research Fellow at the Oxford abandon the large-scale subsidisation of petrochemical Institute for Energy Studies products. He argues that the removal of subsidies has JOERG SPITZY is Senior Research Analyst at the OPEC led to a remarkable and unusual opening up of China’s Secretariat, Vienna state-driven petrochemical sector. However, China’s HAMID TABATABAI formerly worked as a senior pricing reform has also exposed refineries to volatile economist at the ILO, and is an independent researcher living in France international prices without addressing the problems DAMIAN TOBIN is Lecturer at the Department of of small-scale and variable throughput; as well as to Finance and Management Studies, School of Oriental and the political risk as the state retains the ability to force African Studies, University of London refiners to absorb increases in international prices. MAY 2012 | OXFORD ENERGY FORUM | PAGE 3

Why So Controversial? The Dilemma of Trying to Assess Energy Subsidies LAURA EL-KATIRI and BASSAM FATTOUH explore why opinions on energy subsidies and their reform differ so much

Energy subsidies are a controversial poli- maintains prices for consumers below the decide to finance the subsidy programme cy tool, and assessing them confronts an market level or prices for producers above through off-budget activities. Off-budget analyst with an even greater dilemma. the market level or an action that reduces subsidies are less transparent and more A lot of this is due to the nature of costs for consumers and producers by giv- difficult to calculate. For instance, where subsidies: they are by default elusive as ing direct or indirect support. This defini- producers of fossil fuels sell domesti- a concept, and invite starkly differing tion underlies the price-gap approach, cally produced oil, natural gas or coal views on which benchmark price to which remains the most commonly used at production cost price, rather than at assess them against. Subsidies can be method for calculating subsidies due to international market prices, one could implicit or off-budget, and as such raise its simplicity. The price-gap approach argue that the effect is an implicit subsidy. doubts by some as to whether they compares the observed price for a good This subsidy is invisible in the budget: should indeed be considered subsidies at or a service against a certain benchmark it is the opportunity cost of foregone all. Subsidies are also intended to fulfil or reference price. A joint report by IEA/ government revenues. Many producers very legitimate policy concerns such OPEC/OECD/World Bank for the would disagree with the classification of as welfare and development objectives, 2010 G-20 Summit in Toronto notes these pricing options as formal subsidies. with diverging views on the effective- the existence of a major disagreement In view of this controversy, quantifying ness of subsidies in delivering on these among international organisations the size of subsidies and their impact on policy goals. Finally, adverse experience concerning the choice of the reference national economies remains a tedious with failed reform, and the political price, and consequently ‘a commonly task, and one whose outcome is unlikely cost of popular protest against energy agreed definition of subsidies has proven a to be universally accepted. price rises renders the reform of energy major challenge in the G-20 context and Legitimate Objectives versus subsidies in the eyes of many policymak- countries have decided to adopt their own ers too costly. What is needed is a more definition of energy subsidies’. Specifically, the Effectiveness of Subsidies constructive approach towards energy international organisations such as the Domestic energy pricing policies often subsidies – with the acknowledgement IEA and the World Bank estimate the size serve very legitimate broad welfare and that subsidies may achieve some of of the subsidy based on the differential development objectives. Critics of current the intended objectives but also have between prices of fuels in international subsidy systems tend to highlight what important unintended consequences. markets, and the price at which these fuels many see as a lack of effectiveness of are sold domestically. On the other hand, A Matter of Definition subsidies in achieving these policy goals; the same report stated that ‘OPEC is of where they are ineffective, they may The elusive nature of subsidies is reflected the opinion that the benchmark price indeed exacerbate existing socio-economic in the various definitions used in the to be used in the case of energy resource problems. literature. At the very general level, a well-endowed countries should be the cost 1. Expanding access to energy. Accord- subsidy can be defined as ‘any government of production’. ing to the UN Environment Programme, assistance, in cash or in kind, to private Energy subsidies can be on-budget or an estimated 1.6 billion people have no sector producers or consumers for which off-budget. On-budget subsidies con- access to electricity, while more than 2 bil- the government receives no equivalent stitute explicit cash transfers made by lion people are still reliant on traditional compensation in return, but conditions the government to either the producer fuels such as wood and charcoal for cook- the assistance on a particular performance or the consumer receiving the subsidy, ing and heating. Energy subsidies are often by the recipient’. This definition (by the registered on the state’s budget (these are intended to help the poor access more US Congress Joint Economic Committee also referred to as explicit subsidies). For qualitative sources of energy such as liquid in 1972) can lead to the categorisation instance, a government may mandate that fuels, LPG and electricity, by making of many different forms of government a public utility sets the selling price below them more affordable. Critics of energy assistance as subsidies, including direct the cost of production. The government subsidies point out the ineffectiveness of payment to consumers tied to consump- then finances the public utility’s losses subsidies in specific country contexts. For tion (cash subsidies), the administration of by transferring funds from the budget. instance, where fuel subsidies are universal interest rates on consumer credits (credit These funds can be secured by cutting (i.e. rather than targeted to individual subsidies), tax incentives (tax subsidies), government expenditure in other areas, beneficiary groups) they are often found procurement subsidies, and in-kind increasing direct or indirect taxes, and/ to result in considerable leakages to subsidies. or by borrowing in local or international higher income groups, which consume Others provide a more narrow markets. relatively more energy than low income definition of subsidy as a measure that Alternatively, a government may groups. Where subsidy schemes are poorly PAGE 4 | OXFORD ENERGY FORUM | MAY 2012 implemented, losses incurred by producers Governments can also offset temporary perspective, governments may see energy and distributors of energy, particularly commodity price fluctuations by control- subsidies as a policy that provides citizens in electricity, can result in systematic ling energy prices, and there are good with what they demand – where critics underinvestment within the energy sec- reasons for doing so: consumers and would add that the positive and negative tor; in such cases, subsidies may hamper producers may incur costs in adjusting impacts of subsidies are not necessarily infrastructure growth, such as electricity their consumption and production in the well enough understood by the public. network expansions into rural areas. face of volatile energy prices. Subsidising 2. Protecting the poor. Protecting domestic prices when prices in interna- Reforming Subsidies households with low incomes from high tional markets are high, and increasing Energy subsidies are often entrenched fuel costs is considered to be one of the taxes when prices in international markets in institutional barriers and lock-in key factors behind subsidies. Energy forms are low, can smooth consumption in the mechanisms, which makes it difficult to an important part of the consumer basket, face of highly volatile energy prices. Critics abolish them. This is because subsidies, by such that price rises proportionally hit low may argue that many other costs of subsi- definition, entail the creation of rents for income groups most. Protecting energy dies, for instance the often enormous fiscal certain industries, regions, or groups of prices – particularly for essential forms burden they cause, outweigh the gains on people. Since these rents accrue dispropor- of energy such as electricity, and fuels the grounds of consumption smoothing. tionately to certain groups (industrialists consumed primarily by the poor such as Some observers would also argue that or particular classes of consumers) while kerosene – against price increases is often energy subsidies in emerging markets seen as one main tool by governments isolate these markets from global energy the costs are widely spread, the prime to protect the income of low income prices, and hence stall the global demand beneficiaries of the rents will always have households. This factor is most relevant in response necessary to drive down prices an interest in defending the continuation countries where alternative social safety for oil and other energy commodities. of the programmes, because the benefits exceed the costs to them. These groups networks do not or not sufficiently exist. 5. Avoiding inflationary pressure. One Critics of energy subsidies point towards of the main worries facing many govern- will also have the greatest incentive and the regressiveness of non-targeted subsi- ments is that international increases in capability to organise effective political ac- dies – these benefit the rich by tendency prices of key commodities such as energy tion, leading to what is known as political more than the poor. Leakages to high and food induce inflationary pressures. mobilisation bias, where the government income groups cost the state funds which Energy is an important component of would respond to the interests of small would have been potentially available for the consumer basket, and any increase but homogenous groups rather than to alternative schemes, including targeted in the price of energy is automatically some vague wide general interest. Re- assistance based on contingency and reflected in an increase in the consumer sponses seen in previous cases of subsidy economic need. price index (CPI). It is also argued that reform have involved a variety of negative 3. Fostering industrial development. high fuel prices cause an upward shift in reactions, ranging from industry threats of Energy-intensive industries – such as ce- the cost structure of industries, which loss of international competitiveness and ment, fertilisers, and petrochemicals – are is then passed on to consumers. One of of jobs, to mass popular protests against likely to benefit the most from subsidies, the key concerns of governments who governments in place – for example in as energy constitutes an important are reforming subsidy systems is typically Nigeria, Indonesia, Malaysia, and Bolivia component of their intermediate cost. the possibility of causing upward infla- in the past ten years. Many governments’ The rationale behind such subsidies is tion, eroding gains made elsewhere in adverseness to tackling subsidy reform to induce firms to provide their goods the economy. Critics would argue that hence also results from a lack of relevant, and services to consumers at affordable generally, the experience of holding down positive examples elsewhere, and concerns prices; to help protect local industries fuel prices through administered controls over political consequences. against foreign competition; to enhance in order to control inflation is extremely In a recent report we prepared for the their export competitiveness; and to adverse, as it leads to distortions in the UNDP (Energy Subsidies in the Arab protect local employment. From a broader economy that have to be removed at a later World), we observed all these factors. One perspective, subsidising the industrial stage. Furthermore, if not financed by of the main lessons from the past year has sector can, by promoting and protecting a cutting government expenditure in other been a tendency to delay – in some cases national advantage, be part of a country’s areas or increasing taxes, financing energy indefinitely – previously planned pricing industrial and economic development subsidies could induce inflationary pres- reform as a result of last year’s political planning. Critics of industry subsidies sures, for instance by increasing pressure uprisings that shook many parts of the on the other hand argue that subsidies on money creation. region. However, in the Middle East as encourage inefficiencies and waste, owing 6. Political considerations. Fuel subsidies elsewhere in the world, many governments to a lack of incentive to rationalise the are often very popular and they can have increasingly found themselves in a energy input; and that they lead to a therefore be introduced or increased, as financial position where the reform of misallocation of resources towards energy- appropriate, to alleviate popular discon- energy subsidies is no longer a question intensive industries which may not be tent. In addition, in countries with large of choice. This has been particularly the internationally competitive in the absence own hydrocarbon reserves, citizens often case for net importers of energy, whose of subsidies. consider low-priced energy as a right rather budgets have been increasingly unable to 4. Consumption smoothing. than a privilege. Following from this stem the mounting fiscal burden of energy MAY 2012 | OXFORD ENERGY FORUM | PAGE 5 subsidies. The oil price rises of the 2000s, citizens’ ‘right’ to low-cost energy seem distortions that subsidies entail. In an compared to relatively stable and low to render reform even more difficult, unusual step, one of the region’s major prices during the 1990s, has in many cases we suggest that governments explore producers of oil and gas, Iran decided to led to a sharp rise in import bills, which alternative ways to distribute rents more reform its domestic subsidy system com- many developing countries are less and efficiently, for instance through universal prehensively starting in December 2010. less able to stem. cash transfers (as proposed by Paul Segal One of the most relevant questions at this Moreover, in many energy producing in his article on Mexico in this issue of stage is arguably what can be learned from and exporting states, energy subsidies Forum) or through targeted transfers. such cases by other potential reform- constitute one way of distributing oil and Both methods enable populations to ers – keeping in mind that there can be gas rents to their populations. While in participate in producing countries’ energy no one solution that fits all countries’ these countries, popular perceptions of a wealth, but avoid many of the economic circumstances. ■

Energy Subsidies – an OPEC Perspective JOERG SPITZY argues that energy subsidies are still legitimate policy tools

Reasons for Providing Subsidies social and economic costs and benefits developing world use them widely to in General – subsidies as a and, therefore, distinguishes between eradicate poverty and facilitate access common policy tool efficient and non-efficient subsidies – to modern energy sources. Three billion defining efficient subsidies as those that people are denied access to electricity Subsidies have a long history and have enhance socio-economic development, around the world and 2.7 billion rely been used widely by almost every economy while non-efficient subsidies can harm on the traditional use of biomass for in various forms up to the present day. such development, since the costs out- cooking, according to the latest figures Sector-wise, they range from multi- weigh the benefits. A tool that is available from the International Energy Agency. billion(US)-dollar farming, fishing and to assess this is ‘social cost-benefit analysis’ Particularly for resource-abundant energy subsidies to the trillions of dollars (SCBA). economies, providing energy subsidies to of subsidies that have been channelled A brief overview shows that the global consumers could be a simple and relatively into the bail-out of the global banking sys- figure for subsidies is large. In 2010 an efficient way of improving conditions for tem since 2007. Usually, they are provided OECD Secretariat report on Agricul- their populations as a transitional process. via direct transfers of funds, while there tural Policies showed that support for the While there might be a long way still to go are also subsidies that come indirectly via agricultural sector in the OECD stood to achieve the UN Millennium Develop- forgone revenues, like tax incentives. Both at $379 billion in 2008 and at $384 bn ment Goals (MDGs), consumer subsidies forms have a real cash effect. in 2009. The majority of these subsidies, for energy sources have been used for a Then there is support that does not $262 bn and $252 bn respectively, were long time with a positive effect on the involve cash-related flows and should not, producer subsidies, despite the fact that socio-economic development of many of therefore, be classified as subsidies. This food prices – to the benefit of produc- these countries. Although some develop- includes state guarantees for the cheaper ers – increased by more than 20 per cent ing economies have started to phase out funding of specific sectors, guarantees for between 2007 and 2010. At the same consumer subsidies for energy, with the financial instruments or selling energy time, subsidies supporting the consumer next step of channelling some of these resources in resource-well-endowed coun- increased too, by more than 20 percent, funds into a social welfare system that tries to the population at production cost. i.e. covering inflation in agricultural prod- could compensate individuals better and There is no public fund outflow involved ucts. Subsidies used since 2007 to bail out is more specifically targeted than broadly and they do not burden the funds of the global banking system have been on a distributed energy subsidies, this has an economy, but, nevertheless, they are much larger scale, but they are extremely turned out to be a very challenging task, usually supportive of socio-economic hard to define, because of the complexity as has been observed on many occasions in development. These forms of support of the bailout, and are estimated in terms recent years. hardly qualify as subsidies. of multi-trillion dollars in the USA alone. The magnitude of the funds, which The main question, when providing However, before moving on to the energy are aimed at eradicating poverty and subsidies, is whether it makes sense in sector in greater detail, it has become improving socio-economic development socio-economic terms to invest funds to obvious that sovereign states may have through such consumer subsidies for support a specific sector, the population many reasons to believe that, through energy in mainly the developing econo- or any other important area of concern. subsidies, socio-economic factors can be mies, is estimated by the IEA’s price-gap It should be noted that, according to the improved, whether this be in the wealthier analysis (PGA) at $409 bn in 2010. Since agreement of the Group of 20 (G20), the OECD or poorer developing economies. these assumptions are applied mainly to answer to this question should be treated When it comes to energy subsidies developing economies, it is worth noting as a sovereign decision. Usually, such a and, particularly, consumer subsidies, that producer and consumer subsidies sovereign analysis tries to balance the resource-abundant countries in the in much wealthier OECD economies in PAGE 6 | OXFORD ENERGY FORUM | MAY 2012

2010 have been estimated at an aggregate population with these lower fossil fuel for 83 per cent of the world’s nuclear and value of around $45–75 bn per year over prices. However, when these producer renewable energy-based electricity genera- the period 2005–10, by the OECD. price levels in resource-well-endowed tion, according to the US Department It is also important to highlight the economies are applied, then the amount of of Energy’s Energy Information Admin- fact that the amount that has been raised consumer subsidies is reduced significant- istration, and two-thirds of its biofuel through negative subsidies in OECD ly to around $250 bn. Furthermore, the production. Based on GSI estimates, economies on fossil fuels is around twice PGA does not accommodate any purchase non-fossil fuel energy sources and biofuels the sum that, according to the IEA’s PGA, power parity (ppp) adjustment, which, are subsidised at an average rate that is has been used for consumer subsidies for in many of these countries – even when significantly higher than that for fossil energy. These negative subsidies obvi- taking into consideration an international fuels. The per unit subsidies to nuclear ously play a vital role in economic policy, reference price – would significantly and renewable energy are up to 11.6 US particularly in the energy field. Based on reduce the amount of this subsidy calcula- cents per kilowatt hour and 15.4¢/kWh energy demand, price and tax data pub- tion. Therefore, even by applying the base respectively, compared with up to 0.7¢/ lished by the IEA, OPEC estimates that, number for 2010 of $409 bn, a ppp-based kWh for fossil fuels. For transportation, between 2005 and 2010, around $850 bn approach would lead to a much lower biofuels receive a subsidy of 3.3 ¢/kWh, were raised annually by OECD countries figure of around $300 bn. compared with 0.5 ¢/kWh for oil-related through taxes on petroleum products, Furthermore, any link between the products (Table 1). including taxes on goods and services virtually assumed amount of fossil fuel The findings on nuclear energy are and value-added taxes. This compares consumer subsidies and the funds needed of particular importance and probably with an estimate of $800 bn in the years to reduce greenhouse gas emissions is become even more accentuated, when between 2004 and 2009. These funds misleading. First, many estimates of considering the long lasting effects of are then redistributed to other areas, in consumer subsidies for fossil fuels seem potential accidents and all the long-term accordance with sovereign decisions in to be overstated and are, secondly, only challenges related to nuclear waste. these countries. Based on IEA and OECD a fraction of the quantity of negative The cost of the clean-up following the data, negative subsidies are the highest, subsidies that have been raised by OECD meltdown of the Fukushima accident, for in relative terms, for oil-related products, economies, and are also only a rather small example, has been estimated at around followed by natural gas and coal. In amount, in contrast with the massive $250 bn and this does not even consider 2010, the average amount of tax on oil in subsidies given to the financial services the economic consequences of this tragic OECD countries stood at $51.1/barrel sector in recent years. incident. of oil equivalent; for gas, it was $3.1/boe, and for coal, $0.2/boe. Comparison of the Amount of Distinguishing Efficient and In addition to these comparisons, Subsidies per Energy Unit Inefficient Energy Subsidies it should be said that the PGA-based estimate of fossil fuel consumer subsidies When reviewing energy subsidies, it is Energy subsidies can be very supportive seems to overstate the figures significantly. always important to compare them on for particularly immature economies, This is discussed in the IEA, OPEC, a per energy unit, instead of as a total but decisions about subsidies are a OECD, World Bank joint report for the amount, since fossil fuels account for the sovereign matter. However, with respect 2010 G-20 summit. First, producer prices majority of energy resources provided. to the use of subsidies as a policy tool, in many resource-abundant economies are Figures show that the subsidies for fossil it is important to distinguish between relatively low, and, therefore, these lower fuels are by far the lowest, when compared efficient and inefficient ones. This must prices cannot be compared with the usu- with other energy sources. Based on esti- also be considered according to the G20’s ally higher prices in importer countries, mates provided by the Global Subsidies mandate, when deciding upon phasing where prices are also diluted by taxes, i.e. Initiative (GSI), the rates of subsidisation out fossil fuel subsidies over the medium negative subsidies, and administration, for non-fossil fuel energies are at relatively term. The complex, but most useful tool marketing and freight costs. Due to this high levels, compared with fossil fuels and for analysing this matter is social cost- lower level of cost, in many economies no are provided mainly by OECD countries. benefit analysis (SCBA). Such an analysis extra funds are being used to provide the These countries are currently responsible can only be pursued by the sovereign

Table 1: Energy Production and Subsidies Energy produced OECD share of Subsidies per energy unit US Energy type (2009) production (2009) cents/K Wh (2009) Nuclear energy 2,600 TWh electricity 83% 0.5–11.6 Renewable energy (excluding hydropower) 500 TWh electricity 83% 1.7–15.4 Fossil fuels to electricity 12,900 TWh electricity 0.1–0.7 Biofuels to transport 51 Mtoe 66% 3.3 Oil products to transport 2,205,570 Ktoe 0.5

Sources: Global Subsidies Initiative and US Energy Information Administration MAY 2012 | OXFORD ENERGY FORUM | PAGE 7 authority, since it is the only institution have shown a notable negative impact in • The negative GDP effect for Member that holds all the necessary information the short-to-medium term, particularly Countries in this scenario is triggered for providing a comprehensive answer. when taking into account that, in many primarily by a significant increase in An example of how this can be used of these countries, the low prices of fossil inflation, which negatively affects the to examine the social, economic and fuels reflect the lower costs of production competitiveness of the manufacturing environmental impact of energy subsidies and that price increases would artificially sector as it lifts input prices for the is provided in Figure 1. burden, in many cases, populations that non-oil sector and puts pressure on While, for the poorer resource-well- are already relatively poor. real income and consumption levels. endowed countries, such an analysis could These simulations were pursued The average consumer price index for probably support the reasoning for the pro- with the Oxford Global Macro Model Member Countries will rise by 4.4 vision of consumer subsidies for fossil-fuel and analysed a phase-out of fossil fuel percentage points, compared with the related energy, most developed economies subsidies that was gradual and spread baseline assumptions. have concluded that it supports nuclear equally over five years. Furthermore, it • A major impact of this would be a and alternative energy, i.e. those areas was assumed that 60 per cent of the value significant loss of jobs. Employment where they sense a comparative advantage, of the fuel subsidy would be recycled back would decline by 2.3 percentage when it comes to the energy agenda. into the economy through government transfers, while the rest would be used points, compared with the baseline Economic Impact, when Phasing to reduce budget imbalances. The actual assumptions. out Energy Subsidies level of expenditure on fossil fuels was It is obvious that any call for increasing estimated, using IEA data for 2009, on prices on fossil fuels in resource-abundant As has been mentioned already, the chal- average subsidy rates as a proportion of the developing economies would significantly lenges for phasing out energy subsidies full cost of supply. Three main dimensions hurt these economies. This is even more are significant and many recent cases were analysed: the repercussions on GDP the case, when considering that infla- have highlighted the economic sensitiv- growth, the impact on inflation and the tion in most of the potentially affected ity of such reduced support. This seems effects on the labour market. economies has risen significantly already obvious, when taking into account the in recent years and that any measure that severe economic impact this could have • The analysis showed that, when increases the pressure on households can on these developing economies, where the phasing-out energy subsidies, the hardly be justified. This sensitivity is also majority of the population is considered to GDP effect on Member Countries supported by the findings of the World be relatively poor. Modelled simulations would be an annual average of –3.4 Bank’s Poverty and Social Impact Analy- of the economic consequences of such a percentage points for the first five sis (PSIA), which has shown that the policy for OPEC’s Member Countries years. proportional impact of subsidy removal

Figure 1: Social, Economic and Environmental Impact of Energy Subsidies

Increases Direct Effect on Direct Marginal Composition of emissions & Environment Revenue Production in the resource use Damage

Economy onment ecipient secto r Decreases Indirect Effect Indirect Output effect in Marginal onment policy on emissions & Environmental recipient sector gy subsidy Production resource use Damage Ener

Accrues Indirect output Existing envir Directly to effect in other Income sectors Environmental Assimilative capacity of envir Protection Expenditures Supply and demand conditions in r Direct and Indirect Effects on Economy

Social Impacts

Source: United Nations Environment Programme, 2003, Energy Subsidies – Lessons Learned in Assessing their Impact and Designing Policy Reforms, p29 PAGE 8 | OXFORD ENERGY FORUM | MAY 2012

(or price-increase) can be the greatest for between efficient and non-efficient Those countries that decide to phase out the poor, even in those cases where the energy subsidies. This can be pursued via a subsidies may face challenges in imple- rich receive more. social cost-benefit analysis. The price-gap menting reforms, and the reforms may approach cannot provide this information, lead to some restructuring of the economy Conclusion and Key Take-aways but instead supplies only a total amount that will need to be managed carefully. that is potentially misleading, since it The findings illustrate some of the chal- Therefore, any reform has to be designed is not only impossible to distinguish with great care and will require consider- lenges and sensitivities involved in phasing between efficient and inefficient energy out energy subsidies and highlight the able time. In conclusion, it seems sensible subsidies by means of the PGA, but it also to recall that these fossil fuel consumer low levels of subsidies that are being used treats lower production costs as subsidised subsidies are addressing the vital needs for fossil fuels, compared with non-fossil prices and does not even adjust for of the poorest people on the globe. No fuels. Furthermore, it is important to con- purchase power parity assumptions. one-size-fits-all model exists.■ sider any decision on subsidies as being a Phasing out consumer subsidies for sovereign matter, as well as the importance fossil fuels in many resource-abundant This text has been provided on behalf of the of the sovereign authority distinguishing economies simply means raising prices. OPEC Secretariat.

Getting rid of Fossil-fuel Subsidies is a Triple-win Solution FATIH BIROL calls for the removal of fossil fuel subsidies

Fossil-fuel subsidies remain common- easy, it would probably already have burdens on countries importing energy at place in many countries. They result in happened. world prices and selling it domestically at an economically inefficient allocation of lower, regulated prices. resources and market distortions, while Fossil-fuel Subsidies have A related motivation for phasing out often failing to meet their intended Unintended Consequences fossil-fuel subsidies stems from their objectives. Moreover, volatile energy adverse impact on investment resources. markets and the prospect of higher fossil The most common justifications for fossil- Where fossil-fuel consumption is subsi- fuel prices mean that fossil-fuel subsi- fuel subsidies include alleviating energy dised through consumer price controls, dies threaten to be a growing liability to poverty, redistributing national resource the effect, in the absence of offsetting state budgets. This prospect has created wealth, or promoting economic develop- compensation payments to companies, a strong impetus for reform, strength- ment and diversification (Figure 1). In is to reduce energy companies’ revenues, ened by other associated benefits. But recent years there has been growing mo- which discourage investments in energy fossil-fuel subsidy reform is notoriously mentum to phase out fossil-fuel subsidies infrastructure. This problem is particular- difficult as the short-term costs imposed as many were seen to be failing to serve ly prevalent within the electricity sector of on certain groups of society can be very effectively the aforementioned objectives. many developing countries, but also exists burdensome and induce fierce opposi- While also, in a period of persistently high in the oil, natural gas and coal sectors. tion. If removing these subsidies were prices, imposing unsupportable financial Subsidies can encourage wasteful

Figure 1: Potential Unintended Effects of Fossil-fuel Consumption Subsidies

Encourage wasteful consumption Disproportionally benefit the middle class and rich

Hasten the decline of exports Drain state budgets for importers

Threaten energy security by increasing imports Distort markets and create barriers to clean energy investment

Encourage fuel adulteration and smuggling Dampen global-demand responsiveness to high prices

Discourage investment in energy infrastructure Increase CO2 emissions and exacerbate local pollution

Source: World Energy Outlook 2011 MAY 2012 | OXFORD ENERGY FORUM | PAGE 9 consumption, thereby leading to faster eliminate incentives both to adulterate subsidy levels. The series of estimates from depletion of finite energy resources, and fuels and to smuggle them across borders. 2007 to 2010 demonstrate clearly the risk can also discourage rationalisation and ef- Fossil-fuel subsidies are mostly to which governments are exposed by ficiency improvements in energy-intensive counterproductive in reaching local and regulated domestic prices in international industries. There is a strong empirical link global environmental goals. Subsidised energy markets subject to unpredictable between low energy prices and excessive energy prices dampen incentives for price fluctuations. consumption. Extremely high rates of consumers to use energy more efficiently, Today, fossil-fuel subsidies remain most electricity consumption in many develop- resulting in higher consumption and prevalent in the Middle East, amounting ing economies such as in parts of the greenhouse-gas emissions than would in 2010 to $166 billion, or 41 percent Middle East can be shown to derive from otherwise occur. Furthermore, fossil-fuel of the global total. At $81 billion, Iran’s cheap electricity tariffs rather than solely subsidies undermine the development and subsidies were the highest of any country, from demography or economic growth. commercialisation of renewable energy although this figure is expected to fall The resulting subsidy, in certain cases, and other technologies that could become significantly in the coming years if the has over-burdened government resources more economically attractive. sweeping energy-pricing reforms that at the expense of social and economic commenced in late 2010 are implemented expenditures. Fossil-fuel Subsidies and successfully and prove durable. Two Fossil-fuel subsidies exacerbate energy their Costs leading oil and gas exporters – Saudi price-volatility on global markets by Arabia and Russia – had the next-highest Within the framework of the World dampening normal demand responses subsidies in 2010. While the magnitude of Energy Outlook (WEO), the IEA has to changes in international prices. For fossil-fuel subsidies in 2010 was also large been measuring fossil-fuel subsidies in China and India, they are considerably example, the first half of 2008 saw robust in a systematic and regular fashion for smaller when viewed as a share of their demand despite dramatic increases more than a decade. Its analysis is aimed economic output or relative to their huge in crude oil prices. This has now been at demonstrating the impact of fossil- populations, amounting to less than 0.5 attributed in part to artificially low energy fuel subsidy removal for energy markets, percent of GDP and $20 per person in prices in many countries, which blunted climate change and government budgets. both cases. market signals. A survey of 131 countries The IEA’s latest estimates indicate carried out by the International Monetary that fossil-fuel consumption subsidies Fund (IMF) found that in 2008 around Fossil-fuel Subsidies are not worldwide amounted to $409 billion in Benefiting the Poor two-thirds of countries failed to fully pass 2010, up from $300 billion in 2009, with through the sharp rise in international subsidies to oil products representing One common justification for fossil-fuel prices for gasoline and one-half failed to almost half of the total (Figure 2). The subsidies is that they are needed to help pass through the full increase in the cost magnitude of energy subsidies fluctuates the poor gain or maintain access to energy of diesel. Cutting subsidies, by shifting the from year-to-year with changes in world services essential to basic living standards. burden of high prices from government prices, domestic pricing policy, exchange However the IEA’s WEO-2011 estimates budgets to individual consumers, would rates and demand. Of these factors, that only 8 percent of the $409 billion lead to a much faster and stronger demand movements in world prices typically have spent on fossil-fuel subsidies in 2010 was response to future changes in energy by far the greatest impact on variations in distributed to the poorest 20% of the prices and free up government revenues for other urgent needs. Fossil-fuel subsidies can encourage Figure 2: Global Economic Cost of Fossil-fuel Consumption Subsidies by Fuel fuel adulteration, and the substitution of subsidised fuels for more expensive fuels. 600 150 In some countries, subsidised kerosene intended for household cooking and 500 125 lighting is diverted for unauthorised use Electricity as diesel fuel due to wide price differen- Coal tials. Fuel smuggling can also arise, since 400 100 an incentive is created to sell subsidised Natural gas el (nominal) products in neighbouring countries where 300 75 Oil prices are unsubsidised and, therefore, IEA average higher. This has been an issue for years crude oil 200 50 in many parts of the world, particularly import price in southeast Asia, Africa and the Middle Billion dollars (nominal) (right axis) Dollars per barr East. The effect in subsidising countries is 100 25 a substantial financial transfer to smug- glers, while recipient countries experience 0 0 losses from uncollected taxes and excise 2007 2008 2009 2010 duties, due to reduced sales in the legiti- mate market. Removing subsidies would Source: World Energy Outlook 2011 PAGE 10 | OXFORD ENERGY FORUM | MAY 2012 population. (This finding does not include it may be as an objective – would cut over the medium term inefficient fossil subsidies specifically provided to extend global primary energy demand by nearly 5 fuel subsidies that encourage wasteful access to basic energy services.) Compared percent by 2035, compared with a baseline consumption’. In November 2009, APEC to other fuels, subsidies to kerosene tend in which subsidies remain unchanged. leaders meeting in Singapore made a to be best targeted on the poor, despite its Oil demand savings would be equal to similar pledge, thereby broadening the tendency to be sold in the black market. 4.4 million barrels per day. Phasing out international commitment to reform. In 2010, nearly 15 percent of the kerosene fossil-fuel consumption subsidies could Since making these commitments, many subsidies in the countries analysed reached represent an integral building block for G-20 and APEC member economies have the lowest income group; subsidies to tackling climate change: their complete publicly identified inefficient fossil-fuel LPG, gasoline and diesel benefited the removal would reduce carbon dioxide consumption and production subsidies poor least, with only 5–6 percent going to emissions by 5.8 percent, or 2 Gigatonnes, and outlined plans for their removal. the lowest group. Subsidies to electricity in 2020. Conversely without further Many other countries outside of the G20 and natural gas were in the middle of the subsidy reform, the IEA estimates that and APEC groupings have also taken range, with shares of 9 and 10 percent the total cost of fossil-fuel consumption steps to bring their energy prices in line disbursed to the lowest group (Figure 3). subsidies would reach $660 billion in with international levels. In total, of the These results demonstrate that subsi- 2020 (year-2010 dollars). 37 economies identified in the WEO- dising fossil fuels is an inefficient method Curbing the growth in energy 2011 global survey as having fossil-fuel of providing assistance to the poor. demand via subsidy reform has several consumption subsidies, at least 15 have Fossil-fuel subsidies tend to be regressive important energy security implications. either implemented reforms or announced disproportionately benefiting higher In net-importing countries, lower energy related plans since the beginning of 2010. income groups that can afford higher demand would reduce import dependence This includes a number of energy-rich levels of fuel consumption. Poor house- and thereby spending on imports. For net- exporting countries that have moved to holds may not have access to subsidised exporting countries, removing subsidies phase out subsidies, or expressed inter- energy directly, lacking a connection to would boost export availability and est in doing so, concerned not only by electricity or natural gas and owning no earnings. For all countries, it would also the high cost of the subsidies but also vehicle. The same level of financial sup- improve the competitiveness of renewable the resulting low efficiency in domestic port could be distributed more efficiently energy in relation to conventional fuels energy use: the consequences can be sharp to low-income households at a lower cost. and technologies, further diversifying the domestic demand growth and reduced In general, social welfare programmes are energy mix. Lower energy demand would availabilities for export. a more effective and less distortionary way also alleviate upward pressure on interna- While the above-mentioned reforms of helping the poor than energy subsidies. tional energy prices, while the elimination represent an encouraging start, much of subsidies would make consumers more Phase out Fossil-fuel work remains to be done in order to responsive to price changes, which should realise the full extent of benefits from Consumption Subsidies for a contribute to less volatility in interna- Healthy Energy Economy subsidy reform. And in this period of tional energy markets. persistently high energy prices and with Reforming inefficient energy subsidies Signs of Progress but much growing concerns about climate change would have a dramatic effect on supply more Remains to be Done and mounting risks to energy security, it and demand in global energy markets. is imperative that countries now follow The WEO-2011 estimates that a universal In September 2009, G-20 leaders, through on their commitments by phase-out of all fossil-fuel consumption gathered at the Pittsburgh Summit, implementing subsidy reforms that are subsidies by 2020 – ambitious though committed to ‘rationalize and phase out well-designed and durable. ■

Figure 3: Share of Fossil-fuel Subsidies Received by the Lowest 20 Percent Income Group by Fuel, 2010

LPG Gasoline Diesel Electricity Natural Gas Kerosene

5% 6% 6% 9% 10% 15%

Source: World Energy Outlook 2010 Note: Countries surveyed were Angola, Bangladesh, China, India, Indonesia, Pakistan, Philippines, South Africa, Sri Lanka, Thailand and Vietnam. MAY 2012 | OXFORD ENERGY FORUM | PAGE 11

Oil Subsidies in Mexico PAUL SEGAL argues that oil subsidies in Mexico are both extremely popular and wholly unjustifiable

The popularity of oil subsidies arises that oil should be cheap in those countries than the non-oil economy, or Venezuela, from a very natural sense of oil na- that produce it seems to follow naturally where it comprises up to a third of GDP. tionalism, which developed in many from this sense of ownership. But this is But oil provides 30 to 40 percent of producer countries over the twentieth unfortunate because, as I will show, oil Mexican government revenues. For this century through painful struggles with subsidies are both inefficient and inequita- reason it is highly significant. international oil companies. Mexico was ble, and do not properly express the right The cost of petrol within Mexico is at the leading edge of the wave, in 1938 to the benefits of the oil that citizens can set by the government using an implicit becoming one of the first countries in legitimately claim. tax known as IEPS (Impuesto especial de the world to nationalise its oil industry. productos y servicios), which includes a While the 1917 constitution had already mechanism for smoothing the domestic declared that subsoil resources belonged price relative to changes in the interna- to the nation, this proposition was never tional price. I describe the tax as ‘implicit’ fully accepted by the international “The popularity of oil subsidies because the government is the sole vendor oil companies that extracted the oil: arises from a very natural of petrol so it receives the entire net price nationalisation was the result of their sense of oil nationalism.” of petrol sold. To the government’s credit, refusal to respect domestic laws and it estimates the opportunity cost and institutions, and the corollary of this reports the difference between the price difficult experience was the constitu- and this opportunity cost as the tax or tional amendment of 1960 that banned subsidy. The petroleum component of concessions. Since then, the national Mexico is a major producer of oil, but IEPS as a share of GDP is shown in Figure oil company Pemex has been the sole it is also a large economy. Oil revenues 1. It was indeed a tax up until 2005, in producer of Mexican oil. have comprised between 7 percent and which year it was worth 0.2 percent of Given this history – shared in several 10.5 percent of Mexico’s gross domestic GDP in revenues to the government. But important respects with many oil produc- product (GDP) in recent years. (For brev- with rising oil prices it had already fallen ers – it is no surprise that Mexicans have ity I use ‘oil revenues’ in Mexico to refer from its peak of 1.7 percent of GDP in a strong sense of ownership of their oil. to hydrocarbon revenues more generally, 2002, and by 2006 it had become nega- While references to ‘oil nationalism’ which are dominated by oil.) The Mexican tive, i.e. a subsidy, of 0.4 percent of GDP. are often disparaging, its first and most economy is therefore not as dependent on In 2008, when oil prices reached a peak, it important meaning is this legitimate oil as the major exporters of the Middle cost the government 1.8 percent of GDP. concern for self-determination. The view East, where oil production is worth more The subsidy disappeared in 2009 when international oil prices fell, but they reap- Figure 1: Petrol Tax (IEPS) as Share of GDP; negative indicates subsidy peared in 2010 as these prices recovered. This ‘cost’ to the government is not,

2.0% of course, the same thing as the cost to the country, because that 1.8 percent of 1.5% GDP was effectively being handed back to citizens. But such subsidies do imply a cost 1.0% to the country, because they are inef- ficient. This is easy to see if one considers 0.5% the simple experiment of exchanging $1 of fuel subsidy for a cash benefit of $1. With 0.0% the cash benefit the recipient can choose to spend the $1 on fuel, in which case she –0.5% is in the same position as with the subsidy. But she can also choose to spend some –1.0% share of the $1 on something else. The fuel subsidy implies forced expenditure on fuel –1.5% as opposed to on other goods and services that might be preferred. The result is –2.0% over-consumption of fuel relative to other 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 products. Fuel subsidies are also regressive Source: Secretaría de Hacienda y Crédito Público (SHCP), http://www.shcp.gob.mx/ because richer people tend to spend a PAGE 12 | OXFORD ENERGY FORUM | MAY 2012 higher share of their incomes on fuel, Table 1: Benefit Incidence of Subsidies the money is not spent on subsidies, it will largely because richer people are more on Gasoline and Diesel due to IEPS: disappear into the pockets of government likely to own cars. Mexico in 2006 was no share of total benefit received by each officials, or down the black hole of govern- exception. Table 1 presents government decile ment inefficiency. estimates of the distributional incidence What is needed, therefore, is a strategy Share of total benefit of fuel subsidies, in particular the extent that convinces citizens that the fiscal received by decile to which each decline of the population savings will benefit them. The challenge benefits: in 2006, more than 70 percent Decile 2006 2008 is particularly keen when oil prices of the benefits of fuel subsidies went to 1 0.80% 2.10% rise. Such a rise necessarily makes an the top 30 percent of the population. 2 1.70% 3.80% oil-exporting country richer. But when Surprisingly, in 2008, when fuel subsidies the only direct sign that citizens see is a grew massively, the estimates imply that 3 2.80% 5.00% corresponding rise in fuel prices, with no their impact was much less regressive. 4 3.70% 6.80% obvious translation into benefits for them, They were still absolutely regressive in 5 4.50% 8.50% then the call for subsidies is understand- that the rich gained more from them than able. One possible solution is a ‘resource 6 6.70% 9.20% did the poor, with the richest 10 percent dividend’, that is for hydrocarbon gaining over 10 times as much as the 7 8.40% 11.30% revenues to be given directly to citizens poorest 10 percent. But in relative terms, 8 12.40% 12.20% as an unconditional cash transfer. Such a the picture is much less clear. In 2008 the 9 18.80% 16.10% policy would be both highly progressive bottom 10 percent received 1.7 percent and poverty-reducing, as well as efficient. of market income and 2.1 percent of the 10 40.20% 24.90% Since the dividend would rise when oil subsidy, while the top 10 percent received Total 100% 100% prices rise, citizens would feel the benefit

46.1 percent of market income and 24.9 Source: SHCP 2008 and 2010. of higher oil revenues. Other taxes would percent of the subsidy. So relative to have to rise to compensate for lost govern- income, the gain of the top 10 percent was ment revenues, and in this respect the smaller than the gain of the bottom 10 subsidy incentivises an inefficient reliance fiscal system of oil producers would come percent. This is unusual; so much so that on fuel rather than other inputs, reducing to look more like that of a non-oil-rich one might legitimately doubt the accuracy overall value added. country – which would be no bad thing. of the estimates. Despite this, we know that oil subsidies Alaska’s Permanent Fund Dividend Despite the regressiveness of fuel are popular because we know how is closely related, as is Bolivia’s Renta subsidies – at least in absolute terms even difficult it is for governments to remove Dignidad, a universal pension for the if not relative to income – there remains them. The withdrawal of such subsidies over-60s paid for with hydrocarbon a perception among some that they are has often met with violent popular revenues – which, pre-dating the proposed an appropriate form of social assistance. resistance, sometimes including riots. reduction in subsidies mentioned above, For instance, a government newsletter In Bolivia, for instance, a World Bank/ could not be presented as a quid pro quo (SHCP) at the beginning of 2010 justified UDAPE document concluded that ‘the for their elimination. But perhaps the the fuel subsidies of 2008 as ‘supporting elimination of hydrocarbons subsidies is most interesting recent development on those who have least, because it is they one of the policies that has met with the this front is in Iran. On 20 December who suffer most from the effects of the fiercest opposition from society and is 2010 the Iranian government cut fuel and international recessions,’ describing the therefore avoided by the government, in other subsidies, with petrol prices nearly subsidies as ‘part of a packet of counter- view of the repercussions this may have quadrupling to 38 US cents per litre. cyclical policies proposed by the Federal on the population and productive sectors.’ Households were given a one-off cash pay- Executive to support the family economy A recent attempt by the government of ment of about US$80 each, and since then against the global crisis’. As we have seen, Evo Morales to reduce subsidies in Bolivia all Iranians living in the country have the view that fuel subsidies are a plausible ended in failure, the policy withdrawn in been entitled to, and nearly all receive, a mechanism for helping ‘those who have the face of widespread protests. monthly cash transfer worth about $45 least’ is impossible to justify. If fuel subsidies are both inefficient per person from the government. These Perhaps even more oddly, the same and inequitable, how can a government go unconditional transfers are officially newsletter insisted that, by keeping the about reducing and removing them? Part known as ‘cash subsidies’, presumably price of gasoline and diesel below that in of the problem is that, in addition to a to cement the perception that they are a the USA, it ‘maintained, in this respect, legitimate sense of ownership of their oil, replacement for the lost fuel and other a competitive position for the national Mexican citizens, like those of many oil subsidies. productive apparatus.’ This is another producers, are somewhat suspicious of the Mexico, like many oil producers, needs common misperception: that cheap fuel, benefits they receive from the government. a way to wean itself off inefficient and by subsidising domestic industry, makes So appeals to the fact that removing fuel inequitable fuel subsidies. Policies that that industry more ‘competitive’. Just as subsidies will enable a rise in government enable Mexican citizens to see the benefits in the case of consumption, if you want expenditures, or a reduction in taxes, do of their oil independently of the fuel to subsidise your industry a fuel subsidy not immediately convince. Too often such prices that they pay may help to reduce the is a highly inefficient way to do it: such a an appeal is met by the response that, if political pressure behind such subsidies. ■ MAY 2012 | OXFORD ENERGY FORUM | PAGE 13

Energy Subsidies in India: Proactive versus Reactive Change ANUPAMA SEN says energy price reform in India is work in progress

In June 2010, the Indian government three fourths of the rural population de- as natural gas, which was supplied to the deregulated the retail prices of petrol. pend on non-commercial energy for their power and fertiliser sectors. This system Shortly afterwards, the ‘administered’ needs, and about a quarter of the popula- was implemented without much difficulty price of gas was raised to double its tion (roughly 300 million) lack access to as both the producing and the consuming previous level. The prices of ‘sensitive’ electricity entirely. India’s population in sectors were run primarily by state-owned petroleum products – diesel, kerosene 2011 was 1.2 billion. Energy use per US$ companies. In addition, subsidised and LPG, have also progressively been 1000 of GDP was 195.4 kgoe in 2010, kerosene, used for lighting and cooking by increased; petrol prices rose by roughly while energy use per capita was 585 kgoe. low-income households was distributed 33 percent between June 2010 and In 2010, total primary energy use through the Public Distribution System, November 2011, while diesel rose by in India was 524 mtoe, of which coal wherein the government supplied retailers just under 2 percent. Simultaneously, comprised roughly 53 percent, oil roughly with a predetermined quantity which measures also began to be put in place to 30 percent, natural gas 11 percent, and eligible consumers could purchase using reform the method of meeting distri- other energy sources 6 percent. Of the Ration Cards. butional objectives in energy, by way of three main primary energy sources, coal Although the system succeeded in direct provision or transfer of subsidy lies in the public sector, and is produced, keeping the domestic prices of energy amounts to consumers. As energy in priced and sold according to allocations low, it has come at an immense cost to the India has historically been priced very made by the government. Natural economy and has predictably succumbed low, these changes reflect a transition in gas is produced by public and private to the unintended consequences of energy the energy sector, which is arguably part companies, and priced according to one subsidies. First, there are enormous leak- of a wider movement of the economy, of three fiscal regimes for hydrocarbon ages. Between 40–60 percent of subsi- from a system of central planning and production that operate in the country; dised kerosene is illegally diverted to the quantitative allocation, to one based on hence, in 2010, 33 percent of gas was market to arbitrage the price difference market principles. priced through the Administered Price between subsidised supply and market Energy subsidies in India are extraor- Mechanism (or ‘APM’), roughly 40 supply. Second, subsidies have been regres- dinarily complex to analyse. Broadly, percent at prices determined on produc- sive and have failed to address the divide they operate at two levels: the first is tion sharing contracts through a formula between the rural and urban poor in the ‘macro’ or economy level, where with bounded linkages to Brent, and the India. Whilst a shift in consumption away subsidies were initially intended to fulfil remainder comprised LNG imports. Gas from kerosene to LPG is seen with higher the distributional objectives of economic produced within India is first allocated incomes in urban areas, in rural areas, development, but which have ironically or rationed by the government at these the poorest income deciles continue to led to problems of exclusion and inequal- different prices to ‘priority sectors’ (power, alternate between kerosene and firewood, ity of access. The second is the ‘micro’ or fertiliser and city gas) and then released to depending on whichever is cheaper and sector level, where subsidies were used others. Seventy percent of oil is imported easily accessible. Ration Cards require a for low priced intermediate inputs for – the oil import bill in 2010 was nearly 7 permanent address and have thus excluded percent of GDP – and until recently, oil a large section of the low-income informal ‘priority’ industry sectors, but which have imported at international prices was sold sector. Third, the method of financing caused inefficiency, and in some sectors as refined products in the Indian market subsidies has led to a mounting burden on such as electricity, the bankruptcy of through public sector Oil Marketing the government budget and finances of state-owned companies. Across both these Companies at subsidised prices. public sector companies. levels, the method of delivering subsidies The primary rationale for energy Energy subsidies in India are very to low income consumers has led to rent subsidies in India has been to keep the difficult to quantify. Although they were seeking and entrenched corruption. prices of energy low within the domestic initially borne directly on the government The Macro Level economy, and, to a lesser extent, to budget, as they increased, the burden was influence consumption. Price controls shared with state-owned oil exploration India has been growing at a rate averaging and subsidies became explicit government companies (that sold crude to the market- 8 percent per year; GDP in 2009 (at 2004 policy in the mid 1970s, after the spike in ing companies at a discount, as well as prices) was US$ 977 billion (or US$ international oil prices. Prices were kept transferred part of their profits from 2643 in PPP terms); per capita income in low through a subsidy to large consumers production to the marketing companies) 2009 was US$ 1984 in PPP terms. Yet, (‘priority’ sectors) buying energy as an and marketing companies (that sold 70 percent of Indians still live in rural intermediate input (input subsidies) and refined products at prices lower than the areas and 37 percent of the population live also, through a simultaneous subsidy costs of supply, taking on the difference below the poverty line. Although India to consumers buying the final product as an ‘under-recovery’). Additionally, consumes a large amount of energy in (output subsidy). Thus, petrol, diesel, the government issued ‘oil bonds’ to absolute terms, access remains very poor; kerosene and LPG were subsidised, as well marketing companies that could be traded PAGE 14 | OXFORD ENERGY FORUM | MAY 2012

Table 1: Energy Subsidies in India 2010 Average Subsidisation rate 13.5% Subsidy (US$/person) 18.2 Total Subsidy as Share of GDP 1.4%

Subsidy by Fuel (US$ Bn) 2008 2009 2010 Coal 0 0 0 Oil 32.1 11.5 16.2 Gas 4.2 2.7 2.2 Electricity 7.8 6.2 3.9

Source: International Energy Agency (based on difference between domestic and world prices) on the markets, in order to compensate strongest resistance to their reduction provision has excluded small farmers as an them for some of these under-recoveries. or removal has tended to come from unintended consequence. In many ways, As oil bonds did not count towards the these sectors. As an example, consider this argument can be extended to other Statutory Liquidity Ratio for banks and the case of natural gas in the fertiliser energy consuming sectors for other fuels other financial institutions, the market sector (which is state-owned), which in used as intermediate inputs, suggesting a for bonds became saturated very quickly, 2011 consumed roughly a quarter of gas system of interlinking distortions. worsening the financial position of these produced by the NOCs (also called ‘APM companies. In an effort to cope with this, gas’), primarily for the manufacture of A Fragile Transition, in Progress the government in 2008 cut federal taxes urea, a fertiliser product that is used to The literature on subsidy reform sug- on petroleum products whilst keeping treat crops along with phosphates and gests that a good way of setting about the retail price unchanged. This had a potash in the optimal ratio 4:2:1. The correcting such distortions is to end limited effect, as under the system of fiscal policy objective for the fertilisers sector is the input subsidy and provide a direct federalism, state taxes (VAT) are levied to attain ‘self sufficiency’ in manufactur- output subsidy in the short term, and separately by states, ranging up to 20 ing and it is allocated subsidised gas for to eventually eliminate, or, if there is a percent, and representing a major portion this purpose. Additionally, a subsidy is strong case for the distributional objec- of states’ revenues. provided on roughly 50 percent of the tive, replace the output subsidy with a In May 2011, energy subsidies were es- retail price of urea to the end consumer direct transfer to the eligible low-income timated (based on the difference between (the farmer). Studies show that this has consumer in the long term. The first step domestic and international prices) to have led to an over-use of urea where the ratio primarily involves raising prices, and the reached around 3 percent of GDP. Given used for treating crops has risen to 7:2:1. second involves reforming the method of what has been shown by the UN Environ- Consequently, shortages have occurred delivering the subsidy or transfer such that ment Programme about other subsidy in the production of urea. This feeds back only eligible recipients benefit from them. programmes on this scale, we should into the cycle, as to meet these shortages In India, where rapid economic growth expect that this has led to considerable the Ministry of Fertilisers generally has had little impact on poverty, there economic distortions, constraints on fiscal chooses the cheapest out of three op- exists a strong case for direct transfers. policy and even headwinds on economic tions for the production of urea: using The creation of distortionary linkages development. domestic subsidised gas, importing LNG between energy producing and consuming The Micro Level on spot markets, or importing urea on sectors through the provision of input the international market. Of these, the and output subsidies suggests that subsidy Looking at subsidies from a sector or first option is almost always the cheapest. reform is required not just in energy, but ‘micro’ level, they are endogenous to This further distorts demand signals, also in sectors such as fertilisers. As stated policy objectives in downstream energy both for fertiliser and natural gas. Studies earlier, changes began to be made towards consuming sectors; consequently, the also show that this system of subsidy this in 2010. There are three main policy

Table 2: Retail Prices of Fuel in Delhi ‘Desired’ Price Price Before Excise & VAT Retail Selling Price 2010 Petrol (US$/litre) – 0.82 1.40 Diesel (US$/litre) 0.91 0.28 0.32 Kerosene(US$/litre) 0.95 0.71 0.87 LPG (US$/14.2kg cylinder) 16.53 7.97 8.52

Source: Petroleum Planning and Analysis Cell, Government of India (2012); subsidy is applied between Desired Price and Price before Taxes MAY 2012 | OXFORD ENERGY FORUM | PAGE 15 measures in progress. First, the 2010 likely to be susceptible to problems, it may in the broad direction of liberalisation federal Budget replaced the input subsidy reduce leakages from the illegal duplica- and reform. But partial reform often has in petroleum products and gas, with a tion of identity. The system was trialled the effect of displacing the problems, for direct subsidy to marketing companies at in 2011, and was scheduled for launch example from upstream to the consuming the point of sale. The 2011 Budget con- in March 2012. It has, inevitably, run sectors, presenting new policy challenges, tained an identical policy measure for the into delays. Finally, a significant reform requiring further changes. The current fertiliser subsidy. Second, a new system of in taxation, the Direct Tax Code, was situation is, arguably, a stage on the way. social security, the ‘Unique Identification due to come into force during 2012. This Although there is reason to be optimistic, Number’, began to be put in place, which includes a Goods and Services Tax, which it is a fragile transition. Indian policy- aims to provide every Indian citizen with will allow for a unified market, whilst makers currently face rising international a unique number upon the collection of maintaining the fiscal autonomy of states. oil prices, a depreciating Rupee, a poten- his or her biometric data, through which This could further influence fiscal policy tial slowing of GDP growth (estimated all direct transfers will be made in the in relation to energy subsidies, but it is as to be down to 7 percent for 2011) and future. This system attempts to overcome of now unclear how the energy sector will growing public discontent. With the problems such as the exclusion of informal be affected. recent defeat of the ruling Congress sector workers by requiring only national- As before, it can be argued that recent Party in State Assembly elections, and ity to be proved, and by linking it to reform measures are part of a wider a General Election fast approaching informal sector work programmes such as transition in the Indian economy. During in 2014, the longevity of these reform the National Rural Employment Guaran- this transition, as distortions mount, measures is likely to be severely tested in tee. Although an immense exercise that is parts of the system are modified, usually the next couple of years. ■

Pricing Reforms and Capacity Constraints in China’s Petrochemical Sector DAMIAN TOBIN assesses the impact of China’s changed energy pricing system on its downstream sector

As an economy where the state of large-scale oil refining could be put (or 0.642 million barrels per day) was continues to exercise control over the in place. The following describes how accounted for by China. What is surpris- procurement of a wide range of goods the early removal of subsidies offered a ing is that despite the impressive capacity and services, China offers a fascinating powerful incentive for enterprise reform; increases, China’s refining infrastructure example of how economic necessity, but how it has also hindered the ability continues to appear poorly equipped to mostly as a result of rapid growth in of refineries to overcome longstanding deal with large-scale oil refining. Foreign manufacturing, has forced the state to capacity and production constraints. participation in the sector remains low abandon the large-scale subsidisation of and many domestic refineries are small in petrochemical products. China’s Petrochemical Sector size, geographically dispersed and suffer Recent data from the IEA show that from the historical problems of low and In theory the gradual phasing out of state China’s subsidisation of oil is among the variable throughput levels. price subsidies and the benchmarking lowest of developing nations, having fallen China’s growth has had two specific from US$ 27 billion in 2007 to just US$ of production against international impacts on the petrochemical sector. 7.77 billion in 2010. The withdrawal prices alongside the reduction of tariffs First, the upstream or exploration part of subsidies has had a dramatic effect in product markets should have enabled of the sector has no longer been able to on state-owned refiners, who had long China’s petrochemical sector to improve fully supply the downstream or refining benefited from a complex system of price its efficiency. Indeed over the past decade part. In 2010, in order to meet domestic subsidies for crude oil inputs and tariffs China has achieved a remarkable increase demand China imported 4710 thousand and quotas on imported petrochemical in refining capacity. Its aggregate refining barrels daily of crude oil, equivalent to products. Their withdrawal has meant capacity increased from 5407 thousand 12.5 percent of global crude imports. that the crude oil purchased by China’s barrels daily or 6.5 percent of global refin- China’s largest refiner Sinopec could no refineries is now priced close to the ing capacity in 2000, to 10,121 thousand longer expect to meet its crude oil demand international price, but the retention of barrels daily or 11 percent of global through self-supply. In 2009, Sinopec state control over oil and petrochemical refining capacity. China is now second imported some 75 percent of the crude oil product prices has meant that it is often only to the USA in terms of global refin- for its refining business from international state-owned refiners who are forced to ing capacity. China’s position is such that suppliers. absorb the costs of this adjustment. The it is now the principal driver of increases Secondly, difficulties in increasing result is that China’s refineries have in global refining capacity. Of the 0.7 refining capacity have meant that faced market prices long before a refining million barrels per day increase in global domestic capacity alone could no infrastructure appropriate for the needs refining capacity in 2010, 91 percent longer match demand. State-owned PAGE 16 | OXFORD ENERGY FORUM | MAY 2012 refineries typically sought to increase an attempt to keep pace with internation- were slower than the increase in the price capacity through acquiring refining al developments and support enterprise of international crude. For petrochemical capacity from their state-owned ministry profitability. Such adjustment encouraged companies this meant that they were un- level parent companies or by acquiring the hoarding of inventories as enterprises able to pass on the full cost of price rises. smaller production units. As demand could easily predict future price move- increased, expanding capacity via internal ments. The decision in October 2001, to Capacity Constraints and acquisitions was no longer appropriate switch to the issuing of guidance prices Squeezed Margins to meet market demand. By 2010, China based on prices in three international Although the early removal of subsidies imported 1253 thousand barrels daily of markets therefore represented an impor- forced refineries to benchmark their prices refined products, equivalent to 8.1 percent tant shift in regulatory policy. Guidance to international trends, it has not resolved of global imports. These pressures led to prices are calculated on a transparent the problems of low capacities and variable an early erosion of the privileged status of formula thereby allowing enterprises more throughputs. If anything the current petrochemicals as purchasers of subsidised certainty. Although the state still retained pricing structure has created the incen- crude oil and a subsequent opening of the some control over prices, the new pricing tive for refineries to reduce throughputs sector to international markets. structure was sufficiently flexible to allow enterprises price products according to and slow production in order to protect Pricing Reforms the price of inputs. This has been particu- already slim profits margins. It also creates larly important since 1996 when under the political incentive for the state to China’s oil pricing policy has largely GATT domestic refiners faced increasing pass on international price increases to evolved in line with its increasing in- competition from imported petrochemi- refiners. The magnitude of this problem volvement in global manufacturing. cal products. For China’s petrochemical is succinctly illustrated in Table 1, which Benchmarking the price of oil and enterprises, this had the effect of reducing shows the primary distillation capac- gas to international prices became an the tariffs on imported products in their ity of Sinopec’s largest refineries. The economic necessity once China became product markets from a range of 9 percent shaded areas represent refineries that are a net importer of crude oil in 1993. to 40 percent, to a range of 5 percent to regarded as meeting international capacity The increasing demands of industry for 22 percent. Under the WTO tariffs on standards. Even those larger refineries that petrochemical-based inputs alongside imported ethylene, synthetic resins and meet international minimum capacity the failure of domestic state-owned oil fibres, and gasoline were scheduled to fall standards continue to suffer from variable companies to discover new oil supplies significantly after 2003, 2008, 2004, and throughput levels. Low capacity utilisa- of sufficient quantity meant that the 2001 respectively. tion of refineries has been a historical subsidising of refiners was no longer Under the current pricing mechanism feature of China’s petrochemical sector. economically viable. This was to impact in place since 2009, the National Develop- Although the sector achieved considerable not just on the margins of refiners, but ment and Reform Commission (NDRC) improvements following the international also and as a consequence, the extent to can consider changing benchmark listings of refineries in the 1990s, there which they would be able to maintain and retail prices of oil products when the still appear considerable variations across increase production throughputs. international crude price rises or falls by a individual refineries. For Sinopec, China’s Prior to 1993, petrochemical enter- daily average of 4 percent over 20 days. In largest refiner, throughput as a percentage prises faced a three tier pricing system for theory this provides refineries with a cred- of primary distillation capacity declined crude oil requirements. This consisted of ible and transparent pricing mechanism. from 85.8 percent in 2007 to 80.1 a price heavily subsidised by the state (a In practice fuel prices remain a politically percent in 2009 even though overall yield state low price), a less heavily subsidised contentious issue and price adjustments increased from 93.9 to 94.5 percent over price (a state high price), and an unsubsi- can be more arbitrary with upward and the same period. dised market price. For example, in 1992 downward adjustment delayed due to The data in Table 1 indicate that the state low price for crude oil from political considerations. It also means although refineries have been successful in Daqing and Shengli oilfields was RMB265 that the margins of refineries are still after bringing on-stream new refining capacity, per ton, while the state high price for oil more than 30 years of economic reform, market conditions and in particular pres- from Daqing and Shengli was RMB621 ultimately dependent on government sures on refining margins and profits, may and RMB544 respectively. This compared pricing policy. For example in 2000 it mean that the historical problem of low with an average market price of RMB was reported that in Beijing, the local capacity utilisation remains. Although 1000 per ton. In 1993, the pricing system government started providing taxi drivers large state enterprises in China’s oil and was reformed to reflect market conditions with 100 Yuan in subsidies a month to gas sector continued to account for a and all subsidised oil was charged at the help defray rising fuel costs. In 2003, large and increasing proportion of state state high price. This coincided with China delayed adjusting prices, as it was enterprise profits (31 percent of all SOE China’s first year as a net importer of oil. feared that higher fuel prices might hurt profits in 2010 up from 19 percent in Up until 2001, crude oil prices were some of the country’s more vulnerable 2009), the same is not true for the down- generally updated monthly on the basis of industries as a result of the SARs crisis. In stream refining side. Enterprises involved Singapore prices. For example, between 2011, China raised prices for gasoline, jet in petroleum, coking and fuel procession November 1999 and August 2000, the fuel and diesel reflecting the rising global account for about 7 percent of total state raised oil prices on six occasions in prices of these products. But the increases SOE profits and have substantially lower MAY 2012 | OXFORD ENERGY FORUM | PAGE 17 returns on assets and sales than those refineries at full capacity, particularly if it growing industrial base. The removal of on the upstream side. Survey data from results in losses. subsidies and the early opening up of the China’s State Statistical Bureau for 2011 sector to imports has gone hand-in-hand indicate that the oil refining, coking and Going Forward with a dramatic expansion in capacity and nuclear-fuel processing, communications The removal of state subsidies and the improvements in efficiency. But it has also equipment and computer manufacturing reduction of tariffs on a wide range of exposed refineries to volatile international sectors saw profits plunge 83.9 percent in petrochemical products have led to a prices without addressing the problems the period January to September 2011. remarkable and unusual opening up of of small-scale and variable throughput. It The suspicion is that the current pricing China’s state-driven petrochemical sector. also exposes refiners to political risk as the structure allows the state to delay adjust- But it has also created considerable uncer- state retains the ability to force refiners to ing prices and force refineries to absorb tainties, particularly in terms of the future absorb increases in international prices. the cost of any change in international role of the state as both price regulator Addressing this will require important prices thereby further putting pressure on and owner as well as how it intends to political compromises in a sector that has refining margins. Pressures on margins create a modern refining infrastructure a long history as a strategic part of China’s make it difficult to justify running capable of supplying China’s rapidly state-owned industrial base. ■

Table 1: Primary Distillation Capacity of Sinopec’s refineries (Unit: Million barrels/year) Throughput as % primary Refinery 1998 1999 2000 2004 2005 2006 2007 2009 capacity (2009) Maoming 95.85 95.85 95.85 95.8 95.8 95.8 95.8 95.5 96.3 Zhenhai 67.45 85.2 85.2 142.0 142.0 142.0 142.0 169.69 80.3 Qilu 74.55 74.55 74.55 74.55 74.55 74.55 74.5 74.55 96.2 Yanshan 67.45 56.8 56.8 56.8 56.8 56.8 92.3 92.3 83.1 Guangzhou 54.67 54.67 54.67 54.67 54.67 93.72 93.7 93.72 84.8 Gaoqiao 51.83 51.83 51.83 78.1 78.1 78.1 78.1 78.1 95.5 Jinling 49.7 74.55 74.55 92.3 92.3 92.3 92.3 92.3 95.4 Tianjin 35.5 35.5 35.5 0 0 0 39.0 88.75 34.4 Yangzi 39.0 39.0 39.0 56.8 56.8 56.8 56.8 56.8 100.0 Shanghai 37.6 44.7 44.7 62.5 99.4 99.4 99.4 99.4 62.9 Changling 35.5 35.5 35.5 0 0 0 0 0 Luovang 35.5 35.5 35.5 0 0 0 46.1 56.8 80.0 Jingmen 35.5 35.5 35.5 0 0 0 0 0 Wuhan 0 35.5 56.8 56.3 Fujian 0 28.4 85.2 58.3 Hainan 0 56.8 56.8 102.5 Qingdao 0 0 71 90.0 Others 35.5 35.5 – 388.4 386.2 460.8 331.6 343.6 Total 715.7 754.7 719.2 1101.9 1136.7 1250.3 1362.5 1611.7

Notes: a) Converted using 7.1 barrels per tonne for Chinese Crude. All figures rounded to one decimal place. b) Refineries meeting the international capacity standard are highlighted. The international capacity standard is of the order of 10 million tons of crude per year equating to approximately 71 million barrels per year

Sources: Form 20-F Sinopec various years

Reforming Energy Subsidies: The Iran Model HAMID TABATABAI traces the Iranian subsidy reform experience since 2010

A Radical Reform and Nigeria are only the latest examples. dominated by a rival political current. It Price increases do not have to be huge to is all the more remarkable, therefore, that Removing fuel subsidies is a tricky busi- provoke opposition. Iran had that experi- in December 2010 Iran itself managed to ness. Many governments try and fail, often ence a few years ago when a government- put in place one of the most radical fuel having to backtrack in the face of public decreed 20 percent increase was rolled subsidy reforms ever attempted anywhere protest or political opposition. Bolivia back after a year by a parliament and make it stick. Prices of various fuels PAGE 18 | OXFORD ENERGY FORUM | MAY 2012 and related products (electricity, water, were reflected in the main provisions of differed significantly in some key respects. and so on) were raised not by a paltry the Subsidy Reform Law of January 2010. First, for reasons that I have more fully percentage but several-fold, overnight, The Law authorised the government elaborated elsewhere, there was a nine- and all at the same time. And that was to raise prices of fuel, electricity, water, month delay in launching the reform, only the first round. A second round of transport and postal services as well as of which was put off from March to Decem- increases is now around the corner, to be some subsidised foods over the five-year ber 2010. This long delay was justified followed by yet more in due course until period from March 2010 to March 2015. by the government as being necessary to domestic prices are brought into line with Domestic sale prices of petrol, diesel fuel, allow better preparation of implementa- international prices. and other fuels are to be raised gradually tion modalities. It did indeed serve that It is true that the starting prices to reach at least 90 percent of Persian Gulf purpose too but the main motivation was were inordinately low. The country had FOB prices. For natural gas, domestic to enable the government to implement had a cheap fuel policy for decades. In prices should eventually exceed 75 percent the reform more in line with its own views November 2010 just before the reform of average export price, and for electricity than with those of the parliament, views was launched, fuel prices in Iran were the and water to cover their full cost price. In that it had been unable to get incorpo- lowest of any country in the world, except the cases of wheat, rice, cooking oil, milk, rated into the Law. In particular, the delay Venezuela. Petrol cost 10 US cents a litre sugar, air and rail transport, and postal made it possible to vastly accelerate the and diesel fuel only 1.65 cents throughout services arrangements are to be made for pace of reform, as the government desired the country. For many years, Iran’s curren- the gradual elimination of subsidies over all along and the parliament resisted. cy, the rial, has been subject to a managed the same five-year period. Secondly, to the consternation of many, floating exchange rate regime that kept it the initial price increases decreed by the pegged to the US dollar at rates hovering government went far beyond levels widely around US$1 = Rls10,000. An unusual presumed. The price of petrol for private turmoil in the foreign exchange market “… in December 2010 Iran cars went up from 10 to 40 cents a litre over the past few months has led to an itself managed to put in place (an increase of 300 percent) for the first official exchange rate of Rls12,260 and a one of the most radical fuel 60 litres of monthly consumption, and free market rate nearer Rls20,000. For the subsidy reforms ever attempted from 40 to 70 cents (75 percent) beyond sake of simplicity, the rial figures in this anywhere” that limit. Diesel fuel shot up from 1.65 article are given in equivalent dollar terms cents to 15 cents a litre (800 percent) for using the exchange rate of Rls10,000 for purchases up to a certain amount depend- figures referring to the start of the reform ing on the vehicle concerned and to 35 over a year ago, and Rls12,260 for current The other side of the coin was the com- cents (2000 percent) for more. Similar figures. pensatory ‘cash subsidies’ to a nation of increases came into force at the same time Gas, electricity and water too were 75 million that had come to regard cheap for gas and other fuel products, electricity exceedingly cheap, as were a few staple fuel as a birthright. The Law authorised and water charges, and bread flour. This foods such as bread. The result was the government to spend up to 50 percent price shock took the country half the way overconsumption, inefficient production, of the net proceeds from price rises for (i) towards targeted final prices overnight, waste, pollution, smuggling to neighbour- cash and non-cash subsidies payable to instead of gradually over the first two to ing countries and, not least, a lopsided all households nationwide, taking into three years of the reform process as the distribution of benefits as the bulk of the consideration household income; and parliament intended. subsidies went to the better-off sections of (ii) implementing a comprehensive social Thirdly, household income was not the population who consumed more. By security system for the targeted popula- taken into account in the determination official estimates, price subsidies in recent tion. Cash payments would be made of entitlement to the cash subsidy. Every years had been costing some US$100–120 Iranian citizen residing in the country through the banking system to the head billion annually – about 30 percent of the was declared eligible to receive the same of each household. The payments would GDP – of which 70 percent went to only amount of transfer. The cash payments be exempt from income tax. The Law also 30 percent of the population, mostly in to each household thus depended on its set aside 30 percent of the net proceeds to urban areas. (It should be noted that the size, not its income, and would be paid help producers adopt energy saving tech- subsidies are mostly implicit, not financed to the head of the household on behalf of nologies, to compensate part of losses to by oil exports or the budget. They arise all its members. To claim it, each head of companies and municipalities providing because domestically produced oil and household had to fill out a routine form utility services, to develop and improve gas – the sector is nationalised – are sold and provide a bank account into which cheaply on the local market.) public transport, and to promote non-oil the money could be deposited. The big idea behind the reform strategy exports. The remaining 20 percent of the Finally, with a view to winning public was not to abolish price subsidies as such net proceeds would go to the government support and cooperation, the monthly but to convert them into ‘cash subsidies.’ for improvements in infrastructure. transfer amount was set at Rls455,000 The objective was twofold: improving eco- Implementation (about $45 at the time) per person, an nomic efficiency through rationalisation amount that was way above what would of subsidised prices, and reducing income Clear as the Law may appear to be, the have been consistent with the provisions disparities through cash transfers. These government’s actual implementation of it of the Law. As a result, transfers to MAY 2012 | OXFORD ENERGY FORUM | PAGE 19 households consumed 80 percent of the inflation was the most controversial issue in the new environment. Hard evidence net proceeds from price hikes in the first prior to the reform. The Central Bank on impact on productive sectors is too year of the reform instead of 50 percent, figures now suggest that while the price limited to draw reliable conclusions at this leaving rather little for producers and the shock accelerated inflationary pressures, stage and the government and its critics government. Put before a fait accompli, the impact has fortunately not been as sharply differ in their assessments of the the parliament eventually went along dire as had often been predicted by some situation. What is clear though is that and modified the original percentage analysts and parliamentarians. To take cash transfers tended to favour consumers shares of households, businesses and the the most common indicator used in the more than the producers who did not get government from 50-30-20 respectively to country, the annual rate of urban inflation their envisaged share of 30 percent in the 80-20-0 for the new Iranian year starting in the months preceding the reform was proceeds from subsidy cuts. And what on 20 March 2012. There was of course 9–10 percent. With the launch of the they did get appears to have been mostly no question of antagonising the public reform on 19 December 2010, this rate in the form of loan rather than grant. by forcing a reduction of the transfer started climbing by about 1 percentage Income Distribution. Another main amount. point a month to reach 20.6 percent in objective of the reform was to reduce At the start of the reform, some 60 December 2011. The acceleration appears income disparities. The cuts in subsidies million people or 80 percent of the to have been entirely due to price reform. affect household incomes in proportion population were participating in the The relatively subdued impact on overall to their consumption of subsidised goods cash transfer programme. This went up inflation – when subsidised prices had and services. While some basic foods to nearly 73 million or 96 percent of the been raised several-fold – was due in part were among them, the cuts overwhelm- population within a few months after the to price controls that were intensified ingly concerned energy products whose start of the programme, in part because when the reform was launched. Price consumption correlates positively with of the dramatic extent of price increases controls have since been relaxed but not income. The compensatory transfers are and the correspondingly high level of cash entirely withdrawn. however the same for everyone and hence subsidy. Consumption Pattern. One of the the short-term impact of the reform on Minor incidents apart, the reform main objectives of the reform was to re- income distribution can only have been process took off fairly smoothly. The most duce excessive consumption of subsidised egalitarian, although the extent of it is not important factor was no doubt the cash goods and services, notably of fuel. This known since no hard data are available as subsidies, cleverly paid before the higher seems to have been achieved, perhaps even yet. prices began to hit people’s pockets. But to excess. Official data show substantial an extensive public education campaign declines across the board. Between 2010 preceding the reform played an important and 2011, the years before and after the role as well. It emphasised the wasteful reform, the average daily consumption of aspects of the price subsidies and their petrol fell from 62.8 million litres to 59.3, “The fear of runaway inflation inequity. It was endlessly repeated that or 5.6 percent. The corresponding declines was the most controversial subsidies were not being eliminated but for diesel fuel are from 81 to 73 million issue prior to the reform.” transformed from a bad form – price litres (10 percent less), for liquid gas from subsidies on products – to a good form 12.3 to 11 million litres (10.6 percent less), and for furnace oil from 18.1 to 11.5 mil- – cash subsidies for households. Reassur- lion litres (36.5 percent less). The savings ing messages emphasised that inflation are all the more remarkable in view of . Finally, it may be would not get out of hand, that poverty Public Opinion past trends that witnessed growth of fuel useful to consider selected results of an would be substantially reduced, and that consumption of the order of 10 percent opinion poll on the reform carried out by no-one would go to bed hungry anymore. a year. Fuel smuggling has also dropped an unidentified official agency. It covers Extra allocations of cheaper fuel were sharply, although some still goes on given Tehran, the capital city, and sheds some also made in the early months to smooth the continuing price differences across light on the hopes and anxieties of the the transition to higher price fuel. Price national borders. Electricity consumption public about a year ago, soon after the controls were reinforced too to moderate fell by 8 percent, compared to an increase reform was launched. A majority of the ripple effects. of 10 percent in the previous year. The respondents (62 percent) were of the view Early Results consumption of wheat and bread flour that most people would not be able to plunged by over 22 percent, much of it cover the extra expenses due to higher The reform process was launched over a presumably through reduction in wastage. prices despite the transfer, even if they year ago and evidence is now beginning Production. Such huge drops in reduced their consumption. Some 33 to surface on the results. Such evidence, consumption had their mirror image in percent thought that they could do so. A although from official sources, is at times production (and imports), particularly in similar majority (65 percent) felt that the disputed by independent experts and the small business sector. Caught between reform would help ‘correct’ the consump- observers, occasionally even by other of- higher energy prices, lower consumer tion pattern, although over a quarter ficial bodies. But the picture that emerges demand, and price controls, small busi- (28 percent) had little confidence that is likely to be valid in broad outline. nesses felt the pinch and many of them it would. Perhaps most importantly, the Inflation. The fear of runaway have found it hard to operate profitably respondents were split down the middle PAGE 20 | OXFORD ENERGY FORUM | MAY 2012 between those who had much or very ground and to cruising speed – may subsidy in whole or in part (the options much confidence that the reform pro- now be past but various challenges still are the entire amount, half the amount or gramme would be a success (40 percent), remain. The second phase of the reform is any addition to the transfer amount in the and those who had little or very little slated to begin shortly. While speculation second phase of the programme). No one confidence in the same (39 percent). And about the next round of price hikes is rife, knows how they will respond. If enough more people rated the chances of the cash no official announcement has yet been of them agree to withdraw, the matter will transfers continuing as little or very little made. The parliament has put a cap of 20 have been settled. If not, the government (42 percent) than those who rated these percent a year for new increases, which will have to decide how to proceed. chances as high or very high (36 percent). could mean that fuel prices would likely Two final points may be made about It should be noted that public opinion in rise by about 40 percent in the second the role and importance of the cash rural and other urban areas that are less round since there was none during the last subsidy component of the reform strategy. privileged than Tehran is likely to be more Iranian year just ended. It has officially The first is that the compensatory charac- favourable to the reform as price subsidies been announced however that the transfer ter of these transfers made it possible for tended to favour the better off whereas amount would rise by Rls280,000 (about the price reform to go deeper and faster, cash subsidies are the same for everyone, $23) per capita when new prices go into thereby amplifying the impact of relative thereby benefiting relatively more those effect. price changes on resource allocation. In with lower incomes. A further challenge now is to reduce efforts at price reform, therefore, the scale the number of participants in the cash of price adjustments may not be as critical What Next? transfer programme so as to leave more as it is often presumed to be, so long as The Iran model of reforming the system funds for distribution to those with lower the adverse effects can be moderated or of energy subsidies is a bold attempt at incomes. The sad fact of the matter is that, removed entirely through compensation, pursuing the twin objectives of enhancing as things stand today, there is a trade-off particularly for poorer people. economic efficiency and social justice at between the coverage of the population The second point has to do with a the same time. While the extent of its suc- and the amount of the transfer per fortuitous outcome of the reform effort, cess so far may be judged differently, and person since the net proceeds that can be although no one was looking for it as such. its longer-term impact remains to be seen, distributed to households is determined Iran has now become the first country in it has already passed a major test with exogenously. The funds now going to the the world to boast of a nationwide basic flying colours: it has survived. This is no rich are entirely at the expense of those income that pays every citizen a certain mean feat in view of its ambitious scope less well off. The current plan is to urge amount of cash on a regular basis, uncon- and scale, more so as it was attempted at higher income earners to opt out of the ditionally. The proponents of basic income a historical juncture in Iran that was far transfer programme voluntarily. House- are particularly keen to see the experience from ideal economically, politically, and holds with an income above a couple of in Iran succeed in institutionalising an in terms of the country’s relations with thousand dollars a month (a fairly large idea that, despite its promise, has been the rest of the world. amount of money in Iran) are being rather hard to sell, not least in the rich The hardest part – getting it off the invited to consider giving up their cash countries. ■

Iran’s Energy Subsidy Reform: lessons – and a predicament SHIRIN NARWANI argues that Iran’s subsidy reform still faces many challenges

After several previous failed attempts that any undesirable secondary impacts efforts, several attempts at subsidy reform at reforming its subsidy system, which would be offset by complementary policies by other countries have either failed to dated from its war with Iraq in the that would redirect revenues received take off in the face of massive public 1980s, Iran, in December 2010, imple- from price increases to low-income opposition (Bolivia, Pakistan) or been mented reforms that addressed one of its groups and energy-intensive industries. characterised by a common pattern of two economy’s most enduring distortions. The government laid the groundwork steps forward, one step back (Nigeria). This was made possible because the for a functional system of compensa- Although the reform process is far from government built a consensus among tory disbursements (initially targeted complete in Iran, useful lessons can be the public, industry and political at poorer segments of the public then drawn by analysing the rationality and figures, across differing political views, broadly expanded) and an escalating tariff long-term sustainability of the measures about the benefits of subsidy reform: structure that helped soften the impact on employed in the context of Iran’s particu- reducing waste and consumption and the less wealthy. lar circumstances. the secondary benefit of redistributing Given the lack of mass protests despite Predicament One Year Later the country’s energy revenues in a more staggering price increases, the initial phase equitable way. of the plan appears to have been well A year into the reform process, the A communications strategy emphasised conceived. In comparison, following Iran’s government’s main objective of reducing MAY 2012 | OXFORD ENERGY FORUM | PAGE 21 waste and consumption appears, accord- revenues generated from partial subsidy approaching subsidy reform. One subsidy ing to official figures, to be realised; yet removal, and given that there may be less is replaced by another, thus continuing or, the policies employed to ease the removal funds available as a consequence of a drop in Iran’s case – increasing the burden on of subsidies have been either only partly in the price of oil, sanctions leading to the government budgets. implemented or appear to be unsustain- discounting of oil or a decrease in exports, able. the government will either have to reduce Taking the Shock Route: a high impact the number of recipients or augment on demand Iran’s Cash Compensation Scheme annual deficits. While Mohammad Reza Iran’s reform strategy of maximising A compensatory scheme that helped raise Farzin, the head of the Subsidies Reform initial price increases was the most the public’s acceptance of the reforms Organisation, has said that 10 million of effective way to significantly impact has emerged as a major dilemma for the the wealthiest individuals will be removed demand and reduce the risk of future government. The original subsidy reform from the cash-back scheme during the popular opposition to consecutive price statute stipulated that revenues received second phase of the programme, President adjustments. Previous attempts at a as a result of price increases would be Ahmadinijad has promised that he will gradualist strategy of subsidy reform, part distributed by allocating 50 percent double or triple the amounts paid out to of Iran’s Development Plans from 2000 in compensatory disbursements to the those remaining. onward, had either failed or been stopped public, 30 percent to energy-intensive by politicians. President Ahmadinijad and agricultural and industrial enterprises, his administration argued that a gradual and 20 percent to the Treasury to cover approach to price adjustment, while still the administrative costs of the reform “Given the lack of mass causing some economic hardship, could programme. protests despite staggering create rising inflationary expectations. A With more recipients than originally price increases, the initial subsidy reform statute that was initially forecast, the Majlis (parliament) later phase of the plan appears to ambiguous about cost/price adjustments increased the public’s share from 50 to have been well conceived.” over the five-year period, allowed the 80 percent, the share for agriculture and president to maximise the price shock industry was reduced to 20 percent, while rather than gradually increase prices, as the Treasury’s share was withdrawn. favoured by the Majlis (though a later However, even this decrease of the The government’s dilemma is that the amendment to the law only allows a 20 Treasury’s share has proved insufficient elimination of even 10 million individuals percent annual price rise). to meet the IR455,000-a-month (about from the programme will only result in Iran’s domestic fuel consumption $40-a-month) payment to recipients, who savings of about $4.8 billion; even if this mainly comprises gasoline. With smart now, according to the government, make is not reallocated to the rest of the re- cards introduced during gasoline ration- up almost all Iran’s 75 million population. cipients, it will not make the programme ing in 2007, an escalating tariff structure The government has had to find other self-financing. Further pressure will also was already in place; in December 2010, sources to fund these payments; these be placed on the Treasury if the Majlis this structure remained and was used include loans from the central bank, succeeds in ensuring the production to raise the price of gasoline between revenues raised from the export of oil and sector’s stipulated allocation. Despite their fourfold and sevenfold. Diesel fuel, by other goods, energy company loans and significant problems, however, the cash comparison, was raised about ninefold. public funds. The resulting public deficit handouts are now regarded as permanent Other products’ prices were raised incurred from December 2010 through by many and will not be reduced or between 3.5 and 10 times. Electricity September 2011 is $13.8 billion. withdrawn easily. The government prices were doubled, then on an escalating An assistance policy that was intended has so far been unwilling or unable to tariff structure. to provide aid to low-income groups and remove recipients from the cash transfer A year into the reforms and the energy-intensive industries over the span programme and has asked wealthier consumption of oil products has shown of the reform has instead emerged as a individuals to voluntarily abstain. Shifting a marked decrease. According to the uniform payment to almost all citizens political currents will make it difficult to government, the country’s gasoline con- and, according to reports, has not dis- eliminate families from this scheme, and sumption is down 9.9 percent, from 81 to tributed the requisite amounts stipulated it is highly unlikely, that state support will 73 mn litres a day (after growing 9 percent by law to the production sector. These be withdrawn from middle-to low-income the previous year); kerosene consumption industries and companies have argued groups. is down 2.9 million litres a day, a drop of that the higher price of energy input is Iran’s experience and potential future 19.7 percent; furnace oil consumption has affecting their competitiveness and that difficulties point to the conclusion decreased 36.5 percent, from 18.1 million there have been few or no mitigating that, unless administered as originally litres a day to 11.5 million litres; and measures to assist them. It is not, as was intended – with compensation using only electricity consumption is down 8 percent originally planned, self-financing, and it revenue raised from price adjustments and (from an increase of 10 percent the has placed substantial new fiscal obliga- mitigation measures that protect industry previous year). The National Iranian Oil tions on the Treasury. and low-income groups for a limited Products Distribution Company puts the Given that the monthly cash transfers time period – a universal and uniform decline in demand for oil products in the to the public are not being met by cash-back scheme is not the best way of ten months after the reforms at between 4 PAGE 22 | OXFORD ENERGY FORUM | MAY 2012 and 19 percent, with gasoline declining by higher for all figures.) In a country that smuggling. The fall of Iran’s currency 5 percent, kerosene by 19 percent, diesel had among the lowest fuel and gas prices against the US dollar has made its fuel ex- by 4 percent, and LPG by 14 percent. in the world and a consumption rate that tremely cheap to neighbouring countries; Although these figures differ, the least was doubling every decade, maximising this has reportedly led to a significant case scenario still reveals a significant drop and front-loading the price shock was increase in fuel smuggling, which had in demand. the most effective way of facilitating a eased following subsidy reform. Because of The price adjustment for natural gas significant demand response and ensuring international sanctions banning fuel sales also had an initial significant impact on progress in the reform process. to Iran, the country needs all the gasoline demand, particularly in power generation. it produces for domestic purposes. The Iran experienced two gas price shocks Challenges Ahead government may have to adjust the price within six months; the first was an Iran’s subsidy reform programme has suc- of free-market gasoline upward to counter increase of more than 400 percent fol- ceeded beyond early expectations in that the effect of the devaluation of the rial, lowed by a further 20 percent adjustment. the government was able to substantially while maintaining some price support for Comparing gas consumption in power and permanently adjust prices without domestic consumption with quotas for generation in the five months from March mass protests. The reforms have also man- semi-subsidised gasoline. to July 2011 with the same period a year aged, in their initial phase, to achieve their With all of Iran’s current economic earlier reveals a 10.8 percent reduction. main objective of a reduction in energy and political problems, subsidy reform When taking into account a negligible consumption. However, the authorities is not a priority. Although there is a reduction in gas consumption in the face political and economic challenges general consensus on the need to push residential and commercial sectors, the that do not bode well for their objective of ahead with the reforms, the government total reduction in gas consumption during raising prices of subsidised energy close to continues to clash with the Majlis on the this period was 5.7 percent compared with prevailing world levels. Some of these chal- same issues: compensation, the pace of the previous year. lenges were present before the reforms: price adjustment and the timing of the Even negligible reductions in demand high unemployment and inflation; and reforms. Phase two of the reforms has are significant because, previously, there the adverse effects of economic sanctions. reportedly been delayed from March until were large increases in annual energy New pressures include: tougher sanctions; July of this year. The recent parliamentary consumption. Critics of shock therapy the need to deal with the reported 1.6 mil- election results indicate that President believed that the initial large price adjust- lion households that are not paying their Ahmadinijad may face a more hostile ments would lead to high-double or even gas bills (they have been advised to pay environment in the last year of his second triple-digit inflation. Although there was a in instalments); the challenge of finding term. This, combined with the possibility rise in anticipated inflation, it has not been affordable mitigating measures to com- of a new government in 2013 opposed as high as expected. Iran already faced pensate both individuals and industry; to President Ahmadinijad’s vision of ac- inflationary pressures and had reduced and decisions on proceeding with further celerated subsidy reform, may mean that inflation down from 25.4 percent in 2008 price adjustments against a background of the reform process continues at a slower to 10.8 percent in 2009 and 12.4 percent increasing economic hardship. pace or that it is stopped in its tracks. in 2010; inflation rose to about 20.6 per- A recent new problem that may press Ultimately, the reforms will continue cent this past year. (These figures are from the issue of price adjustment is the impact to be vulnerable to changing political the Central Bank; unofficial estimates are of the devaluation of the rial on fuel currents. ■

Energy Subsidies in Russia: Natural Gas is the Final Challenge JAMES HENDERSON discusses Russia’s gradual reform of energy prices since the breakup of the Soviet Union

The fuel subsidies available in Russia to gas) domestic prices have been below For example, as early as 1992 the IEA over the past two decades have been the marginal cost of production and reported that domestic oil prices were a legacy of the Soviet era when cheap transport to market. However, the largely being determined by market forces, energy offered an economic benefit to gradual removal of these subsidies has and the domestic market for crude oil was industrial and household consumers been a key strategy of many of the Rus- fully liberalised on 1 January 1995, with founded on the USSR’s fortunate sian governments during the post-Soviet oil product prices following later in the inheritance of abundant hydrocarbon era, with the goal of improving the same year. Producers and distributors were resources. Largely they have involved the country’s energy efficiency and resource then allowed to market their crude oil and sale of oil, gas and electricity to do- management as well as addressing the products in the domestic market at prices mestic customers at below comparable imbalances in the energy economy, and determined by the forces of supply and international prices, although in some for a number of fuels these goals have demand. The effect was that the domestic instances (in particular with reference already been met. crude price rose from 1 percent of global MAY 2012 | OXFORD ENERGY FORUM | PAGE 23 levels in 1991 to 30 percent in 2000, with the continued low price of gas in Russia. a number of the key goals set out in the the continuing gap being due to a domes- Market reform has also impacted the country’s energy strategy but also to tic oversupply caused by bottlenecks in electricity sector, thanks to a privatisation distort the balance of Russia’s energy the Russian crude export pipeline system, and price liberalisation process that was economy. the large amount of transfer pricing catalysed by the bitterly cold Russian The price for gas sold in the Russian within Russia’s vertically integrated oil winter of 2005–06 when certain regional domestic market by the country’s largest companies at artificially low prices and the transmission and distribution systems company, Gazprom, has been regulated intermittent imposition by the Russian were operating at beyond their theoretical since the end of the Soviet era, reflecting state of limits on crude and oil product maximums and brown-outs became a real Gazprom’s near monopoly position exports. However, by 2005 the domestic threat. With the need for new investment in the 1990s and the fact that it had crude price had effectively reached export obvious, the Russian government was inherited the majority of its production netback parity, meaning that it is now forced to create an environment in which from the Soviet Ministry of Gas at very priced at global levels less transport costs both domestic and foreign companies low cost. Other gas producers can sell and export tax, with the result that the could hope to make adequate returns and at market prices, but as Gazprom has Russian government’s control over the as a result the state monopoly UES was historically accounted for 80–90 percent price level is now restricted to its power to broken up and sold while price deregula- of production the regulated price has set the level at which these two variables tion was also gradually introduced. Al- tended to act as a dominant benchmark. are charged. Perhaps more importantly, oil though even as recently as 2009 the level This regulated price has generally been products in Russia are also priced on a par of domestic electricity prices implied a set at well below the international price with global markets. (According to data state subsidy totalling $15 billion, by Janu- for Russian gas, and indeed this led to from InfoTEK and Renaissance Capital ary 2011 full liberalisation of the whole- Gazprom making a loss on all its domestic the Russian oil product basket has been sale market had taken place and prices for sales until 2009. The discrepancy between trading in line with the export netback Gazprom’s export and domestic sales is equivalent since 2005.) Indeed at times emphasised by the fact that even in 2010, of high demand in Russia the prices for after a decade of significant domestic gas gasoline and diesel have exceeded export price increases, export sales to non-FSU netback parity due to a historical shortage “The fuel subsidies available countries account for only 30 percent of of upgraded domestic refining capacity in Russia over the past two sales volumes but more than 50 percent of that has occasionally resulted in the need decades have been a legacy of revenues, meaning that prices for domestic to import higher value products (such as the Soviet era.” customers continue to be subsidised by the gasoline) into western Russia at global high prices which Gazprom can charge for prices plus additional transport costs. its export sale. The Russian administra- Russia’s coal industry has also seen a tion, spurred on by a desire to increase transformation from heavy subsidisation energy efficiency, meet WTO standards in the early years of the post-Soviet era industrial customers are now being set on and encourage industrial restructuring, to a fully privatised and market-oriented a cost-reflective basis. Prices for residential has made a number of efforts to reduce sector in 2012. The change over less than customers remain regulated by region, and this implicit subsidy to Russian consumers 20 years has been dramatic, as in 1993 indeed specific caps were imposed in early over the past 20 years. In the mid-1990s, the Russian state budget supported 80 2011 due to pressure from consumers over as oil and coal prices were being liber- percent of the sector’s activities, with the price rises that were regarded as excessive alised, gas prices were tied to domestic subsidies to the industry accounting for by the federal government. These caps left inflation, which was so high (up to 2000 more than 1 percent of GDP. However, a number of power companies struggling percent in 1995) that export netback the government committed to a plan to to balance their books due to rising parity was rapidly reached (see Figure 1). remove subsidies by 2001, and in tandem fuel input costs, but as this sector only However, this had a disastrous impact with this strategy also implemented a accounts for around 20 percent of Russian on industrial and residential consumers, sector-wide privatisation programme power demand it is clear that the goal of who could not afford the dramatic rise in that led to more than three quarters of removing subsidies from the industry has prices, and non-payments rose so sharply production being in private hands by the largely been achieved. that Gazprom received cash for only 12 end of 2001. As a result Russian coal price However, in contrast with the liber- percent of its domestic sales in 1997. is now fully liberalised and the domestic alisation seen in the oil, coal and power Gazprom’s position was undermined market operates on a competitive basis, sectors in Russia prices in the gas sector even further by the economic crisis in with the major pricing issue being the cost remain at a significant discount to the 1998, when domestic gas prices collapsed of transportation to both internal and ex- international market (even on a netback to US$12/mcm, equivalent to only 12 port markets. Indeed, as will be discussed basis) and have only recently reached a percent of the export netback price, mean- later, coal finds itself at a disadvantage to level at which the cost of production and ing that Gazprom was not only providing gas, its major competing fuel in Russia, in transport to market can be covered. This cheap gas relative to international prices any location other than the regions where anomaly is gradually being addressed by but was selling to domestic customers the coalmines are situated both because of the Russian government, but as of early at well below marginal cost. The arrival high transport costs and also because of 2012 it continues not only to undermine of Putin as President of Russia in 2000 PAGE 24 | OXFORD ENERGY FORUM | MAY 2012

Figure 1: Russian Industrial and Export Netback Prices, 1991–2010

120% 250

100% 200 t netback

80% 150

60%

100 US$/mcm 40%

50 20% Domestic price as % of expor 0% 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Export netback Domestic industrial price Domestic/Export netback

Source: IEA, Federal Tariff Service of Russian Federation, Author’s calculations saw a renewed emphasis on provision of politicians to become concerned about the place the reforms that would allow it to support to state energy companies, but impact of much higher gas prices on the control the gas sector via an independent price increases of 20–25 percent p.a. from domestic economy. As a result the target transport system rather than via control of 2000–2005 still left domestic gas prices for full market liberalisation has been prices. And fourthly, there would appear at only 42 percent of the export netback moved from 2011 to 2015, and a more to be no need to force netback parity level in 2005. By this stage Gazprom was likely outcome is perhaps closer to 2020 or on an economy where an abundance of feeling increasing financial pressure as the beyond. relatively low-cost gas could be produced core fields on which it had been relying to Indeed the pressure for achieving and sold profitably by multiple suppliers provide cheap gas during the post-Soviet netback parity for domestic gas prices has based on a market-related pricing system. period were now in decline and it was Therefore, it would seem most likely also facing growing competition from that the implicit subsidy of low domestic ‘independent’ producers such as Novatek gas prices in Russia will only be removed and the Russian oil companies, who were in gradual stages (see Figure 2). Over the keen to expand their sales at unregulated “The arrival of Putin as next five years (approximately) it seems prices. A further issue for the Russian President of Russia in 2000 likely that a regulated prices system will gas industry was that domestic demand, saw a renewed emphasis on remain in place, increasing domestic prices encouraged by low prices and rapid GDP provision of support to state by around 15 percent per annum. During growth, had grown by 12 percent since energy companies.” this period the re-introduction of a Gas 2000, and export sales had increased by a Exchange, which was initially used to similar amount, adding to the pressure on establish a market price for small amounts gas supplies. of gas in 2007–08, could help to establish As a result Putin announced a 5-year the levels at which industrial consumers plan in late 2006 to fully liberalise the been alleviated by a number of factors. are prepared to buy extra gas. In a second domestic gas market by 2011 and to en- Firstly, regulated prices in 2012 now stage, perhaps from 2015–2020, this Gas courage gas prices towards export netback exceed $100/mcm and are close to Exchange could begin to become a fully- parity. At that time the international the $120–130/mcm range that would fledged price-setting mechanism, allowing oil price, which is the main benchmark underpin the development of Gazprom’s greater competition between Gazprom for Russia’s gas export price, was $50 per huge new developments on the Yamal and independent producers to establish a barrel, implying that Russia’s domestic peninsula. Secondly, it would appear that true market price for domestic gas sales. A gas price would have to approximately non-Gazprom producers such as Novatek third stage (beyond 2020) could then see double by 2011 for the target to be met. have very significant productive capacity full liberalisation of the gas market, with However, doubling of the oil price since that could be profitably brought onstream an independently regulated transport 2006, with the consequent increase in even at current prices, potentially replac- system and free trading of gas for the the price of Russia’s gas export price, has ing the declining gas production from majority of consumers (in particular in moved the export netback parity target Gazprom’s mature fields. Thirdly, the the industrial and power sectors). At this significantly, leading many Russian Russian government has yet to put in point it is clear that the domestic price MAY 2012 | OXFORD ENERGY FORUM | PAGE 25

Figure 2: Potential Development of the Pricing of Russian Gas in the Domestic Market

STAGE 1STAGE 2STAGE 3 250

Regulated price growth 200 (e.g. 10–15% p.a.) Price set by market, perhaps below netback parity 150

Increasing impact Fully liberalised

US$/mcm 100 of Gas Exchange market Gas Exchange 50 developed

0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Export netback (at $100 oil price) Domestic/Export netback

Source: Author’s estimates would certainly be above the marginal districts will keep coal uncompetitive for incentivise consumers to invest in the operating cost of production and trans- the foreseeable future, meaning that any necessary change without using the type portation, although there is no certainty plans to reduce the share of gas as a fuel of regulatory enforcement that has seen that it would be at export netback parity, input to the power sector are likely to fail. the oil companies forced to reduce gas especially if Russia maintains its current Indeed the influence of gas on the electric- flaring over the past five years. single export channel. ity sector is set to increase as major gas Therefore, although gas is now being It would therefore appear likely that producers diversify into power generation sold in Russia at prices that can allow pro- the subsidisation of gas prices in Russia to take advantage of the extra margins ducers to make a profit, it remains the case will be removed over the next decade as that can be generated. As evidence of this that low gas prices for domestic customers prices rise towards export netback parity continue to be effectively supported by the in an increasingly liberalised market. higher prices that Gazprom can charge for Residential customers may be offered its export sales. This anomaly is gradually some extended protection, although “In the power sector the being unwound, with potentially pro- prices in that sector have been rising imbalance of coal and found effects on both domestic and export ahead of industrial prices in recent years, gas prices in key demand customers for Russian gas, but the full but the cost of gas in the industrial and areas located away from impact is unlikely to be felt until 2020 power sectors could more than double by mining districts will keep at the earliest. Importantly though, two 2020 on the assumption that the global coal uncompetitive for the factors that could accelerate this process oil price remains above $100 per barrel. foreseeable future” would be a collapse in the global oil price However, the gradual nature of this or a change in the pricing structure for change will mean that other distortions Gazprom’s export sales, both of which in the Russian energy economy will also could lower the price for Russia’s gas in be relatively slow to change. Perhaps international markets and bring netback most importantly, until a fully liberalised trend Gazprom is now Russia’s largest parity closer in the domestic market. market is introduced Russian gas produc- power generator by installed capacity. With Gazprom already being forced to ers will not be able to provide the country In more general terms, Russia’s overall renegotiate the terms of its contracts with with its optimal supply mix, as Gazprom’s energy efficiency targets will also be European buyers to include a non-oil higher cost production will be supported harder to meet while the price of its major related spot price element, it may be that by a rising regulated price. Only when fuel remains low. Russia’s energy strategy the removal of the domestic gas price market forces determine the choice of to 2030 envisages the potential for saving subsidy is ultimately taken out of Russia’s gas supply can the lower cost gas that is 45 percent of total primary energy supply, hands. ■ owned by many non-Gazprom producers including a 240bcm reduction in gas make a full contribution to Russia’s gas demand/waste. However, as long as the balance. Furthermore, in the power sector price for the fuel which accounts for over the imbalance of coal and gas prices in key 50 percent of TPES remains well below demand areas located away from mining international levels it will be difficult to PAGE 26 | OXFORD ENERGY FORUM | MAY 2012

To the Editor:

In response to your Issue 87 (February minimum, North America will be export- completed actions will literally connect 2012) devoted to oil market benchmarks, ing more oil products and, its importance the Midcontinent southward to US Gulf I have a number of comments to share as a cog in the world oil market will markets (notwithstanding several other and observations to make. There are strengthen, not weaken. In addition, existing points of connection), and this three areas which I believe received either Canadian and US oil production are will bolster the WTI mechanism. In inadequate attention or none whatsoever freely tradable and much of each already terms of prognosis, the only thing market from your collection of ten contributors: re-trades several-to-many times over in the participants are speculating on regarding 1. What are the long-term implications physical market. WTI’s importance in the this mechanism is how it may expand for market-based benchmarks, especially oil market originated in its role as physical further over the mid-term, in light of in light of long-term production trends; market numeraire and the growing North increased US and Canadian production 2. The immediate issue that looms over American market is going to continue to and increased throughput to the US Gulf. the BFOE (Brent Blend, Forties, Oseberg, require and benefit from such a numer- Ekofisk ) market – price convergence aire; so North America will continue to Near Term – Brent Market between its several legs; and, 3. What be an important source for a crude oil Convergence are the direct implications of what major price reference. Even with at least five of your Issue 87 producers and China are saying about oil Meanwhile, the decrease in North Sea contributors focusing significantly on benchmarks? I will address each of those production has already impacted perfor- Brent, they largely chose to sidestep directly. mance of the BFOE mechanism at times – there may be disagreement over how much the most important immediate issue Long Term – Production and how often – but, as the production regarding Brent – the performance of the Countdown decline continues, this is becoming more convergence processes between the sub- commonplace. Has the market reached components of the Brent complex. This Both the North Sea, especially the BFOE consensus that adding more letters to issue has spawned disagreement within streams, and North America have been the string BFOE is the prescription to the industry as to who is chiefly respon- undergoing substantial changes in oil prevent this? Isn’t anyone else concerned sible and one of your contributors did production levels and prospects for future that there needs to be at least a minimum take a side in that dispute. The bickering, oil production, and these changes are in level of production to support a pricing however, has not centered on the processes opposite directions – the North Sea is mechanism based on loadings of cargos? of convergence. In fact, it may be serving depleting and North America is increas- Among the contributions included in more as a distraction from what is truly ing. With respect to the North Sea, this Issue 87, the one that debunked myths important – how convergence processes could be said to date back more than 20 about the Dubai benchmarks concluded work and how they perform. years but, in less than five years, BFOE very persuasively that production (as well Building on the detailed work provided has declined by more than one-third and as some other things) does matter. The by several of your contributors, I divide currently struggles to stay above 1 million structural changes that await the North the BFOE market into the components barrels per day. But even that characterisa- Sea benchmark would appear to dwarf of futures, forward cargos (which are tion can be misleading because, despite anything that has been either applied or considered ‘paper’ because they have not it being referred to as BFOE, it is really contemplated to date. We are surprised been assigned loading dates) and dated only F – forties – whose price serves as the and puzzled that this received so little cargos (which are considered ‘physical’ benchmark and that has been the case for attention in Issue 87. because they have been assigned loading nearly 10 years. In the everyday mechanics Regarding the future for North dates). In principle, these are the compo- of price determination, B, O and E are America and WTI in particular, the nents that need to connect in terms of essentially ballast. future begins right around the scheduled pricing. Traded dated cargos are priced The situation is completely reversed for release date for this Issue (88); because predominantly as differentials to the the USA and Canada. Production is up that is when the Seaway pipeline will Platts Dated assessment. Similarly, the significantly in onshore US, and Canada begin to flow oil, including WTI, Platts Dated assessment is also frequently and is expected to rise even more sharply. southward to the US Gulf. This is only used in some national oil company Projections are that US and Canadian the beginning, but another of your sales formulas as well. The Platts Dated production will increase by more than 5 contributors provided many details of the assessment is essentially derived from the million barrels per day over the mid-term scheduled additions in both pipeline and mathematical sum of two other assess- and that would be in addition to the 1 to railway capacity that are forthcoming; and ments by Platts that are determined in 2 million barrels per day increases it has those additions in capacity are substantial their eWindow Market-on-Close (MOC) experienced in recent years. in scope (1–3 mmb/d) and they will mechanism. Each of these assessments The impacts from these changes will have a substantial positive impact on the is for a financially settled swap contract not be limited to simply shifting the continuing evolution of oil benchmarks. though, for one of them (BFOE partials), relative prices between oil delivered in In the near-term, the Seaway reversal there is the extremely rare occurrence the USA and oil delivered in Europe. At and other completed or soon-to-be when the obligation matures into physical MAY 2012 | OXFORD ENERGY FORUM | PAGE 27 delivery. Sidestepping the precise details termination dates; so, even if the bickerers exported to the Far East. However, of either swap, the essential reality is that reach consensus on those items, they are major Arab Gulf producers have stated the Platts Dated assessment is not either not addressing anything related to the they do not want their actions to be the bounded by or grounded in physical deliv- self-selection character of reporting traded determinative factor in establishing, ery obligations; so, from that perspective, forward cargos which has led to virtu- increasing or reducing a benchmark’s use. it is not tethered to the physical market. ally none being reported. In fact we at Historically, the Platts Dubai-Oman and However, from a different perspective CME Group (NYMEX) feel so strongly Oman futures prices have maintained a it is connected to the physical market about trying to improve the convergence correlation of approximately 99 percent in because it is the base by which virtually all process that we introduced a new Brent their daily Singapore Window timeframe traded dated cargos (which are physical) futures contract at the end of 2011 with price changes. Oman futures trade more are priced. Though it is never identified as a new cash-settlement mechanism that than 5 million barrels per day (and is me- such, the Platts Dated assessment process, eliminates the self-selecting component al- thodically rising) and results in physical especially as conducted through the two together from the mechanism. We believe delivery of about 10 million barrels each MOC processes, is really a negotiation that leads to a much healthier convergence month. Collectively, these mean that: 1. mechanism for oil market participants process. Oman futures provide an extremely reli- to determine the physical price of BFOE Meanwhile, the reduction in BFOE able hedge for Platts Dubai-Oman based cargos. That is an important role and it production has led to frequent disrup- pricing; and, 2. Oman futures converge would probably be more illuminating if it tions in scheduled loadings over the past smoothly with the physical market. were described precisely in those terms. year and it is reasonable to suggest, as Major Arab Gulf producers have Regarding futures contracts, they some market observers have, that these further said that they would follow the need to terminate either through physical unscheduled disruptions have impacted lead of their customers in establishing, delivery or financial settlement, and Brent BFOE prices and pricing; arguably more increasing or decreasing the use of any futures are terminated through financial than market supply, demand or storage. benchmarks. Perhaps, figuratively, China settlement. The settlement mechanism is During the first quarter 2009, the front is assuming that leadership. China is supposed to be structured to mimic the part of the Brent curve, especially Platts a significant consumer of oil – over 11 value for the underlying commercial mar- Dated versus the 1st-month forward, mmbd – and it has said publicly that it is ket and, for Brent futures, the underlying was in backwardation more than 30 concerned that higher oil prices hurt its commercial market is ‘reported’ traded percent of the time even though OECD economy’s growth and that is one of the BFOE forward next-month cargos (and petroleum storage levels were at historical reasons it is supporting the development its predecessors from previous decades) on highs and the world was suffering the of oil futures in China. contract termination day. However, for most substantial levels of demand I mention each of these because I some time now, there has been a dearth destruction since the onset of the Brent expect them to become increasingly more of such cargos when the futures contract mechanism. Since November last year, influential during the next several years expires. There are several reasons for this: OECD’s commercial stocks have been – producer sentiment on the adoption 1. The reduction in production of BFOE approximately at the same levels they were of benchmarks, the potential for Oman has resulted in a continuing reduction in in 2009 in terms of day’s supply and, yet, futures to increase its use for hedging the number of cargos; 2. The ‘reporting’ the BFOE market – in terms of futures and China’s hint that consumers will of cargos is purely self-selecting and most and Dated to 2nd-month forward – has be adopting more aggressive positions cargos are not reported – in fact very been stubbornly backwardated; are these in price determination. All of these are few next month full-cargos seem to get market fundamentals or are these market notable and warrant more attention. reported during any part of a calendar mechanism impacts? If it is the latter, are month; and 3. By the time the most there other impacts as well? In Issue 87, Conclusion active Brent futures contract expires, a one of your contributors emphasised that significant portion of the next month’s Thank you for the opportunity to share the WTI-Brent spread during 2011 can- forward cargos have been displaced by my views on oil benchmarks. I believe that not be explained by WTI fundamentals dated cargos. long-term trends in production capacity even though he was solidly convinced that The disagreement I referred to derives and levels favour North American bench- WTI’s price is governed by fundamentals; from the perception by some in the oil marks versus the North Sea. I also believe so he attributed it to expectations of WTI market that the third reason has been that current issues on price convergence in exacerbated this year because of a change fundamentals. However, BFOE’s history Brent can be improved but they must first in the minimum required notification over the past several years to defy the be confronted. And I believe some of the period that a forward BFOE cargo is commercial stocks data directly increases most important influences on oil bench- scheduled for loading. But I wonder if the probability that the explanation lies marks over the next several years could the bickering has diverted attention from elsewhere. emanate from outside the established other more chronic issues that influence View from Outside benchmark realms. the quality of convergence. The self-selec- tion which governs the reporting of traded Frequently there is industry discussion Robert Levin, Managing Director cargos is independent of both minimum about devising a new Arab Gulf based Commodity Research and Product notification periods and futures contracts benchmark, especially for crude oil Development, CME Group PAGE 28 | OXFORD ENERGY FORUM | MAY 2012 Asinus Muses

Colonialism and its discontents a $6bn fuel surplus in 2006 to a $3bn Axel Kicillof, former leader of the student deficit last year. political group with the incendiary name Poor Spain. Suffering one of the worst of TNT (which, they would joke, stood depressions in history, burdened by an From elephant to ruminant for Tonto, pero No Tanto, or silly, but austerity imposed by outside powers, out The Financial Times’ usually-stiff upper lip not so much). Kicillof has become an of the blue comes a further humiliation. has been sent aquiver, and it seems able to international celebrity overnight. While In an outrageous show of personal power report on little else. This obsession may be suffering various smears – the Financial and disregard for international norms, a symptom of cognitive dissonance. With Times, after snootily commenting that he one country’s head of state has personally ‘does not appear to own a tie,’ repeated brought to heel a foreign colossus, inviting one hand it branded President Cristina ‘a populist lunatic seemingly determined the myth that he had learned German international opprobrium and dismay, and in order to read Marx in the original – further damaging their country’s already- that her people do not participate in an economic golden age for Latin America’, Spanish Vanity Fair breathlessly described dismal reputation. That’s right: from a him as ‘Attractive, super dad, nerd, and country known for the ritual torture of while with the other hand it quoted a former Repsol executive as saying that the brain behind the expropriation of YPF’. bulls, King Juan Carlos of Spain shot an Alongside pictures of his beautiful wife, elephant on safari in Botswana, with the company’s ‘business model has been based on YPF being a cash cow, and reinvest- it went on to quote him as immodestly head of the Spanish World Wildlife Fund declaring, ‘I am the present and the future reporting that ‘This unfortunate episode ing that into other areas’through the company’s extravagant dividends policy. of Argentina.’ Unfortunately they has become known across the world and had taken this ‘quote’ from a satirical Such a model is hardly designed to please we are receiving vast numbers of energetic Argentine newspaper. One thinks they President Cristina, for whom the nation- complaints.’ might have noticed since in the same alisation is but one of many steps taken Speaking of energetic complaints, column Kicillof is presented as describing to keep dollars in the country. Moreover, in other news, Argentina’s President himself as having ‘innate sensuality,’ being as an honest beast of burden, Asinus is Cristina Fernández has decided to ‘Informal, but serious. Sexy, but consist- particularly sympathetic to the outrage at re-nationalise YPF, seizing shares owned ent.’ Despite Argentines’ notorious self being likened to a mere ruminant. by the Spanish energy group Repsol. As confidence, Asinus feels that this should history has shown repeatedly, Argentina’s Fifth-rate fulminations have raised editorial suspicions. appearances on the global stage never lack charisma. Like any great performer, Perhaps the most eloquent contribution The wrong sort of rocks it reprises its signature role with enough to the debate has been footage from 2008 After Fukushima, energy and earth- variation to sustain the audience’s interest: of Mariano Rajoy, current Spanish Prime quakes already had an uncomfortable having played the international financial Minister, unearthed for the occasion and association. This was hardly improved pariah to pitch-perfection in its snub of aired on Argentine television. In response by the finding that shale gas fracking (or the international bond market at the end to the possibility that Lukoil might buy perhaps that should be fracking shale gas) of 2001, its latest performance features a shares in Repsol, he declared ‘Our oil, twice caused tremors outside Blackpool snub of the international stock market. our gas and our energy can’t pass into last year. Yet, an extension of fracking to By taking ownership of 51 percent of the hands of a Russian firm, because that the rest of the UK has just been approved the shares of the formerly-national oil would convert us into a fifth-rate country.’ by the government. Apparently the seis- company YPF, privatised in the 1990s Again, not a promising background for mic implications were due to an ‘extremely under the famously-corrupt President someone who wants to argue against the rare’ combination of factors, including Menem, it has once again sent waves of re-nationalisation of an oil company. pre-existing faults in the rocks. Asinus is fear and loathing through the community Mis-placed vanity reminded of Network Rail’s classic excuse (I use the word ironically) of international for train delays that ‘the wrong sort of investors. Among other things, the Argen- After President Cristina herself, the leaves’ have fallen on the train lines. Silly tines objected to a lack of investment and charismatic Argentine most involved in Blackpudlians for having inferior geologi- production that had led to a swing from the nationalisation is 41 year-old Professor cal formations underfoot.

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