Masood AhmedBy Masood Ahmed

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Of all the regions in the world, the Middle East and North Africa region stands out as the one that relies the most on generalized energy subsidies. In energy-rich countries, governments provide subsidies to their populations as a way of sharing the natural resource wealth. In the region’s energy-importing countries, governments use subsidies to offer people some relief from high commodity prices, especially since social safety nets are often weak.

The question is: does this well-intended social protection policy represent the most efficient way to channel aid to the most vulnerable? The answer is no!

Costly and harmful scheme
Energy subsidies are very costly, explicitly and implicitly. In 2011, they amounted to about $240 billion, more than 8.5 percent of regional GDP. Particularly in the region’s oil importing-countries, subsidies eat up a large part of governments’ budgets, which often leads to higher deficit and debt levels.

In addition, there is a clear opportunity cost to providing energy subsidies—spending money there means limiting valuable investments elsewhere. Areas such as health care, education, or infrastructure that are essential to improving the long-term economic prospects of the region can easily end up neglected, thus dampening growth.

Moreover, in oil-exporting and oil-importing countries alike, energy subsidies are highly inequitable. If we look at who actually benefits from those subsidies, it’s clear that the bulk of the benefit goes to the better-off, who use energy the most—people with automobiles, air-conditioned houses, and electrical appliances.

Energy subsidies also have other harmful effects on the economy. When something comes cheaply, people tend to buy more than they need, resulting in excessive consumption and higher pollution.

Furthermore, subsidies can also lower profits—or cause losses—for energy companies, making it less likely that they will invest in the energy sector and potentially leading to energy shortages. And subsidies encourage capital-intensive investment rather than job-creating investment.

Despite the many good arguments for dismantling energy subsidies, in practice this has not been easy. Reform attempts face resistance by vested interests and by households who are not convinced that the government will use wisely the resources saved.

Now, how do governments go about reforming energy subsidies once consumers have become accustomed to them?


Weaning off subsidies

To succeed, governments need to carefully plan subsidy reform and make sure to not unduly affect the most vulnerable. The IMF has just completed a review of 22 country case studies of energy subsidy reform. The results varied, but  suggest the following six key ingredients for success:

A comprehensive energy sector reform plan. The plan should include clear long-term objectives, an assessment of the impact, and consultation with those affected by it.

A good communications strategy. A strong communications campaign helps generate broad understanding and support for change and should be undertaken throughout the reform process, emphasizing not just the cost of subsidies but also the benefits of reform.

Measures to compensate the poor. It is crucial that those who are hardest hit by the removal of subsidies are compensated from the beginning. There are many ways to subsidize the poor, either by subsidizing the goods they consume, targeting regions where they live, or by providing them lifeline tariffs and cash transfers.

Phased price increases. Phasing in price increases and sequencing them differently across energy products can be helpful. Too sharp an increase in energy prices can generate intense opposition. A phased strategy will allow people and businesses to adjust and governments to strengthen social safety nets.

Improved efficiency of state-owned enterprises to reduce producer subsidies. State-owned companies—especially power generation—often receive substantial budgetary resources to compensate for inefficiencies in production, distribution, and revenue collection. Improving their operational efficiency can strengthen the financial position of these enterprises and reduce the need for subsidies.

Depoliticized price setting. Durable reforms require a depoliticized mechanism for setting energy prices and allow the transmission of changes in world prices to domestic prices. Automatic pricing mechanisms can reduce the chances of reform reversal, while price smoothing rules can help avoid large price changes.

IMF technical expertise can help
The IMF can be a key partner for subsidies reforms that can unlock growth, reduce inequality, and help the environment.

The IMF can help make the case for subsidy reform by explaining how costly subsidies really are, and provide—in collaboration with the World Bank and other stakeholders—the technical expertise on how to design and sequence the removal of subsidies, strengthen targeted social safety nets, and establish automatic mechanisms to smooth price movements while protecting the government’s budget. It can also share the lessons of experience from across its membership.

The IMF’s advice can help countries free up fiscal space to preserve or expand social spending and investment, a crucial objective in many countries in the region—particularly those in transition—where governments must support better their citizens but also face a difficult fiscal environment.

Supporting the people
The economic and social challenges facing many countries of the region underscore the widespread desire to shift away from the status quo and to embrace new socioeconomic policies. A shift from subsidizing energy to supporting the people would help respond to the region’s social needs, raise investment, eliminate distortions, enhance human capital, and create jobs.