Olkaria Geothermal Power Station in Kenya © AFD
A recent study by the IMF estimated that at a global level, energy subsidies amounted to a mindboggling US$ 1.9 trillion. Subsidies come in different forms. In advanced economies, they result mainly from underpricing of energy relative to its true cost to society from pollution and climate change. In many oil producing economies, they are simply the opportunity cost of selling energy products below international market prices. In Sub-Saharan Africa, both types of subsidies occur. But more importantly, the widespread practice of subsidizing fuel and electricity prices has led to underinvestment in the energy sector that seriously threatens Africa’s economic growth prospects.
With many low-income countries in Africa facing tight budget constraints, energy subsidies divert resources away from many more productive and deserving spending programs.
Energy subsidies are costly
In Sub-Saharan Africa, direct energy subsidies averaged close to 3 percent of GDP in 2012 – as much as public health spending in many countries. They are costly to the budget and crowd out other spending, including on much-needed infrastructure and social services. And this estimate does not include the cost of environmental externalities, which would add a further ½ percent of GDP. With many low-income countries in Africa facing tight budget constraints, energy subsidies divert resources away from many more productive and deserving spending programs.
Energy subsidies are poorly targeted
If subsidies are so costly, why are they still so wide-spread? Most countries would cite two main objectives: promoting access to energy, particularly for the poor, and boosting the competitiveness of the economy by providing cheap energy. Unfortunately, subsidies rarely work to achieve these laudable objectives.
In most countries, energy subsidies are not well targeted to poor consumers. While all consumers of subsidized energy benefit by paying below-cost prices, most energy is consumed by the relatively well-off groups. In Sub-Saharan Africa, it is estimated that the top quintile of the income distribution captures about 45 percent of the subsidy; the bottom quintile only receives 8 percent. The poor do not drive cars or run air conditioners. Indeed, more than half of the population in most African countries does not have access to electricity and hence receives no benefit at all from subsidized electricity.
Energy subsidies are inefficient
Moreover, rather than making economies more competitive, subsidies often distort investment decisions. For example, pricing electricity below its cost has severely affected the performance of power companies in sub-Saharan Africa. Unable to recover costs, these companies have found it difficult to properly maintain (much less modernize or expand) power generation and distribution systems, resulting in frequent power outages that force consumers to invest in costly self-generation. Private investors are not willing to invest in power generation because they are unsure of recovery of their costs. Therefore, it is no surprise that per-capita energy production in sub-Saharan Africa has remained virtually unchanged since the mid-1980s. This has left sub-Saharan Africa lagging considerably behind other regions, which have invested heavily in energy production. And because of underinvestment and poor maintenance, energy is also more expensive in Africa than elsewhere.
Energy subsidies cause environmental damage
Finally, setting energy prices below true costs has significant environmental costs. Energy subsidies encourage overconsumption of fuel products, which accelerates the depletion of natural resources. They also reduce the incentive for investment in cleaner energy. Africa is blessed with considerable sources of renewable energy—such as hydro, geothermal and solar—but subsidies continue to encourage fossil fuel dependency and undermine the competitiveness of these renewable sources.
The way forward
Energy subsidies persist, in part, because they are a convenient fiscal tool, requiring little administrative capacity, to provide benefits to the population. Lack of public support for subsidy removal is in part due to a lack of confidence that governments would use the savings from removal of subsidies for programs that would benefit the poor or address pressing economic and social needs. For these reasons, many countries have had difficulty reforming subsidies.
But positive experiences are beginning to emerge. Since the early 2000s, Kenya and Uganda have taken a number of steps, including raising electricity prices to cost-recovery levels and reforming state-owned utilities. In both countries, the reforms have encouraged private investment in power sector and also led to many improvements, including increased power supply, better service, and a substantial increase in number of customers served by grid-supplied power.
Designing and implementing effective subsidy reforms
Based on a review of many subsidy reform episodes from across the world, IMF staff identified six key ingredients that should be part of any subsidy reform program.
- Clear communication on the size of energy subsidies and their beneficiaries is the first step to kick start reform. In 2003, Ghana commissioned an independent study and made the findings about the costs and beneficiaries public, before starting the removal of subsidies.
- A carefully prepared reform plan is important. The plan should include a long-term strategy for the energy sector with clear objectives and be prepared in consultation with key stakeholders. In the mid-2000s, the Kenyan government agreed with unions that there would be no retrenchment of staff in the utilities and came to an agreement with large consumers on power tariff increases based on a commitment to use the revenues to increase supply.
- A gradual removal of subsidies has a better chance of success, especially if subsidies are large or have been in place for a long time. This allows time for consumers to adjust their energy consumption and for government to put in place adequate social safety net programs to mitigate the impact on the poorest groups.
- Governments should protect the poorest when energy prices rise. For example, the Nigerian government utilizes a portion of the subsidy savings from its 2012 fuel subsidy reduction for conditional cash transfer programs for pregnant women.
- Making state-owned companies more efficient will help reduce subsidy costs and limit the need for tariff increases. Promoting energy trade across countries in Africa, which has also the potential to promote renewable energy generation, could also reduce subsidy costs.
- Depoliticizing the setting of energy prices appears to be important to enhance the sustainability of subsidy reforms. Toward this end, some countries in Africa have introduced automatic price adjustment mechanisms (e.g., power tariffs in Kenya).
In sum, energy subsidy reform is a key policy challenge that is central to realizing the growth potential of Africa. Given the large potential payoffs from successful reform, we now need to approach subsidy reform with renewed vigor.