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August 21, 2012

Africa's other big BRIC – India

August 21, 2012

If fossil fuel subsidies are so bad, why can't we get rid of them? Time for some politics

August 21, 2012
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My mate Matthew Lockwood (right) has decided (again) to abandon development and focus on UK climate change issues. In an earlier exit Matthew_lockwood125(from development to climate change) he wrote The State They’re In, a brilliant book on the political economy of African development. This time, as he heads for the exit, he is writing some valedictory posts on some of the biggest dilemmas he has worked on as head of the climate change team at IDS. He is always worth reading.

“In trying to put together the climate policy and development agendas over the last couple of years, one issue that I really think is very important but doesn’t receive enough attention from both policy makers and researchers is why it is proving so hard to reform subsidies for oil, electricity and coal in developing countries.

In recent years $500 billion a year or more has been spent globally on making high-carbon fuels cheap, with around 40% of that coming from developing countries, including some of the big emerging economies such as China, India, Indonesia and South Africa.

From a policy perspective, reducing fossil fuel subsidies is a no-brainer. To begin with, they are a kind of negative carbon pricing (i.e. a carbon subsidy). Moreover, the lion’s share of the benefits is captured by the middle classes rather than the poor. The IEA estimates that of $22.5 billion spent by India on fossil fuel subsidies in 2010, less than $2 billion benefitted the poorest 20% of the population. Such patterns are fairly typical – ratios for Indonesia, Thailand, Pakistan and South Africa were similar, and only slightly better for China. As a form of social protection, subsidies are very poorly targeted.

Subsidies take up fiscal resources that could be spent on public services or better targeted social protection. In some Indian states in the mid-2000s, as much as 50% of the state budget went on subsidies to (largely coal-fired) electricity. Up until 2009, Indonesia spent more on energy subsidies than on health, education, social security and defence combined.

endfossilfuelsubsidies-640x424Small wonder then that in the run up to this year’s G20 and Rio+20 summits on-line campaigning group Avaaz called for an end to “black subsidies”. The group wanted to see a “climate spring”, launching a petition that would persuade world leaders to phase out fossil fuel subsidies once and for all. Simples.

Or not so simples. Reform of subsidies has in fact been on the G20 agenda since the Pittsburgh Summit in 2009, but has proved difficult to achieve in practice, despite the fact that large rises in oil prices in recent years have ratcheted up the fiscal costs for governments.

Where attempts at subsidy reduction or removal have taken place, they have often been reversed within a few days (e.g. Ghana in 2008, Nigeria in 2012), postponed (Indonesia in 2012), or at best been highly partial (India since the 1990s). Fuel price rises often provoke violent street protests – the most recent example is Sudan, which follows a series of riots this year sparked off by reform attempts in Nigeria in January and Indonesia in March.

David Victor, a Stanford political scientist working with the Geneva-based Global Subsidies Initiative (GSI) of the International Institute for Sustainable Development, argues that governments give subsidies as part of a political bargain – they are “a visible way to deliver benefits in exchange for political support”, and administratively cheap and easy to deliver compared to alternatives. Once a subsidy is there, it gets locked-in and often increased, as it becomes a key symbol of populist action by successive politicians.

The political role played by subsidies is then key to understanding how a reform package might be more successful. Victor suggests several lessons for reformers. One is that any reform strategy must begin with the political logic that led governments to create the subsidy – powerful interests that currently benefit have to be compensated or reform has to be inoculated from their opposition. A second is that transparency about the costs and purpose of subsidies usually aids reform. Another is that it is very helpful to have available or to develop better administrative tools for redistribution, to replace broad spectrum subsidies, which are a blunt instrument.

Thus, for example, Ghana’s 2005 reform of fuel subsidy reductions succeeded where previous efforts failed partly because good information about the costs and the incidence of subsidies was widely shared with key stakeholder groups like trade unions. In Indonesia fossil-fuel-emissions-007in 2005, a new alternative form of compensation for poor households was introduced in the form of a means tested safety net which allowed subsidy reduction without major protests. The GSI has started to propose reform packages for specific countries based on this explicitly political approach.

But perhaps one of the most difficult issues in the politics of subsidy reform concerns the compensating measures that are widely seen as necessary to legitimise reform. Even though poor households capture only a small part of the direct benefits of subsidies, the effects of subsidy removal on their incomes is proportionately higher than for better off households. This is partly because of the indirect effects of subsidy reduction or removal – higher fuel costs increase the price of everything that is moved by road, including food. As a result, a key component of reforms is now the introduction of better targeted social protection for the poor. For example, in Indonesia in 2008, following unsuccessful attempts at subsidy reduction in 1998 that led to protests that ultimately toppled the government, a reform programme included a cash transfer scheme called Bantuan Langsung Tunai (BLT) to compensate for the fuel price increase. This was an ambitious scheme designed to reach about a third of the population. Current plans for further subsidy reform, due to be renewed in the autumn, include an updated version of BLT called BLSM. However, the BLT has proven controversial, in large part because the targeting process left the door open to corruption and politicisation of the benefit. Unlike a fuel price, which people can monitor easily, a non-universal benefit is inherently more open to discretion (and thus, corruption). Unhappiness about the history of BLT is now a big factor in resistance to the current round of reform.

A possible explanation of what is going on here comes from new institutional economics in the form of a “commitment problem”. If corruption is a major problem, promises to compensate people for the loss of fuel subsidies with a targeted benefit face a big credibility problem. People see that there is no incentive for ruling regimes to eliminate corruption and distribute resources fairly, and there is no impartial third party which can enforce the promise. This partly explains why Nigerian demonstrators held placards saying “Remove fossil fuel subsidies 2corruption, not subsidy”.

Thus in some situations, while there may be a set of ideal, or “first-best” designs for reforms, these may not be possible, and second-best responses will be more realistic. For example, if compensating targeted benefits are not a credible element of a reform package, then alternatives will have to be considered. These may include consumer food subsidies, which do often have drawbacks, but may not be as damaging as fossil fuel subsidies.

There is a real need for more research to look at the dynamics of reform from these perspectives. As oil prices rise, as the climate challenge grows, the pressure to resolve the fuel subsidy issue will only increase. It is of course a laughable cliché for an academic to say that “more research is needed”, but this really is an area where a better understanding of the political economy of reform could help bring about practical change that benefits poor people and the environment in a major way.”

Matthew Lockwood is a Research Fellow at the Institute of Development Studies at the University of Sussex. From October 2012 he starts work on a four year project on innovation and governance in the UK energy sector.

3 comments

  1. This is a very timely issue of critical importance. I liked the way it brings together core aspects of this debate so well, along with sharp and useful statistics. Whilst i agree that any withdrawal of subsidy for fossil fuel can have indirect negative impact on households living in poverty and therefore cash transfers by other means is essential, I would also urge that other innovative approaches in developing countries should be considered .The example below gives one other innovative opportunity for the UK government to see how it can support good efforts in combating Climate Change as a part of its port folio.
    At this moment of time, I am indeed involved in one such initiative. The Karnataka Growers Federation with more than 50000 members consisting mostly of small holders is supported by Centre for Social Markets in Bangalore ,India, in initiating an innovative effort that will quantify the importance of shade grown Coffee plantation in regulating local ecological balance in the three districts of Southern Karnataka region: Hassan,Chikkamaglur.and Kodagu districts. A powerful partnership with the globally recognized, Pavan Sukhdev`s research consultancy –Green initiatives for sustainable Tomorrow; Forestry College at the cutting edge of such work in the local district,Kodagu and a mass based organization like KGF- is enabled by Centre for Social Markets, in Bangalore, testing new grounds and responding to new political realities in India- please see
    http://www.csmworld.org/Climate-Change/sustainable-coffee.html
    Indeed this work is being popularized with a second walk I am engaged in:
    http://www.oxfam.org.uk/get_involved/campaign-with-us/north-of-england-blog?type=mostpopular –I invite one and all to join and support this Gandhian and Fairtrade inspired walk through your blog-If I may, Duncan.

  2. Many thanks for this excellent article, full of cogent analysis and pertinent recommendations. I would, however, like to make one observation on what you refer to as “first-best” and “second-best” responses. You define the “first-best” option as being to perfectly target all the recovered resources from subsidy removal to the poorest in the form of social transfers (as with BLT in Indonesia). But this is “first-best” only in an idealised Utopia. Our real world, as the rest of the article makes plain, is not like that. First, it is impossible to accurately identify the poorest; second, even if you could, they would not be the poorest for very long; and third, you will never get political support for such an approach since you are essentially telling rich and middle-class voters (a powerful majority) that you are depriving them of the benefits of the subsidy, and giving all of the proceeds to someone else.
    In the real world, therefore, I would suggest that the “best” solution (better than your “second-best” option of consumer food subsidies) is to spread the benefits of reform equally across society by targeting transfers universally to groups who are generally perceived as being deserving: children, pregnant women, the elderly and those with disability. These groups are much more easily identifiable, so the dangers of corruption and politicisation are minimised; and the whole political economy argument is turned on its head, since support for the reforms from the middle class and the wealthy becomes much more likely (it was decidedly not the poorest who were protesting outside Indonesia’s parliament or in Nigeria’s urban centres earlier this year). Giving the same to everyone is already far more equitable than giving everything to the wealthy (as subsidies tend to), but it will also be much more popular than giving everything to the poorest (which is impossible anyway), thus making reform much more palatable. The best way to help the poor is not necessarily to target the poor!

  3. “In recent years $500 billion a year or more has been spent globally on making high-carbon fuels cheap, with around 40% of that coming from developing countries, including some of the big emerging economies such as China, India, Indonesia and South Africa.”

    this is a real statistics? where did you find the source? thanks

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