In the quest for energy affordability, macro-prudence and energy sector reforms are as essential as relying on social protection measures

Rising electricity and fuel costs are hitting consumers worldwide, making it a big challenge for many fiscally strapped governments. Malaysia is no exception. Even before the pandemic, about a quarter of the average household budget was spent on necessities such as housing, water, electricity, gas and other fuels, even with subsidies. The debate on improving targeting for fuel subsidies is longstanding. Still, it is not the sole factor that will help improve affordability.

One could establish that social protection measures could cushion energy price shocks. However, social protection measures in the absence of macro- or sectoral- reforms are not fiscally sustainable. 

First, at the macroeconomy level, the government could put a national price-smoothing mechanism that builds fiscal buffers when times are good and draws them down when times are bad. This is often implemented in the form of a fiscal rule. Suppose commodity prices go above a certain pre-established threshold. In that case, proceeds from the excess could be relayed into a national savings fund for future generations. 

By contrast, if the situation is the opposite and prices drop below that threshold, the fund could be used for pre-defined purposes. This could provide a fiscal cushion to fund current expenses on wages and pensions (almost two-thirds of Malaysia’s revenues go towards spending on wages, pensions, and debt servicing). 

The proposed Fiscal Responsibility Act provides such an opportunity for Malaysia to establish a fiscal rule. If this is done, the country will be on its way to emulating Norway. The Nordic country is widely considered the gold standard for such a fiscal rule and has avoided macro-economic destabilization and crises that countries like Nigeria and Venezuela have recently experienced (in the absence of fiscal rules).

The second structural reform looks at the energy sector. Sectoral resilience could be strengthened by furthering competitiveness, diversifying into non-fossil energy sources, and improving efficiency.

Malaysia’s energy sector has undertaken various reforms in the recent past. For instance, the gas supply market was opened as part of the 10th Malaysia Plan in 2010, with third-party access permitted. Similarly, reforms in the electricity supply industry have also been implemented, with Malaysia’s Energy Commission practicing incentive-based regulation of its electricity sector since 2014. This sends a better price signal and promotes efficiency. In terms of diversification, renewables have received a strong push in recent years through programs such as large-scale solar auctions and net energy metering for rooftop installations.

However, the energy sector can be even more efficient. Direct and indirect subsidies remain rife. Transport fuel prices are capped, reducing incentives for using public transport and switching to electric vehicles. Electricity tariffs contain significant cross-subsidies from industry and commerce to smaller residential customers, harming efficiency, competitiveness, and financial viability.

Why is the prevailing emphasis on social safety nets a first resort to managing the fallout of energy prices? For one, it is more immediate, visible, and tangible. When prices rise, social protection measures look better than promising sectoral reform to ease relief. It is also in part a reaction to the misguided policies of the past. 

A case-in-point is BNM’s oft-cited 2014 report. The B20 received a mere 4 percent of the fuel subsidy, in sharp contrast to the wealthiest 20 percent, which received over 40 percent. The exact incidence might have shifted since 2014. Still, the broad finding – that the B20 barely benefits from the subsidy – is highly likely to prevail. Our next piece will explore what optimal safety nets look like and share lessons from other countries that may be instructive for Malaysia.

The bottom line is that it is only when underlying volatilities have been absorbed at a macro- and sectoral level that social protection can best do its intended job in cushioning the residual volatility at a household level.