Amid energy price shocks, five lessons to remember on energy subsidies

Energy subsidies are proliferating as governments try to shield consumers from rising and volatile energy prices — but these come with significant risks. 

Energy commodity prices have been rising since 2021, as economic recovery from COVID-19 led to a rebound in energy demand across the globe, while supply remained constrained. The Russian invasion of Ukraine, and subsequent supply uncertainties and sanctions, further exacerbated the situation, pushing Brent crude oil and natural gas prices to near-historic highs, within knock-on effects on power sectors. The World Bank’s latest Commodity Markets Outlook anticipates that energy prices will rise more than 50 percent in 2022 before easing in 2023 and 2024.

Governments have introduced measures to shield households, firms, and economies from price shocks.

Government responses have varied based on their dependence on Russian energy supplies and end-users’ vulnerability to price shocks. Several had already introduced relief measures in response to rising energy prices in the second half of 2021, even before the Ukraine crisis. 

In Europe, which is highly vulnerable to energy disruptions in supplies from Russia, several governments announced support packages to shield households from record high energy bills — ranging from price controls to tax relief and direct support to affected consumers. This helpful analysis by Bruegel compiles measures across Europe.

Beyond Europe, several governments announced multi-pronged packages to deal with the impacts. Our recent review of 135 countries indicates that 57 countries introduced fuel price-related measures between February and mid-May 2022, while five additional countries are considering similar moves. Thirty-seven countries are maintaining existing fuel subsidies for now. Governments are taking comparable action to address affordability concerns in the electricity and natural gas sectors. 

The measures adopted or being considered to respond to rising energy prices since mid-2021 involve several delivery channels, for which we share a non-exhaustive set of examples in the table below:
 

After declining in the last couple of years, energy subsidies are coming back rapidly and at much higher levels than before COVID-19.

Some countries have decided to maintain or expand existing subsidy programs (e.g., Malaysia), reverse past subsidy reform efforts (e.g., Pakistan), delay planned efforts (e.g., Nigeria), or introduce subsidies for the first time (e.g. Japan).

The expanded or new subsidy programs create an additional burden on governments amid tightening fiscal space and spending pressures on other priorities.

In countries with subsidy programs in place, the costs of these programs are rising due to higher prices. To finance these costs, governments are mobilizing resources, including expanding budget allocations (e.g., Dominican Republic, Indonesia) or withdrawing from price stabilization funds (Colombia, Peru).

The expansion of new programs and creation of new ones in other countries are introducing new costs that need to be financed and budgeted.

If price pressures and crisis conditions persist, these measures will require significant cumulative resources and pose serious risks for energy sector performance and fiscal sustainability.

The longer these measures last, the higher the risk that some of the “temporary” measures could become increasingly difficult to reverse, creating new challenges to future reform.

Universal energy consumption subsidies — untargeted price controls or tax breaks — are harmful to the environment, the energy sector, and public finances, and do not benefit the poor.  

As governments grapple with tough choices and work to protect the poor and vulnerable, it is worth remembering these five lessons from international experience in relation to broad-based and untargeted energy subsidies :

1. They almost always benefit the rich more than the poor;

2. They incentivize the consumption and production of fossil fuels, harming the environment and impacting the climate;

3. By maintaining artificially low energy prices, they send misleading signals on the true cost of energy consumption, impacting consumer behavior, investment in cleaner alternatives, and creating distortions in the economy;

4. They have a significant fiscal impact, especially when delivered through tax breaks and discounts that forego revenue; and not fully and explicitly reflected in budgets,

5. They work against climate change mitigation tools such as carbon taxes and emission trading.

How can countries protect their economies and people from volatile energy prices?

To the extent possible, short-term measures should be well-targeted to meet the needs of the poorest and most vulnerable. Properly targeted transfers are more effective (and often lower cost) instruments for reaching the most vulnerable households, rather than broad-based price subsidies. In contexts where adequate social protection mechanisms to enable targeted support are not in place, and where electricity or gas retail prices are regulated, tariff design offers policymakers the opportunity to meet households’ basic needs through carefully crafted lifeline rates, while enabling cost recovery.

No matter what approach is chosen, lessons from international experience strongly suggest that any subsidy measure to keep fuels, electricity or gas affordable in response to a crisis should be time-bound, transparent, and fully budgeted. 

If the goal is to protect consumers from price shocks, it is important to recognize the potential of energy efficiency and conservation as the “first fuel,” and ensure that short-term measures do not disincentivize energy efficiency and conservation.  

While the current crisis continues to test governments’ resolve for green, resilient, and inclusive development, providing the right price signals to the energy consumers, while protecting the most vulnerable, will be an essential piece of the puzzle.

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