By Liliana D. Sousa
It might be surprising, but the majority of Central American households receive electricity subsidies, benefiting up to 8 out of 10 households in some cases. Without a doubt, this provides many poor and low-income families with access to affordable electricity.
However, a recent World Bank study shows that, by reforming their electricity subsidy systems, Central America has the opportunity to increase the benefits for families in need and thus contribute to greater poverty reduction – all while taking much needed steps to reduce their fiscal impact.
According to this report, a significant share of subsidies currently go to the households who least need them, that is, the higher-income (figure 1). An example is Nicaragua, one of the poorest countries in Latin America, where only 25 cents out of every dollar spent on electricity subsidies go to the poorest 40 percent of the population.
What is driving this?
After digging into the subsidy mechanisms in each country of Central America, the study identifies two key factors. First, electricity subsidies only help households that are connected to the power grid. Considering that many families living in poverty, especially in rural areas, are not connected, they are automatically excluded from these benefits.
Second, as a result of the design of the subsidy mechanisms, the more a household consumes, the more subsidy it receives (figure 2). These are typically higher-income households, as they have more appliances and electronics.
Figure 1: Poorer households receive less subsidy benefits
Share of Subsidies Received by the Bottom and Top 40 percent, 2016
Figure 2. Higher income households consume more subsidized electricity
Electricity consumption of subsidy recipients by income decile, 2016 Source: Hernandez et al 2017.
Household income decile is based on per capita income. Labels: D1-D10 indicate deciles 1 through 10 of per capita household income; Costa Rica (CRI), El Salvador (SLV), Guatemala (GTM), Honduras, (HND), Nicaragua (NIC), and Panama (PAN).
Two lessons can be drawn from this analysis. First, “design matters.” Electricity subsidies are typically assigned based on consumption thresholds that aim to exclude higher volume consumers. The extent to which these thresholds succeed at reducing subsidies to higher volume consumers largely determines the efficiency of targeting.
This can be seen in figure 2. In countries like Honduras and Panama, where the threshold is very high relative to local electricity consumption, higher income households consume much more subsidized electricity than others. In El Salvador and Guatemala, where the threshold is much lower, the difference between high and low income households in subsidized electricity consumption is smaller.
But even in El Salvador and Guatemala, the wealthiest 40 percent receive more subsidies than the poorest 40 percent. This points us to the second lesson: Eligibility based on electricity consumption is an imperfect tool if the goal is to benefit those who most need support. How come? The mechanisms include some higher-income households who consume less than the threshold, and they exclude some poor households who either consume over the threshold or are not connected.
These two lessons suggest that electricity subsidies would be more effective at helping low income households if they were targeted using a combination of low inclusion thresholds and information on household need. This second dimension can be accomplished in several ways. For example, households in some high-income neighborhoods (such as gated communities) are not eligible for Honduras’ most generous subsidy.
Another option is to replace subsidies that are reflected as discounts on electricity bills as direct cash transfers for eligible households who consume less electricity than the threshold. These transfers could include households who are not connected to the grid, addressing one of the factors that leads to distortions in the allocation of subsidy benefits. According to the study, replacing the current subsidy mechanisms with cash transfers through the countries’ already existing cash transfer programs could reduce poverty by over 3 percent in El Salvador, Panama, and Nicaragua even while reducing the cost of subsidies by 20 to 50%.
Improved targeting will also help the fiscal situation in the countries of Central America, who spent $1.3 billion annually between 2012 and 2014 on subsidies. The fiscal impact of subsidies ranges from no fiscal costs in Costa Rica, whose subsidy system is self-financing, to Nicaragua, where electricity subsidies represent 1.4% of GDP. By reducing the fiscal burden of subsidies, these countries could reallocate more funds to areas, like health and education, that will play a critical role in improving the future for Central Americans.