5 lessons from reducing energy subsidies

Energy subsidies are common throughout the world.  The bulk of subsidies are paid in the Middle East and North Africa where my colleague, Shanta Devarajan, has eloquently blogged about their corrosive impact on economic growth, on employment, on human health and on water conservation.  Where I sit, in Central Europe, many countries are in the process of liberalizing their market for energy and bringing subsidies to an end.  What lessons does the experience of energy price liberation in this group of countries offer to their neighbors in the south?  Based on the work of my colleagues, Nistha Sinha and Caterina Ruggieri, I would draw five lessons.

The first lesson is that energy price liberalization takes time.  It is a lot easier to do when economies are growing and household incomes are rising.  Taking advantage of the rapid growth of income at the turn of the century,Romania and Bulgaria were able to make significant progress in liberalizing prices and reducing subsidies for electricity and gas.  In Bulgaria energy subsidies fell from over 10 percent of GDP in 2000 to less than 3 percent in 2013.  In Romania the trajectory was similar from nearly 5 percent of GDP in 2000 to less than 1 percent in 2013. The current decline in world energy prices is a good opportunity for the countries to liberalize prices further.

Second, consumers need to see what they getting in exchange for rising prices if the process is to be sustained. InBulgaria, the last increase in prices in 2013 led to widespread protests which brought the government down.  While low growth and poor employment prospects were contributing factors, public perception that the energy price increase was unjustified was an important factor behind the protests.  The fact that the quality of service had not improved since the previous price increase added to the feeling that energy companies were benefitting at the expense of consumers, and the regulator had failed to balance the interest of different parties.  Strong communication on the need for price liberalization and trust in the ability of government to handle competing interests is important to sustain price increases.

Third, whether energy is perceived to be affordable is very context-specific.  In the cold winters of Romania and Bulgaria being able to heat one’s home to an adequate level of warmth is very important to people’s sense of well-being. A quarter of the poor in Romania say they are unable to keep their homes adequately warm (compared to 11 percent for the non-poor) and 40 percent of the poor are in arrears on their energy bills (compared to 22 percent for the non-poor).  On a recent visit to a school in Romania which runs after-school programs for children from poor families, one mother told me that what she valued the most was that the program allowed her children to go to warm place after school as she could not afford to heat her one-bedroom apartment adequately in the afternoon when the children came home from school. The source of heating fuel varies depending on whether the family lives in a single family home common in rural areas where they would typically use electricity or wood for heating, or a multi-family apartment building more common in urban areas, where they may have access to gas heating supplemented by electricity.

Fourth, energy bills are higher than they need be because homes are energy inefficient.  They “leak” heat through inadequately insulated windows, doors, floors and roofs.  The mother I spoke to at the school took me to her ground floor apartment.  Apart from single-paned windows which were draughty, it had an unfinished floor of earth and stone which she was trying to keep warm and dry with cloth and rugs.  Energy efficiency investments, even low cost ones, can help save energy and make it easier to adjust to higher energy prices.  Schemes to encourage greater energy efficiency can be an important to the overall success of attempts to liberalize energy prices.  Making energy efficiency investments is however typically unaffordable for the poor.  Supporting such households to make these investments is particularly important in apartment buildings with a mix of poor and non-poor residents.  Housing laws typically require the approval of all residents before building modifications can be made.  Resistance from low income residents in a mixed income building means that the entire building cannot invest in energy efficiency improvements.

Fifth, although liberalizing energy prices and reducing energy subsidies means the government saves money, this does not automatically make its way into social safety net programs to soften the impact of the price increase on the poor.  Ministries of Finance come under many competing demands to reallocate the savings.  In Romania and Bulgaria, the social safety net is fragmented across many schemes.  The schemes that are well targeted at the poor often do not receive enough public money to cover poor households adequately.  In Bulgaria the number of beneficiaries of the social safety net schemes targeted at the poor more than halved during the period that energy prices were being raised.  In Romania, less than a third of the poor are actually covered by social safety net schemes, although this is now slowly rising. Civil society pressure as well as monitoring by external financiers can often be important to ensure that safety nets are adequately resourced to support energy price liberalization.

In summary, the experience of Romania and Bulgaria shows that energy price liberalization takes time. Consumers have to be convinced of the need for higher prices if the process is to be sustained, and this means that governments and energy companies need to be seen to act transparently in the use of the additional revenues from higher energy prices.  Higher energy prices also make energy efficiency investments more attractive as they help households cope better with higher prices.  But the upfront cost of these investments can be high – and practically unaffordable for the poor without some element of public subsidy.  Despite the evidence that energy price increases are more palatable when the poor are protected from the increase, greater revenues for government do not ‘automatically’ lead to higher allocations for safety net programs.  If anything, the experience from Romania and Bulgaria shows that it requires concerted effort from civil society or from external financiers to ensure that safety nets are funded adequately.

This post first appeared on The World Bank’s Future Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with Forum:Agenda subscribe to our weekly newsletter.

Author: Mamta Murthi is Country Director for Central Europe and the Baltic Countries.

Image: A technician works an electrical line, Arkansas April 29, 2014. REUTERS/Carlo Allegri.