With many governments around the world announcing the provision of generous subsidies to cope with rising commodity prices, the relationship between fossil-fuel subsidies and oil price volatility has once again become a major concern on the international agenda. To help explain the connections between these two issues, Subsidy Watch spoke with the International Energy Agency’s (IEA) Senior Energy Analyst Amos Bromhead.

GSI: When the G-20 committed to reform fossil-fuel subsidies in 2009, it asked four IGOs, including the IEA, to analyze the issue of energy subsidies. Can you summarize what work the IEA has done in this area since that time?

Bromhead: Since the G-20 Pittsburgh Summit in 2009, we’ve been working with our partners the Organisation for Economic Co-operation and Development (OECD), the World Bank and the Organization of the Petroleum Exporting Countries (OPEC) to provide ongoing support to the G-20’s commitment to phase out inefficient fossil-fuel subsidies.

We’ve collaborated on a series of reports aimed at building momentum for reform, including essentially four broad areas of analysis. First, we’ve been compiling estimates of the costs of fossil-fuel subsidies. Second, we’ve been doing modelling to highlight the positive benefits that can be obtained through reform. Third and fourth, we’ve identified case studies of successful reform programs and highlighted the positive action that has taken place since 2009. For example, the Asia-Pacific Economic Cooperation (APEC) also committed to the phase out of fossil-fuel subsidies, and some countries that aren’t part of either group have been pursuing reform independently.

In addition, the IEA’s World Energy Outlook 2010 devoted significant attention to fossil-fuel subsidies. We estimated that consumer subsidies were worth US$ 312 billion in 2009. In the current economic climate, this is a significant amount of money which could be used to more directly tackle priorities such as poverty alleviation, health or education. Our modelling also showed that if subsidies are reformed by 2020, global energy demand could be reduced by 5%. This has significant implications for energy markets and efforts to combat climate change.

GSI: Is the IEA preparing more analysis on fossil-fuel subsidies for the next G-20 Summit?

Bromhead: We’re working with the OECD, the World Bank and OPEC to prepare another report for delivery to the G-20 Leaders’ Summit, which will take place in Cannes in early November. Apart from that, we’ve made our fossil-fuel subsidy database available on the IEA website. This helps educate people about the size of the subsidies. We’ll be developing it further as new data become available and will provide more detail in terms of what’s going on behind our estimates.

We’ve been able to identify a couple of additional countries that can be added to our consumption-subsidy estimates. That means that our coverage will be more comprehensive, although our existing data set already covers an estimated 95% of subsidized energy consumption globally. We’ve also identified countries that no longer subsidize fossil-fuel consumption, either because subsidies have been phased out or movements in international oil prices have eliminated the subsidies.

In addition, we plan to quantify the causes behind variations in subsidy spending in different years. The estimates will be able to say, “This percentage change has come from policy action including reform efforts; this percentage change has come from movements in international prices; and this percentage change has come from demand shifts.” You would imagine that, given what’s happening with fossil-fuel prices on international markets, estimates of spending will rise this year. On the other hand, you’ve seen some countries take steps to reduce subsidies, which will work in the opposite direction.

Finally, we’re also going to conduct analysis that looks specifically at APEC economies as a group, since they’ve made a similar commitment to the G-20.

GSI: It’s clear that commodity price volatility, including oil price volatility, is high on the G-20’s agenda for 2011. Can you give us a quick overview of the issues involved?

Bromhead: Very sharp and unpredictable swings in energy prices can have significant consequences for both consumers and producers. In particular, they cast uncertainty over future revenue streams which can limit supply-side investment and also complicate economic management. Nonetheless, while price volatility is very important, we need to keep in mind that the overall price level is even more important. Most energy consumers would prefer to have a very volatile oil price at an average of, say, US$ 50 per barrel, than a constant price of US$ 100 per barrel.

There are obviously many factors that go into determining price levels – including speculation, if there are tight markets or there is geopolitical unrest – but we think the primary drivers remain the fundamentals. By that I mean the demand and supply today and expectations of demand and supply tomorrow. Since last September we have seen international oil prices rise by about 40%. Prices at current levels pose a real threat to the fragile economic recovery by impacting balance of payments and growth. High oil prices also drive up inflation as the cost of oil has a knock-on effect on many other products. For example, the increase in oil prices has been one of the many factors that have put upward pressure on food prices, since agriculture can be very energy-intensive, and in some cases oil prices have an indirect effect on demand for biofuels.

GSI: There are a number of links between oil price volatility and fossil-fuel subsidies. Back in 2004, for example, many countries introduced subsidies when oil prices started to rise, and we’re now witnessing a number of governments guarantee hand-outs in North Africa and the Middle East due to increased commodity prices and of course the ongoing protests and social unrest. Usually, the stated intention of subsidies is to provide support for the poor, but how does this work out in reality? Do fossil-fuel subsidies make the welfare impacts of oil price volatility better or worse?

Bromhead: Fossil-fuel subsidies have many unintended consequences. The one with most relevance to this topic is that subsidies tend to dampen the normal demand responses to changes in prices, which exacerbates volatility. We saw this in 2008. Analysts were surprised to see that, even though the international price was rising sharply, there was still very robust global oil demand. One reason for this was that many consumers were buying subsidized fuel, so they didn’t face the higher prices that would normally encourage more efficient consumption.

As regards energy poverty, many states have recognized that most subsidies are ineffective and inefficient at making energy services more affordable and accessible to the poor, so they aren’t good policies to cushion poor populations from economic shocks when prices rise. The cost of subsidies falls on an entire economy, but the benefits are conditional upon the purchase of subsidized goods that high-income groups can afford to buy in larger quantities. For example, poor households may not have the ability to afford even subsidized energy. Similarly, you can’t benefit from subsidized gasoline if you can’t afford to own a vehicle. We calculated that subsidies to kerosene, electricity and LPG, often considered to be fuels that support the basic needs of the poor, represented only 15% of our estimated US$ 312 billion of subsidies in 2009.

GSI: And presumably, at least when oil prices are moving upward, a subsidy regime can be a fiscal liability too?

Bromhead: A very good point. That’s been an issue for many developing countries over the last few years and in some cases has triggered reform efforts. For example, many countries in Asia have moved to phase-out subsidies because the economic burden was becoming too high.

Budgetary pressures, and concerns that high rates of domestic demand might curtail future export earnings, have also led a number of major producers to introduce subsidy-reform programs. For example, in December 2010 Iran sharply increased domestic prices for petroleum products and electricity as it sought to cut its enormous subsidies worth about 20% of GDP. These were a heavy burden on the economy that had forced it to rely on refined product imports.

As part of our work for the G-20, we estimated that, given rising fossil-fuel prices, and in the absence of further reform efforts, subsidy spending would increase from US$ 312 billion in 2009 to US$ 600 billion in 2015. So we’re talking about significant amounts of money. And the key point is that only a small percentage of spending is going to help meet the basic needs of the poor.

GSI: Not all subsidies are designed in the same way – are some worse than others?

Bromhead: There are many different types of subsidies. At the IEA we are looking at fossil-fuel consumption subsidies, which you can group into three general categories. First, there are countries that have fixed prices, with no linkage between domestic and international prices. Venezuela is an example: here, you have the gasoline and diesel price 98% below U.S. levels, and essentially the price does not change. In other countries, prices are partially deregulated. Some product prices are following more or less market trends while others remain capped. In the third group, prices have been formally liberalized, but the government still exerts considerable influence in terms of price movements in a bid to minimise domestic price volatility. Although the intent of this third category may not be to hold average prices below market levels, experience has shown that subsidies can be an unintentional consequence. Governments often find it hard to raise domestic prices when international prices are increasing, and to not immediately pass through the benefit of price declines.

Countries with fixed prices generate the most waste as there is absolutely no incentive to reduce consumption as prices rise. Those with partial deregulation are somewhat better because, generally, the fuels that are subsidized are targeting the poor, whereas other fuels, used by higher-income segments of the population, are linked to international prices. The third group is close to having fully liberalized prices as consumers have an incentive to curb consumption as prices increase, but will not be directly linked to the world price.

But ideally, we believe, prices should be fully liberalized. The countries we have identified as taking steps to phase out subsidies tend to incrementally transition through these categories, so in many cases, these three stages are a good path to follow to bring people towards market liberalization.

GSI: If governments reform their subsidies, how else could they tackle price volatility?

Bromhead: We are always going to have some degree of volatility and I think we can live with that. At the same time, we can take action to limit the scale and frequency of major price swings. On the demand side, getting the prices right – essentially subsidy reform – gives consumers clear signals when to cut back on demand. On the supply side, efforts can be made to develop stable and predictable investment climates and tax regimes to encourage adequate investment and prevent tight markets from developing. Furthermore, we can make the market more transparent by improving the availability of data on oil demand, oil supply and inventories. This is one of the reasons that we are a partner organisation in the Joint Oil Data Initiative (JODI), which aims to exchange data to enhance the transparency of global energy markets.

GSI: So far we’ve focused on petroleum derivatives. Do we also see natural gas and coal prices affected in this way by subsidies?

Bromhead: Subsidy programs have the same unintended consequences, whether they apply to oil, natural gas, coal or electricity. If you subsidize energy, you dampen consumer responsiveness to high prices, create barriers to investment and drain state budgets. Most of the benefits will be accrued by the middle classes and the rich. And at the end of the day, you increase CO2 emissions and exacerbate local pollution. Nonetheless, there are differences between different fuels. Subsidies for liquid fuels are particularly difficult to target, given the ease with which such fuels can be sold on the black market. In comparison, the distribution of electricity and piped natural gas is more easily monitored and controlled.

GSI: How important is the reform of fossil-fuel subsidies to mitigating the impacts of oil price volatility?

Bromhead: I think it is one of the key steps, but that we have to do more than just reform subsidies if we want to minimize volatility in energy prices. As I mentioned, we also have to work on the supply side, as well as improving data availability and transparency. At the same time, I think there are many benefits of subsidy reform, and that reducing price volatility is just one of them. The others – such as reducing energy demand and emissions, and improving fiscal sustainability – are probably even more important.
 
Amos Bromhead is a Senior Energy Analyst at the Paris-based IEA with a focus on economic analysis of energy policy. He is a contributing author to the IEA’s flagship World Energy Outlook series and recognised as the most authoritative source on energy analysis and projections. Prior to joining the IEA, Mr.Bromhead worked as an analyst within the Petroleum and International Energy Division of the Australian Department of Energy, Industry and Tourism.