Why Fuel Subsidies in Developing Nations Are an Economic Addiction

Emerging economies worldwide struggle to end budget-busting subsidies
Illustration by 731

Once again, Ukraine is turning to Europe and the International Monetary Fund for assistance, this time a $15 billion bailout. For years, negotiations with the IMF had stalled over a single point: Ukraine spends 7 percent of its gross domestic product on natural gas subsidies for consumers. The IMF wants that cut by a third before approving any loans.

Violetta Viktorova, a doctor in Kiev, says if the IMF gets what it wants, the utility fees she and her husband pay will go up. “We live from paycheck to paycheck. The rise in price would hurt us,” she says, though not as much as it would the country’s pensioners. Ukraine is balking at the IMF’s request.

In the developing world, it’s tempting for a country to keep the price of fossil fuels artificially low. The subsidy can take the form of a price cap, preventing oil companies from charging too much at the pump. Or it can come as a tax break to a domestic oil producer, which then usually passes on the savings. In both cases, the government has to make up the difference.

Subsidies usually start as an attempt to avoid inflation and shield citizens from the pain of price increases in global energy markets. But energy subsidies are expensive; they eat up national budgets. Benefits end up going mostly to the richest citizens and crowd out more productive government spending on education or infrastructure and reduce energy efficiency. Subsidies mess with the law of supply and demand, discouraging investment in both alternative energy and fossil fuel exploration.

“It’s a failed policy,” says Fatih Birol, chief economist for the International Energy Agency (IEA), “but we see that many countries continue to follow it.” Subsidies endure because, as Ukraine’s politicians know, getting rid of one means immediate pain for citizens, a drop in popular support, and sometimes even civil unrest.

The IMF pegged government support worldwide for petroleum products, electricity, natural gas, and coal at $1.9 trillion, or 2.5 percent of global GDP in 2011. This number includes the costs of damage done by subsidized fuel to public health, the environment, and infrastructure; subtract those costs, and countries still pay $480 billion a year for subsidies, or 0.7 percent of global GDP. The spending is concentrated mostly in the Middle East, Asia, Central Europe, and the countries of the former Soviet Union. The world’s heaviest subsidizer of natural gas, at 26 percent of GDP, is Uzbekistan. Venezuela supports domestic petroleum prices at about 8 percent, Iraq at 14 percent. The U.S., the biggest subsidizer in the developed world after Luxembourg, supports gas and diesel at 2 percent.

The struggle to hold on to fuel subsidies intensified as energy prices rose in the mid-2000s. Developing economies increased their subsidies to keep pace with world prices. In Ukraine, subsidies rose when Russia started charging more in what are now called the gas wars of 2004 and 2009. Since 2007, when the IEA began tracking subsidies, they’ve risen 40 percent in Ukraine. Assessing this troubling trend, the IMF, the World Bank, and the IEA have made cutting subsidies a priority worldwide.

Governments like to describe fuel subsidies as social programs. But the bulk of the assistance doesn’t reach the poor. The IMF says 61 percent of the benefit of gasoline subsidies goes to the richest 20 percent of citizens, who own cars; the number is slightly lower for diesel and natural gas. “The poor go hungry if they miss a day of work,” says Ramadan Mohamed, an apple peddler in Cairo, “and yet the rich enjoy access to subsidies.” Egypt spends 9 percent of GDP to keep gasoline prices low. He says it would be better to spend that money on health care and education—pretty much what the IMF and the World Bank believe. “There’s so much that the poor need,” Mohamed says.

Fuel subsidies also reduce efficiency, says the IEA’s Birol. According to the World Bank, energy intensity, a measure of the amount of energy used per $1,000 of GDP, is twice as high in Ukraine as it is in Latvia or Estonia, post-Soviet economies that have slashed their subsidies. “If something is much cheaper, we humans tend to use it in a wasteful manner,” Birol says. He points to electricity plants in North Africa and the Middle East that are powered by subsidized gasoline, an extravagance when natural gas is the logical choice. “To use oil for electricity is absolutely very uneconomic,” he says. “It’s like using Chanel perfume to fuel your car.”

Price supports for oil and gas suppress investment in both oil exploration and alternative energy. Brazil, which had successfully reduced gasoline subsidies in the 1990s, reintroduced them in 2011 when inflation resurfaced, stoked in part by rising fuel prices. Petrobras, the state-run oil company, has had to buy gasoline abroad and sell it domestically at a 15 percent discount. The gasoline purchases are causing losses that make it difficult for the company to develop its new offshore oil finds. And the policy has made it harder for Brazil’s ethanol producers to compete. Investments in new ethanol production have fallen since their peak in 2008. The policy “needs to end,” says Adriano Pires, director of the Brazilian Center for Infrastructure, a think tank. “It’s causing many more problems than solutions.”

Consumers, who are also voters, usually see only the benefits of subsidies, making them hard to kill for politicians. Last year the IMF produced a list of energy subsidy reforms by country since the 1990s. Of 22 attempts, the fund deemed 12 successful. Nigeria in 2012 dropped its gasoline subsidy from 4.7 percent of GDP to 3.6 percent. The IMF labels this a partial success; the original plan, to remove subsidies altogether, sent millions into the street in a weeklong general strike.

Both the IMF and the IEA recommend the same basic steps to shed subsidies. Countries should stop hiding the costs of subsidies from their citizens. Both Brazil and Ukraine bury theirs in the accounts of state-owned utilities. Include subsidies as a line-item cost in the budget, Birol says, so citizens understand they’re being charged for a bad policy. The IMF also suggests identifying who will be hurt by a subsidy cut and finding a way to make the transition easier for them. Perversely, though energy subsidies often help the poor the least, removing them hurts the poor the most—a small loss makes a bigger difference on a tight budget.

A 2013 IMF report pointed to Iran’s 2010 fuel subsidy reform as a model. The country ran a public information campaign to explain both the policy change and the schedule for phasing it in, and converted the subsidy to cash transfers directly to citizens. Cash does not warp energy prices as subsidies do.

In Kiev, Violetta Viktorova says she hopes that if the government lowers gas subsidies it will raise salaries to make up the difference. Or at least that a new legal environment could discourage corruption. “If you could really put something in and get something out as a result,” she says, “then we would be willing to pay the price for it.”