5 reasons we need to cut energy subsidies

Half the world’s energy subsidies are in the Middle East and North Africa Region.  These subsidies have been criticized on grounds that they crowd out public spending on valuable items such as health, education and capital investment.  Egypt for instance spends seven times more on fuel subsidies than on health.  Furthermore, the allocation of these subsidies is heavily skewed towards the rich, who consume more fuel and energy than the poor.  In Yemen, the portion of fuel subsidies going to the richest quintile was 40 percent; the comparable figure in Jordan was 45 percent and in Egypt, 60 percent.

These criticisms, while valid, may be understating the real damage done by these subsidies to the economies of the MENA region.

Growth.  By their sheer magnitude (5-10 percent of GDP), energy subsidies may be undermining economic growth in MENA.  There is a positive and statistically significant association between per-capita GDP growth and gasoline prices in the MENA region between 1998 and 2012.  By contrast, in the Europe and Central Asia (ECA) region, where fuels are taxed rather than subsidized, the relationship between per capita growth and fuel prices is negative. These findings suggest that in MENA, there are efficiency gains from raising fuel prices to market levels, whereas in ECA, increasing these prices increases the distortions from taxation.

Employment.  The MENA region has the highest unemployment rate in the developing world.  While there is a host of reasons for this, energy subsidies may be a contributing factor.  Energy subsidies help energy-intensive firms.  These firms tend to be more capital-intensive, larger and older.  But productive jobs are created by young, dynamic, small firms—which are solely lacking in the region.  In other words, energy subsidies are a tax on labor.

Road safety.  The MENA region has some of the highest rates of road accidents in the world.  While there is variation across countries in the region, there is a negative and statistically significant relationship between fuel prices (both gasoline and diesel) on the one hand and road death rates and road injury rates on the other.  Low fuel prices are an incentive to drive more and possibly faster.

Air pollution.  Urban areas of MENA have some of the world’s highest rates of air pollution in general, and motor vehicle air pollution deaths in particular.  Both common sense and measured elasticities of demand indicate that fuel subsidies contribute to more vehicle-kilometers traveled, more trips, and less use of alternate modes, such as walking, cycling or public transport.  In short, low gasoline prices encourage fuel consumption that, in turn, generates air pollution.

Water. At 500 cubic meters per capita per annum of renewable water, MENA is the most water scarce region in the world.  Renewable water resource availability is below 30 cubic meters per capita per annum in Kuwait, UAE and Qatar, followed by Yemen.  Only a few countries in MENA, such as Iraq, Iran and Lebanon, have more than 1,000 cubic meters per capita. Renewable water availability has also been declining over time, with a rate of decrease of 35 percent over the last decade. For some countries, such as UAE and Qatar, the rate of decrease has been as high as 75 percent.  Even more troubling, the ratio of water withdrawn to availability is highest in MENA, amounting on average to just below 400 percent. In other regions they range from 6 to 54 percent. Countries such as Egypt and Jordan are reaching the 100 percent threshold. Lebanon, Morocco and Algeria are the only countries where water withdrawal is less than 50 per cent of availability.

By making it cheaper to pump water out of the ground, fuel subsidies contribute to this water depletion.  Globally, countries with lower than average diesel prices are characterized by higher (and statistically significant) water depletion than those that have increased diesel prices. In MENA, the gap is much higher.

Most water is used for agriculture, a sector whose productivity is low compared to other countries as well as other sectors in the region.  MENA countries use groundwater for irrigation to a greater extent than any other region. The evidence suggests that countries with lower than average diesel prices are characterized by much higher (and statistically significant) harvested irrigated crop area and irrigation water requirements than those that have increased diesel prices.

In Yemen, energy subsidies account for 9 percent of GDP, most of which is used for diesel to power electric generators.  Although Yemen is one of the most water-scarce countries in the world, pumping for irrigation and drainage accounts for 28 percent of total electricity and diesel consumption, a share much higher than the 6 percent average for the MENA region.  The ground waters on which more than half of agricultural output now depends are almost fully exploited and reserves are being rapidly depleted. Behind this depletion lies specific crop selection. In particular, qat – a stimulant widely chewed by Yemenis – accounts for about 40 percent of total water resource use. While profitable at current (subsidy-included) prices, qat crowds out production of food or export crops, and its consumption creates both social and health problems.

In sum, the debate on energy subsidies in MENA needs to go beyond the drain on public resources and the skewed allocation to the rich—to the corrosive effects of these subsidies on economic growth, employment and the health and livelihoods of the people of the MENA region.

This post first appeared on The World Bank’s Future Development Blog

Author: Shantayanan Devarajan is the Chief Economist of the World Bank’s Middle East and North Africa Region.

Image: A bulb hangs inside a restaurant. REUTERS/Andrea Comas