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Feature Article of Wednesday, 1 February 2012

Columnist: Adam, Mohammed Amin

Petroleum Price Subsidy Unavoidable But Who Pays For It?

Mohammed Amin Adam

ENERGY ECONOMIST – IBIS GHANA

INTRODUCTION

The debate over petroleum subsidy often evokes emotions, accusations and counter accusations. The latest withdrawal of subsidies on petroleum products in Ghana is not different. Predictably, petroleum politics have always led to political tensions and in some cases political instability. But the reality is that international crude oil prices, a major determinant of petroleum product prices is out of the control of importing countries. The Governments of these countries must therefore formulate policies including sustainable subsidy schemes that address market objectives without compromising political and social stability. In developed economies where the markets are allowed to determine prices, full-pass through pricing of petroleum and other energy products is the norm. In Ghana on the other hand, our markets are not fully liberalized and there would continue to be distortions if the markets were allowed to determine petroleum prices. Historically, since the National Petroleum Tender Board and its successor, the National Petroleum Authority were established, they have moved between different subsidy and pricing regimes, ranging from partial subsidies to cross subsidies. Subsidy from the price-gap approach is the difference between the domestic price of a product and its international reference price. The recent withdrawal of subsidies on petroleum products has therefore put Ghana on a new path to full-pass-through pricing. But whether this is sustainable or not depends on the political will of Government in the face of current protestations by civil society organizations and trade unions.

ASYMMETRIC RELATIONSHIP BETWEEN CRUDE OIL PRICES AND PETROLEUM PRODUCT PRICES

Due to the Government’s inability to provide funds for previous subsidies, consumers were denied the benefits of fluctuating crude oil prices. Fact is, the petroleum pricing formula used by the National Petroleum Authority is supposed to reward consumers when crude oil prices fall; and penalize them when crude oil prices rise. However, under-recoveries by the Tema Oil Refinery as a result of non-payment of subsidy bills by Government has often led to the use of the gains from falling crude oil prices to finance the under-recoveries. Thus, while petroleum prices increase with increasing crude oil prices, they do no decrease with decreasing crude oil prices. The relationship has been asymmetric, demonstrating an inconsistent application of the petroleum pricing formula. With the removal of subsidies, the question of under-recoveries no longer exist, and consumers, it is expected will get the full benefits of fluctuating crude oil prices. It is important to state nonetheless that there are conditions under which the pricing formula could be put on hold and subsidies appropriately justified. One major condition is the consistent galloping of crude oil prices. For example, Ghana, which deregulated its petroleum prices in line with crude oil prices in February 2005 with price ceilings fixed by the National Petroleum Authority, had to abandon it between May and November, 2008, when crude oil prices rose above $140 per barrel. Other countries that abandoned their formula during the period included Malawi, Mozambique, Bangladesh, Cameroon, China, Ethiopia, India, Indonesia, Malaysia, Nepal, Pakistan, Rwanda, Sri Lanka, Tunisia, and Vietnam. Senegal was the only country in Africa with an Automatic Adjustment Formula which was not interfered with during the same period.

Subsidies are therefore unavoidable under some circumstances but these should be clearly defined in a subsidy policy and transparently managed. What remains challenging, however, is how to finance these subsidies.

SUBSIDY IS GOOD BUT WHO PAYS FOR IT?

The economic and social effects of full-pass-through pricing may be too high for the Government to contain. However, subsidies are expensive and financing it has become very difficult for developing countries especially. For example, India spent $6 billion on petroleum subsidies in 2009. Egypt spent $11 billion in 2008; and Ghana spends $432 million annually. The opportunity cost of this expenditure is gargantuan in a country faced with serious development challenges. Government can definitely not continue to afford this. It is therefore important to initiate innovative subsidy financing options and lift the burden off Government to attend to other economic and social problems. The intervention by Government becomes inevitably only when all options are exhausted. There are different options for financing subsidies including consumer subsidies which are well known in the Ghanaian petroleum industry. During the cross subsidization era, consumers of petrol subsidized the consumption of diesel. The Cross Subsidization Fund which was established to manage these subsidies received extra charges on petrol and used to reduce the price of diesel. This stemmed from the fact that diesel was and continues to be consumed by commercial and long vehicles unlike petrol, and such subsidies could reduce the impact of petroleum product prices on patrons of commercial vehicles and its associated high cost of living. Also, through the Petroleum Price Unification Fund, consumers of petroleum products close to the Tema Oil Refinery subsidize consumers away from the refinery.

Against this background, Ghana’s subsidy policy which should aim at ameliorating the effects of subsidy withdrawal on poor people must be seen from the perspective of price stabilization in which consumers contribute to hold prices in check. Thus, attention should be shifted from Government financed subsidy to consumer subsidy and free the Government’s hands to provide social and economic safety nets for the vulnerable.

PETROLEUM PRICE STABILIZATION FUND – AN OPTION FOR GHANA

Price stabilization takes different forms but often backed by Price Stabilization Funds. In Peru, a Petroleum Price Stabilization Fund established in September 2004, operates as a classic price-smoothing fund, in which the price of each petroleum product is allowed to vary within a price band with a ceiling and a floor, such that when the market-based price for a petroleum product is lower than the floor, the difference is deposited into the fund; but when the market-based price is higher, the fund reimburses petroleum suppliers. Colombia also established a Petroleum Price Stabilization Fund on January 1, 2009. Several other countries have price stabilization funds, including Argentina (for LPG and natural gas), Cameroon, Chile, Colombia, Ethiopia, Malawi, and Thailand. While different options exist for financing stabilization funds, Ghana could introduce a Price Stabilization levy on every litre of oil, in addition to hedging, where the levy and gains from hedging could be deposited into the Fund. The Fund is deployed only when crude oil price increases above certain agreed international reference price.

Therefore, before a Petroleum Price Stabilization Fund is established, there need to be consensus on the following policy issues:

i. A reference crude oil price beyond which subsidies will be allowed ; ii. A price stabilization levy

It is important to state also that Price Stabilization Funds have had problems where increases in crude oil prices have become consistent over a longer period of time. The Stabilization Funds have become exhausted in most cases. This is where the Government intervention of financing subsidies comes in. Thus, Government cannot avoid completely the financing of subsidies in cases where the Stabilization Fund is no longer in good balance to support the subsidies.

CONCLUSION

Subsidies are intended to cushion the poor but are often distorted and serving the interest of the rich instead. The distortions have therefore defeated the purpose of the subsidies. Targeting the poor is an important exercise requiring significant amount of scientific data; and other mechanisms to prevent smuggling and dilution of subsidized and non-subsidized petroleum products. The fiscal cost of subsidies to the Government and its macroeconomic implications are also very grave. However, subsidy reforms require significant political will as social and political tensions are most likely to derail such reforms. Political will in this case includes the formulation of a subsidy policy that relies among others on non-government financing of subsidies such as cross subsidization, price smoothing schemes and price stabilization levies. These are more sustainable while providing fiscal relief to the Government to concentrate on the supply of social and economic infrastructure.

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