C EPA
CENTRE FOR POLICY ANALYSIS
ACCRA -GHANA
The Energy Subsidy Issue
1. Introduction
A subsidy can be explained as a "financial contribution" by a government or public body
that confers a "benefit" to the recipient. This financial contribution can be by way of a
direct transfer of funds by government (e.g. grants) or by way of foregone revenue (e.g.
tax credits) and is provided on terms that are more favorable than would otherwise have
been received under pure market conditions.
Often times, the benefit conferred upon the recipient (the consumer or the producer of the
product being subsidized) is a price that is either below or above a benchmark / market
price. In the case of a consumer subsidy, the price paid by the consumer is below the
benchmark price; while in the case of a producer subsidy, the price received is above the
benchmark. Where the product being subsidized is traded, the benchmark price is the
international price of the good. However, where it is mostly non-traded (such as with
electricity) the appropriate benchmark price is the cost-recovery price for the domestic
producer.
Subsidies, ultimately, must be paid by someone. Where government fully incurs the cost
of the subsidy, the subsidy will be reflected in the budget as an expenditure item and
financed, for example, through higher taxes, increased debt, or higher inflation if the debt
is monetized. Often times, however, the subsidy may be financed by state-owned
enterprises (SOEs) and reflected in operating losses or lower profits, lower tax payments
to government, the accumulation of payment arrears to suppliers, or non-performing
loans to creditors.
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2. The Inefficiency of Subsidies
While subsidies are aimed at protecting consumers, they have macroeconomic, social,
and (in the case of energy subsidies) environmental consequences that render them
inefficient.
 Energy subsidies, for example, can negatively impact on growth for a number of
reasons:
They can discourage investment in the energy sector, particularly in the
case where the cost of the subsidy is borne by the producer (SOE). This is
because the subsidies can result in lower profits or outright losses, making
it difficult for the producer to expand, and unattractive for private sector
investment. In the specific case of electricity, this results in shortages /
load-shedding exercises which slow down economic activity.
They can crowd-out growth-enhancing public spending by diverting
resources away from priority areas like public health, education, and
infrastructure development.
 Energy subsidies make it difficult for both oil importers and exporters to deal with
the volatility of international energy prices. For oil importers, changes in
international oil prices create volatilities in the balance of payments and
complicate budget management. For oil exporters, energy subsidies accentuate
macroeconomic volatility by increasing subsidies during periods of international
price increases.
 Subsidies encourage excessive consumption of energy which can cause
distortions in resource allocation – such as reduced incentives for investment in
efficient energy sources and renewable energy.
 Energy subsidies are often poorly targeted, with the bulk of the benefits accruing
to the better off. This reinforces inequity.
The inefficiencies associated with subsidies can, thus, imply sub-optimal social welfare
achievements as shown in Figure 1 below.
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In the Figure, points on society’s utility possibilities frontier represent the different
combinations of utility for groups R (the rich) and P (the poor) that can be achieved in the
case where there are no subsidies. These utility combinations arise from different market
outcomes, and as such represent points of efficiency. Movements along the frontier,
example from Y to Z, thus involve pure redistribution – the gain in utility to group P
comes purely at the expense of a loss of utility to group R not from reducing any
inefficiency in society.
The introduction of subsidies, however, creates inefficiencies which result in utility
combinations such as ‘X’ which lie inside society’s utility possibilities frontier. In such
cases, efficiency can be gained / improved by moving from ‘X’ to a point on the utility
possibilities frontier – such as ‘Y’ or ‘Z’.
Movements from X to Y, for example, involve improvements in efficiency but at the
expense of making someone worse off. Specifically, at Y, group P is worse off than at X
(PY < PX). Movements from X to Z, however, make both groups better off – (PZ > PX),
(RZ > RX) – and as such represent the optimum / preferred case.
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Figure 1: Social Welfare Function and Efficiency / Equity Trade-Off
While the move from X to Y achieves efficiency at the expense of group P, it also
provides a means to compensate group P, by re-distributing some of the benefits to group
R, to be at least as well off as before – e.g. to a point on the frontier vertically above X.
Whether such a move would occur or not is a political not an economic problem.
3. Achieving an Efficient Outcome: the role of economics and politics
Neglect of income distribution issues by economists probably reflect the fact that
economics itself does not provide tools to make formal statements about whether one
distribution of income is better than another especially if a more equitable distribution is
associated with slower growth. Economists emphasize that interpersonal comparisons of
utility are not valid. That is, while it may be possible to say that a given individual is
better off if that individual has more income, it is not possible to say how much better off
that individual is relative to another who received the same additional income. For this
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reason it is not possible to invoke the economic principles of diminishing marginal utility
of income to argue that redistribution from the rich to the poor will increase total welfare
because a cedi taken from the rich reduces their utility less than the increase in utility of
the poor who receive the cedi.
While it is true that it is not formally possible to make economic welfare comparisons on
the basis of interpersonal comparisons of utility, however, they may nonetheless prove
useful as a policy guide.
For example, it may be reasonable to believe that a cedi to the rich means less than a cedi
to the poor, even though one can never formally prove that proposition. Such different
distribution of weights for the incomes of the rich and the poor can be inferred from the
existing income tax structure.
Because economics by itself does not enable one to say whether one distribution of
income is better or worse than another, economists have tended to recommend separating
the issues of economic efficiency (resource allocation) from the issues of equity
(distribution).
The belief is that economists could tell policy makers how to allocate resources in the
most efficient manner so as to attain the largest economic pie. Distributive issues of how
that pie should be divided would be left to the political process and the value judgments
of society.
The virtue of attaining economic efficiency is that it would provide the means – the
largest economic pie – to make everyone at least as well off as they were in the
inefficient state. In this context, it is worth distinguishing between two situations:
 One where everyone is at least as well off and some better off, and
 Another where some have gained and some have lost but the gainers have gained
sufficiently so that they could potentially redistribute to make the losers at least as
well off as they were before the move.
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Economists tend to emphasize that, in the second case, whether or not compensation is
made is irrelevant from the point of view of economic efficiency: it is purely a
distribution issue about which economics has little, if anything to say.
An explanation for the failure to adopt necessary changes is simple (or not so simple)
irrationality: societies, like individuals, put off making difficult choices even though they
know they must be faced and will only become more difficult with time.
There seem to be economic phenomena for which irrationality may be the most
compelling explanation and thus be empirically important. Especially in the study of
reform, there are policy choices which are difficult to reconcile with rational behavior.
For example, Anne Krueger, among others, has argued that myopic deficit spending, and
exchange rate policies have been widespread in developing economies:
Regardless of the form of government… the political process typically demanded
more resources than were available from tax revenues in the early stages of
growth (cited by Drazen, page 410)
At the same time, attributing economic phenomena to irrational behavior strikes at the
whole basis of economic analysis. Instead, our task is to take phenomena which appear to
have no logical explanation and to provide that missing explanation.
A goal of political economy analysis is to show how policies which seem suboptimal –
hence irrational in terms of basic welfare economics – can be shown to be the result of
the political mechanism under which the decisions of rational, self-interested agents are
aggregated.
Even where putting phenomena in a fully rational framework is beyond our grasp,
economic analysis can limit the role played by irrational decisions. Inefficient outcomes
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are often the result of individually rational behavior, given their information and the
political system under which they operated.
Energy subsidy reform has been a long-standing policy challenge for both advanced and
developing countries. In Ghana, as elsewhere in sub-Saharan Africa (SSA), the fiscal cost
of subsidizing energy is quite high. Moreover, energy subsidies are poorly targeted with
the bulk of the benefit accruing to the better-off.
The Association of Ghana Industries (AGI) Business Barometer lists unreliable energy
supply among the top constraints on growth. And the latest MPC Press Release of May
22, 2013 reports in paragraph 7 as follows:
The latest surveys conducted in March and April by the Bank of Ghana showed
weakened sentiments by both businesses and consumers. The Business
Confidence Index declined to 99.0 in March 2013, from 104.1 in December
2012. This was partly due to the energy crisis which lowered business optimism
about growth prospects and heightened inflation expectations over the mediumterm horizon.
Public discussions and analyses of the current energy crisis have brought to the fore the
issue of how energy should be priced – specifically the apparently distorted cost / price
relationship and its consequence for reliable power generation.
Economic principles of efficiency would dictate full-cost-recovery pricing. This
presumably would encourage consumers to conserve this critical item of production and
consumption and assure producers of profitability of efficient production. Arguably,
keeping the price “artificially low” to consumers encourages them to use too much
energy, threatening losses on producers.
Economists tend to argue that full-cost-recovery pricing would promote efficiency and
provide the means or potential to make everybody – producers and consumers – betterCEPA: The Energy Subsidy Issue
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off. The producers who gain through the higher price could be taxed on their profits and
the revenue thus mobilized used to subsidize those who lose because of the higher price –
such as the poor or, more generally, ‘low-income’ households.
In Figure 1, this would be akin to a move from Y to Z; with everyone being better off
than in the inefficient situation at X – PZ > PX and RZ > RX. The case appears straight
forward:
 charge the full-cost-recovery price – this will cause a movement from X to a point
such as Y where group R is better off at the expense of Group P
 tax the gainers (producers) and compensate the losers (the poor that society feels
should be compensated) – this will cause a movement from Y to Z where both
groups are better off than at X. Though the tax reduces the amount of utility to
group R by the distance ‘a’ (RZ minus RY), at the optimal point Z, both groups
would be better off than at X and social welfare would be maximized.
The belief is that economists could tell policy makers how to allocate revenues in the
most efficient manner so as to attain the largest economic pie. The virtue of attaining
efficiency is that it would provide the means – the largest economic pie – to make
everyone at least as well off as they were in the inefficient state – the formal notion of
Pareto efficiency.
The critical point: a move in which some have gained and some have lost but the gainers
have gained sufficiently so that they can potentially redistribute to make the losers at least
as well off as they were before the move – a potential though not actual improvement.
Problem: economists tend to emphasize that whether or not compensation is made is
irrelevant from the point of view of economic efficiency. That is purely a distributive
issue about which economics has little to say. But politically the choice is important.
People may feel the needed compensation / subsidization of the poor may not occur, in
which case the choice has to be made between an inefficient subsidized regime at X and
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the full-cost-recovery efficient regime at Y knowing that the bliss point (the optimum) Z
is unlikely to occur.
Clearly, one can imagine policy makers choosing the inefficient subsidized regime at X.
In the typical low-income country like Ghana with widespread poverty, the frequency
distribution of income would be skewed to the right – have a long tail to the right –
reflecting the fact that there are a small number of households with extremely high
incomes. Of the three common measures of central tendency, the mean – the arithmetic
sum of all incomes divided by the number of income units – would be larger than the
median – the level of income that divides the population into two equal halves – and most
likely larger still than the mode – the level of income that has the largest number of
income units with that income – i.e. the most common level of income.
In this situation of pervasive poverty, the potential losers, the poor, constitute the
dominant sub-group of the voting public. In that case, the (analytical construct) social
welfare function would reflect their preference and the policymaker would be politically
astute in choosing the economically inefficient regime X rather than the efficient regime
Y.
4. Challenges to Energy Subsidy Reform
The discussion above points to the emergence of energy subsidies
 A desire to avoid the transmission of international / dollar price spikes and / or
large depreciations of the exchange rates to the domestic economy. A good rule of
thumb in economic management is to finance temporary shocks adjusting only to
“permanent shocks.” However, the ‘empirical evidence suggests that shocks to
international / dollar prices of petroleum products can be quite persistent, making
it difficult to identify temporary price shocks. As a result, all too often, temporary
subsidies become permanent’. (REO page 60).
 The goal of expanding the population’s access to energy product – electricity,
kerosene, liquefied petroleum gas (LPG) and natural petroleum gas (NPG).
Cheaper energy is deemed naturally more affordable especially to the poor. The
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problem is that lower than cost-recovery prices could make it impossible to attract
private capital into energy production. The resulting underinvestment, inadequate
maintenance, and high transmission losses could actually reduce rather than
increase access to energy.
 The appeal of a highly visible and readily available fiscal tool, requiring little
administrative capacity. Low income countries often feel that they lack other
mechanisms to provide benefits to the population. The reality of high and
unsustainable fiscal burdens is to develop more effective targeted systems of
reaching the intended beneficiaries – the poor who cannot afford full-costrecovery prices. This would avoid the recourse to general price subsidies to rich
and poor alike.
In addition to the above, there are also several implementation problems inherent in
subsidy reforms including the following:
 Impact on the poor: Reform advocates often focus on the skewed nature of the
benefits to the rich. The truth, however, is that the poor also receive significant
benefits. Indeed, empirical studies strongly suggest that, as a percent of their total
expenditure, the poor spend as much on energy as rich households.
Consequently, the removal of energy subsidies must be accompanied by
complementary social safety net programs to shield the poor from the adverse
impact of the subsidy withdrawal. Indeed, such a complimentary compensatory
program is a sine qua non for socio-politically successful subsidy reform.
 Potential loss of competitiveness. The AGI Business Barometer reports the
concerns of business of the inevitable loss of competitiveness, at least in the
short-run of subsidy withdrawal. Electricity tariffs are already high in SSA,
elevating the costs of domestic production relative to competing imports. This
has led to promises of future improved supply and quality of service have been
made on occasion of upward tariff adjustments approval by the PURC. These
promises which would reduce energy costs to consumers, including by reducing
their reliance on costly self-generation alas have only been honored in the breach.
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 Impact on inflation. On impact, significant upward tariff adjustments have
elevated the headline inflation rate. The extent to which they result in a
persistently higher price level depends on the strength of “second-round effects
on wages and the prices of other inputs such as transport charges. In Ghana, as
happened recently in both 2012 and 2013, the Tripartite Committee on the
determination of the minimum wage has been convened soon after subsidy
withdrawals. Last year 2012 the Committee decided on 18 percent increase and
this year’s 17 percent increase was only marginally lower. CEPA estimates that
as a result the public sector wage bill could increase by about 23 percent.
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