The Energy Subsidy Bubble

According to the World Energy Outlook (click HERE) published by the International Energy Association, global fossil-fuel consumption subsidies amounted to approximately $550 billion in 2013, a staggering sum larger than the economies of Norway, Nigeria, or Taiwan and equating to approximately 0.75% of global GDP. While 2014 likely saw a major drop in subsidy spending, it’s probably still a big number.

All subsidies produce distortions, but the unintended effects of energy subsidies are noteworthy. Subsidizing oil consumption pressures government budgets, generates expectations of continued entitlements, and distorts basic supply and demand decisions. By encouraging fossil fuel use, subsidies probably increase carbon emissions as well.

Few citizens think about energy use when gasoline costs US$0.04/gallon at the pump, as it does in Venezuela (click HERE for a gasoline price infographic from Bloomberg that tracks more than 60 nations!). Maintaining this price means that each gallon pumped costs the government money. More use, bigger deficit. Consumers pay pennies per gallon while the government risks defaulting on international obligations! According to BusinessWeek (Click HERE), Venezuela spends more than 8% of its GDP on subsides for petroleum products.

Removing subsidies also risks social unrest. Countries from Jordan to Nigeria to Indonesia and Ecuador have had mass protests in reaction to subsidy removals (Click HERE for a World Bank report on subsidies; BOX 4 on page 85 highlights “Subsidy Reform and Civil Unrest”). Populations are often addicted to subsidized prices and governments fear the inflationary impact of removing them.

Lastly, subsidies encourage oil use while simultaneously discouraging supply-generating investment…this means that subsidies actually have the potential to create a vicious cycle in which subsidies effectively increase prices, generating the need for more subsidies and further increasing prices.

So what? The G20 economies and APEC stated in 2009 that they would remove all energy subsidies in the medium-term (click HERE for their report). The reaffirmed this objective in 2012. The recent plunge in oil prices offers a wonderful opportunity for both oil producing and oil consuming nations to immediately remove energy consumption subsidies. Doing so would have three major impacts: (a) generate government resources for healthcare, education, and other much needed social spending, (b) mitigate the risks of future instability from subsidy-removal in a higher price or inflationary environment, and (c) reduce the self-fulfilling dynamics that have the potential to drive oil prices higher.

The blunt reality is subsidies are unsustainable. Despite the many political risks of removing them, a world free of energy subsidies will exhibit greater resilience to higher prices. Today’s low prices offer cover from many consequences of energy reform (click HERE for the Economist’s latest cover story on this topic), providing an opportune time to pop the subsidy bubble.