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Tuesday, 21 May 2013

Removal of Fuel Subsdies (Guest Post)

By Gabriel Pollen

In discussing the question of fuel subsidies, we first need to explicitly define what a subsidy is. A subsidy is an amount paid by government to keep prices below free market. The amount is equal to difference between the consumer pump price of fuel versus the total actual cost of producing or importing.

Arguments against fuel subsidies are based on the understanding that fuel subsidies cause distortions that result in huge economic costs such as rent-seeking behaviour and smuggling . Proponents for the removal of fuel subsidies argue that several studies in recent years have quantified fossil fuel consumption subsidies and examined whether they are effective tools for poverty alleviation. Generally, lower-income populations only receive a tiny share of the benefits and fossil fuel consumption subsidies are not an effective strategy to protect “real” incomes of poor households, since they involve substantial leakage of benefits to higher-income groups.

Fossil fuel consumption subsidies are often justified to offset the costs of petroleum, liquid petroleum gas (LPG), kerosene and electricity. Subsidies intended to reach the poor are often economically inefficient because richer households use more fuel and benefit much more from the subsidy, while poor households are only able to afford a small amount, even at subsidized rates. Artificially low prices can also lead to the fuel being diverted to other uses than for which the subsidy was intended, including selling fuel across borders or on the black market or being used for less efficient end uses.

All in all, a fuel subsidy is a major fiscal and financial burden on the nation because present level of subsidy is not only unsustainable given the competing needs for public funds but it also does not reach intended beneficiaries and inadvertently benefits mostly the rich.

Given the aforementioned discussion points, I fully support the removal of fuel subsidies and advance that saved revenue can be used for many other pressing social and infrastructural development projects in sectors like health, education, power supply and roads. The revenue could be invested in capital projects and used to reduce our domestic and external debt.

The step to remove the fuel subsidy by the government is a bold step. World over, some studies observe that reform is tricky, however, and social unrest has erupted during national efforts to eliminate consumption subsidies, demonstrating how carefully efforts need to be designed and implemented. Where subsidy reform has been successful, social safety nets, including targeted payments to the poorest in a population have been effective. This unrest is evident is Zambia.

The other dimension we need consider is Zambia’s acquisition of fuel. ZIPAR carried out an interesting study on “How to reduce Zambia’s fuel costs”. It noted that Zambia’s fuel costs are among the highest in the world. In recent years there have been increasing calls for fuel taxation to be reduced in order to bring pump prices down. However, reducing taxation is not a solution because it simply reduces government revenue, since Government owns Indeni refinery and has stake in TAZAMA pipelines.

All Zambia’s fuel is supplied through the Indeni except in exceptional circumstances. Indeni does not purchase crude oil feedstock itself or own and sell the products it produces. Instead, it operates on a tolling arrangement. GRZ is the supplier and proprietor of the feedstock and owner of the products produced and lifted from the refinery.

Finished products are sold to private licensed Oil Marketing Companies (OMCs), which distribute them throughout Zambia. While OMCs are allowed to import finished products, since 2008 they have attracted 25% import duty, whereas Indeni, until now paid 5% duty on its feedstock (it has now been removed).

The Energy Regulation Board (ERB) determines maximum retail fuel prices (except for sales to mines and certain other industries). In most oil importing countries fuel supplies are seen as the responsibility of the private sector; there is rarely a market failure or security reason for government involvement. In Zambia, the government is responsible for everything.

This might be acceptable if it were demonstrated that GRZ was performing well in terms of fuel costs and reliability. However, as noted above, Zambia has higher basic product costs than its neighbours and frequent supply disruptions. International experience suggests that few governments are equipped to conduct commercial operations efficiently.

In conclusion, the removal of fuel subsidies should have been accompanied with correcting inefficiencies involved in fuel procurement and acquisition. Correcting the inefficiencies in the procurement of fuel would have probably offset the price increase resulting from the removal of the subsidy. Bringing fuel prices down permanently requires efficiency improvements which cut basic product costs.

The evidence in the ZIPAR paper suggests that given: (a) substantial investment is required in the sub-sector just to maintain current operations; (b) scarce public resources are urgently needed elsewhere for basic public services; and (c) the private sector will invest (in the right policy environment), continued GRZ involvement in fuel operations appears hard to justify.

Gabriel Pollen is a lecturer in the Economics Department at the University of Zambia.

Copyright © Zambian Economist 2013

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