Wednesday, May 19, 2010

Rural Energy Subsidies: “It's Déjà Vu All Over Again”

By Doug Barnes

I have noticed that there has been quite a bit of material circulating recently on energy access and subsidies.  The World Bank has prepared
Cooking with Ecofogon Stove, Nicaragua
Photo: PROLEÑA/Nicaragua
a background paper that will be published soon, and it is quite good. However, in reading this paper and other related material, I almost felt I had read it before—a kind of déjà vu.  So in this period when everybody is asking "Where is my bailout?" it seems a good time to review the justifications and implementation challenges for energy subsidies.

Jonathan Halpern and I had written both a paper and a short note on this subject about 10 years ago at a time when there were strong anti-subsidy sentiments in many development agencies. This blog contains a summary of that paper on energy subsidies published in 2000. So go to the original paper and read it, or read on. Or read on and then go to the paper! This work hopefully has withstood the test of time, but you can be the judge.

Why should we examine the role of energy subsidies for access to energy?  The answer seems obvious.  Energy policies that have the purpose of alleviating poverty must in some way bring down the costs of safe, clean, reliable energy services to make them more affordable. Low-income households often lack access to or cannot afford the initial costs of “modern” energy services. A good subsidy scheme is one that enhances access for the poor while sustaining incentives for efficient delivery of energy services without significant distortions in energy markets. But that is not all: the subsidy scheme must also be within the financial and human resource constraints of the government. This is quite a balancing act.

Much more below the break....
Three criteria should be borne in mind in recommending subsidies as incentives for energy interventions that help the poor. Subsidy policies should be carefully assessed according to their efficacy, sector efficiency, and cost-effectiveness. These are often characterized as the three Es. Efficacy implies that the subsidy should reach those for whom it is intended—mainly the poor.  To ensure sector efficiency subsidies need to be structured in ways that encourage provision of service at least cost. This is one aspect that often is addressed in energy sector restructuring work which at times does not take into consideration impacts on the poor without existing high quality energy services. Cost-effectiveness means that the subsidy achieves social goals at the lowest program cost while providing incentives to businesses to serve poor or rural populations. Also, a key point is that programs actually have to work because obviously subsidies would be wasted in poorly performing projects.To put it simply, the objective is to have a subsidy that has high benefits for society without draining the treasury. One other subsidy justification involves promotion of environmental benefits, but we will not review this issue here.

Diesel-Biogas Genset for Small Electricity Grid,
Karnataka India: Photo:  D. Barnes
Who to Subsidize: As a general rule, in developing countries, subsidies should be directed at those currently without access to higher-quality energy services, typically rural households and the poor. In the case of electricity the share of the population without service can varies significantly, from 10%-50% of the population. Households that already have service are generally the better-off. In the case of oil-based products the efficacy of reaching target groups may not be so clear cut. The poor may have access to kerosene at very high prices because of the small quantities that they purchase, though they generally have difficulty getting LPG because of the large purchases and service initiation fees involved. But the general rule of thumb is that household with access to clean high quality energy services are better off than those without access to them.

What to Subsidize: Subsidies should be applied to access costs (various types of connections or equipment), and not to operating costs (ongoing consumption). The poor spend a significant amount of their income or their time collecting fuel for energy services that are low in quality. Subsidizing some of the access barriers that they face can encourage the poor to climb the energy ladder to better services. For example, for poor households the costs of the electricity connection fee, solar home systems, or even improved biomass stoves can be kept low by providing a partial subsidy for the capital costs. Sometimes the upfront costs of service can be spread out or blended with subsidies to make it more affordable, and this would include rolling the rest of the cost into monthly bills or financing them through loans. An example of such a subsidy program is Chile’s rural electrification program where subsidies are provided to rural communities for the capital costs of acquiring electricity service. This program encourages electricity companies to service rural populations by subsidizing the costs of connections for poor consumers in communities that will result in positive financial flows for the companies after the subsidy. Similarly, to encourage poor households to use LPG in urban areas and for businesses to extend service to more remote areas, the initial service fees or equipment costs could be subsidized.

Solar Home System, Brazil
Photo:  IDEAAS
One caution is that there often is a fine line between subsidies that encourage service provision and those that encourage only the purchase of equipment. This is an especially important problem for renewable energy. Many of the early photovoltaic and stove programs encouraged manufacturers or artisans to produce for a government subsidy rather than for an actual market. Most solar home system programs are better today because they rely on small subsidies for the systems coupled with participation of NGOs and microfinance organizations to spread costs over time. The improved biomass stove program is currently being revamped in India, and it appears that the new program will take subsidies for market development seriously.

How to Subsidize: In general, demand side subsidies work better than fuel or supply side subsidies because they have better targeting properties and provide stronger incentives for expanding coverage and sustaining services. Demand-side subsidies involve partial funding of connections or access to energy systems. Supply-side or fuel subsidies are easier to implement but should generally be avoided because they are hard to target and often undermine efficient service delivery, raising costs above what they would otherwise be. For instance in India the LPG and kerosene subsidies have lead to considerable expenditures for the government. It is estimated that about US$ 2 billion per year of subsidized kerosene earmarked for poor households is diverted to other purposes. Today there are experiments with the use of smart cards to prevent the theft. There also about US$ 4 billion annual subsidies for LPG that go mainly to the well-off and middle class households.

In a few countries with strong administrative capability supply side subsidies (cross subsidies and under pricing fuels) have not undermined the involved businesses. One example is the rural electrification program in Thailand. A bulk electricity supply subsidy was important for expanding electricity to well over 95 percent of the population. The Thai program was sustained because of the many measures taken to keep costs low and to safeguard the financial viability of the service providers through cross-subsidies from urban areas which were required to pay a higher bulk electricity price to the national power producer than the companies serving rural areas. Where governments have ample resources to spend on service expansion and where efficiency considerations are not paramount, supply schemes may work, but at a cost to the country.

Finally, a bit of economic blasphemy. There are strong cultural factors at work on how to subsidize energy services for the poor. Some types of subsidies are politically acceptable in some countries, but quite unacceptable in others.  From a social point of view those subsidies that narrowly single out the poor often are very unpopular and lack political support.  In tough financial times they often are the first subsidies to be cut from national budgets.  So perhaps, just perhaps...broader subsidies that are not too wasteful may actually help the poor more than very narrowly targeted ones.   This was the case in Guatemala where all households--rich and poor--in rural communities received rather expensive improved biomass stoves financed as one option under a social investment fund. 

So bringing high quality household energy services to those without access is difficult but not impossible to achieve. However, it requires both dedicated governments and sensible policies.

So what do you think about subsidies for rural energy and energy access? Take the poll and leave a comment!

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