Dismantling Energy Subsidies in Latin America

Summary: The drop in oil prices creates a unique opportunity for some Latin American and Caribbean nations to reduce their costly energy subsidies. The region’s most populist governments – including Venezuela, Argentina, Ecuador and Bolivia — have by far the highest and therefore represent the best opportunities for change. The why and how this needs to take place, using Argentina as the first agent of change.

Carlos St James closeupAbout the AuthorCarlos St. James is an advisor to energy investors and developers in emerging markets. He founded the Argentine Renewable Energies Chamber in 2005; has been a board member of the Latin American & Caribbean Council on Renewable Energy since 2010; founded the Middle East-Americas Energy Council in 2014; and is publisher of the Latin American Energy Review.

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It is a common perception that oil-producing countries in Latin America and the Caribbean (LAC) typically have the largest energy subsidies as a percentage of their economies. But this is not strictly accurate. As it happens, the more important determinant of a country’s extent of subsidization is not its availability of oil but the quality of its institutions. And those with the most solid and transparent institutions have the lowest subsidies — regardless of oil wealth.

Let’s first take a comparative look at electricity (as opposed to fuel) prices in the region.

Electricity prices LatAmThe Latin American Energy Organization (OLADE, by its initials in Spanish) maintains electricity data on its 26 member countries. In 2011 the region’s average residential electricity price stood at just over 18 cents (all of this discussion is in USD) per kilowatt-hour (kwh). But the range from country to country proved to be astounding: it went from as low as two cents/kwh in Venezuela and Argentina to well over 30 cents/kwh in some Caribbean island nations and 28 cents in Uruguay on the continent. Those lower energy prices had to come from massive subsidizations – and reason would suggest that only energy-rich nations could afford them. (Click on the graphs and charts to see them more clearly.)

The International Monetary Fund recently completed a study on the cost of electricity and of fuel subsidies in LAC[1]. They started by dividing each country into one of two categories: oil producers or importers. They then added two more categories: those with well-regarded and transparent institutions, and those with lower-ranked indicators of institutional quality (by using scores from such annual analyses as the World Bank’s Doing Business survey, Transparency International’s Corruptions Perception Index, and Institutional Investor’s Country Credit surveys, among others).

They then placed each country in one of four quadrants. For the sake of time I have foregone diplomacy and added nicknames:

  • oil producers with reputable institutions (examples include Brazil, Mexico, Peru and Colombia). These are where the Best Big Business opportunities lie — where everyone wants to invest first;
  • oil importers with reputable institutions (such as Chile, Uruguay, Panama and Costa Rica). These are the It’s a Shame They’re So Small countries, because they have really proven to be class acts but are invariably little;
  • oil producers with lower-ranked institutions (including Venezuela, Argentina, Bolivia and Ecuador). These have the highest concentration of Populist Governments, and while they generally don’t acknowledge it, are on a path to implode;
  • and perhaps the least fortunate group, oil importers with lower-ranked institutions. These are the Caveat Emptor countries, where only those with very good market information and access should try to do business, energy or otherwise.

Subsidies by Dual CategoryPlacing every LAC country in one of those four quadrants, a clear pattern emerged as seen in the graph. The “Populist Governments” group, oil-producing countries with weaker institutions, have far greater energy subsidies as a percentage of their gross domestic product (GDP) than any other group, to the tune 5.1% of GDP. This is three times higher than the region’s average of 1.8% of GDP.

But what is noteworthy is that countries with highly regarded institutional frameworks – be they oil producers or importers – had the lowest level of subsidies, and well below the regional average. The It’s a Shamers are the model of subsidy efficiency.

Populist SubsidiesI want to focus on the Populists here because I believe they represent the next frontier with the greatest opportunities in the coming decade. Change is currently being led by Argentina, with its new pro-business government, a decade of pent-up demand, and a stated desire to attract $20 billion in investment in 2016 alone. This is more than double the country’s annual average for the last decade and something of a hurdle.

Many of the region’s energy subsidies grew in the 2000s when oil prices were trending upwards (peaking at $138/barrel in 2008) as a way to protect the disenfranchised. As prices began to fall the more successful countries took the opportunity to establish mechanisms like fuel price stabilization funds; the Populists chose to not save for a rainy day, and the subsidies became entrenched.

Nonetheless, the current low level of oil prices creates an opportunity to begin to dismantle these subsidies and establish more open and transparent mechanisms. And lest I’m accused of being coldhearted, bear in mind that it is well documented that energy subsidies benefit the wealthy far more than the poor:

  • in OECD countries, 80% of the benefits of gasoline subsidies went to the richest 40% of households;
  • closer to home, in Venezuela the richest 20% receive six times more fuel subsidies per person than the poorest third of the population;
  • in Bolivia, the poorest 40% of households benefit from only 15% of fuel subsidies; and
  • in Haiti the ratios are even worse.

This is ineffective, very expensive and could be better used in areas with greater distributional impacts.

Argentina has announced that it will begin to eliminate energy subsidies immediately. How they go about it will determine their success, and if so, can be the catalyst that accelerates change in the other Populists. We need Argentina to be successful.

Unfortunately the margin for error is tiny.

  • Subsidies have been in place for so long that they are perceived as a de facto entitlement. This creates a powerful force to resist change – especially since President Macri’s political party does not control congress. Establishing a joint and multi-party commission to address this could create new stakeholders and bring the opposition into the fold.
  • Subsidy rationalization should ideally take place during economic expansions, yet Argentina’s economy is expected to shrink by about 1% in 2016. Unfortunate timing. Macri’s government will have to communicate effectively and a lot to make its citizens aware of the untenable situation.
  • The pain has to be shared equally. The opposition believes that businessmen and foreigners will now plunder the country at the expense of the working class. It is important that all energy reforms be open, transparent, and show that the big bad multinationals will pay local taxes and be held accountable for any negative environmental impacts.
  • Reforms need to be gradual. But Argentina cannot afford to take its time. So 2016 may turn out to be a memorable year.

Fossil fuels like oil, natural gas, shale and LNG all have a significant place in the economies of the Populists. But one thing to consider as energy reforms begin is that harnessing the power of cleaner natural resources will ultimately benefit all of them even more. Would you rather get your energy from a generator whose raw material price fluctuates wildly, or one that’s absolutely free of charge as is the wind and sun?

That perhaps will be the true energy revolution in Latin America.

© Latin American Energy Review 2016

 

About the Author:

Carlos St. James is the founder of the Argentine Renewable Energies Chamber (CADER, by its initials in Spanish); board member and was elected the first President of the Latin American & Caribbean Council on Renewable Energy (LAC-CORE); founder and chairman of the Middle East-Americas Energy Council (MEAMEC); and founder and publisher of The Latin American Energy Review. His private sector background is focused primarily on finance and bringing together stakeholders so that deals get done. He advises governments on renewable energy policy, counsels private equity firms seeking to enter the region; and brings together stakeholders, including investors, for new energy projects.

He obtained his undergraduate degree in international economics from DePaul University and his masters in international relations from the Fletcher School at Tufts University.

 

[1] Energy Subsidies in Latin America and the Caribbean: Stocktaking and Policy Challenges, IMF Working Paper WP/15/30, February 2015

 

 

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2 thoughts on “Dismantling Energy Subsidies in Latin America”

  1. Hi,

    Just out of curiosity, why is it that the result showing populist countries being the highest subsidy-givers be a surprise? Isn’t that a typical characteristic of populist regimes?

    Is it because one might have an inclination to generally picture the mighty Gulf while thinking of energy subsidies? 🙂

    Thanks,
    Prateek

  2. I think this article is somewhat incomplete, because even the “well-ran” countries engage in a lot of indirect subsidies for fossil fuels.

    For instance, take Colombia. Its stabilization fund is one part of the equation meant to remove subsidies while keep prices of fuel relatively stable. On paper, it looks like subsidies for fossil fuels don’t exist, right?

    Wrong. Colombia’s national oil company, Ecopetrol, benefits from a tacit financial guarantee from the Colombian government, its greatest stockholder. Because of this, Ecopetrol is able to take risks and engage in projects that no private company would ever take. For example, take the Reficar refinery in Cartagena, Colombia. Originally budgeted to cost $3.7 billion dollars, its final cost ballooned to over $8b USD. The expected IRR for this project will lower than Ecopetrol’s cost of capital – and yet, this project moved forward.

    The only way in which the shortfall was made was through the issuance of bonds. And all analysts agree – Ecopetrol’s debt is a good buy, because it has a backstop from the Government of Colombia. A subsidy in all but name.

    Other indirect subsidies of the fossil fuel industry in Colombia include the way in which fuel and natural gas prices are set by the central government, as opposed to by an open market. This leads to political interference on the part of producers and consumers – and at the end of the day, Ecopetrol, Colombia’s national oil company, receives a regulated price for its products sold within Colombia without the need to compete from imports from the U.S. Gulf Coast, where there exists excess refinery capacity that provides gasoline and ULSD at lower wholesale prices than they are able to offer.

    Regulation, state-backed guarantees, price-setting and, yes, the fossil fuel industry’s inability to pay for the externalities of their activity (which are more than carbon dioxide emissions) are all part of the equation in which governments in the region subsidize fossil fuels while using “fiscal impacts” as an excuse to put up walls against the development of alternative energy sources. The economists who set policy would do well to drink their own Kool-Aid when it comes to a balanced approach to subsidizing fossil fuels vs. alternative energy.

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