by Estefanía Marchán, Ramón Espinasa, and Ariel Yépez-García.
The G20 – a group comprising the world’s 20 leading economies – will meet in Argentina next year for its 10th annual summit aimed at coordinating action to strengthen the global economy and tackle pressing global challenges including climate change. The phasing out of fossil fuel subsidies—a pledge first made by the group 9 years ago—is sure to be on the agenda.
Governments in Latin America and the Caribbean (LAC) and around the world subsidize fuels and electricity for many reasons: to help mitigate the impact on vulnerable consumers of high energy prices, curb inflation, promote economic competitiveness, or—in the case of many oil and gas producers—to distribute the country’s resource wealth to the public. Yet subsidies often have unintended adverse effects on a country’s economy, its energy sector, and the environment.
To start, subsidies are expensive. In The Other Side of the Boom: Energy Prices and Subsidies in Latin America and the Caribbean during the Super-Cycle, we find that energy subsidies in LAC averaged US$84 billion a year, or 1.6% of the region’s GDP, before the price of oil collapsed in late 2014. Fuel subsidies made up roughly 63% of the total and were highly concentrated in a small set of oil- and gas-producing countries. Here, fuel prices were typically frozen and subsidies ranged from 1.1% of domestic GDP to as high as 9.4% of GDP. Electricity subsidies, on the other hand, were more limited in value but more widespread throughout the region.
This level of spending is difficult to maintain, particularly for countries facing fiscal constraints. In these instances, subsidies can contribute to debt accumulation and put pressure on a country’s trade balance and balance of payments. Importantly too, subsidies can divert government spending away from sectors such as health, education, and infrastructure.
When energy companies absorb the losses resulting from underpricing fuels or electricity, subsidies also threaten the sector’s sustainability. Subsidies result in lower profit margins, reduced efficiency, and increased uncertainty for companies, which can lead to chronic underinvestment in the sector.
Subsidies also harm the environment. Cheap fossil fuels distort the efficient allocation of resources by artificially promoting energy consumption and reducing the incentives to invest in renewable energy. Excessive consumption of fuels leads to elevated emissions, causes more deaths from air pollution, and exacerbates other negative externalities associated with increased vehicle use.
Finally, energy subsidies are an inefficient way to deliver social protection. On average, our study shows that for every US$10 spent on energy subsidies across LAC only US$1 reaches the poorest 20% of households. The remainder goes to higher income groups who typically own more cars and power more appliances. This cost is higher than better targeted social programs implemented in the region such as cash transfers, which cost US$2 for every US$1 transferred to the poorest households.
Given the onerous consequences associated with energy subsidies, they become difficult to justify. LAC countries are adjusting once again to a world of lower energy prices. Although eliminating subsidies can be politically contentious, today’s low-price environment and the fiscal pressures facing many LAC countries—particularly oil producers—present an opportunity for reform.
LAC can move towards greater stability in price-setting for fuels and electricity while also protecting the poor. We show that, in principle, only 19% of the potential savings gained from an increase in gasoline and diesel prices could be redirected towards better-targeted schemes to compensate the bottom 40% of households for the welfare losses resulting from price increases. Roughly 27% and 21% of savings would be needed to compensate the poorest 40% of households for welfare losses resulting from price increases on natural gas and LPG and electricity, respectively.
International experience shows that successful subsidy reform requires an understanding of the effects of subsidy removal on the welfare of key stakeholders and taking steps to address them. As the G20 gears up for talks, one message should remain clear: countries can raise energy prices while still protecting the vulnerable through better targeted compensation schemes.
 Consumption subsidies only; 2008-2014.
 Chapter contributions by Adrien Vogt-Schilb, Kuishuang Feng, and Klaus Hubacek.
 Robles, M., M. G. Rubio, and M. Stampini. 2015. Have Cash Transfers Succeeded in Reaching the Poor in Latin America and the Caribbean? Washington, DC: Inter-American Development Bank.