Revisiting Fossil Fuel Subsidies’ Path in Ecuador

By the end of 1970s, during the oil boom, the military dictatorship of Ecuador implemented fossil fuel subsidies as a fiscal instrument to equilibrate the conditions of disadvantaged social groups. The most notable subsidies were assigned to liquefied petroleum gas (LPG), gasoline and diesel, which were kept untouched until 1982. In the following decades, during the reinstatement of democracy, the prosperity period ended jointly with the international collapse of oil prices, which led to a gradual increase in the prices of gasoline and liquefied gas (Jara et al., 2018). These conditions added to the moratorium on foreign debt and the reduction of fiscal revenues, made governments opt for suppressing fuel subsidies; however, those attempts triggered significant social outbreaks, some of them ended up in coup d'etat destabilizing Ecuadorian democracy.

Facing this political adversity, governments have not been able to address fuel subsidy reforms. Fuel subsidies in Ecuador have become a fiscal leash for its giant political cost; after four decades from the initial implementation, government support on fuels have remained intact even though the economic context has notably fluctuated. A big data analysis of the progress or backsliding of fuel subsidy reforms on a global scale, elaborated by Ross L., Chad H. and Paasha M. (2017), places Ecuador together with other 21 countries in the category of “persistent subsidizers”. This category responds to the analysis of the median price of fuels during 2003 to 2015.

In Ecuador the median price of fuels remained steady below the median benchmark price during the entire period, meaning that the net tax was negative. According to this data, Ecuador had a median negative tax on gasoline of -0.32 US dollars per litre, with a difference of 1.02 US dollars from the average market price; a gap that by definition was covered by the government support.

It is worth mentioning that persistent subsidizer countries which have kept fuel prices under the market level or that their prices have not overcome the benchmark more than two times over a decade, all of them are oil or gas producers. They include OPEC member countries such as Algeria, Angola, Iran, Iraq, Kuwait, Libya, Qatar, Saudi Arabia, United Arab Emirates, Venezuela and Ecuador. This actively demonstrates that oil resources dependent economies tend to subsidize fuels for a political pressure to distribute resource revenues. Developing countries that are net oil exporters tend to maintain fixed prices under the free market level through subsidies policies. These economies performed into the extractive nationalism governance, where the petroleum sector is dominated by state-owned companies and the government typically controls the domestic price control of petroleum derivative products (Fontaine et al., 2020; Gupta et al., 2002)

Considering that subsidy constitutes itself a cost absorbed by the government in order to keep the price to consumers below the market level, the feasibility of an oil producing country to fill that gap is greater than countries which lack petroleum resources. Immediate access to the resource, ownership of refining processes, and exempt costs of border transportation make the subsidy cheap in relative terms (Coady et al., 2010). However, this is not the case of Ecuador, which despite being an oil producer country, does not have the capacity and inputs to produce the amount required to cover its demand; in fact, 30.4% of the demand of fuels is covered with imports (Central Bank Ecuador, 2019). Ecuador’s expenses in imports for gasoline and diesel reached the amount of $34.583 million of US dollars during the decade 2009-2019. In turn, revenue from domestic sales of these imported derivatives reached $16,642 million, which indicates that the gap of $17,941 million was covered by subsidies (Petroecuador, 2019).

The Hard Move of Phasing Out Fossil Fuel Subsidies

After almost half of a century of a massive expenditure in fixed subsidies, the obsoleteness of this government contribution is undebatable. Fossil fuel subsidies in Ecuador are costly and inefficient, likewise without doubt the removal of these subsidies will benefit the economy. In fact, the removal of these subsidies is estimated to generate around $1.4 billion annual savings for the Ecuadorian General State Budget (Jara et al., 2018).

Multiple usages could be employed from the revenues of scrapping fuel subsidies such as mitigating the foreign debt or the public deficit, or reallocating these resources to social investment. Moreover, the elimination of fuel subsidies would contribute to the objectives of mitigating CO2 emissions established in the Paris Agreement₁ (Coady et al., 2015).

However, international and national experience shows that phasing out subsidies is a hard move; the gasolinazo in Mexico 2017, the yellow vest movement in France 2019 and the national protest in Ecuador in October 2019 have exhibited how difficult it is politically to guide this fiscal policy.

Abandoning fossil fuel subsidies requires an ex ante impact evaluation of the removal over the different segments of the population and the compensation measures to attenuate those negative effects. The literature of fossil fuel subsidy reforms indicates that the ditching of these subvention can be regressive or progressive; this means that it can cost poor households a larger share of their income compared to wealthier households or vice versa (Inchauste & Victor, 2017). The elimination of subsidies creates an indirect cost in goods and services that without compensation measures can destabilize the economy and lead to widespread political discontent.

Neither ex ante evaluation nor compensation measures were considered in Ecuador when President Moreno announced hastily a larger austerity package as a sudden ditching of gasoline and diesel subsidies on 1st October, 2019. By the following day, gasoline prices increased by 25% and diesel prices by 46% (Petroecuador, 2019), consequences that lead to an imminent political unrest emerged with riots all over the country. The national strike was led by the Confederation of Indigenous Nationalities of Ecuador (CONAIE) chanting an indefinite general protest until the government retracts the Decreto 883 fiscal measure. Under a national paralysis and state of emergency, Moreno’s government cancelled the reform and reintroduced the subsidies. But, was it feasible to avoid this backlash? Is there any way to phase out fuel subsidies successfully?

Gradual Phase Out

Instead of rapidly eradicating fuel subsidies, governments need to rationalize the reform with the population and gradually phase out subventions. A step by step transition is easier to adapt as it gradually builds trust through socialization (Coady et al., 2010). A gradual change in the fiscal policy legitimates the new subsystem of the policy by formulating the policy jointly with the groups of interest; and its medium- and long-term benefits as well as side negative effects.

The success of this phased approach is evidenced in Egypt’s fossil fuel reform in 2014. The Egyptian government built up a gradual reform by starting with an ex-ante evaluation of the possible direct and indirect negative effects of the scrapping of the fuel subsidies. Jointly with technical assistance from international organizations e.g. the Energy Sector Management Assistance Program (ESPAM), World Bank and as participle of the Global Subsidies Initiative launched by the International Institute for Sustainable Development (IISD), the Egyptian government generated a global diagnosis of the effects of phasing out fuel subsidies.

This formulation process of the fiscal policy included stakeholders both in opposition and advocates of the reform and put them together in dialogue. This socialization of the reform built trust on the benefits of cutting this government contribution and minimized the social unrest.

Faced with this vast consensus and support from many swathes of the Egyptian population, opposition was fairly weak. Although the left opposed the reform especially with regards to the negative impact in low income households, it barely meant debate. On the other hand, the low income population was not keen on reforms and neither did they interfere in the policy process (Moerenhout, 2018). The reform was implemented without major dispute even though Egyptians’ trust in government transparency of management of resources was low, certain trust was built around a just energy transition (El-Katiti & Fattouh, 2015).

Timing

International context matters. Like any fiscal policy, the international market is a reference and a decisive variable for the policymakers. A drop in international oil prices means a window opportunity for removing subsidies (Coady et al., 2015). That was the scenario in 2014₂ when the oil price went from a peak of US$115 a barrel to below US$50 by early 2015. This opportunity was seized by the Indonesian government as a fiscal strategy. In October 2014, the government imposed a ditching of fuel subsidies and given the abrupt international drop the net price for the consumer was lesser than the prior fixed price with subsidy (Suharsono & Lontoh, 2020). This prevented any immediate political backlash that could be faced under regular international prices.

Social Safety Nets

In order to mitigate short run stress and the increase of prices, implementing compensatory measures to protect the low-income population is crucial in reinforcing fossil fuel reforms. Such compensations could focus on existing social welfare programs, for its facility of reallocating savings from the reform in a safety social net that is already in progress. These social welfare programs include conditional cash transfer programs, food price subsidies and public transportation compensations. For instance, the Egyptian government applied a social compensatory policy by adding 20 food products [from the market basket] to a food subsidy system preexistent. This policy was implemented along with an informative campaign that highlighted it as a compensating step for the coming shared sacrifice of cutting fuel subsidies (Moerenhout, 2018), presetting a favorable posture of the population towards the reform.

What’s Next for Ecuador?

After the palpable failure of the rapid ditching of fuel subsidies in October 2019, the government has made an effort to gradually introduce a fuel subsidy reform. This time not all at once, a price band mechanism was introduced, this attempt to move from fixed prices toward market-based schemes was a prudent measure to liberalize fuel prices. The price band mechanism consisted of gradual increases not bigger than 5% per month. Although the political measure was not widely accepted — perhaps due to the delegitimation of the prior intervention — it did not lead to a political backlash.

By enabling free floating prices, this ceiling price measure was a promising fiscal system. However, it failed in analyzing the right time of execution. The measure was implemented in the first half of 2021 when international oil prices experienced an exacerbated growth of up to $84.95 per barrel. The Ecuadorian government had to go back to subsidies and fixed prices to avoid chaotic scenarios like those of 2019.

As evidenced, the Ecuadorian government keeps failing in scrapping fuel subsidies; perhaps, following a roadmap from the international lessons could make the reform tangible.

How to Phase Out Subsidies in Ecuador

1. Ex ante evaluation: estimate direct and indirect immediate and medium-term impacts over population. This preevaluation of the reform can include:

• Simulation studies of possible economic scenarios.
• Analysis of economic impact segmented by quintile distribution of the side effects.
• Diagnosis of social protection mechanisms to mitigate negative effects.

The ex-ante evaluation can be performed by technocrats and civil society organizations. Additionally, international advisory support can be considered e.g. the Global Subsidies Initiative launched by the IISD.

2. Socialization of the reform: building support among stakeholders.

Subsidy reforms create winners and losers, like other policy reforms do. However, the political arena in phasing out subsidies turns more conflictive since loser coalitions share strong incentives to lobby and high capacity to organize for the maintenance of subsidies and benefits from the status quo. The CONAIE coalition has clearly proven to be more powerful and better organized than stakeholders that advocate the removal of subsidies. Hence, in order to legitimize the transition, socialization of the reform and effective communication spaces with the opposition are indispensable. Negotiation strategies that resonate with the belief system of the indigenous community and their demands will enable the energy transition policy. That is why It is important that the opposition coalition = CONAIE actively participate in the ex-ante evaluation processes

Another sector of resistance to subsidy reform in Ecuador came from the general public. Following the logic, the high-income population should resist the removal of fuel subsidies due to the greatest benefits are in their favor. However, public resistance comes precisely from the low-income population. Perhaps this is down to in the praxis what matters is the tangible short-term impacts, which in fuel subsidy reforms are translated directly to general increase of goods prices. Additionally, different from policymakers or technocrats, the general public ignores the fact that fuel subsidy mostly benefits the wealthiest population. Then information is the key to address this problem: publicity campaigns about the false myths of the subsidies could legitimize the subsidy reform in the general public.

3. Creation of a roadmap for fossil fuel reform: As part of the socialization of the reform a roadmap of the coming reform should be presented by the government as follows:

Internalize ex-ante evaluation in the roadmap Disclosure of information: make the roadmap easily accessible to the general public Highlight compensatory measures that will be implemented

4. Gradual pricing reforms: price band mechanism

Once previous steps have been followed implement the price band mechanism. At this moment it is key to determine the right timing.

Proceed with the execution only when the international price tendency does not show imminent increase.

5. Compensatory measures: reallocation of fiscal saving in the existing social protection program Bono de Desarrollo Humano

According to the ex-ante evaluation and its simulations, increase the amount of conditional transfer according to the percentage of price increase. Moreover, ensure that the assisted population is widely informed about the reason for the increase in the conditional transfer. Clarify that it comprises compensation for the increases in prices as a collateral effect of the elimination of subsidies.

₁According to IMF Data the cost of negative externalities of fuel consumption (i.e. air pollution, traffic accidents, etc) is 1,5 higher than the cost of subsidizing fossil fuels. Further data at: www.imf.org/external/np/fad/subsidies/data/codata.xlsx

₂A major drop in the international oil price to US$20.67 per barrel occurred in April 2020 for Covid-19 pandemic. However, the health crisis overlaps health policies and expenses into the sanitary system, hindering agenda setting for other priorities.

Works Referenced:

Coady, D., Gilingham, R., Piotrowski, J., Tareq, S., & Tyson, J. (2010). Petroleum Product Subsidies: Costly, Inequitable and Rising.

Coady, D., Parry, I., Sears, L., & Shang, B. (2015). How large are Global Energy Subsidies? IMF Working Paper No5814.

El-Katiti, & Fattouh, B. (2015). A brief political economy of energy subsidies in the Middle East and North Africa. Oxford Institute for Energy Studies. www. oxfordenergy.org/wpcms/wp- content/uploads/2015/02/MEP-11.pdf

Fontaine, G., Medrano, C., & Narváez, I. (2020). The Politics of Public Accountability. Policy Design in Latin American Oil Exporting Countries. Cham: Palgrave Macmillan.

Gupta, S., Clements, B., & Inchauste, G. (2002). Issues in Domestic Petroleum Pricing in Oil-Producing Countries.

Inchauste, G., & Victor, D. (2017). The Political Economy of Energy Subsidy Reform. World Bank Publications. doi.org/10.1596/978-1-4648-1007-7

Jara, X., Po Chun, L., Montesdeoca, L., & Varela, M. (2018). Fuel subsidies and income redistribution in Ecuador. United Nations University Institute for Development Economics Research UNU WIDER, The economic and politics of taxation and protection Project.

Moerenhout, T. S. H. (2018). The Politics of Fossil Fuel Subsidies and their Reform. Cambridge University Press.

Petroecuador. (2019). Report 009: Accountability oil national production. July- September 2019.

Rosss, M., Chad, H., & Mahdavi, P. (2017). Global progress and backsliding on gasoline taxes and subsidies. doi.org/10.1038/nenergy.2016.201

Schaffit, F., Jakob, M., Soria, R., Vogt-Schilb, A., & Ward, H. (2019). Can government transfers make energy subsidy reform socially acceptable? A case study on Ecuador. Inter -American Development Bank IDB WORKING PAPER SERIES N ° IDB-WP-01026.

Suharsono, A., & Lontoh, L. (2020). Indonesia’s Energy Policy Briefing. Global Subsidies Initiative (International Institute for Sustainable Development IISD)

Cover photo courtesy of Dawn McDonald via UnSplash

~ The views represented in this blog post do not necessarily represent those of the Brandt School. ~