What is my Country’s Starting Position Towards Establishing Market-Based Prices for Fossil Fuels?

The path to fossil-fuel subsidy reform depends on which pricing policies are being used to subsidize individual fuels. The GSI adapts the pricing dimensions that have been put forward by the GIZ (2012), in the context of motor fuel prices, to identify four dimensions by which fossil-fuel pricing policies can vary:

1. subsidies The degree to which subsidies reduce the end-price of fuel by shifting costs onto the government, state-owned energy companies, private energy companies or other actors.

2. Pass-through The degree to which domestic pricing fluctuations match international price changes—

literally, the degree to which an international price change is “passed through” into prices domestically.

3. Transparency The degree to which the composition and regulation of energy prices is open and transparent.

4. Enforcement The degree to which fuel pricing in real life actually follows officially adopted energy pricing arrangements.

In order to identify a country’s starting position towards decontrolling energy prices, it is helpful to assess how current pricing policies compare across each of these four criteria. The following discussion is focused particularly on petroleum products, but many of the principles are transferable to other fuels.

The first and perhaps most important dimension of energy pricing is the degree to which energy subsidies reduce the end-price of fossil fuels or fossil-fuel-derived energy by shifting costs onto other actors. In this respect, policies can be roughly classified into four main categories (see Figure 3).

FiGuRE 3 | DimEnsiOn 1: FOuR CATEGORiEs OF subsiDy in EnERGy PRiCinG POliCy

Below-market fuel Prices

The degree of cost shifting caused by subsidies is usually greatest when policies fix a price, a price cap or a margin of price support. In this case, price regulations can be either market-wide (blanket subsidies) or discriminatory (prices for different categories of consumers are set at different levels). Governments may pay the cost of this themselves or through their ownership of, or other types of pressure on, energy companies that must sell fossil-fuel-derived energy to domestic consumers at a loss.

enerGy-related handouts Some policies allow pass-through of

international prices onto the domestic market, but also provide energy-related handouts to certain groups of energy consumers. This can be done either in the form of monetary transfers or credits bundled with fuel purchases, or in the form of in-kind rations (the latter option being common for electricity).

tax exemPtions, reBates or credits Some countries provide tax exemptions or reductions for fossil fuels. These exceptions from the tax level set out by national law can be considered a subsidy (see Box 5, p. 23) and can be considered subsidies, equal in size to the tax revenues that are foregone.

no enerGy suBsidies

Finally, policies may have no energy subsidies and no corresponding cost-shifting. By virtue of having no subsidies, policies must by definition allow a 100 per cent pass-through of fluctuations in world energy prices. If high ad valorem taxes are charged, the pass-through can be even more than 100 per cent.

In all cases, identifying where in the supply chain a subsidy is conferred is important too. For example, the subsidy might be focused on retail prices, wholesale prices or a targeted group of the population.

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FiGuRE 6 | PRiCEs unDER mARkET-bAsED PRiCinG

The second dimension of energy pricing is the degree of pass-through of international price fluctuations on domestic markets. There are three broad categories of pricing mechanisms that govern pass-through.

1. Ad hoc pricing is when prices are set manually by governments and changed on an arbitrary basis. In this system, there is no “pass-through” of international prices unless governments choose to change domestic prices. In this approach, energy prices are typically kept constant for long periods of time and significantly below the world level, as illustrated in Figure 4. Ad hoc changes to taxation can also be used to minimize the effective price increase domestically at times of high international prices.

2. An automatic pricing mechanism is a policy that places formal constraints on the pass-through of international prices, usually set out in a formula, without direct government decision-making. It is typically used to smoothen fuel price fluctuations: for example, only allowing domestic prices to change when there has been a certain percentage increase in prices internationally.

Automatically flexible taxation systems can also be developed to help smoothen the impact of international price fluctuations.

stabilization funds are a variant of automatic pricing.

They function by taxing fuel when international prices are low and putting the revenues aside in a special fund.

The funds are then released in order to dampen domestic price increases when international prices rise, cushioning the impact of volatility. Depending on the pricing formula and how it is applied, full pass-through may be delayed or may not occur at all.

3. market-based or liberalized pricing (also known as

“passive” or “no regulation” of prices) allows energy prices to be set by the “invisible hand” of the market and gives governments no discretion to intervene.

Market-based pricing provides full pass-through of international prices with minor delays. This is illustrated in Figure 6, which shows how a domestic fuel price would have changed from the end of 2007 to the end of 2008 if all fluctuations in international prices were passed through onto the domestic market.

The third and fourth dimensions of energy pricing—transparency and enforcement—vary in ways that are fairly self-evident. Transparency depends upon the openness and accessibility of information about pricing policy and price composition. Enforcement is relevant because officially adopted prices do not always correspond with prices on the street because of issues like predatory pricing, black markets and smuggling. Even countries with no subsidies need to enforce anti-trust regulation and ensure fair competition to prevent collusion of suppliers and monopolistically high energy prices.

source: Wagner (2010)

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GIZ has developed principles of fuel pricing for motor fuels that synthesize the long-standing discussions that have taken place around good practice across different dimensions of pricing policy. They are summarized in Box 6.

Giz’s PrinciPles of fuel PricinG

Price settinG

• Principle 1: Prices, at the very minimum, cover production/transport/

refining costs, including depreciation and external costs of production (e.g., environmental costs)

• Principle 2: There is a tax on fuels (e.g., a percentage of an excise) that helps finance the transport sector, in particular, road maintenance (as a rule of thumb, minimum of US$0.10 for road maintenance, including 20 per cent for rural roads)

• Principle 3: There is a tax on fuels (e.g., “eco-tax” or a percentage of an excise) that internalizes the external effects of transport sector by directly relating fuel consumption and carbon dioxide emissions, viewed as a proxy for other social costs (like accidents, congestion, etc.).

• Principle 4: There is a tax on fuels (e.g., value-added tax) that will contribute to general government budget and form a major contribution toward financing core state functions such as the health services, education and security. As fuel taxes are relatively easy to collect, they are a major source of revenue in many countries.

Price reGulation

• Principle 1: Fuel prices are adjusted to reflect changes in cost of production,

transport and refining, including depreciation and external costs of production (e.g., environmental costs).

• Principle 2: Fuel prices are adjusted to keep the pace with inflation (and increase in income).

• Principle 3: Fuel prices are adjusted in order to reduce pressure on government budgets and indicate clear exit strategies in cases of subsidies.

Price transParency

• Principle 1: Institutional stakeholders in price setting are known.

• Principle 2: Principles of price setting are known, that is to say, information is provided as to the determinants of fuel prices, frequency of updates and the underlying formula if an automatic mechanism is applied.

• Principle 3: Information on price composition is available.

• Principle 4: Information on prices and price setting are made public in an easy-to-access, comprehensible and accountable manner. Information is displayed on the Web, including: current price data for all fuel products; timelines of price adjustments; price components (production and/or import prices, taxation levels, and other charges);

description of structure and modus operandi of pricing mechanisms (if applied);

underlying legislation.

BOX 6

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