Price control as a means to provide universal service is being practiced for thousands of years. Be it food grain, services or fuel, the idea is to provide relief to the poorer section of the society. In time of famine, the good kings opened their food stock and almost gave it away. The kings used price control to secure their throne and the politicians as a way to entice the voters at the expense of national exchequer. Hammurabi, the ruler of world’s first metropolis Babylon, set a code controlling prices of most essential commodities in about 2000 BC. As a result, trade plummeted and bureaucratic paperwork (on clay table) multiplied. All the early price control measures were mainly aimed at keeping the grain price low. Although the successes of these efforts were limited and short-term, the failures were multifaceted. Starting from farmers’ suicide, there were mass migration to the cities (leaving behind the farms), major food scarcity, emergence of hoarding and black markets and some of them ended in murder and total chaos. 

Large scale energy use and energy trading is a much more modern phenomenon. The most recent measures on energy price controls were initiated after the 1973 Arab oil embargo and the subsequent worldwide price shock. The US federal government introduced price control on gasoline to protect the consumers from the rising cost. It resulted in long agonizing lines at the gas stations and major shortage of supply. The Independent Institute in California described the situation as: 

“In 1973 and 1979, the federal government, blaming everyone from ‘greedy’ domestic oil companies to gasoline station operators to ‘fuel-hogging’ motorists, imposed price controls on gasoline after oil-producing countries greatly reduced the quantities of oil shipped abroad. Had price controls not been instituted by the government, a market clearing would have occurred where the price of gasoline would have gone up, as the demand of required gasoline met the quantity supplied. But since gasoline prices were fixed below the market-clearing level, rationing with long lines resulted. [“Rationing Our Health Care: Price Controls are Hazardous to Our Health,” Simon Rottenberg and David Theroux, The Independent Institute]

In contrast, there was no price control after the recent meteoric rise of gasoline price (doubling in 2006 from the 2004 price) that ensured adequate supply and no line at the stations. In countries where the price of energy is not market-driven, various measures produced various results. In Thailand the government put aside $128 million to ward off the high oil price in the early stage but ended up paying $2.2 billion in 19 months. Eventually they had to stop oil subsidy. Chile, India and Pakistan suspended the formula based automatic pricing mechanism to protect the consumers. Argentina, Chile, Honduras, Pakistan and Thailand imposed price caps. As a result, the governments paid a high price. The following table: 1 tells the story:

Government budget

 Oil companies (example costs)

Oil stabilization fund

Source Copper fund Bonds and bank loans
Tax reductions, exemptions
Many Countries
Source: Bacon & Kojima, 2006

Many countries have been forced to abandon allocating special fund for fuel subsidy (India, the Philippines). Some has run out of funding (Thailand, Chile). Yet others are wondering about the future of oil price! As a consequence of these measures many countries faced smuggling, adulteration and black-marketeering problems that made the situation even worse. Some of them had real threats of supply shortage.

What is Energy Subsidy?

There is quite a bit of confusion about the types, nature and size of energy subsidy. The IEA has defined energy subsidies as any government action that concerns primarily the energy sector that lowers the cost of energy production, raises the price received by energy producers or lowers the price paid by energy consumers. This needs little more explanation. The easiest and most transparent way of subsidizing is to either pay certain amount of money to the producers, helping them to reduce the cost of production or give money to the consumers to help buy expensive energy. Unfortunately, both measures involve a lot of administrative cost and require great efficiency to be successful. Moreover, these efforts require budgetary allocations that may become easy targets by special interest groups. Politicians prefer to hide the subsidy in the form of price control (under pricing) or tax exemption. Any form of subsidy will produce lower price for the consumers than the true market price or the economic price of the product. It is easy to do price control when the marketing and distribution of the products are done by a state owned monopoly. At the same time the government may overprice products through taxes and duties (another form of price control). This is mostly done for transport fuel. 

The cost of energy subsidy can be crippling for a country creating trade imbalance and financial burden that may slow down any economic growth. In many of the oil exporting, developing countries, the subsidy is the highest. Indonesia, Venezuela, Iran, Nigeria almost gave away oil and gas to their population. Indonesia and Nigeria paid a high price for this practice and now do not provide any direct subsidy. Both Venezuela and Iran are struggling economically. The oil rich Middle Eastern countries stopped subsidy long time back. 

Now questions many arise should price of energy be left to the market? A competitive market works with the precondition of a fair distribution of wealth among the citizens. The equilibrium of demand-supply will play out well when the buying capacity of the majority for basic essentials is at a minimum acceptable level. Otherwise, the market will cater only the segment of society where it can maximize profit. Obviously, in developing countries the precondition for market economy does not prevail due to huge contrast in wealth distribution. The natural tendency of all governments is to address this problem through subsidy and cross subsidy. Electricity and diesel are almost universally subsidized in the developing world. The rich car owners and industries pay much higher for their energy to provide cheap fuel and electricity for the ‘lifeline’ users. But does that change their life in the long run? Does price control help the poor for whom it has been designed? At the same time what is the economic and environmental cost?

The Cost of Subsidy

As mentioned at the beginning of this article, subsidy has not been very successful in achieving its objective – bringing economic parity in society. The practice of long-term subsidy creates a vicious cycle of wastage, inefficiency and downward economic trends. The energy subsidy affects both micro and macro economy.

The universal energy subsidy through price control is aimed at the rural poor as well as the urban poor. Unfortunately, these poor populations use very little commercial energy compared to the richer section of the society. The bulk of the savings is actually enjoyed by the rich. 

Does petroleum subsidy really help redistribute income? In most of the developing countries diesel is sold at a lower price than petrol although the international price of diesel is either same or sometime even higher than petrol. The reasoning behind controlling diesel price is mainly for public transport and irrigation. In developing countries trucks use 40 to 65 percent diesel whereas buses use less than 20 percent. Even in public transport, more and more luxury versions, which are used by the richer people, are replacing the standard services. Although trucks do carry perishable items, the bulk of products carried is manufactured goods, which are not used by the poor. Moreover, any price increase of diesel in a developing country, where monitoring and enforcement is poor, is used by transport businesses by raising fare disproportionately for both passenger and freight. Even farmers don’t get the appropriate benefit due to the role of middlemen business opportunists, who operate the irrigation pumps. The volume of the petroleum subsidy is perhaps enjoyed by not more than 20 percent of the population. Even for kerosene, which is mostly used by the poor, the urban/district users (less in number) receive larger share of the subsidy. Fuel adulteration is another major problem of kerosene – diesel price differential.

Petroleum subsidies also affect consumer and institutional behavior. Cheap fuel encourages excessive use, which is also detrimental to environment. To avail subsidy benefit, individuals choose inferior, inefficient and more polluting technology. Heavy diesel subsidy in India has shifted people to diesel driven cars against the general trends around the world. For smaller vehicles, petrol engine is more efficient and less polluting. Recent reduction in diesel subsidy has allowed the petrol-driven vehicles to penetrate the market in a big way. Subsidy of coal in India has also forced heavy industries to choose the most polluting and inefficient technology. 

There is no doubt that electricity connection improves the quality of life, increases the working hours, helps education, allows better entertainment. Subsidized electricity tariffs can never achieve the goal of electrification of every household in the developing countries. After years of such effort, real progress has been very slow and some of the systems have in fact shrunk due to lack of fund. In most countries, residential users are the most heavily subsidized consumers although the cost of supplying electricity to households is the maximum. Rural electric connection is the minimum in all developing countries and even then only the affluent persons in the villages actually take the connection. Once subsidized, it is very difficult to withdraw that or increase the price. People get used to cheap energy and the social resistance is very strong. In fact the resistance frequently comes from the rich and influential, who enjoy the benefit most. Because of lack of buying capacity, only a small portion of the vast majority of poor get the benefit of subsidy (price control) at the huge economic cost of the country.

In macro level subsidy, the price control results in excessive energy use, sometime outright wastage through inefficiency, accelerated resource depletion and large revenue loss for the government. Instead of labor-oriented low energy use, they also promote energy intensive industries. For a highly populated energy starved country, it does not add value to the economy. Subsidy diverts capital allocation to more energy intensive activities by the private sector leaving behind more productive activities. It also restrains government from spending money for more important sectors like health, education, infrastructure development etc that are definitely more important for economic growth. 

Is there any relationship between energy subsidy and economic growth? Countries like Korea, Japan, the Philippines in the early seventies had the highest energy price and yet their economic growth were at par with countries having subsidy. It means subsidy may redistribute wealth (not to the poor) but does not prompt any extra economic growth. Maintaining lower price of imported energy through price control hardly gives any competitive advantage to the local products in the international market. It rather creates large deficits for the government putting it in serious balance of payment problem and debt servicing obligations. Subsidizing indigenous energy resources may reduce import but at a very high price of revenue loss. 

Bangladesh Case

The price of gas in 1974 for both power and fertilizer was Tk 3.7/Mcf. The price of oil was $10.41/bbl and the dollar – taka exchange rate was taka 8.08. In terms of energy parity, 1000 cubic ft (1 Mcf) of gas is equivalent to 0.1765 bbl of oil. Using all these numbers it can be concluded that the price of gas in Bangladesh was about $0.46/Mcf for power sector and in terms of equivalent price for oil this was $1.83/Mcf. For generating electricity, the alternate or replacement fuel for gas is furnace oil or heating oil where no other fuel is available. Assuming the cost of furnace oil being 70% of crude price, the alternate fuel price is $1.28/Mcf - a net saving of over 170%. The following table gives these numbers for the subsequent years (Table: 2).

In the early seventies, gas became the focus of international oil companies due to sudden increase in oil price. Bangladesh started feeling the pain of increasing oil import bills and decided to switch fuel. Chittagong steel mill, re-rolling mills, several power plants started switching fuel from early eighties. By 1990, most of the power plants and other industries completely converted to gas in the eastern part of the country. When the use of gas during 1970-80 was only 0.3 tcf, it jumped to 1 tcf during 1980-90. Due to lack of vision and understanding of economics, Bangladesh lost the opportunity to raise the gas price to the level of price of the fuel it was replacing. Instead, it supplied it at 1/6 the of the replaced fuel price (1985 oil price is indeed the average for the decade). It definitely reduced the import bill but at what cost? Within a decade the generation efficiency plummeted to 25%, some of the fertilizer factories were using 1.5 to 2 times more gas than a more efficient newer plant, domestic sector was using gas for drying clothes and saving match sticks! The slide could not be checked even by doubling the real price of gas in 1990 from the 1985 rate. By looking at the table, it can be seen that the gas price has remained virtually constant since 1990 in nominal dollar term. The average generation efficiency has now increased to 30% due to the introduction of 800 MW of combined cycle (50% efficiency) IPP power plants. 

The case of gas price for electricity generation was picked up because that sector is most heavily subsidized and the highest user (about 50%) in Bangladesh. Despite the system loss (pilferage and technical), the subsidy in electricity tariff along with the gas subsidy did not allow to save any money for even maintaining a reasonable service, let alone adding new generation. Gas is not a tradable commodity yet. Unlike oil, the local price is not dictated by international price. Although with the rapid development of LNG, gas is going to be traded perhaps within next five year. The gas price is typically determined by its opportunity cost. The four most common ways of determining local gas price is by a) cost of service b) border price c) long run marginal cost (LRMC) and d) alternate fuel cost. The cost based pricing includes the actual cost of providing the service (exploration, development and production, transmission and distribution) and a reasonable profit so that the companies can reinvest for future service and expansion. This is based on financial analysis. Because gas is not traded internationally, the ‘border’ price of export is another way of finding its true economic value. LRMC is the cost of supplying a unit of energy (i.e.1 Mcf of gas) if the consumption is sustained indefinitely in the future. The alternate fuel approach has already been discussed. 

With a 15% return on investment, today the true average cost of gas in Bangladesh is about $1.60/Mcf (source: Petrobangla). The ‘true’ has been added because of the presence of ‘old’ gas price in our system. The five major gas producing fields in Bangladesh were obtained for only $10 million in 1974 from Shell Pakistan which was almost free. If the calculation for the cost of gas includes this free gas then the whole analysis gets distorted. The IOC gas cost us $2.4 - $2.9/Mcf. The border price of gas is perhaps about $4/Mcf now. The LRMC is estimated at $2.0 and the alternate fuel is no less than $6/Mcf. The present weighted average selling price of gas is $1.40/Mcf. Most conservatively we are realizing only 70% of the minimum opportunity cost and 23% of the maximum opportunity cost. This is taking a major toll on Petrobangla. The big question is how Petrobangla is surviving, especially after paying 55% of its total revenue as tax and duty. In addition, it has to pay the taxes of IOCs. They have survived so far because of this so-called free ‘old’ gas. In 2005-06, IOCs supplied 31% of our gas and in the current year they are expected to supply 34%. The new gas is not cheap and those who think that Petrobangla would be or were able to find cheap gas require a reality check. The expected deficit for IOC payment this year would be almost $200 million at the current gas selling price. People keep talking about BAPEX being handicapped due to lack of funding but do not realize that under the present pricing framework they are only paid about $0.1/Mcf as the wellhead price (based on old free gas) whereas the actual E&P (wellhead) cost is at least $0.3/Mcf. Unless the gas subsidy is reduced or withdrawn, no local company will be able to explore and find new gas. 

Presently we are going through another historic mistake of energy subsidy. The CNG feed gas is being sold at $1/Mcf (Tk. 8.5/CM). One cubic meter of gas is roughly equivalent to one liter of octane. The octane price is Tk. 67 per liter now. The savings in fuel is 88% for a CNG driven vehicle. The increase in petrol/octane price has served its purpose of reducing gasoline import bill. A major recent thrust in CNG conversion has reduced the gasoline use by almost 40%. The cross subsidy for diesel/kerosene by gasoline is about Tk 15-17 per liter. So the government revenue has reduced from reduced gasoline sale but the subsidy to diesel/kerosene remains the same. This has also created long lines in front of the CNG stations. Most alarmingly, an immeasurable number of diesel vehicles are being converted to CNG everyday. The reason is very simple, even diesel vehicles save 79% on fuel cost. Alarming, because despite saving in foreign currency and subsidy, the government is losing huge revenue and by keeping low CNG price it is discouraging private business participation. The present margin for CNG station owners is not lucrative enough to reduce the congestion at the stations. On average, the payout time for the Tk. 50,000 conversion cost for a petrol vehicle is less than six months and the one lakh needed for a diesel vehicle (trucks or SUVs) is realized in a year. The whole philosophy of raising gasoline price is completely defeated here. The richest segment of the society is being supplied free (almost) fuel for their vehicle! As of December 25, 2005 the price advantage of CNG over other fuel in some select Asian countries is given in the table: 3.

Source: Asian NGV

Both Pakistan and India have 67% saving and to attain that, the price of CNG feed gas has to be Tk. 19/CM and even for a 75% saving the price has to be increased to Tk. 15/CM. The additional money will boost government revenue but the margin for the operators has to be increased as well to make it a more attractive business. This will resolve the scarcity of CNG stations in the country. Apart from subsidizing the rich car owners the low price of CNG gas is not helping the poor at all because all CNG-driven bus owners are not charging lower fare on the pretext of other issues. CNG price must be tagged to octane price as a percentage of savings. CNG is going to replace all road transport fuel in next five year in a big way. The recent situation when three diesel-laden ships were waiting to unload because of insufficient storage is a sign of the future. If appropriate pricing formula is not adopted now, the country will have to pay a high price for its mistake like the past.

The fuel subsidy for kerosene and diesel has been a much talked about issue in recent time. The cumulative debt of BPC was 7000 crore taka over the last few years. This year the government has kept a onetime bailout allocation in the budget of the same amount for making BPC debt-free. This will give them a fresh start. BPC incurred more than 2000 crore taka loss in 2005-06 financial year due to high oil price. At the same time they paid about 2200 crore taka tax to the government. So basically the government forces BPC to borrow money from public bank and other sources to support its subsidy program without losing its own revenue. The one time bailout may not cure BPC if the cause of the problem is not addressed. When fuel cost is only about 20% of long distance bus and truck fare, a 25% increase in fuel price should increase the fare by only 5%. Between 2005 and 2007, the luxury bus fare was increased by 40% (Dhaka – Chittagong fare was raised from Tk 500 to Tk 700) for a cumulative 25% fuel price increase during the same period. Even including inflation and other factors, this kind of behavior by transport sector is unacceptable. Sixty percent of the diesel is used by road transport sector and the disproportionate fare increase for fuel price increase is rampant. The excuse of diesel subsidy is agriculture but only 20% of diesel is used for irrigation during the dry season (about 4 months). The wrong people are again getting the benefit of the subsidy. In whatever way the subsidy is financed, it creates tremendous pressure on government development plan. Equal or more important issues like health, education, infrastructural development suffer from lack of funding. As a result, the objective of energy subsidy is never realized. The poor remain poor and the wealth gets redistributed among some minority urban rich.

A few words must be said about electricity subsidy as well. The main subsidy for electricity comes from gas price. With 1 dollar gas, any new producer can supply power at Tk. 2.5/kWhr or less. With average generation efficiency of only 25%, PDB’s production cost is much higher. On the other hand the production cost of Khulna barge mounted power plant (furnace oil based) went up to as high as Tk.17/kWhr during a certain time in 2006. If the power pilferage can be plugged and the technical glitches in transmission and distribution systems can be removed, the present tariff can be maintained even with a $2/Mcf gas. According to Bangladesh Bureau of Statistics survey in 2000, only 19% of rural household have electricity connection and with 80% urban connection the national average is 31%. That may have gone up little bit now but the rural urban ratio has not changed. From these data one thing becomes clear – the poor are receiving only a fraction of the benefit of electricity subsidy. 

Price Control, Subsidy & Energy Security

The most expensive energy is no energy. In almost every instance, price control has created shortage, rewarded wastage, and sometime promoted environmental damage. Very recently, Bangladesh faced diesel crisis. Hundreds of farmers were looking for diesel even at Tk. 40/liter when the regulated price was only Tk. 30/liter. A massive bailout by government through public borrowing saved the country from a major supply disruption. 

Short-term subsidies are easy to formulate and also easy to withdraw. If the country has a long history of subsidy, it is very difficult to phase it out. Strong resistance from the civil society, trade unions are put up to protect the poor. It requires tremendous political will to take tough decision that results adverse short-term effect. The so called ‘price shock’ due to energy subsidy withdrawal is very much like going ‘cold turkey’ to quit smoking. The sweating and suffering is really bad in the short run but very good for the long haul. The people who get used to cheap energy cannot be blamed when the react violently to major energy price increase. If the goal of price control is to help the families who cannot afford the market price of energy, the help should be provided directly, effectively and for a specified time period. Any universal subsidy program is not sustainable.

Many countries have successfully managed to phase out subsidies by targeted compensation. Sri Lanka in 1979 tripled kerosene price by introducing a kerosene-stamp program that allowed low-income households to receive 6 liter free kerosene per month. The quota was not increased during subsequent increase in demand although the overall consumption decreased by 25%. The financial gain was far more than the administrative cost of identifying the families and supplying the quota. Vouchers or cash compensation is another way of helping the targeted section and removing overall subsidy. The difficulty is in identifying the targeted group. The first task is to define them clearly that may actually turn to be the most difficult job for Bangladesh. Does the government really know the people who are getting the benefit of the present subsidies in the country? Whom they really want to target? Once this is done, a method can be devised to help them directly. If a decision is made, energy related questions could be included in the census or during the enlistment of voters. Once the database is complete, implementing any policy would not be that difficult. 

Apart from targeted compensation, another way of removing subsidy is transparent rate making through public awareness campaign. If consumers understand every aspect of the cost involved in a product, they are more likely to accept the changes as long as it is clear and rational. Public trust in a political government is the key of success for such approach.

In a mixed economy like Bangladesh, energy price perhaps cannot be left at the mercy of market only at this stage. The parity with market price has to be brought in gradually. Phased removal of subsidy, allowing price variation within an adjustable range related to benchmark price (until market price can be introduced) and introduction of a powerful and competent regulator have the best chance of ensuring energy security in Bangladesh.