BULLS AND HORNS: DEALING WITH FUEL SUBSIDIES
Economy

As the Government is in talks with the International Monetary Fund (IMF) to get a bailout package, it is a no-brainer that instituting fiscal reforms is part of the discussion. What immediately comes to mind are fuel subsidies, which have long been a major source of fiscal imbalances. And the latest Monetary Policy Committee statement issued yesterday by the Bank of Zambia points to this. The Hon. Minister of Finance, Situmbeko Musokotwane indicated, in the 2022 Budget Speech, the Government’s resolve to deal with fuel and other subsidies.

Shebo Nalishebo – Economic Statistician

“Madam Speaker, Government cannot afford to keep on accumulating arrears in the manner we have been doing. We must address the causes of these arrears whether it is subsidies or giving out contracts when Government knows it has no money to pay”, stated Hon. Musokotwane in Parliament.

Generally, consumers pay less than the market price for petroleum products. The Government pays the difference between the landed cost of petroleum products and the pump price. That’s considered a subsidy.

Fuel subsidies arose from the failure to systematically adjust retail prices in line with the price adjustment model. The Energy Regulation Board employs a cost-plus pricing (CPP) model. The CPP model, which has been in effect since January 2008, operates on the principle that the final local currency price of petroleum products should cover all costs in the supply chain plus a fair profit margin. The model involves two stages in the price build-up—wholesale and retail—each covering different costs incurred in the supply chain. As the margins at the different stages of the price build-up are largely fixed, changes in the overall cost are mainly determined by two variables: the international oil price and the exchange rate of the Zambian kwacha.

The last time the Energy Regulation Board made price adjustments was in December 2019. In December 2019, Brent crude price averaged $67 per barrel, while in October 2021, the average price of one barrel of Brent crude oil was $83 – a 24 per cent increase. The Kwacha depreciated from K14.38/US$ in December 2019 to K22.58/US$ in June 2021, a depreciation of 57 per cent, before appreciating to K16.99/US$ by the end-October 2021. Despite these fluctuations in the international oil prices and the exchange rate, the Government has maintained the same prices of fuel since December 2019. Additionally, at the beginning of 2021, the Government reduced excise duties on fuel while VAT for diesel and petrol was zero-rated.

The limited implementation of the price adjustment mechanism implies that the Government has been absorbing these costs. In the first 8 months of 2021, the Government spent in excess of K10 billion to partially clear fuel arrears. In his Budget Speech, the Minister of Finance informed us that the stock of fuel arrears as at end-August 2021 stood at US$477.79 million. Therefore, reducing their burden on the budget seems to be a sensible approach.

Clearly, fuel subsidies are wasteful and eat up budgets. They have compromised the Government’s ability to provide social services such as health and education. These subsidies are largely financed through borrowing which affects many aspects of the economy. Increased borrowing threatens public investments – as more government resources are diverted to interest payments, there will be less available to invest in areas that are important for economic growth. It also affects private investments since government borrowing competes for funds in the money and capital markets thereby raising the cost of borrowing for businesses and households.

The fuel subsidy is also poorly targeted as the intended beneficiaries hardly benefit from it. Most of the benefits go to the middle- and high-income groups of the population – 92 per cent of the subsidy is received by the wealthiest 10 per cent of the population, while the poorest families get less than one per cent.

Given that Zambia imports all its petroleum products, the huge import bill puts a lot of pressure on our foreign exchange.
Despite these shortcomings, the Government has long been reluctant to scrap these subsidies. After all, if the government stops underwriting the cost of fuel, pump prices will rise. Due to the price transmission mechanisms, it would lead to a general increase in costs of goods and services and make people upset, very upset. Businesses will not take this kindly either, with the hardest hit being the mines that consume over 50 per cent of petroleum products.

But financing these subsidies is no longer sustainable. The issue is no longer about whether to remove them but when and how to do it. The time for the Government to take the bull by its horns, confront and scrap these subsidies is now. The savings resulting from the fuel subsidy removal should be used to mitigate the adverse effects of a possible fuel price hike. In fact, the Government has already set the groundwork for cushioning the removal of the subsidies. Five such measures immediately come to mind:

1. The increase in the allocations to social protection programmes with demonstrated impacts such as the Social Cash Transfer programme has the potential to build resilience and minimize the impact of the increased energy prices on recipient households. However, this is contingent on improving budget execution and supplementing the already existing social welfare systems.

2. The enhanced Constituency Development Fund which allocates one-fifth of the CDF to empowerment programmes not only reprioritizes spending towards the needy at the community level but also helps to address the issue of fragmentation of social inclusion programmes.

3. The planned dismantling of pension arrears for public service workers will help to safeguard the livelihoods of a key vulnerable constituency – retirees.

4. Commitments to provide free education and increasing the exempt threshold for Pay As You Earn will result in savings for households whose children are enrolled in public schools and the 1 million formally employed population.

5. Plans to recruit 30,000 teachers and 11, 200 health workers, will not only add to the 300,000-strong civil service but will also alleviate the problems of unemployment for a key segment of the population – the young people.

The keys short-term conditions for the success of the subsidy removal reforms are (i) a clear and effective communication strategy, (ii) letting the automatic price adjustment mechanism work, (iii) timely implementation of the mitigating measures, and (iv) improving efficiencies in the fuel supply chain.

• A clear and effective communication strategy will help to address politically-charged sentiments that could undermine progress. The Government has to show transparency by showing (i) how much has been saved from the removal of subsidies; and, more importantly, (ii) where the savings have been reallocated.

• Automatic price adjustment mechanism . With regular and automatic adjustments based on the movement of international petroleum prices and the exchange rate, fuel pump prices will be adjusted to full cost-recovery levels thus not requiring the government to subsidize prices. The savings will then be used to support the mitigating measures of the price hikes.

• Importantly, the implementation of the aforementioned mitigating measures which are already outlined in the 2022 Budget should be timely, preferably within the first quarter of 2022 .

• Going forward, reforms are inevitable to try and make fuel cheaper. The Government should address cost inefficiencies in the fuel supply chain emanating from the non-standardisation of suppliers’ contract prices, high transportation and operational costs for Zambia’s only refinery – INDENI.

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