Opinion | The High Cost of Cheap Energy: Russia’s Fossil-Fuel Subsidies Undermine Sustainable Development

11 July 2011

Russia provides some of the largest subsidies for fossil-fuels in the world. The International Energy Agency (IEA) estimated that Russian subsidies for the consumption of fossil-fuels totalled almost US$34 billion in 2009. Russia is not alone in reducing the prices of fuels for its citizens. The IEA estimated that in 2009 global consumer subsidies for fossil fuels totalled US$312 billion (see graph). These estimates do not include subsidies to fossil-fuel producers, which may be another US$100 billion per year globally.

Russia's fossil fuel subsidies are concentrated around natural gas and electricity (most of which is produced from gas) as consumer prices for oil products and coal have not been subsidised since the 1990s. Russia is the world's largest producer of natural gas, the largest exporter and the biggest reserve holder. After the United States, China, and Japan, Russia is the world's fourth largest electricity producer. Both gas and electricity are sold within Russia at average prices that are well below international market prices. This "price gap" between domestic and international prices was estimated to be approximately US$19 billion for gas and US$15 billion for electricity in 2009: equivalent to US$238 per person and 2.7 percent of GDP, according to IEA estimates. Fossil-fuel consumption was subsidised at an average rate of 23 percent, meaning that consumers paid 77 percent of the full economic cost of energy prices.

This sounds like good news for the Russian people, especially poorer households. But appearances can be deceptive. Energy subsidies actually hold back economic development and are not an effective way to help the poor, not to mention the adverse environmental impacts.

Looking at the social impacts first, studies have found that energy subsidies tend to disproportionately benefit the middle-class and rich. This is because energy subsidies are not usually income tested but provided per unit of energy consumed. There is a strong correlation between wealth and energy consumption. Therefore those consuming more energy receive more of the benefits. A more effective way to help the poor would be to sell energy at market prices and use the revenue (US$34 billion in the case of Russia in 2009) to provide direct assistance to those most in need. This could be delivered through the social safety net as cash payments or through increased spending on social services such as health, education and housing.

From an economic perspective, subsidies artificially reduce prices thus encouraging higher consumption and discouraging investment in new energy infrastructure and efficiency measures. Russia scores poorly compared with other countries in converting its energy resources into economic growth. For example, Russian gas consumption per capita is similar to Canada but consumption per unit of GDP is roughly five times higher than IEA countries. The inefficient use of energy hastens resource depletion and reduces the amount of energy available for export, thereby reducing government revenues available for social programs and infrastructure.

Low prices have also meant that there has been little incentive for energy suppliers to invest in new production or distribution infrastructure, due to the prospect of low financial returns. As a result, Solanko finds that Russian communities have suffered from electricity shortages and there have been large energy losses from an unreliable and inefficient electricity grid. In the gas sector, under-investment has hindered the development of new gas production and distribution infrastructure such as pipelines and transportation, which has put a break on economic development.

The other logical consequence of higher consumption is greater greenhouse-gas emissions and local air pollution. The IEA estimates that phasing out global consumption subsidies for fossil fuels between 2011 and 2020 could cut global CO2 emissions by 5.8 percent compared with a "business as usual" scenario. The OECD estimates that emissions reductions could be as high as 10 percent by 2050 if the same subsidies for fossil-fuel consumption are removed by 2020. Eliminating fossil-fuel subsidies provides a way for countries like Russia to make a major contribution to greenhouse gas reduction without introducing carbon taxes or an emissions trading system.

Subsidies also undermine the incentive to invest in existing cleaner energy sources and technologies by artificially reducing the consumer price for fossil-fuel products. In the same way, energy subsidies discourage innovation in the production and deployment of cleaner types of energy, such as renewables.

The Government of Russia recognises these negative impacts of subsidies and has embarked on a program of bringing gas and electricity prices up to market levels. Gas prices are being gradually increased towards the prices charged to European importers (minus export taxes and transport costs). This process is due to be completed in 2014. According to Solenko, from January 2011, all electricity purchased from the wholesale market for industrial purposes will be at market prices.

But the liberalisation program is far from comprehensive. Household electricity will continue to be cross-subsidised by industry until at least 2014 (Solenko, 2011). Household consumption is 10 percent to 15 percent of total electricity consumption. There also remains significant government ownership in the gas and electricity sector. Gazprom, a state-controlled company, accounts for over 60 percent of Russian reserves and almost 85 percent of Russian production, according to Simmons and Murray. Gazprom owns the Russian gas pipeline system and has a legal monopoly on gas exports. The state is also a major owner of power generation. Three state-owned companies control over one third of power generation capacities. If pricing from state-controlled Gazprom assets are also taken into consideration, Solenko estimates that over half of the electricity generation in Russia remains state-controlled.

Continuing government ownership and control over energy resources may prevent competition and under-pricing could contribute to on-going inefficiency and under-investment. The chief economist of Fortum, a Finnish company with significant investments in power generation and district heating in Russia, commented that subsidies for heating and household electricity remained an impediment to the operation of efficient markets in Russia.

While eliminating gas and electricity subsidies will clearly deliver economic and environmental benefits, it remains true that poorer households will find it difficult to cope with the higher prices. In a survey conducted in 2006, 57 percent of respondents in Russia indicated that higher utility bills had had a significant impact on their lives. For households that depend on subsidies to make energy affordable, energy price rises and possible inflation can put poor households under severe financial stress.

But subsidy reform can be designed and implemented in a way that minimises the negative impacts for poor households. A suite of policies have been used by countries around the world to ease the transition away from energy subsidies. The government can use the revenue gained from subsidies (that are mostly harnessed by the middle class and rich) to those vulnerable to energy poverty. As discussed earlier, this can be delivered through the tax system, social payments, cash transfers, or increased social spending.

The way in which subsidies are eliminated can also ease the transition to market prices and build public support for reform. Best practice includes a clear communications campaign to articulate the benefits of reform, stakeholder consultation, transparency about energy prices, a gradual phase-out of subsidies, and monitoring of the impacts of implementation with adjustments if necessary.

Energy subsidies have played an important role in Russia's past as a way to make energy affordable for industrial and residential consumers. But subsidies are a blunt instrument for delivering support and they cause market distortions that-ironically-lead to energy shortages and waste. Greater efficiency in the sector will help Russia maximise its economic gain from its vast energy resources, so long as policies are in place to ease the transition away from subsidies particularly programs to help those vulnerable to higher energy prices.

Tara Laan is an associate of the Global Subsidies Initiative at the International Institute for Sustainable Development (IISD).This article was first published in Russian in Mosty.

IEA. (2010). World Energy Outlook 2010. OECD/IEA: Paris.

Global Subsidies Initiative, 2009. Achieving the G-20 Call to Phase Out Subsidies to Fossil Fuels. Policy Brief, October, International Institute for Sustainable Development, Geneva

ASIA PACIFIC ENERGY RESEARCH CENTRE, (2003). APEC Energy Overview: Russia.

Simmons, D. and I. Murray. (2007) Russian Gas: Will There Be Enough Investment?  Russian Analytical Digest. Issue 27/07 pp. 2-5.

Solanko, L. (2010). How to proceed with at 1000 twh reform: restructuring the Russian power sector. The Finish Institute of International Affairs.

For example, see: International Monetary Fund. (2008). Fuel and Food Price Subsidies: Issues and Reform Options. Washington: The IMF.

Russia's energy intensity was 0.3 tonnes of energy per US$1000 of GDP in 2008, 72% higher than the global average (IEA, 2010).

Simmons, D. and I. Murray. (2007) Russian Gas: Will There Be Enough Investment?  Russian Analytical Digest. Issue 27/07 pp. 2-5.

IEA, OECD, OPEC and World Bank. (2010).  Analysis of the scope of energy subsidies and suggestions for the G-20 initiative. Joint report for the prepared for submission to the G-20 Summit Meeting Toronto (Canada), 26-27 June 2010.

IEA. (2011). Are we entering the golden age of gas? Special report. World Energy Outlook 2011. Paris: International Energy Agency.

Ollus, S-E. (2011). Russian electricity sector reform: status and success so far - some thoughts from one player in the market. Chief Economist, Fortum Corporation, speaking at the Finish Institute of International Affairs seminar "Russian Energy Sector Reform", 18 January 201. Helsinki: Finnish Institute of International Affairs.

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