Incentivising change: GCC member states are pushing forward with subsidy and price reforms for fuel and utilities

The drop in global energy prices from mid-2014 has had a significant impact on the member states of the GCC, which together produce 20% of the world’s crude oil. Hydrocarbons are the basis for the region’s economies, and the drop in oil revenues has driven all six GCC nations into budget deficits. While the large reserves built up during the years of high crude prices have helped cushion the fall and cover budgetary shortfalls, it has become increasingly apparent that the current fiscal systems are unsustainable in the long term and are in need of reform.

Time For Change

One of the most immediate and important changes catalysed by the falling oil price is subsidy and price reform. Economists and international agencies have long seen the region’s low fuel and electricity prices in particular as unsustainable. Some GCC governments have long planned to reform subsidies and incrementally increase costs for products such as petroleum, and in some cases limited price rises had already been implemented. However, broader reform across the region was delayed for several reasons, such as political sensitivity, particularly during and after the Arab Spring. In addition, low energy prices benefitted domestic manufacturing industries, which have been central to long-term economic diversification and government revenues, meaning that reform did not seem a pressing priority when hydrocarbons prices were high.

As the UK think tank Chatham House said in a 2016 report on price reform in the GCC, “State-controlled prices are one way of protecting national living standards, sharing national hydrocarbons wealth and incentivising industrial growth and investment.” As Chatham House notes, several GCC member states had implemented piecemeal reforms prior to the recent oil price slump. The UAE has occasionally increased transport fuel prices since the 1990s, while in 2007 Bahrain started raising natural gas prices with the aim of reaching cost price by 2021. Oman and Saudi Arabia, meanwhile, piloted new pricing regimes on industrial electricity use, aiming to manage usage at peak times and lower the subsidies bill.

Manifold Benefits

While the challenges presented by pricing reform are significant, the benefits have become ever clearer. First, easing subsidies and raising revenue earned through fuel and utilities sales will ease the current pressure on budgets. Such moves will also lower deficits and, over the longer term, free more money for investment in other priority areas, such as education, health care and the development of new economic sectors. Lower deficits and future surpluses also reduce the need for GCC countries to dip into their sovereign wealth funds, which are meant to be long-term investment vehicles rather than pools of cash that fund government spending.

Second, reducing the use of hydrocarbons – and in some cases water and other limited resources – domestically via pricing mechanisms has a range of benefits, not least of which make more resources available for export or use in key industries, in addition to lowering the rate at which reserves are depleted. The longer GCC nations can make their resources last, the better, particularly as some, such as Oman, face rising investment costs to access new reservoirs of oil. There are also environmental benefits to reducing the use of hydrocarbons. All six GCC member states are in the top-10 per capita emitters of carbon dioxide, according to the World Resources Institute. International pressure is growing on these countries to cut carbon emissions, and all six have committed to improving their environmental performance.

Another benefit of price reform is that subsidies, while desirable in some cases, distort market incentives. By incrementally increasing the costs of fuel and power, governments can encourage efficiency gains in businesses and more prudent use by citizens. Lastly, raising the cost of fossil fuels can provide funds for and incentivise greater investment in alternative energy sources, particularly solar power. Consumption of hydrocarbons and hydrocarbon-derived electricity has been rising strongly in the GCC despite a post-crisis slowdown due to population growth, industrialisation and increased use of automobiles and aeroplanes. While the need for reform has grown, the lower oil price also provides governments with a chance to move retail prices towards market levels without vastly increasing them.

Kuwait Moves

In August 2016 Kuwait became the latest GCC nation to raise petrol prices as part of a package of reforms aimed at relieving pressure on the budget. The hikes were significant in proportional terms, but petrol remains highly affordable by global standards, particularly given Kuwaitis’ strong purchasing power. The price rises came into force on September 1, 2016 and increased the cost of low-octane fuel by 41% to 85 fils ($2.81) per litre, and high-grade petrol by 61% to 105 fils per litre ($3.47). The price of ultra premium petrol – the least damaging to the environment – rose by 83% to 165 fils ($5.46).

The government said it selected the new prices after examining “global rates” following a review established in early 2015, adding that a commission would review petrol costs every three months, keeping them “in harmony with global rates”. Nonetheless, Kuwait still has among the lowest fuel prices in the world. The first increase in petrol prices in Kuwait for nearly two decades came as the country faced a budget deficit of $29bn in FY 2016/17, up from $18.3bn in the previous fiscal period. The move came months after parliament approved contentious measures to raise electricity and water prices for apartments and commercial properties for the first time in nearly five decades.

Electricity prices for apartments will rise from 2 fils ($0.07) per KWh to 5 fils ($0.17) for the first 1000 KWh, 10 fils ($0.33) for 1000-2000 KWh and 15 fils ($0.50) for over 2000 KWh. Most apartments are used by expatriates, and at the time of writing it was not clear whether the rises would apply to Kuwaitis living in apartment buildings. Given that the limited increases were met with considerable opposition in parliament, it is clear how sensitive the issues of utility prices are. However, Ahmad Al Jassar, Kuwait’s minister of electricity and water, underlined how pressing reform was becoming, saying that the government was paying $8.8bn a year to subsidise power and water, a bill that could swell to $25bn by 2035 without price adjustments. Conversely, the measures being imposed are expected to cut consumption by 30% and increase revenues.

Seal Of Approval

Kuwait had faced a degree of criticism for lagging behind some of its neighbours in price deregulation, particularly following a stalled effort in early 2015. However, the World Bank has described the recent changes as “politically and economically bold”. The bank sees the establishment of an automatic pricing mechanism as the first stage in the transition to a fully-liberalised pricing and supply regime. The World Bank also noted that the transport sector is generally less responsive to fuel price fluctuations than other areas of the economy, and that vehicle usage might not be greatly reduced initially. However, combined with Kuwait’s efforts to improve public transport, there could be a longer-term slowdown in petrol consumption.

Long-Term Savings

Kuwait’s reforms followed similar changes enacted in other GCC countries in 2015 and 2016. In August 2015 the UAE announced a new pricing system, shifting from fixed, subsidised domestic prices for petrol and diesel to monthly adjustments based on global market benchmarks. The first move saw the price of petrol rise by 24%, while diesel fell by 29%, and was welcomed by the IMF, which has encouraged GCC nations to pare back their subsidy regimes to relieve budgetary pressure. The IMF estimated that prior to the reform petrol subsidies were costing the country $7bn a year, a substantial proportion of energy subsidies totalling $29bn, or 6.6% of gross domestic product. The UAE Ministry of Energy estimates that transport accounts for 22% of the country’s total greenhouse gas emissions.

The UAE’s reforms have been praised by the IMF, which said that initial benefits in 2015 would be modest but significant, with savings of $500m. An IMF official also told the international press that the reform of petroleum prices could pave the way for similar changes to natural gas subsidies, which cost the UAE approximately 3% of its GDP annually.

The UAE was one of the first GCC countries to implement new pricing regimes on petroleum in the recent wave of restructuring, and in January 2016, Saudi Arabia followed suit as it hiked retail petrol prices by 50%. Having run a deficit of around $100bn in 2015, the IMF warned that the Kingdom could drain its coffers in just a few years without reforms. Also in January 2016, Oman, which has one of the higher breakeven oil prices in the region, deregulated petrol prices to cushion the effect of lower crude revenues. This has allowed fuel prices to rise, buoying the incomes of the country’s three petroleum marketing companies, including one part-owned by Royal Dutch Shell. In the same month Qatar raised petrol prices by more than 30% depending on the type of fuel. This was followed in May by a new regime similar to that of the UAE, with prices set every month and determined by regional and global prices, as well as domestic production and distribution costs.

Gas Pricing

While not as immediately politically sensitive as petrol, natural gas prices are also a challenging issue in the GCC given the heavy use by industries that are central to the member states’ strategies of diversification and increasing value added using resources as inputs to manufacturing rather than merely exporting crude or part-refined products.

Bahrain has continued to raise domestic gas prices following its 2007 decision to move them towards market levels. Oman doubled its domestic price in 2015, and Saudi Arabia did the same in January 2016. The Kingdom also separated the cost of sales gas (mostly methane), which is largely used in the power generation sector, from that of ethane, which is used in various industries, including petrochemicals, and the price of which initially rose by 133%. After discussions with industry, the Saudi government opted for fixed pricing with revisions rather than variable market-based pricing that would lead to greater uncertainty for consumers. Nonetheless, the increases came as a surprise; Saudi Arabia has had the region’s cheapest gas for some time, at $0.75 per million British thermal units, according to Chatham House.

Rises in industrial gas prices have not been universally popular. Omani cement and ceramics producers have been among those reporting lower pre-tax profits, and the UAE’s steel industry is particularly wary of cost increases given the sagging global market for its output. Nonetheless, with many major manufacturers in the GCC being state-owned, governments maintain the ability to absorb rising costs for major industries.