Research & Policy Briefs From the World Bank Malaysia Hub No. 58 November 17, 2022 The Road Not Taken? Responding to the Energy Price Shock in East Asia Hector Pollitt, Ergys Islamaj, Rahul Kitchlu, Duong Trung Le, and Aaditya Mattoo Several countries in East Asia have increased fossil fuel subsidies to keep consumer prices lower than currently high international prices. These subsidies are discouraging the shift in consumption away from fossil fuels, while high prices are encouraging investment in new fossil fuel infrastructure. Providing income transfers instead of price subsidies would encourage consumption of cleaner alternatives, while softening the welfare loss. And subsidizing investment in renewables would avert the risk of being locked in to fossil fuels. The total cost need not be higher than that of fossil fuel subsidies. The Effects of Higher Energy Prices on Consumers, policy responses that aim to ease the burden of higher energy Producers, and Climate Change prices without inducing structural change. Possible outcomes for consumers, electricity providers, and fossil fuel extraction In the face of increased energy prices, East Asian countries are companies are explored below. struggling to meet the triple goals of energy affordability, security, and sustainability. First, the increase is hurting both Status Quo Policy Response: Energy Subsidies for Consumers consumers (because energy for cooling, heating, and transport is important for household welfare) and producers (because The political imperative today is to prioritize affordability. energy makes an outsized contribution to production in all Governments are trying to ease the economic burden of higher sectors of the economy). Second, the Russian invasion of energy prices in different ways. Some governments, notably in Ukraine and the resulting sanctions are threatening the Indonesia, Malaysia, and Thailand, are keeping prices low by security of energy supplies (because of the increased likelihood subsidizing the cost of energy—though Indonesia recently of disruptions in energy production and trade). Finally, higher allowed an increase in prices. Others, such as Singapore, are fuel prices are affecting greenhouse gas emissions (because of letting prices rise but are providing targeted support to their impact on energy demand and supply). Higher energy low-income households. prices reduce energy consumption (although short-term responses in terms of energy demand are typically low), but The temporary crisis measures to keep prices low run may also spur further investments to boost fossil fuel supply. counter to the efforts in major East Asian countries in the last few years to reduce fuel subsidies. Despite previous efforts, The Status Quo Response China and Indonesia have provided among the largest amounts of fossil fuel subsidies, though the share of subsidies in their Status quo responses reflect either current policy inaction or GDP is relatively low (figure 1, panel a). Fuel subsidies grew in Figure 1. Regional fossil fuel subsidies are large in absolute terms and have recently increased a. Fossil fuel subsidies in top-10 countries around the world b. Fuel subsidies in East Asian countries US$billion Oil % of GDP Electricity Percent of GDP Gas China Indonesia 35 Total subsidies as % GDP (right scale) 8 6.5 Malaysia Philippines 30 7 Thailand Vietnam 25 6 3.0 5 20 2.5 4 15 3 10 2.0 2 5 1 1.5 0 0 Iran India Algeria Egypt, Arab Rep. Indonesia Saudi Arabia Venezuela, RB United Arab Emirates China Russian Federation 1.0 0.5 0.0 2015 2016 2017 2018 2019 2020 2021 2022 Source: Haver Analytics; Institute of International Finance; International Energy Agency (IEA). Note: Panel a plots the value of fossil-fuel subsidies by fuel types in the top-10 countries in 2020, based on estimates from the IEA. Panel b uses International Monetary Fund (IMF) data for 2015–21 and World Bank staff estimates for 2022. Affiliations: Ergys Islamaj, Duong Trung Le, and Aaditya Mattoo, EAP Chief Economist Office, World Bank; Rahul Kitchlu, Climate Change Group, World Bank; Hector Pollitt, MTIEAP, World Bank. Acknowledgements: We are grateful for comments from Manuela V. Ferro, Daisuke Fukuzawa, Andrew Mason, Chiara Odetta Rogate, and Ekaterine T. Vashakmadze. Femke Nijsse provided assistance with data. Nancy Morrison provided editorial assistance. Objective and disclaimer: Research & Policy Briefs synthetize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. The Road Not Taken? Responding to the Energy Price Shock in East Asia most countries during 2022, including in Indonesia, which had Figure 2. Increases in energy costs could make green significantly reduced them earlier (figure 1, panel b). technologies more economically viable Keeping prices low through fuel subsidies provides relief to USD/kWh Solar photovoltaic all consumers, including households, firms, and farms. Though Onshore wind these policy measures may be the only immediately feasible 0.4 Offshore wind ones, they have economic costs even when they are temporary. Concentrating solar power They distort consumer choices and inhibit switching of consumption to cleaner alternatives; may help the rich and 0.3 large firms more than the poor and small and medium enterprises (SMEs); and divert taxpayers’ money away from 0.2 expenditure on infrastructure, education, and health. Fossil fuel If energy prices remain high, governments will find it 0.1 costs range difficult to maintain energy subsidies. These subsidies can place a substantial burden on public finances. For example, 0 Thailand’s State Oil Fund, which aims to stabilize domestic 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 prices, was reported to be more than $3 billion in deficit in August 2022 (CNA 2022). The subsidies will impose a welfare cost by distorting patterns of consumption and encouraging Source: International Renewable Energy Agency (IRENA) Renewable Cost Database. use of fossil fuels beyond their international market prices. Note: The figure plots the global weighted average levelized cost of energy, adopting a real weighted average cost of capital (WACC) of 7.5 percent for Previous energy subsidies have left countries in the region member countries of the Organisation of Economic Cooperation and Development (OECD) and China, and 10 percent for the rest of the world. The exposed to currently high fuel prices. These subsidies have led shaded band represents the cost range for fossil fuel-fired power generation. not only to higher volumes of energy imports but also to USD/kWh = US dollars per kilowatt hour. business models and consumer choices (such as on cars) that rely on low prices for their viability. New subsidies could to renewables even with persistently higher-cost fossil fuels. If exacerbate the problem and increase the risk of exposure to inflation leads to higher interest rates, capital-intensive future energy price shocks and/or supply limitations. renewables will face the largest increases in financing costs Fuel subsidies will also undermine efforts to reduce (figure 3). Achieving high penetration rates of renewable emissions and global cooperation to meet agreed-upon climate energy in the power system is especially capital intensive due to goals. Some countries in East Asia are currently exploring the large associated investments in infrastructure that are options for pricing carbon to meet their international needed to overcome the variability in the supply of renewable commitments on reducing emissions. Fuel subsidies effectively energy (for example, in batteries). The combination of a act as a negative carbon price and will make it more difficult to slowing global economy and the lasting effects of the COVID-19 achieve climate targets. Even in the short term, fuel price pandemic on public and private debt levels also means that it subsidies could deter investment in low-carbon alternatives if may be difficult for companies to secure the necessary investors perceive that fossil fuel prices will remain artificially financing for investments in renewables, even if they provided low in the future. the cheapest means to generate electricity. Third, higher prices for other minerals used in producing Status Quo Response of Energy Generators: Impediments to renewable energy will also limit gains from competitiveness. the Switch to Renewables Copper, lithium, nickel, cobalt, and rare earth elements are Sustained high fossil fuel prices could, in principle, encourage essential components of renewable energy technologies (IEA, switching to renewables in the power sector through newly 2021). Both the Russian invasion of Ukraine and the COVID-19 installed renewable wind and solar power because generators pandemic have disrupted supply chains of these minerals and are not likely to be shielded from fossil fuel prices. Such a have increased costs for renewable energy investments. Higher switch is being supported by the drop in the cost of generating material costs have a much bigger impact on the cost of electricity from wind and solar power over the past decade by renewables than they do for fossil-fuel based power up to 90 percent (figure 2)—and further long-term cost generation. reductions are likely. Such a shift would reduce emissions and Fourth, if natural gas prices increase by more than coal the risk of future disruption in imports of fossil fuels, thus prices, or if countries endowed with coal must rely on helping to insulate countries in the region against future price less-reliable imports of gas, the result could be increased shocks. However, there are several impediments to the consumption of coal. A significant share of the natural gas transition to cleaner energy. consumed in East Asian countries is used to generate electricity. In the absence of near-term alternatives promoting First, with a lifetime of 25 years or more, investment in clean energy—such as renewable installed capacity, upgrades renewables is determined by expectations of future fuel costs in the transmission network, and load dispatch management rather than current costs. The effect of higher fuel prices now capacity, plus batteries deployed at scale—the electricity could may be limited if they are perceived to be only temporary. instead be generated from existing coal-fired power plants with More generally, uncertainty about prices can inhibit investment spare capacity. Given the price volatility of natural gas, the role in new technologies. of gas in power systems must be carefully assessed based on 2 Second, tighter access to finance may inhibit the transition country-specific circumstances. Gas-fired power plants may be Research & Policy Brief No.58 Figure 3. At current fuel prices and interest rates, not only is necessary for overcoming the intermittency of renewable existing coal the cheapest source of energy but generators energy, but higher gas prices may increase the total costs of a may invest in new coal-based plants rather than in system with more renewables. Eventually, sustained high gas renewables prices may push back the “tipping point” where cleaner alternatives, such as batteries, become more cost-effective Simulated impact of fuel price and interest rate increases (Farmer and Lafond 2016). on the levelized cost of energy (LCOE) Status Quo Supply Response: Increasing Fossil Fuel Production Interest costs (4pp increase) Back-up cost at current gas prices (25%) If higher fuel prices are expected to persist, they could Variable cost of new wind, new solar and new CCGT encourage new investment in fossil fuel assets. Investments in 160 Change in coal price in 2022 energy infrastructure are typically long lived and may extend USD/MWh (in 2019 prices) Coal price in 2021 120 beyond the target dates set for net-zero emissions in some countries. The sunk costs of these investments could therefore lead to one of two outcomes. If the levelized cost of energy 80 (LCOE) remains below the costs of renewable energy, they could lock energy systems into a higher carbon future that is 40 not compatible with stated emission targets. Alternatively, if the costs of renewables fall sufficiently far, these investments 0 could become stranded assets, leaving behind debts that Existing New coal New wind New solar New CCGT coal (onshore) PV cannot be repaid and creating additional liabilities (for example, for compensation for investors, workers, and communities) (Semieniuk et al. 2022). Source: International Energy Agency (IEA), International Renewable Energy Agency (IRENA), and World Bank staff estimates. Note: The figure shows “levelized” cost calculations of the average unit price of A Greener Path generation using each technology. The levelized cost captures the sum of investment, operational, and fuel costs, divided by the expected revenues Governments can act now to ensure a greener alternative, from the electricity generated. For existing coal plants, the investment costs which can balance the immediate need for affordable energy are assumed to be zero. Most data are derived from International Energy Agency (IEA) publications. The fuel costs have been adjusted to reflect the without compromising security and sustainability (figure 4). latest data. A standard discount rate of 10 percent is used in the calculations, with any increases in central bank interest rates added to the discount rate. Additional material costs are estimated based on the material content of the Alternative Response: Targeted Income Transfers for capital used by each technology (using data from IRENA). The costs are Consumers averages and do not incorporate the substantial variations in costs across the region. CCGT = combined cycle gas power plant; PV = photovoltaics; USD/kWh = US dollars per kilowatt hour. In the absence of energy price subsidies, higher energy prices will have negative impacts on economic production and Figure 4. Implications of high energy prices depend on the measures to shield consumers Higher energy prices Short-term Status quo Alternative choices Demand Supply Supply Demand Smaller increase in Higher consumer consumer prices energy prices Investment in Energy subsidies $ Increased fossil fuels as Income support $ investment in a stopgap; fossil fuels investment in Energy demand falls less renewables Investment Energy demand falls support $ Longer-term outcomes Consumer switch to renewables Smaller reduction Emissions rise Emissions fall in emissions Emissions fall further Energy security Risk of lock-in or Energy security Energy security risks risks unchanged stranded assets $ risks reduced reduced further Source: World Bank staff elaboration. 3 The Road Not Taken? Responding to the Energy Price Shock in East Asia welfare. One option is targeted income transfers, which do not meet commitments to reduce emissions. In addition to the distort consumption choices, can be provided to those most in necessary policy reforms to encourage private sector need, and therefore cost less. participation, providing affordable access to finance at scale and green public procurement would help support low-carbon To date, social assistance programs and price regulation technologies and accelerate the transition to clean energy have not been targeted strictly to those who experienced (Mercure et al. 2014). At current energy prices, cheaper income shocks related to the pandemic. Growing pressure for finance could make investing in wind and solar more attractive fiscal consolidation has increased the need to spend scarce than investing in new coal power plants (figure 3). Such support government resources more efficiently, however. Several would be justified because it would help avert the risk of countries have reduced their assistance budget in 2022, thus locking development into a high-carbon future or creating necessitating better targeting of scarce public resources. potentially stranded assets, thus contributing to both national Means-based assistance could reduce the number of poor energy security and global sustainability. When energy prices people by 2 percentage points more than indiscriminate eventually fall, the introduction of carbon taxes and carbon assistance (World Bank 2022a). More targeted measures that trading mechanisms would improve the viability of renewables offer support to vulnerable households would be cheaper to and could finance support for vulnerable households. governments. For example, in Indonesia, replacing explicit and implicit energy subsidies with targeted support for vulnerable Not all countries in East Asia, however, have the capacity to groups would save the government 0.6 percent of GDP (World rapidly scale up renewable electricity generation. Even if prices Bank 2022b). In Thailand, both fuel subsidies and cash transfers are favorable, most East Asian countries have yet to cross the are mitigating the poverty impacts of price increases, but threshold from which renewable energy can expand without transfers are more cost effective (World Bank 2022a). support (figure 5). It will therefore be difficult to scale up installation quickly. For example, it will take time to build up Governments may still choose price subsidies over targeted supply chains and to develop the necessary labor market skills. transfers for three reasons. First, from a social welfare Electricity grids may need to be improved to handle an perspective, a significant proportion of the poor do not receive increased share of variable supply. Other technologies that transfers because many countries do not have adequate reduce fossil fuel consumption, including electric vehicles that delivery infrastructure, such as comprehensive social registries. require charging networks, face similar issues. Therefore, Second, from a political perspective, targeted transfers do not expansion of fossil fuel production may be the only alternative benefit the majority who are above the poverty line and who to deal with high energy prices and shortages in the short term. feel the pinch of inflation. Third, from an industrial policy Overall, however, the speed and scale at which clean energy perspective, price controls can shield firms from increases in alternatives are deployed will determine how soon countries costs of production that could disrupt recovery from the are able to reduce their reliance on fossil fuels. COVID-19 shock. Finally, from a monetary policy perspective, price controls can help keep inflation in check in countries where the monetary authority lacks credibility or inflation Figure 5. Current wind and solar shares in power generation expectations are not well anchored. Therefore, transitioning to more efficient transfers would require building a stronger Percent delivery infrastructure for households and firms; devising Wind Solar transfers that are consistent with political imperatives, such as 10 timebound transfers also to those just above the poverty line; 8 and enhancing the credibility of monetary authorities and policy. The trade-offs also depend on the duration of shocks: 6 brief shocks may limit the cost of inefficient responses. 4 Alternative Response: Renewable Subsidies for Generators 2 In achieving the goals of energy affordability, security, and 0 Myanmar PNG China Mongolia Vietnam Cambodia Timor-Leste Malaysia Thailand Philippines Indonesia sustainability, policy responses must help meet the immediate need for affordable energy without compromising security and sustainability. Some expansion in existing fossil fuel sources is the most economical way to alleviate the current crisis. Given the lead time to build new capacity, it may be the only way. Source: International Renewable Energy Agency (IRENA); International Energy However, encouraging investment in renewables could reduce Agency (IEA). Note: PNG = Papua New Guinea. longer-term exposure to volatility in fossil fuel prices and help References CNA (Channel News Asia). 2022. “Thailand Readies $4 Billion Loan Guarantee for Oil Fund.” August 16, 2022. Semieniuk, G., P. B. Holden, J-F Mercure, P. Salas, H. Pollitt, K. Jobson, P. Vercoulen, U. Chewpreecha, N. R. https://www.channelnewsasia.com/business/thailand-readies-4-billion-loan-guarantee-oil-fund-2884141. https://www.channelnewsasia.com/business/thailand-readies-4-billion-loan-guarantee-oil-fund-2884141. Edwards, and J. E. Viñuales. 2022. “Stranded Fossil-Fuel Assets Translate to Major Losses for Investors Farmer, J. D., and F. Lafond. 2016. “How Predictable Is Technological Progress?” Research Policy 45 (3): 647–65. in Advanced Economies.” Nature Climate Change 12: 532–38. IEA (International Energy Agency). 2021. “Critical Minerals: The Role of Critical Minerals in Clean Energy World Bank. 2022a. World Bank East Asia and Pacific Economic Update, October 2022: Reforms for Transitions.” https://www.iea.org/topics/critical-minerals. Recovery. Washington, DC: World Bank. Mercure, J-F, H. Pollitt, U. Chewpreecha, P. Salas, A. M. Foley, P. B. Holden, and N. R. Edwards. 2014. “The Dynamics of Technology Diffusion and the Impacts of Climate Policy Instruments in the World Bank. 2022b. Indonesia Economic Prospects, June 2022: Financial Deepening for Stronger Growth Decarbonisation of the Global Electricity Sector.” Energy Policy 73 (October): 686–700. and Sustainable Recovery. Washington, DC: World Bank. 4