As it becomes doubtless that the current era of high oil prices has come to stay for long, increasing attention has been devoted to fiscal, productive and redistributive consequences of policies of detachment between domestic and international prices that have been recently followed in most Latin American countries. A good example is the piece on Colombia posted here last Friday in this blog by Camila Perez Marulanda.
Let me stress today another dimension of consequences of such policies of detachment that should also be considered in any cost-benefit analysis, namely possible losses of opportunity for energy efficiency gains that can be incurred when price incentives are dwarfed. For that matter, one may learn from a revisit to the accumulated experience in the region with policies of dampening the impact of international oil price hikes in the past.
Alaimo & Lopez (June 2008) examined the empirical evidence on the impact of oil price fluctuations on the intensity of oil use (i.e. oil consumption per unit of GDP) throughout the world, with a special focus on Latin America. They show that, as a common feature in the latter along the last decades, oil intensity seems not to have been much affected by the variation of oil prices, even in moments of intense oil price hikes. This experience stands in contrast with what took place in OECD countries.
Chart 1, taken from them, exhibits the evolution of oil intensity along 1971-2004 – measured as daily used thousand barrels of oil over annual GDP in million US dollars – in a large sample of countries. The time span covers the two first oil shocks and the low-level period that followed.
Source: Alaimo & Lopez (June 2008)
Notice how the oil intensity dropped significantly in OECD countries (Panel B) as an aftermath of the shocks, declining at a more moderate pace thenceforth. This is to be contrasted with the relatively mild fall – or stability in some cases – of the oil intensity in the case of Latin America (Panel A) and Middle Income Countries outside the region (Panel C).
The authors extend the existing empirical evidence on the theme and argue convincingly that such a divergence in the evolution of oil intensity can be traced to the different extents to which OECD and most Latin American economies allowed international oil prices to pass through domestically to local users. The opening of several routes toward lower use of oil in OECD countries – improved home insulation, vehicles with better fuel mileage, review of production processes etc. – was sparked by higher domestic oil prices, while very often dampening the local impact of international oil prices ended being the option in Latin America.
Could it be that, instead of an apparent absence of a substitution effort in Latin America, the trajectory of oil intensity might have reflected countervailing trends derived from structural changes in their GDPs (more vehicles per capita, higher shares of heavy industry branches)? The fact that oil intensities were very close among the countries in the two groups by the end of the period (range of 1.1 and 2.1 barrels per day per million dollar produced), despite differences of income per capita, allows one to infer that indeed a wide scope for reduction in oil use had remained untapped in Latin America. Including the case of Brazil, where the first stage of development of ethanol as a substitute for gasoline and the availability of hydroelectric power had already made possible a relatively low level of oil intensity in the beginning of the period.
The evolution of oil intensity in OECD countries in Chart 1 also illustrates another relevant aspect: the “asymmetry” of effects of price rises and falls. The gains in terms of lower oil intensity were not reversed – on the contrary – when oil prices went along the extended phase of low prices.
There are in Latin America some examples, elsewhere in the energy sector, of how price incentives function and of how non-reversing efficiency gains tend to be. Take, e.g., the Brazilian experience of energy rationing in 2001 (see Paul Constance). After a long period of low investments in hydroelectricity and correspondingly decreasing idle capacity, the simultaneous occurrence of severe droughts that year put into jeopardy the full provision of energy. An energy efficiency program then implemented by the Brazilian government contained strong price incentives, rewarding users who managed to curb energy consumption and penalizing heavily those who did not. As a result, electricity consumption fell by 20% in not much more than a month, gains that were not reversed afterwards. Chart 2 – taken from IDBAmerica – Latin America’s Choice – compares the magnitude of efficiency gains in the Brazilian experience with other energy efficiency programs.
Bottom line: price incentives matter and corresponding non-reversible efficiency gains may be significant. And these features seem not to have been fully let to play in the case of oil consumption in the region. Therefore, there is reason for concern with the fact that, as highlighted by Veronica Alaimo and Humberto Lopez, an increasing wedge between domestic and international prices has been allowed once again to take place in many countries in the region, particularly in the case of oil producers. Besides the fiscal burden, when the option is for subsidies, and/or disincentives for producers, when otherwise mandatory price caps are enforced, one should also reckon with both substitution effects and energy efficiency-seeking behavior that are foregone.
Reasons for price detachment are understandable, particularly having in mind concerns with protecting the poor from the painfully heavy impact of skyrocketing oil prices. However, certainly time has come to favor the use of social protection networks that address directly the issue without requiring price wedges – such as “conditional cash transfers” (see here) – instead of resorting to measures that end up subsidizing users on a generalized scale. As the current age of expensive oil unfolds, the bill associated with subsidies and/or burden upon producers, as well as foregone efficiency gains tends to become unbearable.