T

he leaders of the 20 major economies (G20) will meet in a summit on June 18–19 at Los Cabos, Mexico. The summit will build on past commitments of the Cannes Declaration inked last year, when the leaders reaffirmed their commitment to rationalizing and phasing out over the medium term inefficient fossil-fuel subsidies that encourage wasteful consumption, while providing targeted support for the poorest people.

The International Monetary Fund (IMF) estimates that fossil-fuel subsidies result in US$500 billion worth of trade lost annually from global gross domestic product (GDP). Focusing on Indonesia as a model for subsidy reform is crucial, as it is one of the four G20 countries that posted positive economic growth beyond 5 percent (6.4 percent) during the financial crisis in 2011.

Energy subsidies that keep fuel prices artificially below market rates absorb 2.2 percent of Indonesia’s GDP. Indonesia spent over $4.96 billion on consumer-fuel subsidies in 2011, with the wealthiest 20 percent of the population ironically capturing over half of the total subsidy benefits, with only 0.5 percent of GDP going toward social assistance programs.

On March 31 President Susilo Bambang Yudhoyono proposed the removal of subsidies by increasing the price of gasoline and diesel fuel by 33.34 percent to reach 60 percent of the world price. But the House of Representatives vetoed the increment and instead proposed to allocate $24.56 billion for energy subsidies, authorizing the government to raise fuel prices if the Indonesian Crude Price (ICP) exceeds the government budget assumption of $120.75 a barrel. This threshold is important to allow fiscal authorities to intervene to reduce the deficit.

Empirical evidence shows that in Indonesia, rural households pay a slightly higher price than urban households for all commodities except oil, perhaps because of the high transportation costs in rural areas. Each time the government removed a portion of the subsidy, ripple effects caused price increases in distribution and the prices of normal goods that depended on transportation costs.

This effect is crucial given Indonesia’s geography. Because the impoverished are more prevalent in rural areas, the withdrawal of fuel subsidies will hurt them the most.

The revocation of fuel subsidies increases the costs for consumers and reduces the marginal propensity to consume. It is harmful to the economy in the short term; however, the money the government saves could be allocated to increase spending to help the poor and improve infrastructure.

Proponents of ethical arguments on subsidies argue that fuel and energy has a characteristic of common ownership. Common ownership maintains that fuel should be equally accessible to rich and poor because it comes from nature. The poor as well as the rich should equally possess the benefit of energy through the implementation of subsidies.

This argument is, however, flawed. Implementing fuel subsidies is a way of redirecting government funds that allow the rich to benefit at the expense of the poor.

The best foothold is to scrap the producer subsidies. Indonesia subsidizes 17 different production activities for fossil fuels, most of which are in the form of direct compensation for the under-recoveries of state-owned energy companies. Subsidies for producers also manifest as research and development support, and financing for the restoration and rehabilitation of depleted oil and gas fields.

The International Institute for Sustainable Development (IISD) estimates that in 2008, Indonesia’s producer subsidies totaled $1.7 billion.

We should note that Indonesia’s oil sources are finite and fossil-fuel subsidies encourage over-consumption that could affect future generations. Proponents of energy security argue that there should be efforts to find new sources of energy (alternative energy) to reduce Indonesia’s reliance on fossil fuels.

Proponents of social policy argue that fossil-fuel subsidies contribute to economic growth and poverty reduction. Proponents of economy theory argue that subsidies are the best method of economic intervention compared to tariffs and quotas.

But, they argue that although production subsidies increase production, they do not necessarily have a substantial impact on jobs and incomes.

Yudhoyono’s second term is ending in June 2014. He should devote his final years in office to promoting effective governance by removing the production subsidies in the short run, and deal with consumer subsidies in the long run. In addition, the removal of consumer-fuel subsidies should be combined with a short-term implementation of “temporary direct assistance for the people” or cash transfers to target the poorest 30 percent of households, particularly those living in rural areas.

However, further consideration could be given to the type of social protection intervention that would reduce poverty and enhance the vibrancy of the Indonesian economy in the long term.

The G20 Summit at Los Cabos should also introduce longer-term initiatives to encourage new commitments for alternative sources of energy to reduce dependence on fossil fuel. Biofuel and renewable energy should extend the nexus between energy and the effort to control greenhouse-gas emissions.

Encouraging renewable energy will reduce fossil-fuel consumption and thus reduce trade losses in global GDP. Moreover, if done correctly, the renewable energy sector could create job opportunities for people in rural areas that would be the most affected by increases in the transportation margins on commodities.

The writer is currently pursuing a master’s degree in public policy at the John F. Kennedy School of
Government, Harvard University in Cambridge, Massachusetts.