The Yar’Adua study on subsidies (1)

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*Yar'Adua

Olusegun Adeniyi

“Sometime in 2008, my late boss, President Umaru Musa Yar’Adua commissioned a study on ‘subsidies and tariffs in Nigeria’ in five critical sectors: Electricity, Petroleum, Education, Health and Agriculture. The main objectives were to determine the effectiveness of subsidies in these sectors, examine the need or otherwise for continuity and finally, suggest the framework for a gradual elimination with the overall aim of improving the general welfare of Nigerians. I am going to be relying on that report (submitted shortly before Yar’Adua fell ill in 2009) very soon to engage why we need a change of approach in Nigeria…”

The foregoing is excerpted from my 20th May column, ‘Nigeria and the Standing Fan Metaphor’. Following the publication, I received numerous requests to share the paper but have been reluctant to do so because we live in a country where many read their texts upside down. Knowing the contentiousness of the subsidy issue and given how desperate government has become to raise revenue, I don’t want to be seen as pursuing an agenda. However, following the latest (October 2021) World Bank Nigeria Country Report, a copy of which I glimpsed from a top government official on Tuesday, I believe a serious conversation on the economy is in order.

Between 2020 and 2021, according to the report, inflation shock is expected to have pushed an additional 5.6 million Nigerians into poverty while “food insecurity is increasing in both poor and non-poor households” across the country. I already know this from the tales I hear from my wife after every market experience. Since Vice President Yemi Osinbajo is leading a crusade against the huge arbitrage created in the foreign exchange market vis-a-vis its implications for macroeconomic stability as well as transparency and accountability, I also do not need to deal with that aspect of the report. So, the bit that is relevant to this intervention is the issue of subsidy, although the report is restricted to the oil and gas sector.

In 2021, according to the World Bank, Nigeria plans to spend $8 per capita on health whereas subsidy on PMS alone could cost $25 per capita and is not well-targeted. This is even though revenue from oil and gas in the first five months of this year (January to May 2021) were about half of what was projected: N872 billion instead of N1.736 trillion. If crude prices, the cost of imported PMS and current fuel pump prices remain at current levels, the World Bank projects that Nigeria would have spent N2 trillion on fuel subsidy alone in 2021! “With leakages (smuggling or over-invoicing) also being a concern, this—if validated—would make the subsidy even more regressive.”

Our population growth is far outstripping economic growth amid declining per-capital incomes. The World Bank believes that Nigeria must therefore take certain hard decisions to stay afloat. One, we must free up space for the private sector to serve as the engine of growth and job creation rather than continue with a fixation on bubble jobs that are neither sustainable nor capable of taking anybody out of poverty; two, we must “promote Nigeria’s inherent competitive potential by tackling the behind-the-border barriers” that impede the entrepreneurial abilities of our young people; three, we need to “redirect public spending from subsidies and incentives that disproportionately benefit the rich” to investments in the most vulnerable of our society: children, women and the millions who live below poverty line.

Those conversations are important, but the series I am starting today concern a study conducted 13 years ago for my late boss as to how subsidies impact the Nigerian economy in five critical sectors that remain even today, to put it mildly, underperforming. Although the report is mostly in charts and bullet points, I have turned it into a flowing narrative, beginning with the power sector.

PAST EFFORTS at reducing subsidies and increasing tariffs in Nigeria have resulted in resistance from the citizens. As a result, the federal government has continued to bear the burden of low tariff/ high subsidies in its annual budget. By the International Monetary Fund (IMF) estimates, US$4 billion was expended on subsidy in 2007 while US$3.6 billion is projected as petroleum subsidy for 2008. Despite the foregoing, some stakeholders see the removal of subsidy as increasing the burden on the poor.

The objectives of this study are to determine the extent of subsidy and tariff implementation in electricity, petroleum, education, health, and agricultural sectors; examine the subsidy policy in these sectors; determine the effectiveness of the subsidies as it relates to the target groups; propose a new framework for the implementation of subsidies to make it more effective i.e. ensure that those who need it are the ones who benefit and suggest the means of gradual elimination of the scheme while making other recommendations aimed at improving the general welfare of Nigerians.

A subsidy can be viewed as a negative tax in that there is a payment from the government to the individual. It can either be direct (explicit) or indirect (implicit). Types of subsidies include tax exemptions, inadequate returns on equity capital i.e. subvention to public enterprises that are supposed to pay dividend to government, duty waivers etc. There is also cross-subsidies—when one group of consumers pay a higher price for a good or service, so that another group of consumers may be charged a lower price. Meanwhile, tariffs are prices paid for goods or services consumed by individuals provided by government agencies or companies. The structure and level of tariffs determine the viability and sustainability of the services/goods supplied by government. The objectives of low tariff policies are to protect consumers, maintain the financial viability of the provider, encourage demand management, develop schemes that ensure self-sufficient operation and introduce lifeline rates for the poor etc.

Subsidies of course have their uses which include the transfer of income from one group or sector to another, promoting the adoption of some technology, increasing the output of certain commodities which the state accords higher priority, lowering consumer prices by reducing production costs, promoting the exploitation of resources where private initiatives or private resources are limited and providing demonstration effect to stimulate private investment. But let’s begin from the electricity sector. Owned by the federal government with minimal participation by other tiers of government in rural electrification schemes, the services have been heavily subsidized by keeping tariffs lower than the average cost through budgetary transfers. For instance, the total amount collected for eight years (between 1999 and 2007) was N486.4 billion whereas the expected revenue at market rate was N1.034 trillion, thus leaving a shortfall of N547.9 billion for the federal government.

The breakdown: In 2000 when N65.8 billion was expected based on the estimated cost of the power supplied, N26.3 billion was collected, leaving a shortfall of N39.5 billion; in 2001 when N85.7 billion was expected, N31.2 billion was collected, leaving a shortfall of N54.6 billion; in 2002 when N96.6 billion was expected, N48.3 billion was collected, leaving a shortfall of N48.3 billion; in 2003 when N114 billion was excepted, N57 billion was collected, leaving a shortfall of N57 billion; in 2004 when N154 billion was expected, N71.1 billion was collected, leaving a shortfall of 82.9 billion; in 2005 when N170 billion was expected, N78.5 billion was collected, leaving a shortfall of N91.6 billion; in 2006 when N171.4 billion was expected, N85.7 billion was collected, leaving a shortfall of N85.7 billion; and in 2007 when N176.5 billion was expected, N88.3 billion was collected, leaving a shortfall of N88.3 billion.

The industry maintains a discriminatory tariff structure or what can be described as cross subsidies. Consumers are categorized into six major groups: residential, commercial, industrial, street lighting, special tariffs, and welders. Reasons for the discriminating pricing model include protection of SME’s; employment provision; social welfare, equity, re-distribution of income; creation of access to electricity for the poor; and fixing market imperfections. But the approved tariff structure is half the estimated traffic based on the cost structure. For instance, the approved tariff in 2000 was N4 whereas the estimated tariff was N10 leaving a shortfall of N6. The tariff remained the same in 2001 whereas the estimated tariff had jumped to N11, creating a gap of N7. In 2002 when the tariff was increased to N6, the estimated tariff was already N12, leaving a gap of N6. From that period till 2007, the tariff remained the same even when estimated tariff as of 2004 and 2005 was N13 before dropping back to N12 in 2006 and 2007. So, the gap was always 50 percent or more.

Since the mechanism for the implementation of subsidy is through government grants and capital releases, for it to be effective it must be target-based and should ensure a secured revenue flow to the generation, transmission, and distribution companies. While electricity subsidy is meant to implicitly target the poor, it is being captured by the medium and high-income consumers. A comparative analysis of the Nigerian sector with what obtains in a few countries may be important for seeking a better approach:

MEXICO: This is an oil rich country where the electricity sector is also federally owned. In 2006, the total electricity coverage was 97 per cent, driven largely by the reforms and encouragement of private sector participation. Industrial and commercial tariffs are priced on a rational cost basis for the large firms and they receive no government subsidies. Small firms receive relatively small subsidies while agricultural and residential customers receive large subsidies.

INDIA: The industry is structured on retail pricing policy with cross country variation of tariffs and subsidies. There is a minimum price charge of 50 Paise/KWH for agriculture and at least 50 per cent of the average supply-cost for all end-users. There are targeted subsidies (Increasing Block Tariff – IBT) by the regulators to ensure that the poor largely benefit from subsidies supported with the implementation of lifeline rates. The use of stand-alone systems for electricity generation in the rural areas is strengthened by the national policy for bulk power purchase and management of local distribution.

GUATEMALA: In 1998, the government created the Rural Electrification (RE) program using Output Based Aid (OBA) approach. Under the OBA, service providers mobilize private financing for electricity generation, transmission, and distribution, while the government provide subsidy to the service providers based on actual delivery to the consumers. To achieve set objectives, the government set aside US$330 million obtained from privatization proceeds, sale of government bonds and other source.

LESSONS FOR NIGERIA: The OBA is an alternative approach that could be adapted in Nigeria. Increasing Block Tariff (IBT) billing system could be used by electricity regulators to ensure that the poor largely benefit from subsidies, while limiting the benefit to the rich as in India. Lifeline rates for electricity could also be used to specifically target the poor in Nigeria. Periodic and regular review of the tariff structure would eliminate uncompetitive charges that characterize the Nigeria tariff system.

Willingness-to-pay has been identified as a measure of the maximum price a household would pay for electricity services. This varies, depending on households’ preferences, quality, and cost of existing alternatives. Estimate of monthly total subsistence consumption is 50kwlh, an equivalent of a few light bulbs and a radio. That of monthly high subsistence consumption is put at about 120kwlh, an equivalent of a few light bulbs, a small refrigerator, and a television. Charges based on current tariffs is N1.20 per kw/h and N4.00 per kw/h for both groups. Other charges include a flat rate of Nl20 and N130 per month, respectively. This results in N600-N1440 partial cost recovery (operating and maintenance expenses) and N750-N1800 per month at full cost recovery plus capital.

The approval of Multi-Year Tariff Order (MYTO) for the market transition defines average tariff policy. It does not define the interaction of social and tariffs policies–cross subsidies, social subsidies etc. It defines an expected level of subsidy (the equalisation fund), but not the risks (up and down) related to that subsidy. It does not define any components of the expected subsidy. It is therefore an excellent starting point, and provides a good framework, but it is not the end point. MYTO makes assumptions on inflation, affecting capex return and recovery, opex etc. but exchange rate uncertainty will affect capex in terms of generation cost plus transmission and distribution.

Pertinent questions therefore remain: Will current gas policy result in investment for secure gas supplies of proper quality for sufficient time? Will standard transmission cost for gas restrict provision of gas to centres of demand? How long before policy can be implemented (Gas Aggregator)? Impact on forecasts? How does one account for the uncertainty from difference between gas policy and MYTO on indexation? Besides the foregoing, work to date has not covered tariff structures and cross subsidy and customer assistance fund.

Some of the suggested priorities for evaluation include the volume and availability risk, generation investment costs, gas prices and transportation costs, losses reduction and collections – and associated costs of improvement as well as sector liabilities brought forward and macro-economic variables. Meanwhile, priorities for evaluation include the significant range of uncertainties, most of the risks that fall to government given the nature of the MYTO decision as well as policy risks and options if government is not to face a ‘black hole’ in the books in the near future.

ENDNOTE: Of course, the landscape of the power sector today is different from that of between 2007 and 2009 following the fundamental reforms by President Goodluck Jonathan which led to the unbundling and privatisation of electricity generation and distribution companies in 2013. But despite the enormity of investments in the sector over the past two decades, power supply in Nigeria still hovers between 3,500MW and 5,000MW daily. This falls far short of the national peak demand of 28,850MW. Aside weak transmission and distribution infrastructure, gas supply remains a major constraint in the value chain while the problem of cost-reflective tariff is yet to be resolved. But the most important issue is the lesson we can learn from the sector in the conversation about the role of subsidy in the Nigerian economy. Next week will focus on the education sector in the Yar’Adua study report.

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