Assistant Professor of Economics at Cairo University and Senior Economist at the Egyptian Centre forEconomic Studies (ECES)

Introduction

IN Egypt, subsidies continue to be one of the major itemsof government expenditures. The latest figures indicatethat government subsidies exceed 23% of 2005/2006 totalbudget spending (exceed LE50 billion) and around 74%of such subsidies are allocated to energy products(excluding electricity).
Due to the rapid increase in oil prices over the lasttwo years, the subsidy bill of energy products hasquadrupled. Such an increase has presented a criticalchallenge for the Egyptian fiscal authority. Starting thefiscal year 2005/2006, fiscal authority has recorded suchsubsidies, explicitly, in order to reveal the true burden ofsubsidizing petroleum products and natural gas.
This paper investigates the potential impact of removingenergy subsidies in Egypt on energy intensive industries.Partial equilibrium approach is applied to assess suchpolicy. Specifically, it examines the effect of subsidyremoval on energy driven sectors, under different scenariosof increasing prices of energy products. The effects areassessed through selecting a sample of sectors and industriesthat depend heavily on energy products, and then measuringthe impact on profitability per ton of production in selectedindustries, holding other factors constant.

Energy Subsidies in Egypt: Characteristics and Challenges
In Egypt, the government considers the subsidy systemas a primary mechanism to reach a sensible level ofequitable distribution of income. Therefore, the rationalefor subsidy systems in Egypt is justified, primarily, byequity concerns as in most developing countries. Egyptis a leading country in subsidizing fuel products (excludingnatural gas) compared to other developing countries. InEgypt, per capita consumption of energy products (fueland electricity) is lower compared to many Arab countriesand other developing countries (figure 1)


Figure (1): Per Capita Use of Energy

Per capita energy use in Egypt is lower than in Algeria,Jordan, Lebanon, Syria, lower and upper middle incomecountries and is even lower than the MENA region. Levelsof per capita energy consumption in Egypt are only higherthan in Yemen, Sudan, Morocco and LDC (see figure 1).

In the Egyptian context, subsidies on energy products(excluding electricity) are defined as “subsidies given tothe Egyptian General Petroleum Corporation (EGPC) thatkeep prices of energy products below international prices(prices paid to foreign partners), i.e. it is the differencebetween price paid to the foreign partner and price paidby consumers either households, business or governmentsector, in addition to other form of cost.” Specifically,subsidies on energy products include subsidies allocatedto LPG, gasoline (80 and 90), kerosene, diesel, fuel oiland natural gas. The Egyptian government subsidizesenergy products through a mix of explicit and implicitsubsidies. Till the fiscal year 2004/2005 energy subsidieshave never been recorded in the state budget and so theywere considered an implicit form of subsidies. Startingthe fiscal year 2005/2006, subsidies on energy products(excluding electricity) are no longer implicit as they havebeen recorded in the budget (see table 1).

Table (1): Subsidies Allocation in the Egyptian State Budget (2002-2007) (Billions L.E)

Year
Figures of the State budget
Petroleum productsand natural gassubsidies (2)
Total Subsidies
Total Subsidies (1)
Petroleum productsand natural gassubsidies as recorded
(3)= (1+2)[(2002-2005)] (3)=(1) [(2005-2007)]
2002/2003
6.9*
0
**16.1
23.0
2003/2004
10.3*
0
**21.7
32.0
2004/2005
13.8*
0
**20.2
34.0
2005/2006
52.6
40.0
40.0
52.6
2006/2007
53.7
40.0
40.0
53.7

Sources: The End-year Report of Budgeting and Plan Committee 2002/2003 and 2003/2004. The state Budget Statements various issues.  * Actual figures. ** Figures for energy subsidies which are not recorded in the state budget are obtained from the end-year report of budgeting and Plan committee.

The fiscal cost of subsidies on energy products(petroleum products and natural gas) was estimated at 20.2(billion, L.E) in FY 2004/2005, and 40 (billion, L.E) in2005/2006 (5.6% of GDP) and the same figure reportedin the budget statement for the FY 2006/2007. Suchsignificant increase in subsidies’ figures is due to rapidincrease in oil prices. Despite this significant share, figuresdo not include subsidies on the share of the EgyptianGeneral Petroleum Corporation (EGPC). Adding subsidieson the share of EGPC doubles the volume of such subsidies.

Despite this significant burden of energy subsidies inEgypt, the problem with the existing system is not onlyits fiscal cost but also the extent of distortion resultingfrom changing the market incentives. As argued, opportunitycost of energy subsidies seems more appropriate than thefiscal cost in evaluating the economic cost of such a system.Moreover, reaching the poor households or targeting groupsof society has been also a challenging task for theeffectiveness of such a system. It has been argued that theenergy-subsidy system is costly both fiscally andeconomically and even fails to reach and benefit the poor.Figures of energy subsidies compared to other fiscaloperations in the state budget reveals such inefficient useof resources. As shown in table (2), spending on energysubsidies reach about 15 % of total government spendingand exceeds 6% of GDP. Compared to other fiscaloperations in the state budget, allocations for energysubsidies equal twice the sum spent on defense, 3 to 4times spending on health and exceed that on education(see table (2)).

Table (2): Energy Subsidies (excluding electricity) as a Percentage ofBudget Fiscal Operations (2002-2007)

Year
Energy Subsidies
(Billion L.E)
% of Total Expen-
ditures
% of GDP
% of Social Protection spending
% of Defense spending
% of Education spending
% of Health spending
2002/2003
16.1
10.8
4.1
84.7
121.1
78.2
211.84
2003/2004
21.7
13.2
4.8
94.8
148.6
95.6
267.90
2004/2005
20.2
11.2
4.0
71.6
136.5
78.3
276.71
2005/2006
40
16.8
7.2
84.7
256.4
161.9
487.80
2006/2007
40
14.6
6.4
73.7
231.2
146.0
439.56

Sources: Author’s calculation based on the fiscal end-year reports andthe state budget statements.

 

Energy Subsidies Elimination in Egypt and its Impact on Energy Intensive Industries
In Egypt, the manufacturing sector, particularly, energyintensive industries benefit from all subsidies on energyproducts, namely, fuel oil, diesel, natural gas and electricity.Moreover, it benefits, indirectly, from subsidies given tothe transportation sector in a form of lower cost oftransportation fees. Subsidies granted to the manufacturingsector can be, roughly, estimated based on the sector’stotal consumption of different energy products. Thisincludes petroleum products, natural gas, as well aselectricity. The manufacturing sector consumes around29.82% of petroleum products consumption in Egypt. Thisimplies that the manufacturing sector is receiving aroundL.E 5514 million, as subsidized diesel, fuel oil (mazout)and others. Estimation of subsidies is calculated based on the figures of subsidies allocated to such items in the statebudget for the fiscal year 2005/2006. Similarly, the manufacturing sector’s share of total natural gas subsidies exceeds L.E
2.3 billion, as the sector consumes 26.2% of total naturalgas consumption. In addition, the manufacturing sector’sshare of subsidies to electricity is estimated at L.E 1406million. In brief, the manufacturing sector in Egypt receivesaround L.E 5.9 billion as subsidized energy products thatconstitute about 20 to 25% of total energy subsidies.

Assessment Methodology for Energy Subsidy     Removal
The impact of subsidy removal on production sectorsis assessed through two steps. Firstly, samples of sectorsthat heavily consume energy (fuel and electricity) areselected. Secondly, the study considers increasing the costof energy inputs by 10 %, 20%, 40%, 60 % and 100%.As a first step, the selection of sectors is based on the dataprovided by the Annual Industrial Production Statisticsin 2006, which shows that the cement, fertilizers, steel and aluminum production sectors depend, significantly,on fuel and electricity. For instance, fuel and electricityconstitute about 30% of total production requirements and21% of the value of production at factor cost for themanufacture of cement, lime and plaster. Adjustments forelectricity prices (cost) are made to match the removal ofsubsidies on petroleum products and natural gas. This isdue to the fact that petroleum products (natural gas, dieseland mazout) constitute 25% in per unit cost of electricity(kw/h). Thus, adjustments are made assuming that themaximum increase in per unit cost of electricity (kw/h)does not exceed 25%, under the scenario of removing,totally, subsidies on petroleum products (including naturalgas). Thus, scenarios of subsidy elimination assume thatthe expected increase in price of electricity match theincrease in prices of petroleum products and natural gas.
These hypothetical increases in the cost of fuel andelectricity due to increase in their prices affect the cost oftotal production. Under the scenario of increasing pricesof fuel by 100% and electricity by 25%, as noted, the topincrease in cost appears in manufacture of cement (10.92%),manufacturing of basic iron and steel (manufacture ofbasic iron (4.52) and for casting steel 3.48) and 4.10% forfertilizers, glass and glass products (3.3), aluminum (2.91%)and manufacture of paper and paper products (2.2%). Thelowest effect of increasing fuel and electricity costs appearsin the manufacture of articles of concrete, cement and plaster (0.89%), and in chemical and chemical products(1.53). Moving a step forward, the study has selected somespecific industries in order to reach solid conclusionregarding the effect of subsidy removal upon cost ofproduction and profitability.

Table (3) shows the effects of increasing prices of energyproducts on cost of production and then the profitability perton produced for a sample of selected industries. For thenitrogen fertilizer industry two companies that produce about75% of total domestic production were selected for measuringthe effects of energy subsidy elimination. As noted in table(14), the profit ratio per ton decreases from 22.65% to 7.8%as prices of energy inputs increase up to 60% and it turns tobe negative (-2.2%), if prices of petroleum products (includingnatural gas) and electricity increased by 100%.

Table (3): Profit Ratio under Scenarios of Energy Subsidy Removal for Selected Energy Intensive Industries

 
Original
20% inc
30% inc
40% inc
60% inc
100% inc
Fertilizer (Nitrogen Fertilizer)*
 
 
 
 
 
 
Profit ratio based on domestic prices
22.65%
19.9%
17.49%
12.7%
7.8%
-2.24%
Profit ratio based on export price***
40.62%
38.5%
36.6%
33%
29.22%
21.5%
 
 
 
 
 
 
 
Cement Industry*
 
 
 
 
 
 
Profit per ton (L.E/ton)
118
114.58
111.51
106.05
100.08
87.71
Profit ratio per ton
39.33%
38.2%
36.2%
35.4%
33.4%
29.23%
Aluminum**
 
 
 
 
 
 
Profit per ton (L.E/ton)
3437
3358.271
3318.907
3295.288
3224.432
3043.355
Profit ratio per ton
29.42%
28.74%
28.41%
28.20%
27.60%
26.05%
 
 
 
 
 
 
 
Steel Industry**
 
 
 
 
 
 
Profit per ton(L.E/ton)
380
372.7
369.05
366.86
360.29
343.5
Profit ratio per ton
14.18%
13.91%
13.77%
13.69%
13.44%
12.82%

Sources: Author’s Calculation based on information available in Appendix A. * Calculations are based on 2004 figures.
** Only electricity components of inputs have been increased.*** Figures based on export prices are calculated only for fertilizer sincethere is a significant gap between domestic and export prices.

 

Nevertheless, profit ratio per ton is higher in casethose ratios are calculated based upon export prices dueto the significant gap between domestic and export prices.Under the 100% scenario, the profit ratio per ton exceeds21%. Therefore, for companies that export most of itsproduction, increasing energy cost will not affect,profoundly, its competitiveness and profit. However, fordomestic oriented companies, increasing the cost of energyproducts causes a significant decrease in their per tonprofitability. For the cement and aluminum industries thesituation is quite different. For the cement industry, withan average price L.E 250 per ton that is below marketprice in 2005 /2006, the profit ratio falls to 15.4% asenergy prices increase by 60%. While, if an average priceof 300L.E per ton is applied, profit ratio exceeds 33% andbecomes 29.2% when prices increase by 100%, holdingother things constant. This indicates that the cementindustry compared to other energy driven industries willnot face a critical challenge either domestically or in theinternational markets if prices of energy products increase.The same conclusion can be reached for the aluminum industry where profit ratios per ton exceed 27 % and 26%when electricity inputs increases by 60% and 100%respectively. Thus, the removal of subsidies on electricitydoes not seem like a critical challenge to adjust to, sincethe cost of electricity constitutes about 20 % of total costper ton and the removal of subsidies on petroleum productsaffects partially the cost of electricity as previouslymentioned. However, this is not the case for the steel industry since profit ratios per ton are low as they fall toless than 14% and 13% when prices of electricity increaseby 60% and 100% respectively. Obviously, figures ofprofitability ratios under the scenario of subsidy removalindicate that energy intensive industries shall not be,severely, affected.
Main Findings and Conclusion
In brief, the results of this analysis are that:

  • Energy intensive industries in the Egyptian economybenefit significantly from subsidized energy productseither directly or indirectly.
  • Higher profit ratios of energy intensive industriesindicate monopolistic power of such industries. Marketsof energy intensive industries in Egypt are characterizedby high market concentration on the supply side. Thecement and steel industry present an example of marketconcentration. In both industries few firms are dominatingthe market. In the cement market, although there are 11firms in the industry, three firms only account for about

    70% of total production. The steel industry is an examplethat could be more striking since there are about 20producers in the market, however, the market share of twoproducers amount to 2/3 of the whole market. Thisphenomenon of supply side market concentration doesexist also in aluminum and fertilizer markets, where Misr Aluminum Company is an ideal example of a perfectmonopoly. Similarly, the market share of three fertilizercompanies exceeds 92 % of the market (IDSC 2005).

  • Increasing prices of energy inputs does not constitute asevere challenge for energy driven industries. Therefore,government intervention through increasing prices of petroleumproducts and the subsequent rise in electricity prices can beabsorbed by such companies without raising prices by the samelevel of increase. Such intervention will match with the enforcement of consumer protection law which enablesconsumers to stand against exploitation of such companies.Protection against exploitation must be extended to includenot only the final consumers, as the law stated, but alsointermediate industries. This is crucial for consumers since the elasticity of demand for such industries is low and this increasesthe power of such companies and industries to raise prices ina way that does not reflect the true increase in cost because ofenergy subsidy removal.

  • Since the analysis argues that subsidy removal will notseverely affect the profitability of energy intensive industries,it provides a sort of strength for the government negotiationpower with such companies.

    Finally, it is important to stress that the decision of subsidyremoval either partially or totally requires compensatorymeasures in order to reduce its negative impact, particularly,on poor households. These measures should be targeted andtemporary till adjustment is made by both producers andconsumers. Nevertheless, Egyptian government can reducesuch negative impact through intervention to correct marketfailure in the energy intensive market. This lowers, also, thecost of compensatory measures that might apply. Therefore,options for Egyptian government to reform the energy subsidysystem require correcting failure of markets and targeting poorhouseholds to lessen negative impact of reform.

    By Dr. Abdallah Shehata Khattab,
    Assistant Professor of Economics at Cairo University and Senior Economist at the Egyptian Centre forEconomic Studies (ECES)

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