Malaysia's Fuel Subsidy Dilemma - Fiscal vs. Social vs. Climate

Written March 2023 - 15 min read
Picture by CK Yeo

Summary

Fuel subsidies in Malaysia threaten fiscal sustainability with ballooning expenditure while being a highly regressive policy. The artificially lower fuel prices lead to overconsumption and excess carbon emission, which are purely attributed to the subsidy policy. With explicit and implicit subsidies, the government is unable to make the market participants internalise their negative externalities, leading to wastage.

The transportation sector is a significant contributor to the country’s carbon emissions. Removing the subsidies is a step in the right direction, as it will at least reduce excess carbon emissions. Some estimates suggest a reduction of up to 7% in emissions. However, removing fuel subsidies needs to be complemented with additional cash transfers to address some social challenges that may arise. It also must be done gradually to manage inflation.

Instead of entirely removing the subsidies, the government proposed replacing the blanket system with a targeted mechanism with an aim to continue assisting lower-income households while scaling back the subsidies from the rich. However, instead of targeting income, they are targeting the engine capacity of consumers, which may incur large exclusion and inclusion errors. Even with a successful implementation of the target mechanism, there will still be excess carbon emissions. The inconsistencies and reluctance surrounding the subsidies policy raise questions about the government’s commitment to climate goals.

Fuel subsidies threaten fiscal sustainability

The fuel subsidy program incurs high fiscal costs to the government. The cost of fuel subsidy has ballooned from RM7.4 billion in 2018 (3.2% of revenue) to RM37.3 billion in 2022 (12.7% of revenue) (Yeap, 2022). The subsidy bill in 2022 cost more than the whole budget allocated for the Ministry of Health (RM 32.4 billion) for operating and development expenditures. This ministry is also the second highest ministry in terms of budget allocation behind the Ministry of Education at RM52.6 billion (Edge, 2023). The increase in fuel subsidies creates large deficits affecting fiscal sustainability (World Bank, 2023). The resources for the program could also be directed to other productive areas, such as the health or education sectors.

Blanket fuel subsidy is an inefficient policy as it is highly regressive

The fuel subsidy is regressive in nature as the higher-income households benefit more than the lower-income households. According to the Central Bank of Malaysia, in 2014, the top 20% and bottom 40% of households received 42% and 14% of the subsidy, respectively (BNM, 2015). In a recent statement, the ex-finance minister mentioned that of the RM37.3 billion subsidy expenditure in 2022, 53% goes to the top 20%, while the bottom 40% of the household receives about 15% of the subsidies (Yeap, 2022, World Bank, 2023). As a comparison, the amount of subsidies received by the top 20% of the households (RM19.8 billion) is larger than the cash transfers disbursed as income support during the height of the pandemic (RM16.16 billion in 2021), which benefited 10.6 million households and individuals from the lower income and vulnerable groups (Yeap, 2022). The blanket nature of the fuel subsidy incurs significant inclusion errors and is becoming even more regressive should the fuel subsidies aim to aid lower-income households and economically vulnerable groups (MOF, 2022).

Artificially lower fuel prices result in excess carbon emissions

Some of the carbon emissions from fuel usage would not have happened if it was not for the subsidy program. The transportation sector represents 40% of the total energy usage in Malaysia and is responsible for 28% of the country’s carbon emissions (Muzakir et al., 2021; Mustapa & Bekhet, 2016). A certain portion of the emissions could purely be associated with the misallocation of resources from overconsumption and wastage as subsidies keep fuel prices artificially lower than the market price (BNM, 2015). For example, Malaysia has had a 45.1% increase in petrol consumption per capita over the last ten years. This increase surpasses other regional economies and is in the opposite trend compared to many advanced economies (BNM, 2023). Mustapa & Bekhet (2016) estimate that fuel consumption can decline by about 652 kilotonnes or -7% compared to the 2012 base year by simply removing the fuel subsidies. With subsidies, consumers are encouraged to overconsume as the demand for petrol is higher than the demand if the price reflects the market price. Higher carbon emissions will naturally result from overconsumption compared to a policy scenario of no government subsidies.

Fuel subsidies explicitly and implicitly promote actions with negative externalities

Fuel prices should be determined efficiently to internalise some of the negative externalities of fossil fuels (Vernon et al., 2021). The price of petrol should reflect not only the supply costs but also the cost of the environmental damages that comes from carbon emissions (Vernon et al., 2021). Fossil fuel usage is an example of an action with negative externalities because one person’s action can negatively affect another person’s welfare through climate change (De Mesquita, 2016). Individuals may fail to internalise the negative externalities they are causing and continue to overconsume as their cost-benefit analysis does not reflect the environmental consequences of their actions (De Mesquita, 2016). Suppose fuel prices also reflect the cost of environmental damages to some degree. In that case, individuals will be able to internalise the consequences of their actions better as their new cost-benefit analysis will also include the cost of inducing the negative externalities. Demand may fall as a result.

Some fiscal tools, such as taxation and other similar measures, can significantly address the environmental impacts of using fossil fuels (Vernon et al., 2021). These fiscal measures can affect behaviour in a way that will discourage the overuse of environmentally harmful energy sources. This concept is akin to sin taxes on cigarettes that can discourage their overuse (Vernon et al., 2021). Failure to impose some measures will incur implicit subsidies arising from undercharging for environmental costs and revenue foregone from taxing consumption. Globally, implicit subsidies accounted for about 92% of total subsidies (total subsidies: 6.8% of the world GDP) in 2020 (Vernon et al., 2021). The estimate of implicit subsidy for Malaysia is about 4.0% of GDP (Vernon et al., 2021), larger than the explicit fuel subsidy at 2.3% of GDP—the total subsidy bill amount to about 6.3% of GDP in 2022. Not only does the government fail to make the market internalise the externalities, its policies potentially exacerbate the overuse of environmentally harmful energy sources with large implicit and explicit subsidies.

Carbon emissions will be lower without fuel subsidies

Removing fuel subsidies is the first step in the right direction to reduce carbon emissions. The removal of fuel subsidies would increase the price of domestic fuel and discourage some demand and usage. Lower consumption, given higher fuel prices, would translate to lower carbon emissions. Some recent estimates, as dictated by the global commodity prices, indicate that the domestic fuel prices in Malaysia would be about 57% higher than the current prices (Shah, 2023). In response to the price increase, fuel consumption would decline, given the positive elasticity of demand for fuel. Sulaiman et al. (2022) reported that the long-term fuel elasticity among households in Malaysia ranges between 0.28 to 1.15, suggesting that a higher fuel price would lead to lower consumption. However, the authors note that the elasticity might be lower in the short term as it takes time for consumers to respond to the changes in a more significant way, which may include the choice of vehicle purchase, mode of transportation and choices of location to stay (Sulaiman et al.,2022). It is also important to note that there might be heterogeneity in elasticity by income groups and geography (access to public transportation). Regardless, there would be some significant reduction in carbon emissions over time. According to Li et al. (2017), there could be a 1.84% to 6.63% reduction in carbon emissions if fuel subsidies were removed in Malaysia. This estimation is also in the range that Mustapa & Bekhet (2016) reported at -6.55% carbon emissions with similar policy action. Removing fuel subsidies can significantly reduce carbon emissions over time as higher fuel prices discourage demand and usage, and consumers respond by consuming less fuel. Only then can the government start closing the gap of implicit subsidies.

Subsidy reforms require strong political will to address social challenges

The must be a strong political will to implement fuel subsidy removal, as there might be backlash from the political economy. Governments must also consider the social impact of the policy besides the economic impact. Stern and Rydge (2012) emphasised the importance of considering the social impacts of the transition to a low-carbon economy and the interests and perspectives of different stakeholders. Countries that do not fully consider their policies’ social and economic impacts could limit their measures’ effectiveness or implementation. In the context of removing fuel subsidies in Malaysia, the World Bank mentioned that there would be complaints from the middle class as their benefits are rationalised (Vasu, 2023). It is also crucial to note that some electoral issues might arise because they are a significant voting class (Vasu, 2023). Historically, it has been hard for the government to overcome the political economy aspect of fuel subsidies. There might be some short-term backlash from the public that the government can manage by complementing the subsidy rationalisation with cash transfers.

Recycling savings from fuel subsidy removal as cash transfers to the lower income groups to ease the burden

Lower-income households might face a higher burden of purchasing fuel compared to higher-income households if fuel subsidies were removed. To ease the burden on the lower income groups, the government can recycle some of the savings from subsidy removal as cash transfers. Under the latest cash transfer program in 2022, there were 9.6 million recipients with a total budget of RM8.2 billion, intended for the bottom 40% of households (Star, 2022). Households can receive aid up to RM2,600 over the year. From the household expenditure survey by the statistics department, a typical household spends about RM334 on fuel per month (DOSM, 2020), which amounts to about RM4,000 annually. Assuming fuel prices will increase by about 60%, on average, the annual expenditure for the household will increase by about RM2,400 (Shah, 2023; DOSM, 2020). The government could recycle the savings from the fuel subsidy by doubling the cash transfer program, which would easily cover the additional increase in household expenditure due to higher fuel prices. It would still have net savings of about RM29 billion.

There are various factors the government must consider before deciding the magnitude of cash transfers. For example, it is essential to note the heterogeneity of fuel usage within the income brackets (Douenne, 2020). There might also be differences in monthly fuel expenditure between rural and urban households which can create a large range around the average. Fuel expenditure also depends on global commodity prices. The elasticity of demand for fuel might change, given that households are exposed to a higher level of fuel prices. Additional cash transfers are paramount to the implementation of the policy. Hence, the government must carefully factor in the multiple considerations to ensure the success of the subsidy rationalisation plan.

Subsidies to be gradually phased out to manage inflation

A sudden removal of all subsidies might cause inflation to spike. Hence, the government should consider gradually removing the blanket subsidy to manage consumer prices. According to the World Bank (2023), eliminating fuel subsidies can increase consumer prices by about 9%. The direct impact of removing subsidies is derived using the 8.5% weight of fuel in the consumer price index basket (DOSM, 2023). However, the World Bank mentioned that it is also crucial to note the indirect effect, which could be large, stemming from the sectoral input-output interaction that propagates the effect of fuel price increases (World Bank, 2023). The government can also take advantage of the current decline in global commodity prices to minimise the impact of inflation (World Bank, 2023). The inflationary aspect of removing fuel subsidies could also be a consideration in the additional increase in cash transfer programs.

However, the government aims to move from a blanket to a targeted fuel subsidy mechanism to reduce overall subsidy bills while continuing to support lower-income households

Since 2018, the government has been trying to move away from the blanket subsidy to a more targeted mechanism to reduce subsidy expenditure by scaling back aid to the higher income groups. The new government recently renewed this sentiment as the 2023 budget built in the assumption of targeted fuel subsidies instead of the status quo (MOF, 2023). According to a statement by the prime minister, the targeted fuel subsidy mechanism aims to provide continued support to lower-income households amid the rising cost of living while preventing the rich from receiving the subsidies (Lim, 2022). Scaling back subsidies from higher-income households, like the top 20%, will incur considerable fiscal savings for the government. However, the administration is reluctant to remove subsidies altogether.

There are many complications in implementing the targeted fuel subsidy mechanism

Means-tested policies require some variables to determine the eligibility and threshold for the recipients. There will be a verification process which requires the government to maintain a system and database that would facilitate this process every single time anyone is refuelling their vehicle. This database and extra verification procedures will incur costs for the government and petrol stations.

The mechanism for determining access to fuel subsidies remains unclear, and the proposed engine capacity threshold fails to consider potential exclusion and inclusion errors. Although the government aims to target lower-income households, the variable determining the threshold for subsidy eligibility is not income but engine capacity. In 2018, the government proposed an engine capacity of 1.3 litres as the cut-off of the program (excluded if beyond this capacity). The threshold was subsequently increased to 1.5 and then to 1.6 litres in 2019. The policy was set to be implemented in 2020 but was cancelled due to the pandemic and the change in government. Implicitly, a simplistic assumption is made that the higher-income households drive vehicles with larger engine capacity, which might explain the disproportionately higher fuel subsidies received by the higher-income households. However, this assumption does not consider that lower-income households could own older vehicles with bigger engine capacity and higher-income households owning lower engine capacity vehicles. The proposed mechanism does not address potential exclusion and inclusion errors to lower and higher-income households, respectively.

Last year, the government mentioned that the administration is looking beyond engine capacity and working alongside the tax collector, central bank, and the statistics department to expand the database that they could use to determine access to fuel subsidies (Shah, 2023). However, by 14 April 2023, they have not publicly finalised the mechanism’s details. The challenges surrounding choosing and implementing the targeted fuel subsidy further complicate the government’s objective to continue helping the lower-income groups and lowering its subsidy expenditure while climate goals take a backseat.

Excess carbon emissions will still continue under a targeted subsidy regime

In terms of carbon emissions, even if the targeted fuel subsidy is successfully implemented, there would still be additional emissions arising from fuel overconsumption, albeit at a smaller magnitude compared to the status quo. If the fuel subsidy is only for the bottom 40% of the households, then this group could still overconsume fuel as the prices charged to them is still artificially lower than the market price. There would still be some carbon emissions that could have been reduced if there was no fuel subsidy policy.

The government’s policies surrounding subsidies are characterised by a marked degree of inconsistency when it comes to achieving climate goals. One of the policies to achieve the country’s net-zero targets by 2050 under the transportation sector is the promotion of electric vehicles (EVs). The target outlined in the New Energy Policy (2022 – 2040) is 38% of total vehicles by 2040; as of 2018, this number is less than 1% (Shahril, 2022). In 2022, despite multiple policies to promote EV ownership, such as import duty and road tax exemptions, only 0.36% of the total sales were EVs (Chan, 2023). On the other hand, 2022 saw the historical sales of motor vehicles in Malaysia. The subsidies and reliance on fossil fuels as the primary energy source for private vehicles present a large roadblock to achieving the nation’s climate goals. The contradictory approach in the transport sector raises serious questions about the government’s net-zero commitment.

In conclusion, fuel subsidies in Malaysia threaten fiscal sustainability while being highly regressive. This policy leads to overconsumption and excess carbon emissions as the externalities, such as environmental damages, are not internalised by market participants. The removal of subsidies is a step in the right direction, as it would reduce excess carbon emissions, with some estimates of up to -7%. However, removing fuel subsidies needs to be complemented with additional cash transfers to address some social challenges that may arise, and it must be done gradually to manage inflation. The government’s proposal to replace the blanket system with a targeted mechanism is not ideal, as it may incur large exclusion and inclusion errors while not addressing the problem of excess emissions. Lastly, the inconsistency surrounding the subsidy policy also raises questions about the government’s commitment to climate goals.

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