Quantifying Economy-Wide Impacts of Reducing Subsidy to the Electricity Sector in Kuwait

Electricity users in Kuwait pay a nominal tariff of 2 fills (about USD 0.007) per KWh. Almost all cost of generation, distribution and supply are covered by a very generous government subsidy. The 2 fills/KWh was introduced in 1966 and has been retained at that level since then. On the other hand, the cost of generating electricity has sharping risen particularly in recent years. For instance, cost per KWh escalated from about 20 fills in 2000 to about 40 fills in 2010, indicating that cost of production nearly doubled during that decade. The extremely generous subsidy or almost free availability of electricity has given rise to a pattern unsustainable behaviour in electricity use. Krane (2012) expressed the situation as a ‘dichotomy between energy value and price’ to say that excessively low energy pricing induced ‘wanton consumption’ whereby ‘low pricing encourages consumption at rates above those warranted by the opportunity cost of these fuels on global energy markets. Low prices also distort energy allocation preferences while undercutting upstream investment and efficiency incentives’ . These are reflected in a number of key aggregate indicators. For instance, in terms of economic electricity use efficiency, measured in terms of GDP generated per unit of KWh used, Kuwait does not only stand among the lowest but also the situation has gotten worse over the years. In 1990 GDP/KWh was USD 1.4 but it fell to USD1.2 in 2005. This contrasts with experiences of most other countries in the world; for instance, USA which was doing already much better in 1990 (about USD 2.2/KWh) but also electricity use efficiency improved and reached about USD2.7 in 2005. In terms of electricity consumption per capita Kuwait is the second highest in 2005 (after Norway). This figure doubled between 1985 and 2005, rising from about 8 thousands KWh to 17 thousand KWh. It should be noted that while Kuwait’s electricity is generated entirely by using fossil fuels but other countries like Norway have shifted to renewables such as hydro sources. The objective of this study is to quantify economy-wide impacts of public utility reform that may target to start by reducing electricity subsidy. The study is timely and highly relevant to current policy developments in the country. It will inform the ongoing debate regarding far reaching economic reform programmes, mainly aiming at diversification of Kuwait’s economy away from heavy reliance on the oil sector and reducing the dominance of the public sector by promoting private sector developments. Approaches and Methods The study was conducted using a computable general equilibrium (CGE) modelling approach. This was based on a social accounting matrix constructed for Kuwait based base year data of 2010. The 2010 Kuwait input-output table and related system of national accounts provided by the Central Statistical Bureau (CSB) provided core data required to construct a SAM with 17 production sectors. This was supplemented with other satellite accounts such as employment, demographic and capital stock which are separately estimated in line with flow variables in the SAM. The CGE model used for this study is the comparative static version of the standard IFPRI CGE model (Lofgren, et al, 2001), which was substantially revised to customize it to the purpose of this study . While designing the simulation experiments, the focus of this study was on labour market conditions to capture the highly segmented nature of the labour market in Kuwait. Expatriates constitute the bulk of the work force in Kuwait, about 83%. Kuwaiti’s account for the remaining proportion. Critically, the national labour force are highly concentrated in the public sector, including the electricity sector. The average wage level for Kuwaiti’s is substantially higher than expatriate salaries and wages. These conditions are highly relevant in the context of this study. Economic reform in Kuwait is bound to be implemented in conditions of inflexible wages and limited sectoral mobility among the Kuwaitis. However, labour market conditions for the expatriates is likely to be flexible wages and free mobility between sectors. Simulation experiments were conducted by taking these conditions into account. Preliminary Simulation Results Two scenarios of simulation experiments were conducted. These are separately discussed below. Scenario 1: 25% reduction of subsidy on the electricity sector To begin with the intra-sectoral impacts, gross value-added in the electricity sector falls by 34% while electricity tariff rises 260%, which means a rise from 2 fills/KWh to 5.2 fills/KWh. The policy shock reveals interesting macroeconomic and sectoral impacts. The inter-sectoral effects are more or less in line with an inverse proportion with sectoral electricity use intensity – more intensive users experiencing a degree of contraction while less intensive electricity users experiencing some expansions. The mixed impacts at sectoral levels have led to negligible macroeconomic effects. Aggregate GDP (value-added measure) declining by a less than 1% while gross domestic expenditure marginally increased, by about 1%. As we expect government surplus increases by about 3%. Household welfare, measured in terms of equivalent variation, declined but only by 0.5%. In this modelling framework, the net impacts of this policy shock are negligible but distributional impacts are likely to be much higher. We have shown this in terms of distributional effects across sectors but distributional effects across the households is beyond the scope of this research, since this study is based on a highly aggregate SAM which does not distinguish between households by income or expenditure sizes. This are left for future research. Scenario 2: 25% reduction of subsidy on the electricity sector accompanied by household compensation for welfare loss This scenario was conducted aiming at compensating households for the welfare loss they experienced due to the policy shock. It should be noted that the reduction in welfare reported above is negligible. However, if the subsidy reduction was much larger, say 50% or more, then we would expect that the welfare loss to households will be much larger. We have noted that the policy shock will also further increase Kuwaiti government budget surplus. However, unlike other countries with large budget deficits, current economic reforms in Kuwait are motivated more by the need to adjust the structure of the economy and improve efficient resource allocation rather than budgetary considerations. In that context, if the economic reform can help with achieving the main objective of effecting efficient resource allocation, then compensating households for welfare loss may be necessary particularly to reduce public resistance to expected rationalizations of public utilities including the electricity sector. It was with these policy context in mind that the scenario 2 policy experiment was conducted. The additional simulation shock was effected by compensating households by full amount of budget surplus gained by the government as a result of the policy change. In other words, government transfer to households was scaled up by the full amount of the difference between government budget surplus with the policy shock in scenario 1 and the corresponding figure in the base year. This yielded a much higher expansionary effect. In scenario 2, the only sector that experience contraction in terms of gross value added is the electricity sector, the sector that received the shock, but it contracts by about 32%, which is smaller than the contraction it experienced in scenario 1. The rates of positive stimulus to the other sectors ranged from 0.41% in government services to 6% in the construction sector. Aggregate GDP increased by 2.2% and the compensation caused household welfare to improve by 3.4% compared to the pre-reform level.