Phasing out Indonesia’s Fossil Fuel Subsidies

Phasing out Indonesia’s Fossil Fuel Subsidies Accelerate the Transition to 100% Renewable Energies

After an initially unsuccessful effort in 1998, Indonesia began a new path to gradually phasing out its costly fossil fuel subsidies after a Presidential Decree on the subject. Occasional, negotiated subsidy reductions over the past decade culminated in the recent decision to set domestic fuel subsidies at a fixed rate per litre from 1 January 2015. This means that domestic fuel prices now float according to market price.

Finding the ideal means to phase out fossil fuels has proved difficult in terms of  the consequential socio-economic costs and in light of the simultaneously increasing cost of oil. To mitigate the effects of energy price increases on poorer households, the Indonesian Government has provided cash transfers, increased spending on social programmes and introduced tax exemptions for some industries and agriculture.

To date, Indonesia has been a pioneer in the seemingly-impossible task of phasing out market-distorting fossil fuel subsidies.

At a Glance
  • Indonesians are vulnerable to the impacts of rising sea levels brought about by climate change due to a coastline of 81,000 km and a majority of the population living in coastal areas.
  • However, with Indonesia’s ‘Blueprint of National Energy Management 2005–2025’ foreseeing the use of coal increasing from 15.7% to 33% and gas from 23% to 30% by 2025, the policy may be primarily motivated by reducing macroeconomic risk and efficiency rather than directly addressing climate change concerns.
  • The Bantuan Langsung Tunai  (BLT) Cash Transfer programme was intended to alleviate the impact of removing subsidies from Indonesians in the lower-income quintiles. However, its implementation has received critique, as well as its temporary nature, whilst public protests still met each price hike.
  • As long as savings by subsidy cuts are recycled into improving infrastructure which helps those with low income, and welfare spending is sustained, the burden on the poor by increased production and food prices will be largely mitigated in a more efficient and constructive manner than by subsidising fuel.
  • The phasing-out of fossil fuel subsidies in one of the countries worldwide where it is most costly,  proves overall to be a difficult process but one which is crucial in our transition to renewable energies.


Policy Reference

Presidential Decree No. 9/2002 [English]:

“Considering :

a. that in the framework of relieving the tougher burden of the state finance in supplying and providing fuel oil in the country, it is necessary to reduce the domestic fuel out subsidy in phases;
b. that in order to implement the reduction of the subsidy as meant in letter a, it is necessary to adjust retail prices of domestic fuel oil by continuously observing interests of the less capable society through programs for improving their welfare;
c. that base on the considerations as meant in letter a and b, it is necessary to restipulate provisions on domestic retail prices of fuel oils set forth in Presidential Decree No. 73/2001;”

Presidential Decree No.55/2005 [English] and Presidential Decree No.9/2006 [English] on retail domestic fuel prices.

Presidential Decree No.71/2005 on Provision and Distribution of Particular Types of Fuels [English] and the amending Presidential Decree No. 45/2009 [English].


Connected Policies

Indonesia’s Law No.22/2001 on Oil and Gas states the following objectives in its Article 3 to ensure its oil and gas related activities:

  1. guarantee effective, efficient, highly competitive and sustainable exploration and exploitation;
  2. increase state income; and
  3. enhance public welfare and prosperity equitably as well as maintaining the conservation of the environment.

The Energy and Mineral Resources Ministerial Decree No. 0002/2004 provides for the development of renewable energy and energy conservation with ‘Green Energy Development’ legislation.

TheNational Action Plan for Addressing Climate Change 2007sets out objectives and strategy for national development in the anticipation of climate change. The Action Plan promoted subsidy cuts as one of a number of policies to achieve energy diversification, stating that the government needed to:

encourage … economic growth based on low pollution energy growth by increasing the new energy and renewable energy utilization, with eradication of fossil fuel subsidy gradually in stages”.

The Kerosene to Liquefied Petroleum Gas (LPG) Conversion Programme, 2007, intended to encourage households to switch from kerosene-use to LPG-use, on the grounds that LPG is cheaper to subsidise, cleaner and more efficient.

The Energy Law No. 30/2007 provides a renewed legal framework for the overall energy sector, with emphasis on economic sustainability, energy security and environmental conservation (Article 3). Under this Law, the National Energy Council (DEN) was established with the task of formulating and implementing a House of Representatives approved National Energy Policy, determining the National Energy General Plan, and planning steps to overcome any energy crisis or emergency.

The Environment Law No. 32/2009 provides for environment disincentives such as taxes and also requires entities to comply with standard environmental quality requirements and secure environmental permits before they begin operations. Sanctions can include cancellation of operating permits, fines, and/or imprisonment.


Selection as a Future-Just Policy

Energy subsidy reform is perhaps the single most important instrument to finance investment in a clean, equitable and sustainable future, whilst simultaneously reducing macroeconomic risks and accelerating our journey toward greater and shared prosperity.

Phasing out fossil fuel subsidies discourages waste and inefficiency caused by market distortions and allows the development of competitive alternative energy. During the recent periods of austerity, Governments worldwide have turned to cutting the huge costs of subsidising energy from non-renewable sources – a reported total of $20 billion in Indonesia alone, and approximately $544 billion worldwide – a sum which has inflated alongside the huge leaps seen in global oil prices over the past few years.

It is clearly in Indonesia‘s long-term interest to diversify its energy supplies at the same time as minimising energy demand through the promotion of energy efficiency and conservation. Yet doing so, without harming lower income households, is certainly a challenge and the pressure of public opinion led to small reversals throughout the reform process.


Future-Just Policy Scorecard

Our “Best Policies” are those that meet the Future Just Lawmaking Principles and recognise the interconnected challenges we face today. The goal of principled policy work is to ensure that important universal standards of sustainability and equity, human rights and freedoms, and respect for the environment are taken into account. It also helps to increase policy coherence between different sectors.

   Sustainable use of natural resources

  • Phasing out fossil fuel subsidies provides the economic incentives for a more efficient use of energy through renewable sources, helping to ensure the earth’s resources are used in a more sustainable way.
  • The policy does, as part of its rationale, respect natural areas: concerns about rising sea levels are mentioned in the National Action Plan Addressing Climate Change:  Indonesia has 80,000 km of coastline.
  • Indonesia’s ‘Blueprint of National Energy Management 2005–2025’ has planned for geothermal power, bio-fuels and other renewable energy technologies to increase to 5% of the national energy mix. However it also foresees the use of coal increasing from 15.7% to 33% and gas from 23% to 30% by 2025.
  • The policy has helped to address a common concern of air pollution, and indirectly, climate change, by removing incentives for excessive fossil fuel use and replacing kerosene stoves with cleaner, and more efficient, liquefied petroleum gas (LPG) stoves.

Equity and Poverty Eradication

  • Money recouped from fossil fuel subsidy phase-out has been earmarked to finance increases in infrastructure investment and social protection.
  • The Government’s Bantuan Langsung Tunai  (BLT) Cash Transfer programme was designed to ease the transition costs of increasing fuel prices during the removal of subsidies. However, it is reported that due to inaccurate targeting, not all poor households in the lowest and second-lowest income quintiles actually received support. Due to the temporary nature of the programme, living costs have risen to higher than before (subject to fluctuations in the international oil price) but households no longer receive any aid.
  • Many low income households rely on motorbikes for transport: more expensive fuel for these households leads to a negative distributional effect.
  • Subsidy cuts have also disproportionately affected those working in the informal sectors and has been regressive for small businesses in industries such as fishing. This led to strikes by fishermen at the end of 2005 shortly after a new round of subsidy phase-out.

Precautionary approach

  • The National Action Plan Addressing Climate Change highlights that Indonesia is particularly vulnerable to the impact of rising sea levels, as a consequence of climate change, with a coastline of 81,000 km  and the majority of the population living in coastal areas.
  • However, an increase in coal power to 33% of the country’s energy mix, fails to demonstrate prevention and precaution with regards to air pollution.

Public participation, access to information and justice

  • The Presidential Decrees on fossil fuel subsidy phase out do not provide for public consultation and engagement.
  • It has been suggested in a report by the International Institute for Sustainable Development (IISD) that the mechanism for complaints is unclear.
  • No institutions at a local level hold a clear responsibility for awareness-raising; according to reports, brochures explaining how poor households would be identified arrived late and in limited numbers.
  • However, according to research conducted by the World Bank, the cash transfer programme which was designed to ease transition costs, was accompanied by a public information campaign which included newspapers, TV programmes, village notice boards, and the distribution of pamphlets and brochures, as well as information on the back of energy compensation cards given to the recipients of cash transfers.
  • Information and training programmes were also reported to have taken place for local communities and officials after the first distribution of funds was made, largely due complaints and disturbances after an apparent mis-targeting of cash transfers.

Good governance and human security

  • In December 2004, the Constitutional Court ruled that the Oil and Gas Law of 2001 had violated the 1945 Constitution. It stated that the determination of fuel prices for the domestic market ought not to be based on the market price but citizens’ purchasing power and critiqued the 2005 Presidential Decree in a letter. Responding, the government said it would ignore it.
  • Due to rapid changes in the political and legal systems of the country, Indonesia has experimented with giving a number of institutions the responsibility of setting the fuel price. Currently, this role is played by the Ministry of Energy and Mineral Resources, in communication with the Ministry of Finance, although the exact formula and considerations taken into account in price setting are not clear. Price updates are often communicated by the Ministry in its press releases.
  • The cost of subsidising fossil fuels is announced annually by the Government in the Annual State Fiscal Plan, approved by Parliament. During the year, however, it is common for the Indonesian state budget to be revised and budget-adjustment is discussed as a matter of course in the middle of the fiscal year.
  • The approach which has been adopted up to December 2014 of occasional, negotiated price adjustments does not eliminate budget uncertainty. Fluctuations in global oil prices and exchange rates can quickly alter economic circumstances. Implementation has also been vulnerable to political and populist pressure, particularly prior to elections where short-term political motives may outweigh long-term sustainable development.

icon-yes-lightblueIntegration and interrelationship

  • The policy integrates social justice and environmental protection into economic development plans.
  • Socio-economic costs were considered in the development of the policy, providing for mitigation in the form of cash transfers.
  • Amendment, or cancellation, of the subsidy removal is not ruled out, as has been demonstrated by roll-backs. However, these were in response to populist reactions which do not necessarily reflect the need for better infrastructure and social welfare programmes in the long-run.
  • Environmental protection is considered by the removal of incentives to use dirty fuels, for example, by providing liquefied petroleum gas (LPG) burners and cylinders to residents in place of less clean kerosene stoves.

icon-yes-lightblueCommon but differentiated responsibilities

  • Fuel subsidies disproportionately benefited households at the top of the income distribution. Commercial and other users are estimated to have accounted for virtually all (98 percent) consumption of subsidised diesel (World Bank). According to one World Bank report, ‘Fuel subsidies are, in fact, generous transfers of taxpayer money to the rich.’
  • As long as savings from subsidy cuts are recycled into improving infrastructure, helping those with low income, and welfare spending is sustained, the burden on the poor from increased production and food prices will be largely mitigated.
  • Infrastructure development has created more employment, and the financial burden of subsidies to the Government, which crowded out infrastructure and welfare spending, has been significantly reduced.


Context

Indonesia has subsidised fuel (gasoline, diesel, kerosene, and LPG) prices since the 1970s, when the world experienced its first oil price shock. Subsidies were introduced in Indonesia to make available a ‘basic need’ at a price affordable to the poor. Kerosene, which was heavily subsidised, was the main fuel consumed by the low-income urban population and second only to wood as an energy source for rural consumers.

In 1998, a fuel price hike led to riots and is generally thought to have contributed to the downfall of the Suharto Government. Yet the long-time dominance of fossil fuel subsidies in government spending had led to a number of undesired consequences across Indonesia:

  • A lack of spending on infrastructure had left it in a poor state.
  • Oil imports had contributed to a persistent current-account deficit.
  • Subsidies were disproportionately benefiting households at the top of the income distribution, who used more fuel. The subsidies also created disincentives for saving energy, developing alternative energy sources, and reducing carbon dioxide emissions.
  • Pollution in Indonesia caused smog which has disrupted air and sea traffic (costing an estimated $9bn in 2007-2008, as reported by the Financial Times).

The Government then abandoned another attempt to raise petrol prices in 2012 following opposition both in Parliament and by more than 10,000 protesters on the streets. At the time, fuel subsidies accounted for an incredible, and unsustainable, 20% of total Government spending – more than three times the allocation for infrastructure (such as roads, water, electricity and irrigation networks) and three times spending on health.

Around the same time, Indonesia was spending just 0.5% of GDP on social assistance, compared with 1–1.5% of GDP in other emerging economies such as Brazil. Incredibly, it cost more to buy a litre of mineral water than a litre of fuel, from state-owned petrol stations despite fuel subsidies falling to 11% of total Government spending by 2013.


Objectives

Presidential Decree No. 9/2002 states two major objectives in its Preamble:

  1. To reduce the domestic fossil fuel subsidy in phases by adjusting retail prices of domestic fuel oil: “in the framework of relieving the tougher burden of the state finance in supplying and providing fuel oil in the country, it is necessary to reduce the domestic fuel out subsidy in phases.
  2. to continuously observ[e] [the] interests of the less capable [in] society through programs for improving their welfare”.

Both these goals were reiterated in a November 2014 speech to business leaders by President Joko Widodo on opportunities for social and infrastructural development through the reduction of Government spending on fossil fuel subsidies.

Mitigating the consequences of climate change is also a stated objective in Indonesia’s National Action Plan Addressing Climate Change. Yet it seems clear that Indonesia‘s ultimate concern lies primarily with economic development and relieving budgetary pressure, vulnerable to global oil price changes, rather than the reduction of CO2 emissions with a reliance on coal energy contributing to air pollution.


Methods of Implementation

2002
The Government allowed fuel product prices to move in line with international prices.

  • Presidential Decree No. 9/2002 announced the intention to phase-out Indonesia’s fossil fuel subsidies, aiming to set prices for gasoline at 100% of the international market price and 75% for automotive diesel, industrial diesel and fuel oil for both household and industrial users. Kerosene prices for the industrial sector were to be set at 75% of the international market price, while remaining low—at 65% below world prices—for households and small-scale businesses.

2003
Early in the year, the Government attempted to close the gap between domestic and international fuel prices by increasing fuel prices on the same day that it increased various utility prices. However, this reform was poorly communicated and resulted in public protests. The Government rolled back most of the increase and severed the link to world prices. Ultimately, price increases on diesel were reduced from the original 21.9% to 6.5%.

2005
In 2005, the Government undertook two large fuel-price hikes, and the number of fuel products eligible for a subsidy was reduced. The price of diesel fuel doubled and that of kerosene nearly tripled.

  • Presidential Decree No.55/2005 and Presidential Decree No.9/2006 on retail domestic fuel prices.
  • Presidential Decree No.71/2005 on Provision and Distribution of Particular Types of Fuels.

To mitigate the impact of the reform on the poor, the Government introduced an unconditional cash-transfer system “Bantuan Langsung Tunai” (BLT). Monthly cash payments of $10 were distributed to 19 million low-income individuals through local post office branches. In comparison with the first attempts at price rises in 1998, which resulted in riots, violent deaths and the stepping down of a president, the BLT appeared to play an important role in driving through price reforms with minimal opposition.

2007
This year saw the introduction of a programme to encourage rural households to use LPG instead of kerosene, on the basis that LPG would be cheaper to subsidise as it is more efficient, and better for household health since it is cleaner.

2008
Global oil prices reached a record high, with a U.S. light sweet crude price of $147.27 per barrel. The Indonesian budget had been drawn up assuming a price of $95 a barrel, causing subsidy spending to balloon from the $5 billion that had been planned to an estimated $17.6 billion.

In response the government raised the prices of gasoline and diesel by an average of 28.7% and then in July 2008 it raised LPG prices by 23%. The Ministry of Energy and Mineral Resources also announced that, as of May 2008, subsidies for larger industrial electricity consumers would be removed.

In the Medium Term Development Plan of the same year, the Government announced its objective to phase out fossil-fuel subsidies for private cars and restrict it to public-transport providers and motorcycles by 2014.

The Government also funded additional compensation programmes from 2008, including a “rice for the poor” programme (“RASKIN”) which distributes and controls rice prices, financial support in the form of scholarships for the education of children of government employees (“BSM”) and subsidy increases for small-scale credit facilities.

When world oil prices increased again in 2010–12, the Government tried to undertake another series of fuel price hikes, but could not implement them. As a result, energy subsidies remained slightly above 20% of government spending from 2011 to 2014 (against 10% in 2009), creating a considerable fiscal burden and contributing to a persistent current-account deficit.

2013
In June, the Government increased its subsidised fuel price by 33%, and again extended temporary unconditional cash transfers to 15.5 million households through post offices using newly printed Social Protection Cards. In addition, the Indonesian government expanded three existing social assistance programmes: unconditional cash transfers (‘BLT’), school scholarships (‘BSM’), and the ‘rice for the poor’ programme (‘RASKIN’).

2014
After a speech emphasising infrastructure development, the Widodo administration reduced once again the subsidy rate on 17 November 2014, resulting in roughly a 30% increase in gasoline prices, to IDR 8,500 (about $0.70) a litre, and a 36% increase for diesel fuel, to IDR 7,500 a litre. This was prompt and decisive action after taking office just the month before.

On December 19, 2014, the Chief Economics Minister announced that domestic fuel subsidies would be set at a fixed rate per litre from 1 January 2015: a final change which results in domestic fuel prices floating according to market price.


Impact

The low trading price of oil when fuel prices were last raised in November 2014 means that Indonesia has now effectively eliminated retail fuel subsidies, allowing a transition to fixed fuel prices which float according to market price from January 2015.

Each fuel price increase has reduced the current account gap, with Indonesia’s budget deficit forecast at 2.8% of GDP in 2015. One of the principal objectives of relieving budgetary pressure, and reducing macroeconomic risk, is therefore being met.

By freeing up a greater share of GDP for welfare spending, the phasing out of Indonesia’s fossil fuel subsidies has improved the efficiency of social welfare policies in the short-term by replacing indiscriminate subsidies (which saw 70% of subsidies go to the wealthiest 40% of households) with cash transfer programmes targeted at low income households.

A more long-term effect is that an infrastructure spending gap brought about by the fiscal burden of fuel subsidies has been reduced, with a shift from consumptive to productive spending. Much of the recouped money freed up by removing subsidies has been earmarked to finance increases in infrastructure investment and social protection.

The purpose of the BLT Cash Transfer programme was to cushion the economic shock of fuel price hikes yet not all eligible low-income households received any money. The programmes are also temporary, so do not provide equitable mitigation in the medium or long term. Doubts have also emerged amongst civil society over the way recipients have used BLT funds—buying items seen as unhealthy or luxury products, such as cigarettes or mobile phones—raising the possibility that conditional requirements for poor households to qualify for disbursement might be introduced.

If the distribution of cash payments comes to be perceived as a tool that can increase support for a party or a leader, it could lead to poor democratic or economic governance. A decision to add a third payment schedule on March 25, 2009 to the 2008 BLT programme, for example, was intended to help alleviate the impact of the financial crisis. However, a number of commentators also noted that it took place 15 days before legislative elections and three months before national elections.

It is recognised though, that fuel price increases can reduce the purchasing power of the poorest households in particular, and although this distributional effect was mitigated by welfare policies, many low income millions of low-income households have missed out on the benefits. To some extent, the other main objective to “observ[e] [the] interests of the less capable [in] society through programs for improving their welfare” (s. b. Preamble, Presidential Decree No. 9/2002) has also been achieved.

Indonesia’s approach of occasional negotiated price adjustments is also vulnerable to political and populist pressure. For example, nearing his re-election in 2009 (alongside a convenient slump in global fuel prices) Yudhoyono rolled back prices to Rp 4,500, ‘resulting’, according to the Jakarta Globe, in his landslide victory at the presidential election. The World Bank has criticised the lack of a predictable and transparent price-adjustment mechanism towards market prices after sharp, intermittent and unpredictable fuel price increases.

With regards to air pollution, data unfortunately indicates large amounts of CO2 are still being emitted (2.36 million tonnes of CO in Jakarta alone in 2013 was measured in a government air pollution survey). The Jakarta Environmental Management Agency reported a decline in air pollutants from 2005 to 2010.  However large-particle dust, carbon monoxide and nitrogen dioxide (which already exceeded limits set by the World Health Organization) rose by between 40% and 85% in 2011 and pollution in the capital has certainly worsened. (See ‘Jakarta’s Air Quality Conundrum‘)

While the Blueprint of National Energy Management 2005–2025 has planned for geothermal power, biofuels and other renewable energy technologies to increase to 5% of the national energy mix, it forecasts gas use increasing from 23% to 30% and coal (a major emitter of CO2) doubling in use to 33% by 2025. The objective of mitigating climate change stated in Indonesia’s National Action Plan Addressing Climate Change is clearly shadowed by the country’s drive towards economic development.


Potential as a Transferable Model

Energy subsidy reform is a major instrument in financing an increase in infrastructure investment and social protection, while dramatically reducing macroeconomic risks and accelerating the journey toward greater and shared prosperity. The phasing out fossil fuel subsidies discourages waste and inefficiency and instead uses economic incentives to facilitate the the development of competitive alternative renewable energy sources. It is also in many countries’ long-term interest to diversify energy supplies, at the same time as minimising energy demand through the promotion of energy efficiency and conservation.

However, phasing out subsidies requires simultaneous welfare spending to soften the economic shock for low-income households. Indonesia’s experience with the cash transfer programme however, suggests a need for good preparation, deployment and monitoring mechanisms in order to effectively assist the poor in the short-term, and cannot substitute a larger, long-term strategy to combat poverty.

Educating the general population about the benefits of fossil-fuel subsidy reform and establishing support policies is also necessary. One of the principal barriers to reform remains a lack of understanding amongst the general population about subsidies – their negative effects, their inefficiency as a policy to support low-income households and the potential for well-designed reform to promote the welfare of those in the greatest need.

The removal of fossil fuel subsidies remains a difficult, but essential, challenge worldwide. Indonesia however, has shown that this pathway is possible.


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