INTERNATIONAL FOOD POLICY RESEARCH INSTITUTE

IFPRI

Productivity, Growth and Poverty Reduction in Rural Pakistan Pakistan Strategy Support Program (PSSP)

December 13-14, 2012 Islamabad, Pakistan

Macro-economic Implications of Electricity Subsidies

Dario Debowicz, Paul Dorosh and Angga Pradesha

INTERNATIONAL FOOD POLICY RESEARCH INSTITUTE

IFPRI

Resolving Pakistan’s Electricity Crisis: Macro-economic Implications of Alternative Policy Options

Dario Debowicz, Paul Dorosh and Angga Pradesha International Food Policy Research Institute (IFPRI) First presented in Islamabad, Pakistan 25 July, 2012

This presentation is based on a note written by Dario Debowicz, Paul Dorosh and Angga Pradesha. Sherman Robinson, Haroon Sarwar Awan, Wajiha Saeed and Syed Hamza Haider also provided valuable inputs to the disaggregation of the Social Accounting Matrix and analysis of Pakistan’s energy sector. This work was funded by the United States Agency for International Development (USAID) through IFPRI’s Pakistan Strategy Support Program.

Plan of Presentation

Introduction: Electricity Shortages and Subsidies Methodology: Data and Model Simulations

• Additional load shedding with no change in the subsidy; • No additional load shedding; increased subsidy financed

through domestic borrowing and thus reduced investment • No additional load shedding financed through an increase

in money supply (monetizing the fiscal deficit). Concluding Observations: Growth, Employment and

Inflation Tradeoffs

Pakistan’s Energy Sector: Major Problems Frequent electricity shortages (load-shedding)

• Load shedding as a percentage of demand (actual sales plus load shedding) increased from 2.8% to 22.9% from 2007 to 2010.

Arrears in payments Massive fiscal subsidies which are often

seriously underestimated in the budget • In 2007-08, 2009-10 and 2010-11, the realized

(actual) value of the subsidy was two to three time the budgeted amount.

Pakistan Energy-Related Subsidies 2006-07 to 2011-12 (mn rupees)

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12WAPDA Budget 41,934 52,893 74,612 62,903 84,000 122,700

Revised 42,464 113,658 92,840 147,005 295,827 - KESC Budget 13,938 19,596 13,800 3,800 20,447 28,588

Revised 17,699 19,596 18,800 32,521 64,447 - Oil Refineries/OMCs Budget 10,000 15,000 140,000 15,000 10,807 7,921

Revised 25,000 175,000 70,000 11,224 10,807 Fertilizer Manufacturers Budget 980 10,360 12,860 210 185 162

Revised 978 6,360 21,268 439 985 - Total Budget 66,852 97,849 241,272 81,913 115,439 159,371

Revised 86,141 314,614 202,908 191,189 372,066 -

Source: Federal Budget in Brief (various years).

Pakistan Energy-Related Subsidies 2006-07 to 2011-12 (mn rupees)

Source: Calculated from data from Federal Budget in Brief (various years).

Methodology

Dynamic economy-wide real-side CGE model plus a simple equation determining aggregate price level

• Data base: 2007-08 Pakistan Social Accounting Matrix (SAM) • 62 Activities; 27 factors of production; regional disaggregation

of agriculture; 19 household groups

Key model features: – Disaggregation of agricultural sectors – Links to upstream (processing) activities – Inclusion of non-agricultural industries and services – Regionalization by province – differentiation among household with different resources and

sources of income

Main sources of data for the SAM

• 2007-08 National Accounts • Value added by 15 sectors • Macroeconomic Aggregates

• 1990-91 Input-Output Table (97 sectors)

• 2007-08 Agricultural Statistics of Pakistan

• 2007-08 Pakistan Integrated Household Survey (consumption disaggregation)

• Commodity level trade data from the Ministry of Finance

• 2000-2001 SAM for Pakistan which uses the 2001 Pakistan Rural Household Survey (for household income disaggregation)

Rules for Supply-Demand Balances (Model Closure)

• Commodity markets • Prices adjust to equate supply and demand

• Capital is fixed by sector

• Total livestock capital is fixed but is mobile across region

• Land is fixed by region, but is mobile across crops

• Labor markets • Urban skilled labor: Nominal wages are fixed; levels of

employment (and unemployment) are endogenous • Other labor: Total supply of labor of each skill type is fixed

(and fully employed); real wages of other labor adjusts so that demand for labor is equal to supply

Design of Simulations

• Compare three alternative policies to address the electricity crisis: • 1) additional load shedding with no change in the subsidy; (the

base scenario assumes 25 percent load shedding in 2011-12). • 2) no additional load shedding with an increased subsidy

resulting in a larger budget deficit (implicitly financed through domestic borrowing and thus reduced investment); and

• 3) no additional load shedding financed through an increase in money supply (monetizing the fiscal deficit).

• Each simulation is run twice: once assuming flexible real

wages and full employment and a second time with open unemployment.

Productivity Effects of Electricity Shortages

Total factor productivity in each sector is reduced according to the following formula:

PLa = ES ECOSTaTCOSTa

αa

PLa: % decline in output (productivity loss) ES: Electricity Shortage (% load shedding), ECOSTa: cost of electricity (intermediate input) in sector a; TCOSTa: total cost of production of sector a, αa: substitutability factor in sector a.

Simulation 1: Additional Load Shedding

We model additional load shedding (an increase of 50 percent, i.e. from 25 percent to 37.5 percent of the time) with no change in the subsidy.

Assuming flexible real wages, reduced sectoral productivity results in a 1.3 percent decline in real GDP. • Under an assumption of open unemployment (Simulation 4),

real GDP falls further (1.5 percent) and employment declines by 0.6 percent.

Investment also falls (by 1.2 percent with flexible real

wages and 1.6 percent with open unemployment) because the reduction in real GDP implies lower incomes and lower total savings in the economy, thereby limiting finances available for investment.

Simulation Results: Macro-economic Effects of Alternative Electricity Policies

Base data: Real GDP and fiscal balance are in billions of Pakistan rupees 2010/2011; inflation and unemployment are percentages. Sources: Model simulations; Pakistan SAM 2010/11.

Sim 1 Sim 2 Sim 3 Sim 4 Sim 5 Sim 6

Base

Load shedding; no increase in

subsidy

No load shedding; increase in subsidy and budget deficit

No load shedding; monetized increase in

subsidy Sim 1 with open unemployment

Sim 2 with open unemployment

Sim 3 with open unemployment

(% change) (% change) (% change) (% change) (% change) (% change)

Real GDP 17,238.0 -1.3 0.0 0.0 -1.5 -0.1 0.0

Fiscal balance -683.0 0.3 19.7 1.0 0.8 19.7 1.0

Investment 1,983.5 -1.2 -3.8 0.4 -1.6 -4.0 0.4

Inflation 12.0 0.0 0.0 1.6 0.0 0.0 1.6

Unemployment 5.9 0.0 0.0 0.0 0.6 0.3 -0.1

Simulation Results: Macro-economic Effects of Alternative Electricity Policies

Note: Change in inflation and unemployment are in percentage points. Source: Model simulations

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

Real GDP Investment Inflation Unemployment

Perc

ent

Load Shedding Increased Subsidy Increased Subsidy Monetized

Simulation 2: Increased Electricity Subsidy

If the electricity subsidy is increased (by an assumed 50 percent) so that load shedding is unchanged from the base scenario…

The fiscal deficit increases by 19.7 percent (by 0.7 percent of real GDP). • Under an assumption of open unemployment, real GDP

declines by 0.1 percent and unemployment increases by 0.3 percent, but the change in the fiscal deficit is the same: 19.7 percent.

In both simulations, the decline in total savings in the

economy causes a reduction in investment (by 3.8 to 4.0 percent).

Simulation 3: Additional Load Shedding

Financing an increased energy subsidy through expansion in money supply prevents a short-run decline in real GDP but could potentially increase money supply and the price level by about 2 percent.

Real GDP is essentially unchanged under both labor market closures: fixed real wage and open unemployment.

The electricity subsidy is essentially financed through an inflation tax (a loss in the value of money held by households and enterprises) equivalent to about 0.8 percent of total household expenditures.

A full analysis of these policy options would require a fully specified financial sector. These simulations were done using a simple monetary sector framework assuming the subsidy leads to an equivalent increase in M2 with a constant velocity of money.

Household Income Effects

In Simulation 1, the urban poor have smaller declines in incomes than the rural poor or the national average as the decline in total factor productivity in non-agricultural sectors leads to an increase in returns to informal sector capital (a major source of income of the urban poor).

In Simulation 2, by contrast, the large decline in

investment reduces demand for unskilled non-agricultural labor in construction and other activities, reducing the incomes of the urban poor by more than other groups.

Finally, in simulation 3, both rural and urban poor suffer larger declines in real incomes than the urban non-poor since this latter group enjoys a gain in returns to formal capital.

Simulation Results: Household Income Effects of Alternative Electricity Policies

Source: Model simulations

Tradeoffs Between Output/Employment, Growth and Price Stability

• If there is no increase in the electricity subsidy and total load shedding increased by 50 percent relative to 2010/11, real GDP could decline by 1.3 to 1.5 percent with up to a 0.6 percentage point increase in unemployment.

• An increase in the electricity subsidy financed through government borrowing in the domestic economy could prevent a significant decline in real GDP and employment, but reduce investment by 3.8 to 4.0 percent of GDP and hamper future growth.

Tradeoffs Between Output/Employment, Growth and Price Stability

• Financing an increase in the electricity subsidy through increases in the money supply could likewise prevent a fall in real GDP or employment, but would raise money supply and the aggregate price level by about 2 percent.

Next Steps

• Further refinement is needed on: Productivity effects of electricity load shedding across

sectors Behavior of the labor markets in Pakistan to enable

better estimates of the effects of policy on employment. A fuller specification of the monetary and financial

sectors to better estimate the effects of budget deficits on inflation.

• Other approaches to the modeling the macro- linkages between real output, money supply and price level are also being planned: Full specification of financial sector in a CGE model Dynamic stochastic general equilibrium model