The unprecedented spike in fuel prices prompted by the Russia-Ukraine war has forced Indonesia to increase vastly its energy subsidies. This decision has sparked much domestic debate about how best to maintain the balance between economic improvement and Indonesia’s commitment to a green energy transition. We believe that the government should seriously consider reforming the country’s system of energy subsidies if it is to get its climate mitigation back on track without harming the economy.
Recently, Indonesia’s policy of domestic energy subsidies has come under fire due to their massive scale amid the current global downturn. President Joko Widodo stated last month that the state had raised the state budget allocation for subsidies from 152 trillion rupiah ($10.2 billion) to 502 trillion rupiah ($33.8 billion). This significant increase has resulted from the public’s high consumption of subsidized fuel and LPG amid high global crude oil prices. Without a resolution to the conflict between Russia and Ukraine, the allocated energy subsidies will continue to rise. On the one hand, this policy is necessary to maintain people’s purchasing power and stabilize the economy, which is still recovering from the COVID-19 pandemic. On the other hand, the energy subsidy implementation could have a range of unintended consequences.
Indonesia’s energy subsidy policy aims to keep energy prices stable and affordable for all levels of society. By holding energy prices below the market price, it lets low-income people access the energy they could not otherwise afford. The policy also aims to optimize fossil energy utilization in order to drive the Indonesian economy. As the most reliable energy source, securing fossil energy is critical for developing countries to fulfill the increasing demand for energy.
One problem in Indonesia is that the the well-heeled also enjoy access to subsidized fuel due to the government’s weak monitoring system. When Indonesia raised the price of unsubsidized fuel products like Pertamax Plus and Pertamax, most consumers simply shifted to Pertalite, a subsidized fuel. The absence of specific requirements for purchasing subsidized fuel makes it easy for the middle and upper classes to access it. As a result, the demand for Pertalite, despite its lower quality, grew by almost 30 percent, which is unsurprising given that its price is nearly half that of unsubsidized fuels. Thus, the government must allocate more subsidies, burdening the state budget even more.
Implementing energy subsidies also hinders renewable energy development, as it endorses more fossil energy use. Subsidies make renewable energy less competitive with fossil energy, and therefore less accessible to the public. The given subsidy may not adequately price-in the negative externality of the fossil energy used. Therefore, the rising energy subsidies can be considered a step backward in terms of efforts to increase Indonesia’s renewable energy mix and mitigate the impacts of climate change.
With this in mind, the Indonesian government could reform its system of energy subsidies by replacing price subsidies with a direct subsidy.
Energy subsidies are a sensitive matter for society because of the widely shared desire to access energy at the lowest possible price. The more developed a country is, the more energy is needed, so the allocated subsidies will be prominent and impact the state budget. Easing the burden on the state budget by increasing energy prices also often prompts adverse reactions. Increasing the fuel price will reduce the trade balance deficit, especially from oil and gas. At the same time, it can also run the risk of inflation and massive layoffs in the industrial sector.
The introduction of direct subsidies, the actual payment of funds to lower-income people, is often promoted as a solution to Indonesia’s problem. Implementing direct subsidies will improve state budget efficiency and directly benefit lower-income people, ensuring that the burden of rising energy prices will not severely harm them. Direct subsidies will also improve the competitiveness of renewable energy, allowing energy to settle at its market price. Hence, as fossil energy prices increase, renewable energy could appear as an attractive and more affordable alternative.
While direct subsidies are intended to maintain lower-income people’s purchasing power, it also has economic costs. Subsidy reform would also affect industry’s operational costs. Allowing energy to reach its market price will increase operating costs, which will push industry to reassess the efficiency of its operations. In the worst case scenario, enterprises may layoff large numbers of workers. The government therefore cannot turn a blind eye to the side effects of introducing a direct subsidy.
Reforming energy subsidies by implementing direct subsidies cannot single-handedly resolve Indonesia’s energy subsidy issue. The implementation of direct subsidies requires government intervention and collaboration between the various stakeholders.
The application of direct subsidies would have to be carried out in stages. In this case, the government needs to gradually reduce energy subsidies and implement direct subsidies for those in need. This action has to be carefully done so that the impact of market shocks can be suppressed and anticipated while maintaining people’s purchasing power. This policy will also encourage the public to learn the actual price of energy and start changing their lifestyle in order to become wiser and less wasteful in how they use energy. At the same time, the industry should also encourage energy efficiency in business, which would help ensure that changes in energy subsidies have little impact on their business activities.
The application of direct subsidies should also be followed by efforts to present alternatives to the impacted sectors. These efforts include the development of city gas networks, renewable energy power plants, and electric vehicles. To support these efforts, the government should guarantee the ease of doing business by creating legal clarity and certainty. One of the most critical aspects is the acceleration of a renewable energy bill, as well as promoting more fiscal and non-fiscal initiatives in order to attract more investors and accelerate these efforts. With all of these pieces in place, Indonesia will improve its energy security and protect itself from the economic vulnerabilities of rising global energy prices.
