NOTE NUMBER 218 P U B L I C P O L I C Y F O R T H E privatesector OCTOBER 2000 Scorecard for Subsidies Laszlo Lovei, Eugene How Utility Subsidies Perform in Transition Economies Gurenko, Michael Haney, Philip O’Keefe and Maria Shkaratan U n l i ke t h e p o o r i n m a ny d eve l o p i n g c o u n t r i e s , t h o s e i n C e n t r a l a n d Laszlo Lovei is Lead E a s t e r n E u ro p e a n d t h e f o r m e r S ov i e t U n i o n a re h i g h l y c o n n e c t e d t o n e t wo r k u t i l i t i e s . D u r i n g t h e e a r l y 1 9 9 0 s , i t b e c a m e c l e a r t h at w i t h - T H E W O R L D B A N K G R O U P PRIVATE SECTOR AND INFRASTRUCTURE NETWORK Specialist in the Energy Sector Unit of the World o u t s u b s i d i e s , m a ny h o u s e h o l d s wo u l d h ave d i f f i c u l t y p ay i n g t h e i r Bank’s Europe and Central Asia Region. u t i l i t y b i l l s . G ove r n m e n t s s t a r t e d t o ex p e r i m e n t w i t h va r i o u s s u b s i d y Before joining the Bank, s c h e m e s . T h i s N o t e d e s c r i b e s t h e m a i n o n e s , s c o re s t h e i r p e r f o r m a n c e , Laszlo worked in the National Planning Office a n d p rov i d e s a m e t h o d o l og y f o r g ove r n m e n t s d e s i g n i n g s u b s i d i e s t o of Hungary. Eugene d e c i d e w h i c h s c h e m e i s l i ke l y t o b e t h e b e s t f i t f o r t h e i r c o u n t r y. Gurenko (Senior Financial Economist), Michael Haney (Energy The scoring system ▪ The extent to which the poor are being reached The performance of a subsidy can be measured in (that is, coverage). Specialist), Philip O’Keefe (Senior Human several dimensions. Key is its success reaching the ▪ The share of the subsidy that goes to the poor Resources Economist), poor, and the amount of purchasing power it trans- (that is, targeting). and Maria Shkaratan fers to them. However, the evaluation of any subsidy ▪ Predictability of the benefit for the poor. (Research Analyst) also mechanism should go beyond the amount of sup- ▪ The extent of pricing distortions and other work in the Bank’s port provided to the poor. Subsidies have a cost that unintended side-effects. Europe and Central Asia needs to be financed from somewhere. For a given ▪ Administration cost and difficulty. Region. level of purchasing power to be transferred to the Not all criteria are of the same importance. A poor, this cost depends on the targeting efficiency of financially strapped government may assign top pri- the subsidy mechanism. Some subsidy mechanisms ority to reducing the leakage of the subsidy to the are highly unpredictable (which tends to invite cor- non-poor. Another with limited administrative ruption in countries with poor governance). Some capacity may value simplicity more. Few mecha- subsidies distort price signals and other incentives nisms perform well on all the criteria—for instance, resulting in the waste of resources. Certain types of high coverage is usually associated with low target- subsidies demand sophisticated institutions or tech- ing. Furthermore, not all subsidy mechanisms are nology to administer them while others are simple. applicable or perform equally well across the full Thus the following criteria are used to score the range of utility services. Lack of water meters, for various subsidy schemes: example, may pose a problem for lifeline tariffs. It S C O R E C A R D F O R S U B S I D I E S HOW UTILITY SUBSIDIES PERFORM IN TRANSITION ECONOMIES Table Scoring subsidies 1 Coverage Targeting Predictability Pricing distortion Administration cost and difficulty Aggregate score a No disconnection 1 1 0 –2 0 2 Across-the-board price subsidy 1 to 2 0 2 –2 0 2 to 4 Lifeline tariff with 2 blocks 1 to 2 0 2 –1 0 3 to 5 Lifeline tariff with 3 blocks 1 to 2 2 1 –2 0 5 to 7 2 Lifeline tariff with “floating” blocks 1 to 2 1 2 –1 –1 4 to 6 Pricing discount for privileged consumers 1 1 2 –1 –1 4 Burden limit based on actual utility expenditure 1 0 1 –2 –2 –1 Burden limit based on utility expenditure norms 1 1 1 0 –2 3 Other earmarked cash transfer 1 2 1 –1 –2 4 Non-earmarked cash transfer 1 2 1 0 –2 5 a. Calculated with double weights to first two criteria. Source: World Bank staff calculations. is therefore impossible to rank subsidy mechanisms costs and political repercussions. Most countries independently of time, place and sector. in Central and Eastern Europe have abandoned It also matters who has to cover the cost of the across-the-board price subsidies by now, but gov- subsidy. The discussion of each subsidy mecha- ernments in the former Soviet Union have not, nism below includes a brief assessment of their although residential tariffs have been brought financial impact on those who will have to pay: tax- closer to costs than they were in the early 1990s. payers, non-household consumers (businesses), ▪ Lifeline Tariff. Restricting the price subsidy to the and the supplier utilities. initial block of consumption (called the basic The methodology does not cover the need level) offers a less costly alternative to interaction between various utility subsidy across-the-board price subsidies while preserving mechanisms—for example, the combined effect their politically attractive universal protection of a lifeline tariff and a burden limit—or between feature. Not surprisingly, many governments in utility subsidies and other sector-specific subsidies. the region introduced lifeline tariffs for utility services with metered or relatively easily esti- The variety of subsidies mated consumption, such as electricity and gas. There are seven main types of utility subsidies in ▪ Price Discount for Privileged Consumers. The Soviet Central and Eastern Europe and the former Soviet Union operated a system of utility price dis- Union: counts between 25 and 100 percent, not to ▪ No Disconnection. In several countries in the reduce poverty, but to reward certain occupa- region, utilities are pressured by governments tions (police, firemen, judges, and so on), or to not to disconnect households who do not pay compensate for hard labor, war, or man-made their bills. Non-payment by residential (and catastrophes like Chernobyl. Afraid of popular many other) consumers has remained particu- discontent, few newly independent republics larly widespread in the Balkans and the former dared to overhaul this system. Soviet Union. ▪ Burden Limit. An alternative to limiting prices is to ▪ Across-the-board Price Subsidy. At the beginning of help selected households to pay their bills— the 1990s, it was commonly believed in all tran- limiting the burden on household budgets. The sition countries that real wages would start grow- burden limit typically varies from 15 to 30 percent ing in the near future. Many governments of income. In Ukraine, for example, the burden postponed the realignment of utility prices and limit was set at 20 percent in 1998. The subsidy is costs, hoping to minimize the associated social calculated on the basis of actual utility bills, and Box How the scores were determined 1 The scores assigned to each subsidy mechanism were determined in the following way: ▪ Coverage ratios below 33 percent scored zero, between 33 (non-earmarked cash transfer and the burden limit based on util- ity expenditure norms) scored zero. Mechanisms that distort the effective price for most households (across-the-board price subsidy percent and 66 percent scored one, and higher than 66 percent and three-block lifeline tariff), or greatly distort this price for the scored two. A number of subsidy mechanisms scored “one to two,” beneficiaries (no-disconnection and the burden limit based on since the share of the poor who are connected (and can be actual utility expenditures) scored two. The remaining subsidy reached) varies greatly from one utility to another. mechanisms scored one. ▪ Targeting ratios below that attainable by random selection ▪ For administration cost and difficulty, subsidy 3 scored zero, above that ratio scored one, and above twice that mechanisms that can be administered by the utilities with little ratio scored two. extra effort (no-disconnection, across-the-board price subsidy, ▪ For predictability, no-disconnection, the most unpredictable and two-block and three-block lifeline tariffs) scored zero. mechanism, scored zero. Mechanisms that provide benefits with Mechanisms that require significant extra effort (“floating” life- high certainty (across-the-board price subsidy, two-block and line and privileged discounts) scored one. Subsidy mechanisms “floating”-block lifeline tariffs, and privileged discounts) scored needing a network of offices to administer the income tests two. The remaining subsidy mechanisms scored one. scored two. ▪ For pricing distortion, the two subsidy mechanisms that ▪ Scores for the last two criteria were given a negative sign to do not affect the effective price of the last unit of consumption facilitate the calculation of aggregate scores. household income must be verified by employers, Targeting ratios for the across-the-board price the social security office, or the tax authority. subsidy, two-block lifeline tariff, and burden limits ▪ Other Earmarked Cash Transfers. An alternative based on actual utility expenditures were below way to reduce the burden is to provide a subsidy that attainable by random selection. For no- calibrated to ensure a certain level of income disconnection, the two-block “floating” lifeline tar- after paying for rent and utilities. The Bulgarian iff, and burden limits based on utility expenditure government and most Latvian municipalities norms they were somewhat better than random operate such schemes. selection. For the three-block lifeline tariff and ▪ Non-earmarked Cash Transfers. General social income-tested (earmarked or non-earmarked) assistance payments can also help households cash transfers they were at least twice that pro- to pay their utility bills, even though the money duced by random selection. is not designated for that purpose. However, for Across-the-board price subsidies, two-block life- politicians these payments may lack the appeal line tariff and price discounts for privileged con- of introducing specific relief from utility bills at sumers provided highly predictable support to the the same time as utility prices increase. poor. Burden limit, most earmarked and non-ear- marked cash transfers, and three-block lifeline tariff Findings (with a “penalized” third block) had medium pre- The performance of these subsidy mechanisms was dictability. No-disconnection and certain non-ear- analyzed using household survey data and infor- marked cash transfers were highly unpredictable. mation provided by various government agencies No-disconnection and the burden limit based in Central and Eastern Europe and the former on actual utility expenditures created large price Soviet Union. Table 1 sets out the scores for each distortions (by making the effective price of the type of subsidy by the performance criteria. Box 1 household’s last unit of consumption zero). describes how the scores were calculated. Across-the-board price subsidy, and the three- All the subsidy mechanisms reached at least block lifeline tariff created significant price distor- one-third of the poor. Two mechanisms—across- tions for all (or almost all) households. Two-block the-board price subsidy and lifeline tariff— and “floating”-block lifeline tariffs and privileged reached more than two-thirds of the poor, but only discounts created significant price distortions for for electricity and water, since at least one-third of the minority of households connected. Non-ear- the poor do not have access to gas, district heating, marked cash transfers and the “normative” burden and sewerage in most countries in the region. limit created no utility price distortions. S C O R E C A R D F O R S U B S I D I E S HOW UTILITY SUBSIDIES PERFORM IN TRANSITION ECONOMIES No-disconnection, across-the-board price sub- Funding sidy, and lifeline tariffs (with the exception of life- In principle, the cost of the subsidies can be covered lines with “floating” blocks) were very simple to by the utilities themselves (through decapitaliza- administer. Price discounts for privileged con- tion), non-household consumers (by setting the sumers and the “floating” lifeline tariff posed sig- prices they pay above cost), or the budget (from nificant administrative challenges since the general taxation). The first option, however, should viewpoint utilities needed to match meter readings with cer- be used as a short-term buffer only, because it rap- tain household characteristics. Burden limits and idly depletes the working capital of the utilities, is an open forum to other income-tested cash transfers would have undermines their services, and ultimately reverses encourage dissemination of overloaded the administrative capacity of utilities, the poverty alleviation impact of the subsidy. public policy innovations for and required specialized networks of local offices. The second option may also become unsustain- private-sector led and able if demand from industrial consumers is highly market-based solutions for How to use the scoring elastic with respect to price (for example, in the dis- development. The views To find the subsidy mechanism that suits their cir- trict heating sector). In this case, the surcharge sim- published are those of the cumstances best, decisionmakers need to ply drives down demand and fails to raise the authors and should not be ▪ Obtain information on the proportion of the revenue needed for the subsidy. attributed to the World poor connected to each type of utility (this will Thus financing of the subsidy from the budget Bank or any other affiliated help to narrow the coverage scores of across- seems to be the best option in most utility sectors organizations. Nor do any of the-board subsidies and lifeline tariffs). and countries. The higher the targeting efficiency the conclusions represent ▪ See whether reliable estimation and billing of of the subsidy mechanism, the lower this burden is official policy of the World actual household consumption is possible (this going to be. For a given amount of purchasing Bank or of its Executive will show whether lifeline tariffs can be mean- power to be transferred to the poor, the three- Directors or the countries ingfully considered). block lifeline tariff and the income-tested cash they represent. ▪ Determine the weights that they assign to each transfer schemes require the least money. In fact, of the five criteria (if neither metering nor esti- three-block lifeline tariffs can be designed so that To order additional copies mation of actual consumption is feasible, zero the “penalty” at high consumption levels (in the contact Suzanne Smith, weight should be assigned to the price distor- third block) covers the subsidy at low consumption managing editor, Room I9-216, tion criterion). levels (in the first block). ▪ Calculate the aggregate scores for each subsidy Across-the-board subsidies cost so much that The World Bank, 1818 H Street, NW, mechanism and for each type of utility service. most governments have phased them out. While ▪ Identify the mechanisms with the highest aggre- at first sight no-disconnection appears to have no Washington, D.C. 20433. gate scores for each type of utility service. impact on the budget, in reality it tends to be so Telephone: To illustrate how this can be done, table 1 costly for utilities that the budget not only receives 001 202 458 7281 includes aggregate scores calculated with double lower revenues from corporate taxes, but over Fax: weights assigned to the first two (typically most time has to finance maintenance and rehabilita- 001 202 522 3181 important) evaluation criteria. For utilities with high tion costs and assume responsibility for the accu- Email: connection ratios among the poor (for example, mulated debt in order to prevent the utility ssmith7@worldbank.org electricity and water), the three-block and “floating”- collapsing. block lifeline tariffs occupy the first and the second place. For utilities with lower connection ratios Printed on recycled paper among the poor (for example, district heat, gas and sewerage), the first place is shared between non-ear- This Note is based on a longer paper: “Maintaining Utility marked cash transfers and the three-block lifeline Services for the Poor—Policies and Practices in Central and tariff. When no reliable estimate exists for actual con- Eastern Europe and the Former Soviet Union,” by these authors, sumption (or the billing system suffers from major published by the World Bank in September 2000, for the Annual deficiencies), lifeline tariffs drop out, the criterion of Meetings of the World Bank and International Monetary Fund pricing distortions become meaningless, and the top in Prague. score goes to cash transfers and privileged consumer discounts or the across-the-board price subsidy, depending on the connection rate of the poor. This Note is available online: www.worldbank.org/html/fpd/notes/