Why Indonesia needs to reform its energy subsidy system – The Diplomat

The unprecedented spike in fuel prices caused by the Russian-Ukrainian war forced Indonesia to significantly increase its energy subsidies. The decision sparked a lot of internal debate about how best to balance economic improvement with Indonesia’s commitment to the clean energy transition. We believe the government should seriously consider reforming the country’s energy subsidy system if it wants to bring back climate change mitigation measures without hurting the economy.

Recently, Indonesia’s domestic energy subsidy policy has been criticized due to its sheer scale amid the current global downturn. President Joko Widodo said last month that the state raised state budget allocations for subsidies from Rs 152 trillion ($10.2 billion) to Rs 502 trillion ($33.8 billion). This significant growth was the result of high consumption of subsidized fuels and LPG on the back of high global crude oil prices. Without resolution of the conflict between Russia and Ukraine, energy subsidies allocated will continue to grow. On the one hand, these policies are necessary to maintain the purchasing power of the population and stabilize the economy, which is still recovering from the COVID-19 pandemic. On the other hand, the introduction of energy subsidies may have a number of unintended consequences.

The Indonesian energy subsidy policy aims to keep energy prices stable and affordable for all sections of society. By keeping energy prices below market rates, it allows low-income people to access energy they might not otherwise be able to afford. The policy also aims to optimize the use of fossil energy sources to boost the Indonesian economy. As the most reliable source of energy, the provision of fossil energy is critical for developing countries to meet the growing demand for energy.

One of the problems in Indonesia is that the wealthy also have access to subsidized fuel due to the weak government control system. When Indonesia raised the price of non-subsidized fuel products such as Pertamax Plus and Pertamax, most consumers simply switched to Pertalite, the subsidized fuel. The absence of specific requirements for the purchase of subsidized fuel facilitates access to it by the middle and upper classes. As a result, demand for pertalite, despite its lower quality, increased by almost 30 percent, which is not surprising given that its price is almost half that of unsubsidized fuel. Thus, the government should allocate more subsidies, further burdening the state budget.

The introduction of energy subsidies also hinders the development of renewable energy sources, as it encourages greater use of fossil energy. Subsidies make renewable energy less competitive with fossil energy and therefore less accessible to the public. This subsidy may not adequately address the negative externalities of fossil energy use. Thus, the increase in energy subsidies can be considered a step backwards in terms of efforts to increase the share of renewable energy in Indonesia and mitigate climate change.

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With this in mind, the Indonesian government could reform its energy subsidy system by replacing price subsidies with direct subsidies.

Energy subsidies are a sensitive issue for society due to the widespread desire to access energy at the lowest possible cost. The more developed the country, the more energy is required, so the subsidies allocated will be noticeable and will affect the state budget. Easing the burden on the state budget by increasing energy prices also often causes a negative reaction. Rising fuel prices will reduce the trade deficit, especially for oil and gas. At the same time, it could also lead to the risk of inflation and mass layoffs in the industrial sector.

The introduction of direct subsidies, the actual disbursement of funds to people with low incomes, is often promoted as a solution to Indonesia’s problem. The introduction of direct subsidies will increase the efficiency of the state budget and directly benefit low-income people by ensuring that they are not seriously harmed by the burden of rising energy prices. Direct subsidies will also increase the competitiveness of renewable energy by allowing energy to be billed at its market price. Therefore, as fossil energy prices rise, renewable energy can become an attractive and more affordable alternative.

While direct subsidies are intended to maintain the purchasing power of low-income people, they also incur economic costs. The reform of subsidies will also affect the operating costs of the industry. Allowing energy to reach its market price will increase operating costs, forcing industry to overestimate its efficiency. In the worst case, businesses can lay off a large number of workers. Therefore, the government cannot turn a blind eye to the side effects of introducing a direct subsidy.

Reforming energy subsidies through the introduction of direct subsidies cannot alone solve the problem of energy subsidies in Indonesia. The introduction of direct subsidies requires government intervention and cooperation between various stakeholders.

The application of direct subsidies should be phased in. In this case, the government needs to gradually reduce energy subsidies and introduce direct subsidies for the needy. This action must be carefully executed 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 recognize the real cost of energy and start changing their lifestyle to become wiser and less wasteful in their use of energy. At the same time, the industry should also encourage energy efficiency in business, which will help ensure that the impact of changes in energy subsidies on their business activities is minimal.

The use of direct subsidies should also be accompanied by efforts to provide alternatives to affected sectors. These efforts include the development of urban gas networks, renewable power plants and electric vehicles. To support these efforts, the government must ensure the ease of doing business by creating legal clarity and certainty. One of the most important aspects is to speed up the renewable energy bill, as well as encourage more fiscal and non-fiscal initiatives to attract more investors and accelerate these efforts. With all these elements in place, Indonesia will improve its energy security and protect itself from economic vulnerabilities associated with rising global energy prices.