Public Affairs
Nº 872 -
www.lyd.org- Email:lyd@lyd.org
June 6, 2008
ISSN 0717-1528
Fuel Price Stabilization Fund:
A Wrong Solution
International oil prices are at historic
highs with a barrel of oil trading today at more
than US$125, well above the US$72 average
last year.
One of the first areas to be hit is the
family budget. Families spend part of their
income directly on fuel and consumer products
that use fuels in the manufacturing process so
as a result higher fuel prices drive up the cost
of these goods. This leaves families with less
money to spend on other things. In other
words, the increase in fuel prices negatively
impacts family income.
The escalation in prices seen this year
has presented a difficult situation for Chile.
Growth expectations for the economy are
becoming increasingly pessimistic and higher
energy prices moved the Central Bank in its
most recent monetary policy
report to lower its yearly GDP
expectations to a range of 4.5The path to follow is to
5%.
Rising fuel prices also have
an impact on productive
industries in Chile. While
eliminate the fuel tax system, Chile’s main source of energy
comes from hydroelectric
which can no longer be
justified today, when we have power and gas, oil has been
effective toll road mechanisms increasingly been used as an
energy substitute due to the
that allow us to charge the
consumer for their use of road rationing of gas supply from
Argentina and setbacks in the
infrastructure.
completion
of
new
hydroelectric projects.
The government reacted
to these high prices by pouring
money into the fuel price
stabilization fund (FEPCO) so
that consumers do not shoulder
the full cost of the higher prices.
These funds reach the-end
consumer through subsidies that
cause distortions in the economy and in the
short term could have negative consequences
on the principal macro economic variables.
As international oil prices are so high
and the use of other energy sources is scarce,
energy costs have skyrocketed. Some reports
say energy costs have risen 416% in real terms
(an annual increase of the marginal cost at the
end of the fourth quarter 2007),i and this has
repercussions on local industry, which is
increasingly finding it difficult to break even.
Negative effects of high prices
Higher fuel prices have immediate
consequences in Chile whose economy is
highly dependent on different types of fuel for
different productive fields.
In this edition:
In the midst of this adverse situation we
often see certain groups using social and
 Fuel Price Stabilization Fund: A Wrong Solution
 Asymmetry in the monitoring of FONASA versus Isapres
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productivity argument to call for measures to
bring down the prices.
so heavily on their consumption. But if prices
remain high for a long time, the right thing to do
would be to look at the possibility of
reassigning resources.
But the authorities ought to take special
care and be responsible when deciding on
whether or not to implement such policies and
should provide answers that are effective and
consistent with Chile’s macro economic
situation.
The high estimates for the future price of oil
(Morgan Stanley estimates that in July a barrel
of oil will trade at US$150 per barrel, while
Goldman Sachs has predicted US$200 per
barrel in the short term) leads one to conclude
that the high prices are here to stay. Other
analysts, however, forecast that oil prices could
drop towards the end of the year.
How to Confront the Problem
To provide an adequate response to the
predicament Chile faces we have to guess how
long the fuel prices are going to remain high
and decide whether we are witnessing a sort of
shock and that oil will return to previous levels
or that we are confronted with a new long term
higher-than-expected price average. The
correct action to take will depend on which of
these scenarios turns out to be the case.
Chile’s macro economic situation does not
allow for a large margin of error in the
diagnosis and a wrong decision could have
serious consequences in terms of inflation.
If high prices remain we ought to look
for alternative solutions to accommodate to
that new balance. One option would be to
provide subsidies that allow the poorest
families and sectors of industry to reassign
resources and substitute oil.
But the best way to address the
problem, in such a scenario, would be to
eliminate the direct fuel tax.
Arguments are varied and consistent.
To continue charging a fuel tax is debatable
because it was initially created to charge for
the use of urban road infrastructure.
If the price rise is short-lived, a good
solution would be to introduce subsidies for the
poorest people so they do not have to cut back
2
Graph Nº1: Evolution FEPCO 2008
Lower Band (US$/m3)
Upper Band (US$/m3)
1100
1050
Average Price (US$/m3)
Current price(US$/m3)
Since Feb. the fund has only paid subsidies as the current price has always been
above the defined price band.
1000
950
900
850
800
750
700
650
600
24/01/2008
31/01/2008
07/02/2008
14/02/2008
21/02/2008
28/02/2008
06/03/2008
13/03/2008
20/03/2008
27/03/2008
03/04/2008
10/04/2008
29/05/2008
03/01/2008
10/01/2008
17/01/2008
17/04/2008
24/04/2008
01/05/2008
08/05/2008
15/05/2008
22/05/2008
Note: When the existing price is higher than the upper limit of the band the fund hands out subsidies and
when it is lower it charges taxes.
Source: CNE.
in Japan the cost of road tax rises the older the
car gets and has led to a significant
rejuvenation of the cars on the road today, and
therefore reducing pollution.
The tax is refunded to the consumers
that do not use the oil for vehicular use.
It is not justifiable today to charge such
a tax because with the highways built under
the concession program we have effective road
tolls mechanisms and as the government has
stopped investing in maintenance, consumers
should not be taxed twice.
The government’s response
But the path chosen by the Chilean
government has been different. This year it has
spent a lot of resources on cushioning fuel
price rises. This week the government sent to
congress a bill to inject US$1 billion into
FEPCO and US$250 million for the
capitalization of ENAP. To that you have to add
the US$200 million injected into FEPCO in
January and the money to be given to ENAP to
compensate for the lower income it is from its
sales.
The second issue is related to the
negative externalities due to pollution.
The demand for fuels does not seem to
be elastic and in these cases a tax does not
correct the other externality. If the objective is
to reduce pollution, an effective measure would
be to eliminate distortions that restrict the
purchase of vehicles with more modern
technology, such as the increasing cost of road
tax or providing tax incentives that encourage
people to buy newer vehicles. It has been
proved that the oldest vehicles cause a lot of
pollution, much more than the newer models.
Examples of these measures exist throughout
the world and are very effective. For example,
Although many wanted this type of
intervention, when one looks at what cost
would be entailed, it leaves many questions to
be answered.
The FEPCO works by providing
subsidies when oil prices are above a certain
price band and charges a tax when the prices
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are below that level. In this way, if the
mechanism were well designed and long-term
prices were calculated correctly, the fund would
not require support in the long term, as the
value of the revenue (from taxes) would
balance expenditure (subsidies). But it appears
that the system has not worked correctly. What
was designed to be a price stabilization
mechanism has become a fund for paying
increasingly large subsidies, which causes
inefficiency. Table Nº1 shows the recent
development of the fund and we see that all it
has done recently is hand out subsidies.
justified today, when we have effective road toll
mechanisms for charging consumers for the
use of road infrastructure.
For that reason, handing out subsidies
appears to be the wrong measure. The
payouts by the authorities have meant that fuel
purchasing power has not been hit so hard and
the variation in price levels is lower than what
we would experience if the price was a true
reflection of international prices. This situation
has been repeated with the frozen rates of the
public transport system Transantiago. This
situation is not sustainable, the government
cannot eternally keep injecting resources into
the fund and when prices finally reach their
true levels we will experience a sharp drop in
consumption and a negative jump in inflation
that will draw out the process of inflationary
containment by the Central Bank.
iOp
To address the problem of pollution, the
tax is not effective due to the low level of
elasticity in consumption. It would make more
sense to apply another type of measure such
as tax breaks to encourage people to use
newer cars whose modern technology
contaminates less than old cars.
Conclusion
High oil prices in recent times have led
the government to hand out increasingly large
sums to the FEPCO, meanwhile the fund has
ceased to fulfill its purpose of stabilizing prices
and is becoming a mechanism for paying out
subsidies. There is a high probability that the
high prices are here to stay for a long time, so
any injection of resources into the fund will be
used up in the short term, and will not solve the
problem and we will have wasted a large part
of treasury funds.
The path we should take is to waive the
fuel tax, as charging this tax is no longer
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cit.