Columns - The Sunday Times Economic Analysis

Responding to oil price hikes: Conservation and alternate energy

By the Economist

At last the severity of the oil price increases has awakened the government to think of reducing the import of oil. Up to now the issue was looked upon as a problem of rising fuel prices to consumers. In fact the first policy response was to subsidise fuel and electricity prices that was an economically irrational and financially unsustainable policy. Countries that followed a similar policy, such as Indonesia and the Philippines, too have given it up. Discontinuing the subsidy has of course drawn political condemnation and consumer disapproval, as you would expect. Yet this was inevitable in the context of ever rising international oil prices.

International oil prices have risen by as much as about 50 percent in the last year. There is no doubt that the rising price of fuel is a fundamental reason for inflation as it affects prices directly and indirectly. Therefore subsidising fuel prices may seem an anti-inflationary policy and justified in terms of economic stabilisation and growth. This is not so as the subsidy would have to be borne by the people through deficit financing that in turn results in inflation. Apart from the issue of deficit financing causing inflation, there is an inequity in such a policy as the burden of the fuel price increase is then borne not by the users but by others.

And this shifts the burden generally to the poor. Further, the increase in consumption of fuel owing to subsidised prices causes an increase in demand and thereby compounds the problems by increasing the trade deficit and creating a balance of payments problem. This in turn results in a severe drain on foreign exchange.

The increase in the price of petroleum has been the prime reason for the massive trade deficits that have been growing progressively. The trade deficit this year is likely to exceed the massive deficit of over US $ 3500 million last year.

In fact in the last few months of the year the deficit for the same period last year has been exceeded by a substantial amount. With oil prices continuing to rise, it is likely to create a serious dent in the balance of payments. It may be of such a magnitude that the capital inflows this year may not be able to offset the trade deficit as in previous years.

It is worthwhile to point out that the Sri Lankan economy is deriving a few advantages from the oil price increases. Tea prices are rising and therefore tea export earnings are increasing. In 2007, as in the recent past years, tea export earnings alone were adequate to finance our total imports of food, the prices of which were increasing. This year too tea prices are rising in the same manner as oil prices. However there is a possibility that oil prices would rise much faster than tea, and tea export earnings may not be adequate to finance food imports. The oil price increase has had a favourable impact on rubber prices as well. Owing to the higher costs of production of oil-based synthetic rubber, natural rubber prices have skyrocketed. However, we are unable to benefit fully from this price increase as rubber production has declined over the years and the possibility of increasing rubber production in the short run is minimal. Increasing rubber production could be a strategy in the long run. Besides, countries in South East Asia are expanding rubber cultivation on a far larger scale than it would be possible for us, due to land scarcity. The third advantage we have had is in increased remittances from Sri Lankan workers in oil producing countries due to an increased demand for workers in these countries and higher wages consequent to their inflation.

However these advantages are inadequate to cope with the balance of payments problem created by the oil price increases. At last there is a consciousness that oil imports must be reduced in the face of the ever increasing import costs of oil. The price of oil has now reached nearly US$ 140, much above the expectations a few months ago. Despite optimistic expectations of oil consuming countries being able to tame oil prices, there is no evidence that this would happen. Therefore it is vital that the country finds ways of coping with the crisis. How should Sri Lanka respond to the crisis? It should be a three pronged strategy. First, measures must be taken to stabilise or even reduce consumption through conservation of use. Second, there should be efforts to increase alternate energy sources to substitute for oil. Third, the economic growth of the country should focus on tradable goods that increase export earnings to meet the higher costs of oil imports. All three strategies are needed if the country is to cope with the severity of the crisis and bring a measure of relief to the balance of payments.

In as far as conservation of energy use is concerned it appears that even the sharp increases in prices have had minimal effect on curbing consumption. This is due to several reasons. First, petrol, diesel and gas are essential items of consumption and a prior demand on income. Transport is basic for people to earn their livelihoods. Where it is used for less essential needs, the consumers are of two categories, the rich who can afford the increased costs of travelling and those who do not pay for the petrol they consume, such as ministers, members of parliament, high government officials and private sector executives who are given unlimited allowances for travel. A third factor is, much of the oil consumption is for the thermal generation of electricity, military and security operations and public transport. The related issue of conserving electricity use that consumes oil is also one that has some of these attributes. There is wasteful use of electricity by public bodies and corporate entities as the users do not pay the bill. Any programme of attempting to reduce both fuel consumption and electricity consumption must attempt, as much as possible, to devise policies that ensure that the consumer pays. The principle of “consumer pays” can reduce consumption. The implication of this is that unlimited use of fuel and electricity by consumers, whose bills are paid by another party, whether it is a private corporate entity or the government should be avoided.

With the escalation of oil prices the use of alternate forms of energy are becoming more attractive. Explorations of oil in Sri Lanka have in the past been a mirage. More certain are possibilities of solar energy, wind power and bio fuels. Hydro-power expansion on a large scale is limited but small hydro power stations could make a useful contribution to supplement electricity at local levels. What is needed is a comprehensive strategy to develop energy sources. This has been lacking .Now that oil prices have become a serious concern the country must turn towards research and implementation of alternate power sources.

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