Reforming energy consumption subsidies, in particular for fossil fuels, has been frequently referred to as a quick-win policy to enhance environmental mitigation. In addition to producing environmental benefits, the removal of such subsidies may release a sizeable portion of a country's national budget for use on more productive targets. One of the most recognized challenges of such reform is "selling" the new energy prices to citizens, particularly those with a more fragile purchasing power. Several empirical and technical studies, of which some have been acknowledged by international organizations, have prescribed that the reform might be supported by a direct compensation mechanism in order to raise the necessary public support and ensure feasibility.
This is what was done, for instance, during the recent energy subsidy reform in Iran. However, the compensation mechanism implemented in Iran's reform was successful at the beginning, but did not proceed as expected. This has raised questions about the feasibility and sustainability of the direct compensation mechanism, and even of the reform policy itself.
In this paper, we consider a model where direct compensation is the instrument proposed to restore consumers' utility against increased energy prices. We investigate the feasibility of a reform policy under such a compensation constraint, and we incorporate possible side effects of the reform on non-energy production costs. We find that, when prices of Other Goods are affected by the announced reform policy, the feasibility of a subsidy reform critically depends on the value of certain parameters: the initial subsidization rate, the energy intensity of the economy, and the expected side effects of the reform.
Published December 2015 , 15 pages