Why Indonesia Needs to Reform Its System of Energy Subsidies

The unprecedented rise in fuel prices caused by the war between Russia and Ukraine has forced Indonesia to massively increase its energy subsidies. This decision has sparked much internal debate about how best to balance economic improvement with Indonesia’s commitment to a green energy transition. We believe the government should seriously consider reforming the country’s energy subsidy system if it wants to get its climate mitigation back on track without hurting the economy.

Recently, Indonesia’s policy of domestic energy subsidies has come under fire for its massive scale in the midst of the current global recession. President Joko Widodo declared last month that the state had raised the state budget allocation for subsidies from Rs 152 trillion ($10.2 billion) to Rs 502 trillion ($33.8 billion). This significant increase has been the result of high consumption of subsidized fuel and LPG by the public amid high world crude oil prices. Without a resolution to the conflict between Russia and Ukraine, allocated energy subsidies will continue to rise. On the one hand, this policy is necessary to maintain people’s purchasing power and stabilize the economy, which is still recovering from the COVID-19 pandemic. On the other hand, the implementation of the energy subsidy could have a series of unintended consequences.

Indonesia’s energy subsidy policy aims to keep energy prices stable and affordable for all levels of society. By keeping energy prices below the market price, 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 to boost Indonesia’s economy. As the most reliable source of energy, securing fossil energy is critical for developing countries to meet growing energy demand.

One problem in Indonesia is that the wealthy also enjoy access to subsidized fuel due to the government’s weak monitoring system. When Indonesia increased the price of non-subsidized fuel products such as Pertamax Plus and Pertamax, most consumers simply switched to Pertalite, a subsidized fuel. The absence of specific requirements for the purchase of subsidized fuel facilitates access for the middle and upper classes. As a result, the demand for Pertalite, despite its lower quality, grew by almost 30 percent, which is not surprising given that its price is almost half that of non-subsidized fuels. Therefore, the government must allocate more subsidies, further burdening the state budget.

The implementation of energy subsidies also hampers the development of renewable energy, as it supports greater use of fossil energy. Subsidies make renewable energy less competitive with fossil energy and therefore less accessible to the public. It is possible that the given subsidy does not adequately take into account the negative externality of the fossil energy used. Therefore, the increase in energy subsidies can be considered a step backwards in terms of efforts to increase Indonesia’s renewable energy mix and mitigate the impacts of climate change.

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

Energy subsidies are a sensitive issue for society due to the widely shared desire to access energy at the lowest possible price. The more developed a country is, the more energy is needed, so the allocated subsidies will be highlighted and will have an impact on the state budget. Relieving the burden on the state budget by raising energy prices also often provokes backlash. The increase in the price of fuel will reduce the trade balance deficit, especially for oil and gas. At the same time, it may also risk inflation and massive layoffs in the industrial sector.

The introduction of direct subsidies, the actual payment of funds to low-income people, is often promoted as a solution to the Indonesian problem. The implementation of direct subsidies will improve the efficiency of the state budget and will directly benefit low-income people, ensuring that the burden of rising energy prices does not severely harm them. Direct subsidies will also improve the competitiveness of renewable energy, allowing energy to be established at its market price. Therefore, as fossil energy prices rise, renewable energy could emerge as an attractive and more affordable alternative.

Although direct subsidies are intended to maintain the purchasing power of low-income people, they also have economic costs. Subsidy reform would also affect the industry’s operating costs. Allowing power to fetch its market price will increase operating costs, pushing the industry to reassess the efficiency of its operations. In the worst case, companies can lay off large numbers of workers. Therefore, the government cannot turn a blind eye to the side effects of introducing a direct subsidy.

Reforming energy subsidies by implementing direct subsidies alone cannot solve the problem of energy subsidies in Indonesia. The implementation of direct subsidies requires government intervention and collaboration between the various actors.

The application of direct subsidies would have to be done in stages. In this case, the government needs to gradually reduce energy subsidies and implement direct subsidies for those in need. This action must be done carefully 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 learn the true price of energy and begin to change their lifestyles to become wiser and less wasteful in the way they use energy. At the same time, the industry should also promote energy efficiency in business, which would help ensure that changes in energy subsidies have little impact on business activities.

The application of direct subsidies must also be followed by efforts to present alternatives to the affected sectors. These efforts include the development of city gas networks, renewable energy 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 critical aspects is the acceleration of a renewable energy bill, as well as promoting more fiscal and non-fiscal initiatives to attract more investors and accelerate these efforts. With all of these pieces in place, Indonesia will improve its energy security and protect itself from the economic vulnerabilities of rising global energy prices.

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