Indonesia’s Energy Subsidies In Limbo as Oil Prices Rise

Russia’s war against Ukraine has caused world oil prices to surge to record levels. Days after the invasion, oil prices surged from US$92 to US$120 per barrel, the highest level since 2014. Nobody knows how long the conflict will last or how high prices will go. But if the war escalates, there will be significant ramifications on the global energy supply.

Countries must prepare themselves for a prolonged energy crisis. This includes Indonesia, a net oil importer. In 2021, the country experienced a trade deficit in the oil and gas sector amounting to US$13.3 billion. National fuel consumption is around 1.4–1.5 million barrels per day, while its oil production capacity is less than 700,000 barrels per day.

Indonesian Finance Minister Sri Mulyani said the spike in crude oil prices has put pressure on the state budget. This is because the price hike has increased the cost of energy subsidies at a time when the government is trying to economically recover from the pandemic. The spike in crude oil prices caused energy subsidies in January 2022 to reach US$710 million, a drastic increase from January 2021, which sat at US$160 million.

Indonesia has subsidised its energy sector for years. This includes fuel, gas and electricity. In 2014, the government spent 19.2 percent of its budget on subsidies to ensure ‘affordable’ energy prices. The popularised reason for the subsidies is to maintain welfare standards. Energy prices are associated with the poverty level — if prices increase, the poverty rate is also likely to increase. While Jakarta knows that the primary beneficiaries of fuel subsidies are the middle class, it faces tough political opposition to removing them.

Early in President Joko ‘Jokowi’ Widodo’s term, the subsidy budget decreased due to his energy policy reform. But there are still hidden subsidies in the budget in the form of compensations from the government to Pertamina, a state-owned energy company, and PLN, a state-owned electricity company. With these compensations, Pertamina and PLN can sell their products at a retail price below the cost of production.

In March 2022, the average Indonesian Crude Price (ICP) rose to US$95.7 per barrel. In contrast, the 2022 state budget assumes ICP to be US$63 per barrel. Higher ICP increases the economic price of fuel, which increases the burden of providing subsidies for fuel and liquid petroleum gas (LPG).

According to the Ministry of Energy and Mineral Resources, every increase in ICP by US$1 per barrel will increase LPG subsidies by around US$102 million. Kerosene subsidies will increase by US$3 million, and fuel compensation costs by more than US$185 million. If ICP reaches US$100 per barrel, the government will need to provide an additional US$11.5 billion to cover energy subsidies.

Higher oil prices, which also affect other commodity prices, will increase state coffers. But a significant portion of additional revenue will go towards the increased cost of subsidy provision. It may reach a point at which the extra revenue might not be enough to fully absorb the widening price gaps. This is why Pertamina and PLN have been forced to increase retail energy prices. Given the rising inflation rate, the government has little option but to protect people’s purchasing power by preventing energy prices from increasing too much.

With dwindling oil reserves, volatile oil prices and a general decline in the fossil fuel industry, the government should accelerate the transition towards renewable energy. Energy subsidies have discouraged investment in renewable energy, which will need to change if Indonesia is to meet its renewable energy goals.

In anticipation of future energy shocks, Indonesia must rethink its energy policy. As it plans to transition towards a green economy, the government must continue to reduce fossil fuel subsidies.

If Indonesia wants to achieve energy efficiency, it needs an appropriate pricing policy based on the economic costs of energy. Its biggest obstacle is that years of subsidies have distorted the pricing. Any energy policy reform must effectively address the gap between domestic and international prices, which will mean gradually removing fossil fuel subsidies. Former finance minister Chatib Basri said that while this idea is technocratically sound, it is a politically risky policy. There will be strong resistance, especially as Indonesians grapple with surging food prices.

President Jokowi can use the current energy crisis as momentum for the transition towards a green economy. There are encouraging signs that the government will start implementing a carbon tax in April 2022. But shifting consumer behaviour towards energy conservation and renewable energy will require the removal of inefficient energy subsidies.

The government needs to implement this bold policy reform with caution, balancing the political, social and economic consequences. If successful, it will strengthen Indonesia’s fiscal structure and create incentives for investment in the renewable energy sector. The reform will also signify Indonesia’s concrete action towards tackling climate change, a good reputation to have as chair of the G20 summit in October 2022.