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Subsidies don’t influence fuel consumption in China

February 1, 2010

In a previous post, we speculated on possible relationships between fuel subsidies in China, world oil prices, and relative efficiencies in generating innovation gains in energy technology between the US and China.  Our theorising was based on intuition and logic.

Recent analysis supports our view that China’s oil consumption sets world prices, as reported by Kate Mackenzie at the FT’s Energy Source.

However, it appears that a pivotal part of our thinking needs revising:  it seems that removing diesel and gasoline subsidies in China is unlikely to result in a substantial change in Chinese fuel demand – due to very small price elasticity of demand.

Xu Tan and Frank Wolak at the Department of Economics at Stanford University, in the paper “Does China underprice its oil consumption?”, summarise their findings:

 

We find economically significant evidence of under-pricing of gasoline and diesel fuel by China relative to the US over our sample period for all of the approaches to computing the comparable price of these products for the two countries. […..] We estimate that underpricing of oil in the form of gasoline and diesel fuel in China resulted in a total subsidy to Chinese consumers of between 5 and 15 billion dollars in 2007.  We also analyze the likely change in the consumption of gasoline and diesel in 2007 that would result from the elimination of this underpricing and find that it had little impact on gasoline and diesel fuel consumption for short-run own-price elasticities in the range of recent estimates of these magnitudes from cross country studies.

 

The extent of the relative subsidy, and possible impact of a price justification is quite substantial:

Over our sample period the extent of under-pricing of diesel fuel averaged between 10.7% and 18% of the Chinese price of diesel fuel (depending on the counterfactual price used) and the underpricing of gasoline was roughly between 8% and 19% of the Chinese price of gasoline (depending on the counterfactual price use).

They go on to say:

“underpricing of gasoline and diesel fuel is unlikely to have had much of an impact on China’s oil consumption from 2005 to 2008”

The inference that we might draw from this is, that both we and the G20 were misguided: reducing fossil fuel subsidies in China is unlikely to substantially influence Chinese demand, thus, in turn, will not influence the global oil price.

This empirical analysis supports the view of Jeff Vail in an article in the Oil Drum in 2008.  Vail goes on to state that removal of a sub-optimal fuel subsidy may actually enhance oil demand rather than suppress it should the avoided subsidy be applied more efficiently elsewhere in the economy. 

However in an economy such as China, where market economics are already so substantially skewed through State intervention, it is unlikely that an optimal re-allocation would be imaginable.

The relationship between subsidies, price elasticity of demand, and resource re-allocation remains a critical one in attempts to determine suitable climate policy design.  Removal of fossil fuel subsidies retains an important position in the recommendations of the International Energy Agency to reach global climate change targets.

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