Estimating the Impact of Energy Price Reform on Saudi Arabian Intergenerational Welfare using the MEGIR-SA Model.

Author:Gonand, Frederic

    At the end of December 2015, the Saudi Arabian government raised some of its administered retail energy prices. For example, the price of automotive diesel fuel increased from 0.25 Saudi Arabian Riyal (SAR) per liter (1) to 0.45 SAR/1 (reap. 0.07US$/1 and 0.12US$/1) while the price of 95 gasoline increased from 0.60 SAR/1 to 0.90 SAR/1 (resp. 0.16US$/1 and 0.24US$/1)--increases of 80% and 50%, respectively (Platts, 2015). In addition, the price of natural gas increased from S0.75/MMBtu to $1.25/MMBtu (resp. 2.81 SAR/MMBtu and 4.69 SAR/MMBtu), an increase of 67% (Platts, 2015). In the Kingdom of Saudi Arabia (KSA), the retail prices of energy (oil products, natural gas, and power) have traditionally been set by public authorities resulting in the retail prices being below the international market price (ECRA, 2015). This has allowed Saudis to benefit directly from the relatively low domestic marginal cost of oil production. A drawback of these implicit subsidies was that it potentially encouraged an inefficient use of energy, thus reducing the amount of oil available for exports and revenue for the Saudi government.

    The rationale for raising retail energy prices at the end of 2015 is due to the need to improve energy efficiency and the plummeting price of oil on world markets in 2015, given that oil income accounts for 88% of Saudi public revenue (SAMA, 2016) and thus impacts on Saudi public finances. The rapid drop in the price of crude oil resulted in a public deficit of around 15% of GDP in 2015 and triggered cuts of 12% in total public expenditures implemented in 2015 (SAMA, 2016). In this context, additional revenues can usefully contribute to improving Saudi public finances. For instance, higher retail energy prices increase the turnover of the public oil sector and also raise oil exports since higher retail prices lessen domestic oil consumption.

    Given these developments, this paper investigates the possible aggregate effects--positive and negative, current and intertemporal--of raising Saudi retail administered energy prices, as in December 2015, with respect to public finances, private income/activity, and generations. In particular, it assesses how these price increases might affect the welfare of Saudis through a direct increase in energy expenditures; an indirect rise in Saudi public income stemming from a lower domestic demand for oil that fosters oil exports at a given level of domestic oil production; and a direct increase in the turnover of the public energy sector. Moreover, given that these two latter effects can be redistributed by public authorities to the Saudi private agents through either higher current public spending or public investments, the different effects of the different redistributions are also considered.

    To achieve this, we develop an energy sector augmented, dynamic macroeconomic model with overlapping generations for the KSA (called MEG1R-SA, Model with Energy, Growth and Intergenerational Redistribution--Saudi Arabia). This, as far as we know, is the first model of this type developed specifically for Saudi Arabia (in fact we believe that this is the first model of this type developed for any Gulf region country). (1) MEGIR-SA is therefore a bespoke model for the KSA that builds on and develops the overlapping generation (OLG) model of Gonand and Jouvet (2015) by specifically including the particular characteristics of the Saudi economy. MEGIR-SA compares the costs of the higher end-use energy price policy introduced in the KSA with the potential economic gains that come from lower oil domestic consumption from higher energy prices, thus higher oil exports, energy sector turnover and public income recycled in the economy. One advantage of using a numerical general equilibrium model is that it allows for a realistic assessment of the size of the macroeconomic effects, not just their sign as in a theoretical model. Another advantage is that it allows us, in some cases, to measure the net macroeconomic effects when different implied mechanisms partially offset one another. Furthermore, MEGIR-SA computes the net effect on Saudi's intertemporal welfare to capture the potential inter generation effect of the policy. Lastly, we focus on measures triggering directly and exclusively intergenerational redistributive effects. Recent price hikes in 2018 for energy products in KSA have been partially offset by systems of cash transfer for poorer citizens (called "citizens' account") for which clear data are not yet available and which trigger intra-redistributive effects. In this context, we consider different scenarios for the KSA. Note we produce simulations, not forecasts so that the results do not suggest the most probable economic path for the KSA in the long run given current information; instead, the possible impact on growth and welfare in the KSA in the long run arising from the increased retail energy prices is analyzed. We consider polar simulations, with future reality probably being somewhere in-between.

    The paper is therefore structured as follows. Section 2 provides a survey of empirical GE-OLG models with energy and KSA Macroeconomic modeling chronology followed by Section 3 that presents the model. Section 4 provides the results. Section 5 concludes and outlines the key policy considerations.


    2.1. Empirical GE-OLG models with energy

    The study of the aggregate impacts of energy policy often involves the use of general equilibrium (GE) models. Solow (1978) popularized the use of the GE framework for analyzing energy and environmental public policies and since then, energy-related GE models have been commonly used (e.g., Parry and Williams, 1999, Bohringer and Loschel, 2006, Knopf et al., 2010). However, most of these models do not account for intergenerational redistributive effects, despite Solow's (1986) argument that it is essential to capture both intra and intergenerational effects of environmental policies. He further points out that intergenerational issues ought to be analyzed within OLG models because such models simulate the behavior of different cohorts of different age, living in the same economy at the same time. Hence, the OLG model framework has been adopted for the analysis in this paper.

    An important body of literature within an OLG framework has developed since John and Pecchenino (1994) and John et al. (1995); however, most of this has been within a theoretical framework involving only two generations. Therefore, the literature on numerical dynamic general equilibrium models using numerous overlapping generations in order to analyze the effects on intergenerational equity of energy policies is scarce and relatively new; such as Carbone et al. (2012), Carbone et al. (2013), Rausch (2013), and Gonand and Jouvet (2015). This paper therefore contributes to this literature by introducing MEGIR-SA (as detailed in Section 3 below).

    2.2. Previous KSA Macroeconomic Modeling

    There appears to be little previous research considering the macroeconomic modeling of the KSA, despite the Kingdom's crucial role and importance in world energy markets. Table 1 details, as far as we are aware, all the previous research using general equilibrium macroeconomic models for the KSA. (2) This shows that that there is a mixture of calibrated models and econometric models, most of which have an energy component to some degree or a full energy module. Despite this, Blazquez et al. (2017) appears to be the only study that utilized a macro model to investigate explicitly the possible impact of implicit energy subsidy cuts in the KSA. Blazquez et al. (2017) suggest that if integration costs of renewable technology were high in the KSA, then households' welfare would be maximized at around 30-40% renewables penetration. Furthermore, a policy favoring renewable energy would increase the dependence of the KSA on oil, given that a larger share of GDP would be linked to oil exports and so, potentially, to oil price shocks.

    Plante (2014) and Balke et al. (2015) also considered the impact of fuel subsidies, but not explicitly for the KSA. Instead, Plante (2014) and Balke et al. (2015) developed a generic open economy calibrated model for net oil importing and exporting countries; thus, the KSA is included only within groups of similar oil-exporting countries. Plante (2014) suggests that fuel subsidies distort the macroeconomic environment and increase aggregate welfare costs. Balke et al. (2015) finds that the removal of subsidies would be welfare improving for the oil-exporting countries, but the optimal subsidy from the point of view of oil exporters is not necessarily zero. However, as indicated these are generic conclusions, not specifically for the KSA. Therefore, although Plante (2014), Balke et al. (2015) and Blazquez et al. (2017) considered the impacts of fuel subsidies on welfare, they did not consider the intergenerational welfare effects of the reductions in energy subsidies, which are considered in detail in this analysis. (3)

    In summary, although some macro models have been developed for the KSA there has been little published work using such models to analyze the impact of the recent increased administrative prices of energy. Moreover, none, as far as we are aware, has addressed intergenerational wealth effects of the changes. These are the points that we address in our research here as detailed below.


    This section outlines the construction of MEGIR-SA. The main features of the OLG setting are first presented followed by a discussion of the details of the Saudi economic characteristics that the modeling of MEGIR-SA takes into account. Annex 1 in the Online Appendix contains further detailed information.

    3.1. The overlapping generations framework

    This framework allows for detailed modeling of the interactions between the consumption/savings and work/leisure arbitrages. (4) The main output of the OLG framework for...

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