17th October 2008
The Malta Independent - Friday Wisdom
W
e have seen it all before and alas we
are seeing the government playing it again, just like Sam. Whenever
circumstances force it to take unpopular budgetary measures, out comes Minister
Austin Gatt blaming everyone under the sun except the government he forms part
of, explaining in forceful colourful language that reality can no longer be
avoided and that the harsh pill of corrective economic measures has to be
swallowed.
In so doing he prepares for the social partners sitting around the MCESD table, a menu of choices which vary from death through being pushed off a sky scraper or execution by a firing squad. Then after having mentally prepared the nation for a harsh shock, out comes the actual budget measure with very sour medicine but not as horrific as Minister Gatt would have had us believe. The people will thank heavens that it was not as bad as they feared and will praise the Prime Minister for striking a balance between economic necessities and social protection.
The time for such sickening games is long gone. This country needs strong hands on the rudder to veer us through the stormy economic waters that an unavoidable global recession could well bring. The economy must be spared a further shock that could kill the patients rather than massage them gently into adaptation to the hostile economic reality.
Let me set the record straight. I am in full agreement that long-term government subsidies to keep energy prices at unrealistically low levels are no solution. I also agree that there should be no cross-subsidisation across user categories and the current practice of households subsidising industrial and hotel users is regressive and should be abolished. The case against cross-subsidisation along product lines is less clear and I would have thought it makes sense to have higher prices for fuel at the pump to subsidise to some extent basic usage of utility units given that use of the latter is indispensable for basic standard of living whereas use of the former is more discretionary. But I can still live with the concept that no cross-subsidisation along product lines should be allowed and any subsidy should be paid directly and separately by the Treasury.
Where I part company with the minister is the base case assumption regarding current cost of procurement of an imported unit of energy at e0.14,7 per kWh.
This assumption is based on the premise that current costs of energy will remain in force for the long-term. The minister has boasted that hedging agreements saved the country e42 million for the year to September 2008 but with favourable hedging and all, current rates including surcharge at 95 per cent still would leave a hole of e55 million which government can no longer afford to subsidise.
Going forward, the fortunes of the hedging agreement are bound to turn negative as we seem to have hedged at high prices and will not benefit for quite some time from the sharp reduction in energy prices that have been experienced following the price peak of crude oil at USD147 last June. This is not meant as a criticism but purely to show that hedging is not a one-way bet. With crude oil price being so volatile, hedging could present pluses as well as minuses compared to spot rates.
So with a tight budgetary situation what is the best policy to ensure that subsidies are dismantled without shocking the economy more than it will be shocked through the hostile economic environment?
This country has been through such hostile environments before and successfully so. Perhaps Minister Gatt may learn from history and see how past Labour governments navigated past price shocks in basic commodities without structuring in permanent subsidies and without inflicting undue shocks, both economic as much as social.
To my mind, Minister Gatt would do well to consider a price smoothening mechanism similar to the Price Stabilisation Fund operated by Labour government in the 1980s. Price smoothening over the economic cycle is not a subsidy. It simply accepts the reality that over an economic cycle the price of oil will normally move from peak to trough within a spread of say USD50. Let’s take the price range as USD50 at the trough and USD100 at the peak with USD75 being the basic average.
The government should base its tariff on a cost of USD75 at a notional rate of USD1.30 to the EUR which is somewhere close to the purchasing power parity rate. Energy prices, including utility bills and fuel at the pump will be based on the actual cost of procurement within this channel and adjusted frequently to ensure consumer sensitivity to the prevailing international prices.
But there must be a policy that if the price of oil gets higher than USD100 or lower than USD50 these are not reflected in the price mechanism with USD100 being the cap and USD50 being the floor for fixing energy and utility prices for domestic consumption (i.e. excluding bunkering and airline fuel oil which are essentially for international consumption). If the price of energy goes beyond the USD100 mark, the difference is funded by the price smoothening mechanism and this funding is carried forward to be recovered at some future point in time when as normal cycles go, oil will fall below USD50. Any outstanding amounts which remain uncovered or undistributed within five years from origin will have to be reflected for recovery or rebating in future price mechanism by shifting the band higher or lower as may be necessary.
Within this context, hedging is to be used with diligence. For as long as the price of procurement stays within the price band of USD50 to USD100, little hedging is called for as the price movements are immediately reflected in the tariff price adjustments. Hedging is to be actively considered when the price moves outside the normal band with aggressive structural long-term hedging when the price falls below USD50, and tactical short-term risk spreading hedging when the price goes above USD100.
Sometimes it takes a bit of humility to learn from our predecessors when trying to address current problems and we should not assume that we know better simply because we are more IT literate than our predecessors who were used to back of the envelope calculations and human judgement compared to our current sophisticated computer modelling.
As the consequences of the international financial turmoil are showing, it tends to pay in the long run to keep things simple, sometimes as simple as back of the envelope calculations. After all, is it not the sophisticated practices of short selling, financial derivatives, excessive leverage, CDO’s, MBS and other complex securitisation acronym stuff that have brought us to the brink of international financial collapse? Is it not true that our conservative banking practices have saved us from Icelandic nightmares?
Those who thought they can take more risk because we have better and more sophisticated risk management tools have been proven wrong. Perhaps it was worth sticking to conventional back of the envelope risk controls.
e have seen it all before and alas we
are seeing the government playing it again, just like Sam. Whenever
circumstances force it to take unpopular budgetary measures, out comes Minister
Austin Gatt blaming everyone under the sun except the government he forms part
of, explaining in forceful colourful language that reality can no longer be
avoided and that the harsh pill of corrective economic measures has to be
swallowed.In so doing he prepares for the social partners sitting around the MCESD table, a menu of choices which vary from death through being pushed off a sky scraper or execution by a firing squad. Then after having mentally prepared the nation for a harsh shock, out comes the actual budget measure with very sour medicine but not as horrific as Minister Gatt would have had us believe. The people will thank heavens that it was not as bad as they feared and will praise the Prime Minister for striking a balance between economic necessities and social protection.
The time for such sickening games is long gone. This country needs strong hands on the rudder to veer us through the stormy economic waters that an unavoidable global recession could well bring. The economy must be spared a further shock that could kill the patients rather than massage them gently into adaptation to the hostile economic reality.
Let me set the record straight. I am in full agreement that long-term government subsidies to keep energy prices at unrealistically low levels are no solution. I also agree that there should be no cross-subsidisation across user categories and the current practice of households subsidising industrial and hotel users is regressive and should be abolished. The case against cross-subsidisation along product lines is less clear and I would have thought it makes sense to have higher prices for fuel at the pump to subsidise to some extent basic usage of utility units given that use of the latter is indispensable for basic standard of living whereas use of the former is more discretionary. But I can still live with the concept that no cross-subsidisation along product lines should be allowed and any subsidy should be paid directly and separately by the Treasury.
Where I part company with the minister is the base case assumption regarding current cost of procurement of an imported unit of energy at e0.14,7 per kWh.
This assumption is based on the premise that current costs of energy will remain in force for the long-term. The minister has boasted that hedging agreements saved the country e42 million for the year to September 2008 but with favourable hedging and all, current rates including surcharge at 95 per cent still would leave a hole of e55 million which government can no longer afford to subsidise.
Going forward, the fortunes of the hedging agreement are bound to turn negative as we seem to have hedged at high prices and will not benefit for quite some time from the sharp reduction in energy prices that have been experienced following the price peak of crude oil at USD147 last June. This is not meant as a criticism but purely to show that hedging is not a one-way bet. With crude oil price being so volatile, hedging could present pluses as well as minuses compared to spot rates.
So with a tight budgetary situation what is the best policy to ensure that subsidies are dismantled without shocking the economy more than it will be shocked through the hostile economic environment?
This country has been through such hostile environments before and successfully so. Perhaps Minister Gatt may learn from history and see how past Labour governments navigated past price shocks in basic commodities without structuring in permanent subsidies and without inflicting undue shocks, both economic as much as social.
To my mind, Minister Gatt would do well to consider a price smoothening mechanism similar to the Price Stabilisation Fund operated by Labour government in the 1980s. Price smoothening over the economic cycle is not a subsidy. It simply accepts the reality that over an economic cycle the price of oil will normally move from peak to trough within a spread of say USD50. Let’s take the price range as USD50 at the trough and USD100 at the peak with USD75 being the basic average.
The government should base its tariff on a cost of USD75 at a notional rate of USD1.30 to the EUR which is somewhere close to the purchasing power parity rate. Energy prices, including utility bills and fuel at the pump will be based on the actual cost of procurement within this channel and adjusted frequently to ensure consumer sensitivity to the prevailing international prices.
But there must be a policy that if the price of oil gets higher than USD100 or lower than USD50 these are not reflected in the price mechanism with USD100 being the cap and USD50 being the floor for fixing energy and utility prices for domestic consumption (i.e. excluding bunkering and airline fuel oil which are essentially for international consumption). If the price of energy goes beyond the USD100 mark, the difference is funded by the price smoothening mechanism and this funding is carried forward to be recovered at some future point in time when as normal cycles go, oil will fall below USD50. Any outstanding amounts which remain uncovered or undistributed within five years from origin will have to be reflected for recovery or rebating in future price mechanism by shifting the band higher or lower as may be necessary.
Within this context, hedging is to be used with diligence. For as long as the price of procurement stays within the price band of USD50 to USD100, little hedging is called for as the price movements are immediately reflected in the tariff price adjustments. Hedging is to be actively considered when the price moves outside the normal band with aggressive structural long-term hedging when the price falls below USD50, and tactical short-term risk spreading hedging when the price goes above USD100.
Sometimes it takes a bit of humility to learn from our predecessors when trying to address current problems and we should not assume that we know better simply because we are more IT literate than our predecessors who were used to back of the envelope calculations and human judgement compared to our current sophisticated computer modelling.
As the consequences of the international financial turmoil are showing, it tends to pay in the long run to keep things simple, sometimes as simple as back of the envelope calculations. After all, is it not the sophisticated practices of short selling, financial derivatives, excessive leverage, CDO’s, MBS and other complex securitisation acronym stuff that have brought us to the brink of international financial collapse? Is it not true that our conservative banking practices have saved us from Icelandic nightmares?
Those who thought they can take more risk because we have better and more sophisticated risk management tools have been proven wrong. Perhaps it was worth sticking to conventional back of the envelope risk controls.
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