# **1. Introduction**

The underpricing of energy – notably fuel products – has a predictable, and sometimes significant, impact on demand. Energy subsidies – if persistent – can also affect the dynamic factor mix, creating a bias for energy-intensive production and usage. Indeed, existing evidence from MENA indicates that pervasive energy subsidies have created large distortions in markets and investment choices.

One consequence of the underpricing of energy that is relatively understudied and quantified concerns the external costs that arise through the pollution and congestion that result from excess use of fossil-fuel-powered vehicles, as well as the associated transport modal choices. For example, evidence from the Arab Republic of Egypt, notably Cairo, indicates massive – and growing - congestion with high levels of associated pollution, part of which can be attributed to the excess demand for private vehicles and fuel consumption that results from the large subsidies that fuels attract. While transport – particularly road transport – may offer a particularly stark illustration of the external costs, significant costs may also arise in other sectors. In agriculture, fuel subsidies – depending on the institutional and pricing arrangements for water supply – can lead to over-rapid depletion of water reserves and to crop selection that may principally reflect the underpricing of water rather than the comparative advantage of the country or region. Similarly in manufacturing, the sectoral mix of output and employment may be directly affected by the price of energy that may also influence the choice of technology. When energy prices are low, production will tend to be energy intensive and wasteful and this is often associated with relatively high rates of pollution and other external effects.

The magnitude of external effects associated with the underpricing of energy has not been consistently measured. However, the IMF (2013) has attempted to estimate the difference between pre- and post-tax subsidies where the latter include a tax aimed at charging for external effects linked to pollution, CO2 emissions, congestion and so on, as well as an additional tax on energy consistent with the standard indirect tax rates applying in the country. Although their calculation is clearly very approximate, it provides an initial reference point. For Egypt the gap between pre-and post-tax subsidies expressed as a share of government revenues was over 8 percentage points (30.6 versus 39.1) in 2011. This discrepancy is far from trivial and for reasons that will become clear later, is likely to be an underestimate.

This paper is exploratory – not least because of serious data limitations - and as a consequence we restrict our attention to understanding the size of external effects of energy subsidies in two sectors – transport and agriculture – focusing, in the first instance, on the congestion and pollution costs and, in the second instance, focusing on resource (water) depletion and crop selection. At this point, two locations are selected – Cairo in Egypt for the transport dimension and the Republic of Yemen for the agriculture dimension.

The paper is organized as follows. Section 2 identifies the external effects that we are interested in and the main channels or processes through which energy pricing affects the main variables of interest. It then outlines how they affect the performance of economic actors and the economy as a whole. In discussing the main methodological and empirical issues it also reviews the results of earlier, relevant studies. Section 3 then provides evidence for transport from the MENA 2