It is widely accepted that reforming and removing fossil fuel subsidies is essential for reducing fossil fuel consumption and production. Yet doing so presents various social and economic challenges, with the risk of public backlash and even social unrest. Ibrahim Shittu and Abdul Rais bin Abdul Latiff, of Universiti Sains Malaysia, explore these dynamics in the context of Malaysia, a nation seeking to position itself as a high-income country with ambitious climate policies.

Malaysia’s fossil fuel subsidies have long been a double-edged sword. On one hand, they have cushioned vulnerable households and supported industrial productivity. On the other, they have strained government finances, undermined sustainable economic growth and increased emissions of greenhouse gases.

Today, as Malaysia looks to position itself as a high-income nation with ambitious climate goals, and as global efforts to curtail fossil fuel production gather pace, reforming fossil fuel subsidies has become a priority. Our research, which employs a dynamic Computable General Equilibrium (CGE) model, sheds light on the potential economic, social, and environmental impacts of a targeted fuel subsidy removal. Such an analysis is crucial for ensuring that reform is both equitable and maintains public support, particularly in light of Malaysia’s economic development and climate ambitions, as well as the socio-economic backlash that can arise when reforming and removing fossil fuel subsidies.

The Case for Reform

Fossil fuel subsidies have been a historically significant policy tool for Malaysia, particularly during periods of economic stress, such as the COVID-19 pandemic and the energy crisis triggered by the Russia-Ukraine war. These subsidies—on petrol and diesel—were designed to reduce living costs for low-income households but have increasingly become a burden. In 2022, fuel subsidies accounted for 74% of Malaysia’s total subsidy expenditure, amounting to RM 52 billion (£9.2 billion). As a result, much-needed public investments in infrastructure, education, and healthcare have been sidelined.

Moreover, fossil fuel subsidies have disproportionately benefitted wealthier households. The richest 20% of Malaysians receive 42% of these subsidies, while the poorest 20% get just 4%. This regressive distribution exacerbates income inequality and hampers Malaysia's transition to a more competitive, sustainable economy. Reforming these subsidies is, therefore, critical for unlocking fiscal resources, promoting equitable growth, and supporting Malaysia’s sustainability goals.

But reforming fossil fuel subsidies is a fraught endeavour that can give rise to social backlash and, as a result, stymie further policy developments to reduce fossil fuel consumption and production. Our research explores an array of outcomes from a targeted fossil fuel subsidy reform that shields vulnerable households from the brunt of higher fuel prices. By utilizing Malaysia’s 2015 Social Accounting Matrix (SAM) and updating the data to 2030, we examined the effects of subsidy removal on households, firms, and the broader economy:

Gradual vs. Spontaneous Reform

Our analysis suggests that a gradual phase-out of subsidies is less disruptive to households and businesses compared to an abrupt removal. Gradual reform allows time for adjustments, helping to mitigate short-term economic shocks. Under a more expediated removal, fuel prices increase rapidly, leading to higher inflation and reduced household spending. In contrast, a phased approach keeps inflationary pressures manageable, enabling businesses and households to adapt to higher energy costs without significant disruptions.

Protecting Vulnerable Households

A key finding is that targeted cash transfers to low- and middle-income households can offset the welfare losses associated with subsidy removal. By directing subsidy savings into direct financial assistance, vulnerable groups can maintain their living standards, which helps maintain public support for the reforms. However, excessive reliance on cash transfers can spark inflation without corresponding increases in productivity. Therefore, cash transfers must be complemented by strategic reinvestments.

Reinvestment in Key Sectors

Reallocating subsidy savings into sectors like education, healthcare, transportation, and food assistance proved to have the most significant positive effects on economic output and household welfare. This approach boosts long-term economic growth by improving human capital and infrastructure, which raises productivity. Notably, investments in education and healthcare not only mitigate the negative impacts of subsidy removal but also contribute to the country’s long-term development goals.

Ensuring Public Support and Equitable Outcomes

For any subsidy reform to be successful, it must be just and equitable, and it must enjoy broad public support. Our findings recommend a multi-pronged approach:

• Gradual Implementation: Gradual removal of subsidies spreads the economic adjustment over a period of two years, allowing households and businesses to adapt without causing immediate harm to their living standards.
• Targeted Cash Transfers: To ensure equity, cash transfers should be directed to those most affected by higher fuel prices, particularly low- and middle-income households. These transfers cushion the shock, preserving social stability and support for reform.
• Strategic Reinvestment: Reinvesting savings from subsidy cuts into sectors that promote long-term growth—like education, healthcare, and low carbon transportation—ensures that reform benefits are widely shared.

Linking Reform to Malaysia’s Climate Ambitions

Fuel subsidy reform is not just an economic necessity—it is also a climate imperative. Fossil fuel subsidies encourage overconsumption of energy and contribute to Malaysia’s carbon emissions. Our study shows that removing subsidies can reduce carbon emissions by nearly 10% in the short term and even more over the long term. This reduction is critical as Malaysia seeks to meet its climate commitments, including the goals outlined in the Paris Agreement. By reforming fossil fuel subsidies, Malaysia can accelerate its transition to cleaner energy sources, promote energy efficiency, and reduce its reliance on imported fossil fuels. This transition is essential for achieving both economic resilience and environmental sustainability.

A Path Forward

Malaysia’s path to a just and equitable subsidy reform lies in balancing economic, social, and environmental priorities. A phased approach, combined with targeted assistance for vulnerable households and strategic public investments, ensures that subsidy reform is not only equitable but also politically viable. Such a policy shift will free up fiscal space for critical development spending, while supporting Malaysia’s climate goals and economic ambitions. As the country moves toward high-income status, subsidy reform will be a vital step in creating a more sustainable, prosperous future.