solution finder

07 May 2019

Smart subsidies - creating markets instead of distorting them

Author/Compiled by
Urs Heierli (Antenna Foundation)
Raphael Graser (Antenna Foundation)
Reviewed by
Jeske Verhoeven (IRC)
Caroline Saul Jennings (EAWAG)
Astrid Agthoven (Aqua for All)
Fanny Boulloud (Antenna Foundation)
subsidies
Executive Summary

Subsidies are usually provided by governments and are direct or indirect (monetary) benefits to a sector in order to overcome initial barriers of serving certain markets that are barely viable and only very limited providers do want to serve. Market-based approaches for safe water are not in contradiction to subsidies. But subsidies provided by governments, (I)NGOs, philanthropists etc. should be applied in a smart way. Meaning subsidies should grant better access to safe water for the poor and stimulate the creation of markets and not undermine the development of businesses. Smart subsidies should be used in such way that if they are stopped enterprises do still exist.

The smart subsidy factsheet introduces subsidy schemes and provides specific information on how to introduce subsidies in the safe water sector in a smart way.

The case study about smart subsidies in Nepal highlights positive and negative examples of how institutions and NGOs have been dealing with subsidising safe water products and intervening in the safe water market. The example of Tinkisso’s experiences in Guinea reveals that free HWTS distribution has an impact on market development but needs to be executed in a smart way not to undermine private sector development.

Factsheet Block Title
What are smart subsidies?
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In prevalent subsidy regimes governments generally give direct or indirect (monetary) benefits to a company to overcome the initial barriers of serving certain markets that are not viable but provide health improving or public goods. This market intervention allows supplying specific products at a set market retail price (INVESTOPIA, 2017). In a similar way are ODA (official development aid) agencies and governments supporting or have been supporting specific products or services for the poor. Examples are highly subsidised or even free distribution of health products, malaria nets or setting up of water fountains and wells. This practice is unfortunate for sustainable market creation as if these subsidies are not retained, either the products are not available anymore (because the production is not profitable anymore) or it will lead to higher market prices for consumers and thus most likely much lower sales as people are not willing (and able) to pay a significantly higher price for the same safe water product (e.g. filters or safe water). This is specifically the case when catering to the Base of the (economic) Pyramid (BoP). Smart subsidies on the other hand are not market-distorting instruments rather they stimulate market creation processes and support the establishment of safe water enterprises as such in a sustainable and long-term manner. The concept of smart subsidies advocates for potential monetary interventions to intervene at the operational level of an enterprise. Rather than subsidising the production process as such by covering operational costs [OpEx] (as it is often the case with conventional subsidies) smart subsidies support capital expenditures [CapEx] not directly linked to production and the supply chain. Additionally can smart subsidies intervene in the blueprint and validation phase of a business, facilitating feasibility studies, business model evaluation, product development or payment schemes etc. (for more information please see factsheets of the blueprint phase and validation phase). An important consideration whether subsidies are smart or not is the criteria of long-term availability and what happens if the subsidies are withdrawn. If the supply chain collapses, subsidies were not smart. In this sense, one-time subsidies are smart while continued subsidies may distort markets and lead to collapsing supply chains and business models if withdrawn (FERRER DUCH & KELLER, 2010; GOLDSTEIN, 2016; FEDERAL RESERVE BANK OF BOSTON, 2012). The table below provides an overview and concrete examples distinguishing smart and un-smart subsidies:

Summary of smart and unsmart subsidies. Source: HEIERLI, 2018

Distinction smart vs. un-smart subsidies

Smart subsidies…: Un-smart subsidies…:
It is possible to subsidise CapEx costs to make one-time investments more profitable (e.g. subsidizing the infrastructure for water kiosks or water supply is ok). Subsidizing OpEx costs will lead to collapse of a business/ supply chain if subsidies are withdrawn. It is absolutely crucial to ensure operation and maintenance of infrastructure without external subsidies.
Financing social marketing activities of enterprises. Subsidise production that lead to retail prices below production and distribution costs (and is not sustainable).
Subsidies directly targeted to the poorest who cannot afford the sustainable price. This can bring in new customers (e.g. via vouchers) and allow more inclusiveness. It is, however, better to invest in more efficient provisions and bring the prices down to a level affordable for all.

Disturb prices and accordingly lead to unviable markets if a subsidy ends.

Also, low prices or free goods are not appreciated and have a low status. It is better to design aspirational products and services that people are willing to purchase and pay for.
Market creation investments that allow to sell more services or products and realise economies of scale (e.g. social marketing).
 
Direct product subsidies that create no value for a product.
Subsidising start-up costs and allowing a more efficient production and distribution system. Giving products away for free (except in emergency situations). This creates a wrong product perception and no value to a product. If subsidies end, people will not continue buying.
Subsidies may support the transition from emergency to long-term enterprise operations. Often, a good infrastructure is built during emergencies but this will deteriorate if people do not pay for operation and maintenance. Continued subsidies and free provision that suddenly stops after the emergency is over.

 

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Why should smart subsidies be applied?
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Over the past decades, people at the bottom of the economic pyramid (BoP) have always be seen as beneficiaries only, without any purchasing power and neither as consumers (for more information see also BoP factsheet). This perception led development institutions, governments, NGOs and philanthropists to provide products or services for the poor either free of cost or highly subsidised (It must be clarified that the delivery of free goods during emergency situations is clearly an exception, such as the need to contain outbreaks of diseases and provide relief in distress situations, and has accordingly been separated from the discussion at hand). If chlorine tablets are given free of cost, there is no need to buy them, no incentive to sell them, and consequently, they will not be available when needed. The results (of distorting subsidies) are destroyed or inexistent markets, no emerging customer base, wrong product perception and unsustainable supply chains, especially in the safe water sector (GRASER, 2015). Hence it is not surprising that the term “subsidy” often has a negative connotation (MURDOCH, 2006) as it is associated with hampering the real development of markets, leading to unsustainable outcomes and benefitting only a minority of the population. This is the reason why smart subsidies should foster the support of sustainable

Example: Is there a sustainable solution to reach people with safe water?

For example, how come sales of mobile phones are skyrocketing, even if there is no electricity available? People have both the willingness and ability to pay for aspirational products, products that reflect a certain status. Hence selling can work: What is essential is to create a viable supply chain network: If nobody can make money in delivering safe water or household water treatment and safe storage (HWTS) products, there will be no sustainable safe water businesses in the long-run. Many well-intended approaches to bring safe water to the poor have thus failed (HEIERLI, 2018). This is where the concept of smart subsidies comes into play. Proponents of smart subsidies advocate using subsidies not simply by subsidizing production and supply chains, but by supporting the creation of sustainable markets through massive demand stimulation and social marketing activities. And thus, allowing the emergence of viable supply chains and creating a customer base aware of the need to drink safe water. Subsidies can also be used to make safe water more inclusive, but they should be targeted to the poor only and not be applied across the board. For example, in Nepal the price for chlorine was kept artificially low (mainly through NGO subsidies) – below the production cost as the retail price was not adopted over time. This practice has hampered the emergence of a market, no enterprise nor can NGOs afford production in the long term if the revenue does not even cover production costs. It is also important to see that the chlorine was sold through pharmacies to mostly middle-class customers who were not the target of these subsidies (the product was aimed reaching poor in urban and rural areas). Targeting subsidies to only the most vulnerable poor (cf. the base of the pyramid) is very challenging and can usually only be achieved by product diversification with different pricing schemes from standard business approaches and through new approaches like blended finance (for more information please see the factsheet on blended finance)

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For whom is the concept of smart subsidies interesting?
Factsheet Block Body

Smart subsidies are interesting for safe water entrepreneurs, NGOs, investors and governments willing to create sustainable markets for HWTS and water services that benefit the poor, but have thus so far not been able to reach scale and significant impact. This factsheet can be used to reach out to public and private donors to make them understand how subsidies can sustainably be integrated in a market creation process by allocating money in a comprehensive and sustainable manner. Additionally, it can be used by safe water businesses to understand how subsidies could support their business development in a sustainable way especially with a focus on what happens if subsidies stop.

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How can smart subsidies be applied?
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To apply smart subsidies within a safe water initiative one has to reflect on how financial support could develop safe water markets and ensure long-term profitability of a business.

The key criterion whether a subsidy is smart is sustainability. Ask yourself: How will your business be impacted when a subsidy is withdrawn or reduced? If the amount of money is reduced, are you still able to distribute and sell your product or service under the same conditions (price and profit)?

To identify smart ways of subsidising your business, identify what costs and investments can be externally covered that are not affected by the daily production:

  • Costs that can be externally covered, that are not interfering the viability of your supply chain and production process.
  • Investments in social marketing methods that create or enhance markets and customer base such as providing safe drinking water in schools and all methods to enhance awareness creation.
  • One-time investments in CapEx can be smart, while those subsidies that are interfering with the operation and maintenance costs are critical.

 

Specific smart safe water subsidies include market development methods like marketing, social marketing, awareness raising and capacity building. Practical methods can be increasing visibility of products and services, emphasizing health impacts and medical cost savings when drinking safe water and convenience of using household water treatment solutions (HWTS) (for more information please see factsheet on social marketing). Addressing these public tasks of awareness raising about safe water needs to be aligned with government interventions and can enable public-private partnerships (Box PPP Canvas). If governments are though not able or willing to bear the costs of such campaigns smart subsidies are a financing option to consider. Such approaches can include output-based (result-based) investments to strengthen impact through a variety of means (for more information see factsheet on blended finance). One example are result-based subsidies (e.g. carbon finance) which should be used to expand markets and not to subsidise the daily operations. Even if the revenues of carbon credits decline, e.g. due to lower prices in the carbon market – this should not affect the daily operations if the money is used for the CapEx investments.

Concretely can smart subsidies be implemented with the use of the following instruments:

  • Identify ways to develop products or services further to reach larger numbers of customers and thus enhance profitability. Keep in mind: Safe water supply chains are usually a low margin / high volume business.
  • Identify potential public-private-partnership opportunities and partners that are willing to subsidise your CapEx or social marketing activities (for more information see also factsheet on blended finance)
  • Eliminate un-smart subsidies that are directly linked to production and delivery in your actual business model in the mid-term as it bears a high risk to hamper sustainability.

 

The case study about smart subsidies in Nepal highlights positive and negative examples of how institutions and NGOs have been dealing with subsidising safe water products and intervening in the safe water market. The example of Tinkisso’s experiences in Guinea reveals that free HWTS distribution has an impact on market development but needs to be executed in a smart way not to undermine private sector development.

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Library References
Further Readings

Towards 'smart' subsidies in agriculture? Lessons in recent experience in Malawi

This paper discusses Malawi’s experiences in identifying and overcoming the challenges facing “smart” subsidy programmes in the agriculture sector. Emphasise is put on aspects of sustainability and cost effectiveness.

DOWARD, A. ; CHIRWA, E. ; BOUGHTON, D. ; CRAWFORD, E. ; JAYNE, T. ; SLATER, R. ; KELLY, V. ; TSOKA, M. (2008): Towards 'smart' subsidies in agriculture? Lessons in recent experience in Malawi. URL [Accessed: 20.04.2018]

Financing WaterCredit to enhance access to water and sanitation for attainment of SDGs

This paper discusses WaterCredit - an innovative credit-driven model being promoted by Water.Org which enables financial institutions to offer loans to their clients for water and sanitation related products and services via the support of smart subsidies.

GUPTA, S. ; LABH, P. (2016): Financing WaterCredit to enhance access to water and sanitation for attainment of SDGs. URL [Accessed: 20.04.2018] PDF

The ‘S word’: Is it time for the sanitation sector to reconsider subsidies?

This article sheds light on the discussions about smart subsidies in the water and sanitation sector hold at the Stockholm World Water Week in 2017. A special emphasise is put on the discussion around supply-led subsidies and innovative modes of smart subsidies.

EDWARDS, S. (2017): The ‘S word’: Is it time for the sanitation sector to reconsider subsidies? . URL [Accessed: 20.04.2018]

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