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Policy Research Working Paper 10436 The Effects of Energy Prices on Firm Competitiveness Evidence from Chile Juergen Amann Arti Grover Finance, Competitiveness and Innovation Global Practice May 2023 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure AuthorizedProduced by the Research Support Team Abstract The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Policy Research Working Paper 10436 This paper analyzes the impact of changes in energy prices on the competitiveness of manufacturing firms in Chile. Using the Chilean Annual National Industrial Survey data, the paper illustrates that, first, increases in energy prices generally do not hurt firm competitiveness. Second, the impact of energy prices depends on the fuel typewhile electricity price increases are negatively correlated with firm outcomes, fossil fuel price increases have a positive associa- tion with investment and firm productivity, a result that is consistent with the strong version of the Porter hypothe- sis. Third, these effects are heterogeneous and vary by firm attributes such as size, ownership and location. Fourth, investigating non-linear patterns in firm outcomes based on the level of energy prices, the findings show that the positive correlation between fossil fuel price increases and capital upgrading is particularly pronounced when energy prices are at relatively low levels. This paper is a product of the Finance, Competitiveness and Innovation Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http//www.worldbank.org/prwp. The authors may be contacted at agrover1ifc.org. The Effects of Energy Prices on Firm Competitiveness Evidence from Chile ∗ Juergen Amann University of Nottingham † Arti Grover International Finance Corporation, World Bank Group ‡ JEL Classification D21; D24; L60; O14; Q41; Q55. Keywords Energy prices; Fossil fuels; Firm productivity; Firm-level technology adoption, Competitiveness. ∗ This research was completed under the guidance of Marianne Fay, Country Director for Chile. The authors are grateful to Doerte Doemeland and Yira J. Mascaro for their strategic guidance, and to Esperanza Lasagabaster, Vincent Palmade, Richard Record, Erik von Uexkull and several colleagues from the Ministry of Finance in Chile for their useful comments. † email amannj.workgmail.com ‡ Corresponding author, email agrover1ifc.org1 Introduction Green growth requires green technologies, that is, production techniques that econ- omize on exhaustible resources and emit fewer greenhouse gases. Yet, investment in such technological changes is inhibited because carbon, usually used as shorthand for greenhouse gases GHGs, is highly mispriced. 1 For instance, fossil fuels sub- sidies and the failure to implement taxes or controls for internalizing the risks of climate change result in a substantially lower user cost of carbon than is appropriate from a long-term societal perspective. Pricing carbon to reflect its true cost remains challenging due to political reasons. 2 In addition, assessing the effects of energy price variation on firm-level outcomes is difficult due to extensive data requirements and identification issues. Consequently, empirical work analyzing the impact of en- ergy prices on firm competitiveness is still relatively scarcer in developing countries compared to developed economies Burke et al., 2016. This paper contributes to understanding the effects of energy price increases on manufacturing firm-level outcomes in Chile, an emerging economy, which has undergone fast-paced economic development in recent years. 3 Chile is an interesting case as the country has experienced a substantial variation in primary energy inputs, including hydro, coal and gas, as a primary source of energy production in the past; see Figure A.1. 4 The country has also committed to carbon neutrality by 2050, but its industry continues to depend heavily on fossil fuels despite some progress. In the context of its broader tax reform agenda, the Boric administration that took office in March 2022 is considering corrective taxes and subsidy reforms to incentivize the use of fossil fuel-saving technologies. At the same time, the government has announced 1 Note that in this study, we combine various types of fossil fuels which may vary notably in the amount of GHG emissions. 2 Industrial policies have historically supported the provision of subsidized energy, a major in- put in manufacturing, especially in markets where cost-competitiveness is particularly important El-Katiri and Fattouh, 2017. Consequently, policy makers may fear the adverse reactions of in- terventions targeting a reduction of greenhouse gas emissions through changes in the price-setting mechanism. Climate change mitigation in emerging and emerging economies might pose a challenge from a development perspective if it requires more costly, low-carbon energy sources Jakob and Steckel, 2014. 3 Following the historic World Bank Country and Lending Groups classification last access December 2022, Chile was an upper middle-income country at the beginning of our sample period in 1995 and became a high-income country in 2012. 4 Between 1995-2013, more than 95 of Chilean manufacturing firms used electricity, followed by diesel, with 35-54 using this fuel type. The consumption of other fuels such as LPG and petrol is lower; on average 20-30 firms use these fuels. A relatively smaller share of firms uses natural gas, coke, kerosene and pipe gas. 2various measures to promote investment, innovation and productivity growth. Well- designed policy intervention that combines carbon pricing instruments with targeted adjustment support to overcome initial obstacles to adopting new technologies can yield a win-win outcome of higher productivity and lower emissions. However, the current evidence base for policy design is limited. This paper contributes precisely to this gap by assessing the effects of energy price changes on firm outcomes. To this end, the paper uses the publicly available version of the Chilean Annual National Industrial Survey to study the effects of energy prices on firm outcomes. The data contains 100,803 observations on 12,169 plants, with an average of 4,200 unique firms observed across survey years from 1995 to 2015. We estimate separate elasticities of electricity and fossil fuel for various firm-level outcomes such as pro- ductivity, energy efficiency, employment, wages, and profits employing fixed-effects FE panel estimations. 5 We also estimate the heterogeneity in responses by firm attributes and non-linearities conditional on energy price levels. We add to the ro- bustness of our results through an Instrumental Variable approach where we utilize the regional energy distribution cost to account for unobserved reverse causality. This paper makes the following broad contributions First, it finds that overall increases in energy prices generally do not hurt firm competitiveness. Second, it con- firms notable heterogeneity in how energy price surges affect firm performance of the Chilean manufacturing sector in line with other recent works. These depend on the type of energy input, i.e. electricity vs fossil fuels, Amann et al., 2021; Cal ı et al., 2022, among others and hint at various degrees of substitutability between distinct production inputs conditional on firm characteristics Brucal and Dechezleprˆ etre, 2021, among others. For instance, while electricity price increases negatively corre- late with production and employment, fossil fuel price increases are not necessarily detrimental to firm performance. For example, a 10 rise in fossil fuel prices cor- relates significantly with a capital investment increase of 3.1 and an increase in output per worker of 0.8. In other words, our results support the strong version of the Porter Hypothesis Porter, 1991; Porter and Van der Linde, 1995 for fossil fuel increases but not for electricity price increases. Third, it points out extensive hetero- geneities of energy price hikes along many dimensions. We find heterogeneous effects by firm attributes such as size, ownership and location. The heterogeneity analy- sis suggests that the strong version of the Porter Hypothesis can only be observed for large firms with 50 employees or above. By comparison, small firms observe a negative correlation with surges in energy prices in general and electricity prices in particular. Our results also indicate that the Porter-type adoption mechanism is 5 We construct a harmonized unit price index for fossil fuels by combining information on coal, gas, diesel, petrol, LPG and kerosene use of Chilean manufacturing firms. 3more pronounced for exporting firms and firms under foreign ownership, while firms that only operate domestically and are under domestic ownership are more adversely affected by hikes in electricity prices. Fourth, it presents explanatory evidence that is suggestive of a notable change in the relationship between competitiveness indi- cators and fossil fuel price changes conditional on the price level. We find that the positive correlation between fossil fuel price increases and capital upgrading is more pronounced when fuel prices are low. At higher fuel price levels, this effect becomes smaller and eventually insignificant. Similar non-linear effects cannot be observed for electricity prices. The structure of this paper is as follows section 2, provides an overview of the empirical firm-level literature on the energy prices-productivity nexus while section 3 sets a background of the institutional changes pertaining to energy prices for Chilean manufacturing firms. We then introduce the Estructura de la industria manufactur- era data INE, 2015 in section 4, after which we turn to our empirical strategy and the results in sections 5 and 6, respectively, before concluding in section 7. 2 Literature The literature identifies four main transmission channels for how firms may respond to energy price interventions Rentschler et al., 2017; Coste et al., 2018 One strat- egy, where firms innovate by adopting more efficient technologies and reap economic benefit, is often referred to as the Porter Hypothesis. 6 Additionally, firms may pursue other coping strategies, such as cost pass-on to customers and other firms, absorption or adjusting production inputs, i.e., substitution. Evaluating these transmission channels, the empirical firm-level literature finds broad support for the Porter-type innovation hypothesis, where policy-led price in- terventions lead to innovation and notable business upgrading. Brucal and Deche- zleprˆ etre 2021 show that large and energy-intensive sectors in Indonesian manu- facturing tend to reduce energy consumption most significantly in response to an energy price hike. Plants react to higher energy prices by updating their capital stock and investing in new and presumably more energy-efficient technology. Using firm-level data of small and micro enterprises from Indonesia for 2013, Rentschler and Kornejew 2018 explore the impact of input price changes of electricity and 6 The literature distinguishes between different forms of the Porter Hypothesis Ambec et al., 2013 Under its ”weak” form, environmental regulations spur innovations, while under the ”strong” version, environmental regulations will lead to increases in firm competitiveness. The ”narrow” in- terpretation states that more flexible regulations may be better at providing the preferable incentive structures to firms than more prescriptive forms. 4various fossil fuels on firm performance. The authors find that higher prices for all energy types are associated with higher energy efficiency. Cal ı et al. 2023 evaluate energy prices’ direct and indirect impact on firms’ economic performance for eleven developing countries between 2002 and 2013. Using World Bank firm-level survey data, the authors find that higher energy prices do not necessarily hamper economic performance. They also report considerable heterogeneities, as energy-intensive firms report a smaller performance effect in response to a rise in energy prices than their less energy-intensive counterparts. Cal ı et al. 2022 focus on medium- to large-sized manufacturing firms in two emerging economies Mexico and Indonesia. They find that while surges in electricity price harm plants’ performance, increases in fuel prices yield positive outcomes for labor and total factor productivity and profits. The effects are particularly pronounced for capital-intensive manufacturing sectors. In the same vein, Amann et al. 2021 analyze the effects of energy price hikes on manufacturing firms in Oman. They show that increases in fossil fuel prices are causally linked to improvements in productivity and efficiency and lead to notable business upgrading. As Cal ı et al. 2022, the Oman study only observes such innovation effects for fossil fuel price increases but not for electricity hikes, which are more detrimental to firm performance. The extent to which energy inputs can serve as substitutes depends on the country and policy context. Rentschler and Kornejew 2018 find that while electricity can be substituted away by a blend of other energy sources, it plays a minor role in replacing fossil-based energy sources. Amann et al. 2021 evaluate the substitutability of electricity and aggregated fossil fuels and find that Omani firms significantly increase their kWh consumption of electricity in response to rising fuel prices. Firm-level evidence suggests that the effectiveness of the absorption channels depends on firm characteristics and sectoral attributes. Particularly firms in energy- intensive sectors respond more strongly to price hikes. Rentschler and Kornejew 2018 highlight that firm-level response patterns of Indonesian micro-firms are very different depending on the analyzed sector. Brucal and Dechezleprˆ etre 2021 report that for Indonesian manufacturing firms, energy price increases are causally linked to upticks in plant exit and employment contraction, particularly for en