Journal of Economics and Business 87 (2015) 35–49

Contents lists available at ScienceDirect

Journal of Economics and Business

The economic impact of phasing out energy

consumption subsidies in GCC countries
Mahmoud A. Al Iriani a,∗, Mohamed Trabelsi b,1
a
Dubai Economic Council, P.O. Box 112288, Dubai, United Arab Emirates
b
Université de Reims Champagne Ardenne (URCA), Laboratoire d’Economie et Gestion de Reims
(REGARDS), Reims, France

a r t i c l e i n f o a b s t r a c t

Article history: This paper investigates the impact of phasing out energy consump-
Received 13 April 2015 tion subsidies on the Gulf Cooperation Council (GCC) economies
Received in revised form 19 April 2016 using causality analysis between GDP and energy consumption.
Accepted 30 April 2016
The included empirical tests reveal strong support to the feedback
Available online 24 May 2016
hypothesis between the two variables for Qatar and Saudi Arabia,
beyond the sample period. The same tests support the conservation
JEL classification:
hypothesis for Bahrain and Kuwait within and beyond the sample
Q4
period, respectively. Furthermore, the growth hypothesis is sup-
Q43
Q48 ported for Oman beyond the sample period. Finally, the analysis
H2 of GDP-Energy causality relationship in the UAE supports the neu-
H23 trality hypothesis. These results suggest that appropriate energy
policies geared at phasing out subsidies, hence inducing a more
Keywords:
efficient use of energy in this region, should be studied carefully
Energy
and implemented with caution as the impacts of these policies are
Subsidies
Causality expected to differ among individual countries in the region.
GCC © 2016 Elsevier Inc. All rights reserved.

∗ Corresponding author. Tel.: +971 4 2234 555; fax: +971 4 228 5050.
E-mail addresses: maliriani@dec.org.ae (M.A. Al Iriani), mtrabelsi@imf.org (M. Trabelsi).
1
Tel.: + 965 69 00 27 98; fax: + 965 22 24 50 55.

http://dx.doi.org/10.1016/j.jeconbus.2016.04.004
0148-6195/© 2016 Elsevier Inc. All rights reserved.
36 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

1. Introduction

1.1. Background

For decades, subsidizing energy consumption has been a common practice in many of the world’s
developed and developing countries. Governments use energy consumption subsidies (subsidies, for
short reference) as a means to achieving a number of economic and social policy objectives. For exam-
ple, subsidies are used as tools to enhance economic growth through supporting energy-intensive
industries and increasing the competitiveness of the economy as a whole. Governments also utilized
subsidies to improve the access of low-income households to energy and reduce price level fluctua-
tions and overall inflation. In particular, governments in many major oil-exporting countries have been
using energy consumption subsidies as a part of wider subsidy schemes aiming at channeling benefits
of oil revenues to their citizens in order to gain legitimacy and enhance social stability. Governments
typically provide subsidies by maintaining tight controls on the price of electricity and fuel paid by
final consumers therefore leading to substantial decreases in the real prices of consumed energy.
It is widely recognized that subsidies have a number of unintended and lasting effects that are
frequently overlooked by policy makers. Low end-user real prices of energy products lead to more
consumption than would occur if no such price distortions exist. In 2013, the International Energy
Agency (IEA) estimated global fossil-fuel-related consumption subsidies to reach US$ 548 billion (IEA,
2014). In addition, IEA estimates that the world could achieve a 5.8% reduction in global primary energy
demand through phasing out all subsidies by the year 2020 and that phasing out these subsidies would
also reduce energy-related carbon-dioxide emissions by 6.9%. Because subsidies affect how much
energy people consume, they profoundly affect end-use efficiency, the environment, and the national
economy. From an economic point of view, subsidies have detrimental effects on the economy because
they “aggravate fiscal imbalances, crowd-out priority public spending, and depress private investment”
(IMF, 2011, pp. 1). In general, it has been widely acknowledged that subsidies lead to the misallocation
of resources in the economy.
There exists vast literature addressing the economic, social, and environmental impacts of sub-
sidies. The assessment of the extent to which energy consumption is subsidized has been discussed
extensively (see, for example, IEA, 2006; Lin & Jiang, 2011; U.S. EIA, 2000; World Bank, 1997). Examples
of the role of subsidies in encouraging wasteful consumption of energy have been discussed in, among
others (Baig, Mati, Coady, & Ntamatungiro, 2007; IEA, 1999; OECD, 2003). The majority of research has
however been directed toward the implications of subsidies in oil-importing countries. Subsidies in oil
exporting countries, on the other hand, have attracted little but growing attention. Interest in conduct-
ing more research on these issues is now evolving (see, for example, Birol, 1995; Breisinger, Wilfried,
& Ecker, 2011; BuShehri and Wohlgenant, 2012; Fattouh and El-Katiri, 2012). Nevertheless, aside from
a few exceptions, the oil-exporting countries of the Gulf Cooperation Council (GCC) are still under-
represented in the subsidies’ literature. This lack of attention may be attributed to the view that GCC
countries enjoy access to abundant and cheap oil and gas resources. But this view is increasingly ques-
tioned on both the grounds of inefficient use of scarce resources as well as environmental concerns.
Because the GCC region represents a striking example of the practice of subsidies, the extent of
such subsidies and their effects on its economies needs to be further investigated. Until the recent past,
subsidies in GCC countries had not been perceived as a major problem, and these countries had not
felt the detrimental effects of such subsidies due to their vast energy resource endowments. However,
following the sharp fall in international oil prices that started in mid-2014, and the subsequent fall
in oil revenues, the region’s governments have become under pressure to reconsider the level of
subsidies they provide for energy consumption as such subsidies have resulted in financial, economic
and environmental difficulties that need to be addressed. They finally opted for gradually reducing
subsidies. The federation of the United Arab Emirates (UAE) took the lead ln that direction followed
by all other countries in the region with varying degrees.

1.2. Motivation and research objectives

GCC countries have used subsidies for many decades as a means of redistributing oil revenues to
their citizens. Subsidies are provided through low energy prices and tariffs to final consumers. The
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 37

effect of such subsidies on the economies and the environment of GCC countries and the consequences
of phasing them out has attracted little attention from both governments and researchers. This paper
represents an attempt to shed light on the various issues associated with subsidies in this region.
Specifically, in light of the recent decision by different governments in the region to phase out fuel
subsidies, we will test for the likely impact on their economic growth and development.
Section 2 of this paper provides a primer on GCC economies, concentrating on their economic
growth and energy consumption. Section 3 outlines the methodology used to investigate the
GDP-energy relationship. In Section 4, we empirically test the causal relationship between energy
consumption and economic growth using data from the six countries. This allows us to investigate
the potential effects of phasing out subsidies. Section 5 concludes with implications of the empirical
results, and policy recommendations.

2. A primer on GCC economies

The Gulf Cooperation Council (GCC) is comprised of the states of Bahrain, Kuwait, Oman, Qatar,
Kingdom of Saudi Arabia (KSA), and the UAE. The six states extend over 2.6 million square kilometers
of land (84% of which is in Saudi Arabia) and have a combined population of 47 million people. In
2012, the total GDP of the group stood at 1.6 trillion US dollars, with per capita GDPs that are among
the highest in the world (Table 1). A common attribute among this region’s countries is that they are
oil-export dependent (except for Bahrain, which has a small oil reserve but succeeded in turning itself
into an international banking center, attracting a large amount of the area’s petro dollars). Another
common attribute is that the substantial oil revenues following the rapid increase in world crude oil
prices in the early 1970s fueled their economic take-off. With the exception of Kuwait, which went
through a devastating war after the Iraqi invasion in the early 1990s, GCC countries have enjoyed
relatively high economic growth rates since the mid 1970s.

2.1. Energy resources: reserves, production and exports

GCC countries are major producers and exporters of oil and natural gas. They hold approximately
30% of global oil reserves and 23% of global natural gas reserves (BP, 2014). They currently contribute
about 24% to the world’s total crude oil production and more than 11% of its natural gas production.
What distinguishes this group of countries from most other major oil and gas producers is that they
export the bulk of their oil production to international markets. In 2011 the region contributed around
40% and 16% to the total world trade in crude oil and natural gas, respectively. The largest crude
exporter within the GCC is KSA followed by the UAE and Kuwait. On the other hand, Qatar dominates
natural gas exports from the region. It exported around 14% of the global total in 2012.

2.2. Energy consumption and economic growth

In addition to being main oil and natural gas producers and exporters, GCC countries are increas-
ingly becoming major energy consumers as well. Although they consume only a fraction of their own

Table 1
Some economic and social indicators of GCC countries, 2012.

Country Population (million) Area (1000 km2 ) GDP (current $ billion) GDP per capita ($1000)

Bahrain 1.32 0.76 30.4 23.04

Kuwait 3.25 17.8 183.2 56.4
Oman 3.31 309.5 78.3 23.6
Qatar 2.05 11.6 189.9 92.6
KSA 28.29 2150 734.0 25.9
UAE 9.21 83.6 383.8 41.7

Total CC 47.43 2573.3 1599.6 –

Source of data: World Bank (2014).

38 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

Fig. 1. Primary energy consumption in GCC countries and other selected regions.
Source of data: (a) BP (2014) and U.S. EIA (2013); (b) World Bank (2014) and U.S. EIA (2013).

oil production, their share in global oil and gas consumption is rising rapidly. In 2012, the share of
GCC countries in the world’s crude oil consumption stood at almost 5%, and that of natural gas stood
at about 6.4% (BP, 2014). The share of total primary energy consumption in the largest GCC countries
(Kuwait, KSA, Qatar and the UAE) has more than quadrupled from 0.61% in 1970 to 3.1% of the world’s
total consumption in 2013. Since 1980, primary energy consumption continued to grow at rate much
higher than the world’s average. In addition, with their high consumption levels and small popula-
tions the levels of GCC per capita primary energy consumption have become some of the highest in
the world (Fig. 1).
In the early 1970s, international oil prices have witnessed a rapid increase that surpassed their
historical averages, leading to substantial increase in oil exporter’s revenues. Because of the vast
inflow of oil revenues to the GCC countries, they have experienced accelerated rates of growth in
their economies. With this take-off in the economies of the GCC came an unparalleled growth in
energy demand (Fig. 2). Energy consumption in this group of countries has increased from 16.8 mil-
lion tons of oil-equivalent in 1971 to about 416 million tons of oil equivalent in 2010 (BP, 2014). This
represents an average annual growth rate of about 8.4%, far above the 2.2% world average. Realizing
the need to curb this substantial growth in energy consumption, increasing attention is being paid
to the issue of energy conservation in the region. GCC governments have launched some energy con-
servation programs, including Demand Side Management (DSM), but they are still at the very early
stages. Policies to promote efficiency in energy consumption are still inadequate and, in most GCC
countries, are confined to some educational media and moderate energy tariff and price adjustments.
Moreover, despite recent moves to reform their local energy markets, subsidies are still widely present
in GCC countries and are likely to make these countries’ efforts to slow the pace of growth in energy
consumption more difficult.

2.3. Energy consumption subsidies

Substantial energy consumption subsidies prevailing for decades in the GCC countries have
undoubtedly contributed to their economic growth and improved their populations’ standard of liv-
ing. Subsidies lead to lower real energy prices, making cheap energy available for fueling economic
activities. Economic development, population growth, and urbanization have in turn led to an unprece-
dented increase in energy needs. Moreover, the substantial subsidies that have been prevailing in each
country of the region are believed to have significantly contributed to this increase in energy demand,
which, as Fig. 2 indicates, surpassed their average economic growth rates. End-consumer energy prices
in the GCC have been kept artificially low, due to subsidies, leading them to become some of the lowest
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 39

Fig. 2. Real GDP and energy consumption (EC) in GCC countries (index, 1980 = 100).
Source of data: World Bank (2014) and BP (2014).

in the world (see Fig. 3a). Some variations exist within the GCC where, for example, the diesel retail
price in KSA has been until recently only 9.4% of its level in the UAE.
Developed countries as well as many energy-importing developing countries have taken various
measures to eliminate or reduce subsidies. GCC countries however have until recently continued to
subsidize their energy consumption substantially. To appreciate the extent to which subsidies prevail
in that region, Fig. 3b shows subsidies as percentages of respective GDP’s in 2012.
The rapid increase in energy consumption in GCC countries raises legitimate concerns about the
availability of future crude oil and natural gas exports, as well as concerns about the negative impact
of burning fossil fuels on the environment. The existence of subsidies is also likely to hinder GCC
countries’ announced efforts to encourage the use of alternative clean energy and increase efficiency
(Charles, Moerenhout, & Bridle, 2014). The governments of the GCC countries have been able to keep
up with their accelerated growth in energy consumption; but there have been signs of difficulties.
Subsidies have led to an increased burden on GCC governments’ finances and begun to erode their
net energy exports. Some GCC countries like Kuwait and the UAE have recently become net importers
of natural gas, after their domestic production became insufficient to satisfy exploding energy needs.
In addition, KSA’s huge natural gas resources are now barely capable of satisfying domestic demand.
These difficulties have been reflected in the form of occasional blackouts and fuel shortages that have
40 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

Fig. 3. Fuel prices and energy subsidies in the GCC and other selected economies.
Source of data: (a) GIZ, International Fuel Prices 2015; (b) OECD (2014).

occurred lately in a number of GCC countries. Nevertheless, realizing the role of subsidies in main-
taining social stability, the GCC countries have been reluctant to tackle this issue as they considered
subsidies an important part of their oil wealth distribution schemes.
Notwithstanding the role of subsidies in fulfilling GCC governments’ economic and social objectives,
the recent sharp fall in international oil prices and the subsequent decrease in oil export revenues have
put these governments under increasing pressure to reevaluate their ongoing subsidy policies. They
are now keener to consider long overdue fiscal and economic reforms, starting with cutting subsidies.
In this regard, the federation of the UAE took the lead and other GCC countries have followed suit. The
UAE deregulated gasoline and diesel prices starting August 2015. The UAE government still sets and
announces domestic prices monthly using their international market levels as a benchmark. Only a
few months after UAE’s move KSA, Oman and finally Bahrain have adopted some measures to phase
out subsidies.
The transition to less or no subsidies has been smooth in the UAE, KSA, and Oman while public
discontent has briefly surfaced in Bahrain. Qatar on the other hand has not announced any immediate
plans to follow its neighbors in their move. Kuwait has rowed back on its plans to cut subsidies because
of stiff public resistance, but reports indicate that the government has succeeded in obtaining the
parliament’s approval to increase water and electricity tariffs, and is still negotiating further reform
plans. Despite reduced subsidies, fuel prices in GCC countries remain lower than their international
levels, and additional subsidy reforms in the water and electricity sectors are long overdue.

3. Methodology

This paper attempts to address the issue of subsidies in GCC countries and, in particular, investi-
gate the impact of phasing out such subsidies on their economies. In order to achieve that goal, the
analysis starts by econometrically investigating causal relationship between energy consumption and
economic growth in these countries. The uncovered causality relationship is then used to examine
the effects of phasing-out subsidies on the GCC economies. Theoretically, energy contributes to GDP
because it is a factor of production and thus energy consumption is a determinant of economic growth.
On the other hand, as the economy grows, energy consumption increases in all sectors and hence the
level of growth becomes a determinant of the amount of energy consumed. Energy-GDP causality lit-
erature shows that causality relationship between energy and GDP may take any of four forms (Apergis
& Payne, 2009; Squalli, 2007). Causality may be unidirectional running from energy consumption to
GDP (the growth hypothesis), or from GDP to energy consumption (the conservation hypothesis). Alter-
natively, bidirectional causality may exist (the feedback hypothesis) or the two variables may have no
causal relationship (the neutrality hypothesis).
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 41

Investigating the causality direction between energy and GDP in GCC countries is important in our
subsidy analysis because the causality direction has its own policy implications. If causality follows
the growth hypothesis then reducing subsidies will result in a decrease in energy consumption, which
is in turn expected to have a negative impact on growth. Alternatively, if causality follows the con-
servation hypothesis then removing subsidies will not have a negative impact on GDP growth. In fact,
removing subsidies enhances energy efficiency and as a result increases growth in the economy. In
the case of feedback hypothesis, subsidy removal should take into account the feedback effect of GDP
on energy consumption. In this case, other policies should be adopted to reduce the economy’s energy
dependence and to avoid the negative impact on economic growth resulting from the reduction of
energy consumption. Finally, if no energy-GDP causality exists then removing the subsidies, and the
resulting reduction in energy consumption, is expected to have no impact on growth.
The relationship between energy consumption and GDP has been largely studied in the context of
designing efficient energy policies, and the direction of causality uncovered by different studies has
been mixed. The interest in the subject dates back to a pioneering study by Kraft and Kraft (1978).
In their analysis, the authors used data on gross energy inputs and gross national product (GNP) for
the USA, and found that causality runs from GNP to energy consumption. Their study was followed
by several studies on the US and other developed countries, some of which challenged the causality
results of Kraft and Kraft (Akara & Long, 1980; Belke, Dobnik, & Dreger, 2011; Soytas & Sari, 2003; Yu
& Hwang, 1984, as examples). Tests of the relationship between energy and economic growth in the
transition economies were the subjects of studies by Cheng and Lai (1997) and Acaravci and Ozturk
(2010), among others. In general, there is no consensus on the causality direction between GDP and
energy consumption in developed and transition countries.
More recently, more attention has been paid to studying the causality between energy consumption
and GDP in developing countries (Cheng, 1999); and in oil-exporting countries (Al-Iriani, 2006). How-
ever, results are not more conclusive than those obtained from developed and transition economies.
In some cases, the direction of the relationship was presumed to be from energy consumption to GDP
and its magnitude was estimated using a number of different methods (for example, see Moroney,
1989; Shrestha, 2000). Others have used a number of causality estimation methods to investigate both
the direction and magnitude of the relationships (Asafu-Adjaye, 2000). As indicated above, results in
these studies have been mixed and sometimes conflicting. On the methodological front, empirical
findings have shown the nature of energy–GDP relationship to vary depending on the econometric
methodology used and the span of the data.

3.1. Testing for causality: an augmented VAR approach

Traditionally, causality between two variables is widely tested using standard tests based on
Granger (1968), Sims (1972), Engle and Granger (1987), and Johansen (1988). In this approach, the
Johanson’s methodology is first used to test for integration and cointegration of the variables in
question prior to testing causality (Johansen, 1988, 1991, 1995). According to this methodology, a
p-dimensional Gaussian Vector Autoregression (VAR) may be specified as follows:
Zt =  + 1 Zt−1 + 2 Zt−2 + · · · + p Zt−p + εt (1)
where  is a p × 1 vector of constant terms,  i are p × p matrices of time-invariant coefficients, Z is
a vector of integrated variables, ε is a p × 1 vector of identically and independently distributed errors
(IID), and t is time.
If the non-stationary variables in the vector Z are cointegrated, Eq. (1) is re-parameterized in its
equivalent vector error-correction model (VECM) form (see Engle & Granger, 1987; Hendry, Pagan, &
Sargan, 1984; Johansen, 1988):


p−1

Zt =  + i Zt−p + ˘Zt−p + εt (2)

i=1

where  is a difference operator,  i is p × p coefficient matrices i = 1, . . ., p − 1, ˘ is the matrix of long

run parameters, and ε is a vector of impulses (εt ≈ niid). If the matrix ˘ has a rank r that is equal to the
42 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

number of co-integrating vectors, it can be written as ˘ = ˛ˇ where ˇ is the matrix of co-integrated
vectors (p × r) and ˛ refers to the adjustment coefficients (p × r). Thus, Eq. (2) can be rewritten as
follows:

Zt =  + 1 Zt−1 + 2 Zt−2 + · · · + p−1 Zt−p+1 + ˛(ˇ Zt−p ) + εt (3)

In this last equation, the rows of ˇ represent the cointegrating vectors whereby represents ˇ Xt
the linear stationary processes. The ˛’s are the adjustment coefficients toward long run equilibrium
measuring the strength of the cointegrating relationship in the VECM.
Next, in the Vector Error Correction (VEC) approach, we are able to test the direction of causality
and to distinguish between short-run and long-run Granger causality. Indeed, if the null hypothesis
on the adjustment coefficients (H0 : ˛ = 0)1 is rejected, we have a long run relationship between the
variables. As for the short-run causality, it is carried out using the standard Wald test (with F statistic)
where in the null hypothesis (H0 ) the coefficients of the lags of the first differences are equal to zero
( ij (L) = 0).
However, the above methods were criticized as yielding inconsistent results. In addition, in the
recent literature Toda and Yamamoto (1995) and Pesaran, Yongcheo, and Smith (2001) show that
there exist severe biases associated with unit root and cointegration tests due mainly to the fact that
cointegration tests are not reliable in finite samples and low power of unit root tests. The Wald test
does not have a standard distribution and as a result it might not be appropriate in carrying out Granger
causality tests. Furthermore, many studies have shown that when unit root test power is low, Johansen
cointegration tests are not reliable in finite samples, which is likely to create severe biases to these
tests.
To address such concerns, Toda and Yamamoto (1995) and Dolado and Lütkepohl (1996) sug-
gested independently a new procedure to test causality. The new approach does not require prior
conventional tests of integration and cointegration for the achievement of causality analysis, which
helps to overcome the sequential nature in VAR causality analysis with VECM modeling (Giles and
Mirza, 1999; Zapata and Rambaldi, 1997). The Toda and Yamamoto’s (1995) test is called the modified
Wald test (MWALD). It requires the estimation of an augmented VAR and guarantees an asymptotic
distribution of the Wald statistic. More specifically, it consists of testing linear restrictions on the
coefficients of the unrestricted VAR. This test is carried out by determining the relevant lag order of
the unrestricted VAR (p) and the maximum order of integration of variables in the VAR (dmax ). The
causality tests are achieved through the estimation of the VAR system with an order equal to (p + dmax ).
To test the causality between energy and economic growth, we need to estimate the following VAR
system:


p+dmax

p+dmax

p+dmax

Z1t = 1 + ˇ11,k Z1,t−k + ˇ12,k Z2,t−k + · · · + ˇ1p,k Zp,t−k + ε1t

k=1 k=1 k=1

p+dmax

p+dmax

p+dmax

Z2t = 2 + ˇ21,k Z1,t−k + ˇ22,k Z2,t−k + · · · + ˇ2p,k Zp,t−k + ε2t

k=1 k=1 k=1 (4)
..
.

p+dmax

p+dmax

p+dmax

Zpt = p + ˇp1,k Z1,t−k + ˇp2,k Z2,t−k + · · · + ˇpp,k Zp,t−k + εpt

k=1 k=1 k=1

The null hypothesis in testing long-run Granger causality from Zi to Zj is that: ˇji,1 = · · · = ˇji,p = 0, and
ˇji,p refers to the coefficient of the pth lag of the variable Zi.

1
It is the weak exogeneity test of Johansen and Juselius (1992) where we test zero restrictions (using standard t-statistic) on
˛ (i.e. ˛ = 0).
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 43

Table 2
Johansen cointegration test results.

Hypothesized number of Bahrain Kuwait Oman Qatar KSA UAE

cointegrating equations

trace test
None 8.43* 55.35* 63.17* 74.93* 94.68* 50.40*
At most 1 3.40* 24.73* 17.32 34.28* 45.07* 24.29*
At most 2 4.71* 5.64 15.67* 11.77 11.33
At most 3 0.45 0.87
max test
None 35.03* 30.63* 45.85* 40.65* 49.61* 26.11*
At most 1 18.69* 19.09* 10.85 18.61* 33.30* 12.96
At most 2 14.26* 5.21 14.80* 8.26 11.00
At most 3 0.45 0.87
*
Denotes rejection of the hypothesis at the 0.05 level, based on MacKinnon–Haug–Michelis (1999) p-values.

4. Data and empirical results

4.1. Cointegration analysis

Our analysis uses GCC annual data from 1980 to 2011. Real GDP per capita and government expend-
itures were obtained from the World Bank’s “World Development Indicators” (World Bank, 2014) and
IMF’s “World Economic Outlook” (IMF, 2014). Data for electricity consumption, energy use, and oil
price were obtained from the British Petroleum’s “Statistical Review of World Energy” (BP, 2014).
Some more recent data were also obtained from national authorities.
In order to implement the causality tests detailed in Section 3, we had to determine the order of
integration of the different variables that will be used in estimation. For this step, we used three unit
root tests: the Augmented Dickey–Fuller (ADF) (1979), the Phillips–Peron (PP) (1988) test and the
Kwitkowski, Phillips, Schmidt, Shinn (KPSS) test (1992). The null hypothesis of these tests assumes
the existence of a unit root in the data. We conducted the unit root tests but chose not to include the
results here to conserve space especially since they have become standard procedures.2 The results
of the three tests indicated that the series are non-stationary in levels and that the maximum order
of integration is equal to one. Even though the Toda and Yamamoto’s procedure does not require
prior conventional tests of integration and cointegration, the stationarity test helps in determining
the number of lags used in the VAR model (which is equal to one in this case).
Next, we tested for cointegration using VAR-based Johansen methodology developed in Johansen
(1991, 1995). The test results in Table 2 were obtained using electricity consumption (EC) as a proxy
for energy. However, when we used energy use (EU) as another proxy the results were similar. The
results in Table 2 show that the null of zero cointegrating vectors is rejected. In fact, both the Trace and
max-Eigen statistics in Table 2 confirm that there exists at least one cointegrating equation, implying
a long run relationship between our four variables in the case of each country.

4.2. Augmented VAR causality analysis

After confirming the existence of long run relationships between the variables of interest in each of
the GCC countries, we proceed with causality analysis as outlined in Section 3. We stress that regardless
of what we concluded about cointegration this is not going to affect our causality analysis if we use
Toda and Yamamoto’s method outlined above. To conduct the causality analysis, we merely need to
determine the order of integration which will determine the maximum number of lags (d) to be used
in the (p + dmax )-order Gaussian VAR system. The vector of variables is Z = (YPC, EC or EU, G, OP), where
YPC is per capita GDP, EC is electricity consumption, EU is energy use per unit of GDP, G is the ratio of
public spending to GDP, and OP is international oil price.

2
Unit root test results are available from authors upon request.
44 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

Table 3
Granger causality test results.

Country P* MWALD-stat

EC  YPC EU  YPC YPC  EC YPC  EU

1 2 3 4

Bahrain 1 10.50 (0.005) 7.78 (0.020) 6.64 (0.036) 12.51 (0.002)

Kuwait 2 0.96 (0.810) 4.92 (0.295) 11.22 (0.011) 11.38 (0.015)
Oman 1 7.31 (0.026) 0.12 (0.943) 1.12 (0.572) 3.59 (0.166)
Qatar 1 5.92 (0.052) 5.13 (0.077) 12.56 (0.002) 13.79 (0.001)
KSA 1 4.75 (0.093) 0.86 (0.650) 8.16 (0.017) 8.03 (0.018)
UAE 2 3.03 (0.386) 3.16 (0.366) 1.19 (0.756) 0.72 (0.232)

(1) MWALD-stat is the modified Wald statistic for testing the respective null hypothesis and is asymptotically 2 distributed.
MWALD statistic is compared with the asymptotic critical values.
(2) P* is the optimal lag length of the unrestricted VAR and it was determined using multiple criterion (AIC, SC, HQ). LM test
was also used to confirm the absence of residual serial correlation.
(3) Numbers in brackets are p-values.

We used two models to estimate the causality relationship between our variables. To determine the
optimal lag length of the VAR, multivariate versions of information criteria were used. Table 3 displays
the results of the aforementioned MWALD tests of causality with a maximum order of integration
equals to one, using EC as a proxy for energy and then using EU as a different proxy. The table present
the VAR results for the variables of interest only (YPC and EC or EU). All data were transformed to their
log form before estimation. The MWALD statistics in columns 1 and 2 of Table 3 reveal statistically
significant direct bidirectional causality between energy and GDP in the case of Bahrain, Qatar, and the
KSA using any of EC or EU as energy proxy. In addition, causality runs from energy to GDP in Oman.
The results in column 3 and 4, on the other hand, indicate that causality runs from GDP to energy
in Kuwait. Finally, in the case of UAE, the tests does not support the existence of causality between
energy and GDP.

5. Variance decomposition

The above results give us indications of causality directions between GDP and energy. However,
given the fact that the MWALD tests are only relevant within the range of time indicated by the sample,
we use the variance decomposition (VD) approach to decompose the variance of the forecast error
of each variable into proportions related to shocks of other variables in the system. This approach
maintains the validity of causality tests beyond the sample period. More specifically, the VD approach
consists of applying a shock to the innovations εit of the unrestricted VAR that will have an immediate
and future effect on values of the rest of the variables through the dynamic nature of the system. In
other words, the innovation in each of the four variables has an effect on the immediate and future
values of the other three variables in the system. Using the VD then makes it possible to carry out the
breakdown of the forecast error variance of energy proxies and GDP into the future. We use the VD as
a test for the robustness of our causality results presented in Table 3.
The results of VD of the forecast error are presented in Table 4, for the energy consumption proxies,
EC and EU respectively. They show the forecast error variances up to twenty periods ahead by showing
the percentage of variance that each variable explains in each country in the GCC region. The VD tests
is used to gauge the relative strength of the causality results obtained earlier. All in all, the outcome
illustrated in Table 4 seems to support most of the causality results obtained through MWALD tests.
Indeed, the results show that a shock in energy consumption explains at least 20% of the forecast error
variance of GDP per capita after ten years in Bahrain, Oman, Qatar and KSA, hence confirming our
causality results. On the other hand, the VD tests in Table 4 does not seem to support the conservation
hypothesis between economic activity and energy consumption in Kuwait, neither does it support
the neutrality hypothesis for UAE. However, as Masih and Masih (1996) put it, “the decomposition
analysis is a relative exercise and results from it should be interpreted with this mind”.
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 45

Table 4
Generalized variance decomposition.

GDP response to a shock in energy Energy response to a shock in GDP

EC EU EC EU

5 10 20 5 10 20 5 10 20 5 10 20

Bahrain 2.6 3.5 3.9 0.6 0.5 0.6 9.3 18.0 25.7 16.0 17.7 21.0
Kuwait 7.5 8.1 6.6 5.9 5.3 6.2 45.4 35.9 36.1 40.2 32.9 37.8
Oman 10.4 9.3 6.5 6.0 14.2 18.2 6.1 1.8 1.0 0.3 1.1 1.9
Qatar 12.3 13.3 27.4 39.5 55.5 44.6 13.0 19.0 22.0 3.3 2.0 2.1
KSA 5.7 5.6 11.7 9.3 12.9 19.5 19.4 19.1 16.8 4.2 6.7 6.7
UAE 1.0 4.9 17.2 27.5 19.5 16.6 4.5 10.0 9.5 0.3 5.1 13.3

The numbers stand for the percentage of the forecast error variance of real GDP per capita and energy consumption that is
explained by a shock to energy consumption or real GDP per capita after 5, 10 and 20 years.

Table 5
Summary of causality results.

Energy ⇒ GDP GDP ⇒ Energy

GC VD GC VD

Bahrain * *** ***

Kuwait * *
Oman *** ***
Qatar *** *** *** ***
KSA *** *** *** ***
UAE *

Columns with “GC” and “VD” headings indicate model results with Granger causality and variance decomposition respectively.
(***) indicate robustness test is passed.

To sum up, Table 5 summarizes the causality relationship results between energy consumption
and GDP in GCC countries. The empirical evidence presented is supportive of the existence of causal-
ity running from energy consumption to economic growth in Oman. This may reflect the fact that
subsidies in Oman represent the second highest percentage of GDP in the region. Direction of causal-
ity in Oman supports the growth hypothesis, meaning that higher consumption of energy is likely to
directly influence the volume of economic activity in this country. For Bahrain, Qatar, and KSA, the
causality results support the feedback hypothesis, meaning that the two variables are causing each
other. However, the bidirectional result for Bahrain is supported only within the sample period as
indicated by the variance decomposition test. For Kuwait, within sample causality test gives support
to the conservation hypothesis, an expected result given that energy consumption in Kuwait is heavily
subsidized. Surprisingly, the causality results support the neutrality hypothesis in the UAE within the
sample period. This result is difficult to explain, but one explanation may be the fact that this country
has a relatively highly diversified economy, reducing the mutual effects of GDP and energy on each
other.

5.1. Testing for causality: a panel approach

Many have suggested that short data span lowers the power of the unit root and cointegration
tests and hence prevents robust causality analysis (see for example, Lee, 2005; Pierse & Shell, 1995).
In order to deal with this “small sample” problem and increase the power of the tests, we utilize panel
data (Maddala & Wu, 1999)3 to test for integration, cointegration, and finally causality between our
variables of interest. Panel analysis may be used to further test the robustness of our augmented VAR
causality results.

3
We would like to thank an anonymous referee for suggesting this extension of the analysis.
46 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49

Table 6
Panel unit root test.

EC EC EU EU YPC YPC G G

Null: Common unit root process

LLC 17.46 −3.18*** 1.73 −2.41*** 0.35 −1.77** 0.35 −1.23*
Breitung t-stat 1.86 −2.13*** 0.26 −6.31*** 2.34 −3.57*** 1.81 −1.69**

Null: Individual unit root process

IPS W-stat −0.52 −6.48*** 3.07 −7.51*** −1.57** −4.84*** −1.26 −5.98***
ADF-Fisher 2 0.01 63.43*** 3.56 71.62*** 9.48 46.39*** 9.47 54.72***
PP-Fisher 2 0.00 101.60*** 12.82 129.11*** 11.54 60.14*** 11.54 101.94***
*
The rejection of the null hypothesis at 10%.
**
The rejection of the null hypothesis at 5%.
***
The rejection of the null hypothesis at 1%.

Table 7
Johansen–Fisher panel cointegration test.

Hypothesized number of cointegrating equations Fisher stat from trace test Fisher stat from max test

None 122.2* 75.45*

At most 1 68.08* 57.94*
At most 2 25.21* 23.32*
At most 3 13.84 13.84
*
Denotes rejection of the hypothesis at the 0.05 level, based on MacKinnon–Haug–Michelis (1999) p-values.

Table 8
Panel causality test results.

Dumitrescu Hurlin panel causality test*

EC EU

W-Stat Zbar-Stat W-Stat Zbar-Stat

GDP does not Granger-cause energy 13.01 (0.000) 11.36 (0.000) 12.25 (0.000) 10.56 (0.000)
consumption
Energy consumption does not 12.31 (0.000) 10.62 (0.000) 7.45 (0.000) 5.54 (0.000)
Granger-cause GDP
*
Numbers in brackets are p-values.

Our panel cointegration and causality analysis starts with panel unit root tests in order to determine
the order of integration of our variables (Im, Pesaran, & Shin, 2003; Levin et al., 2002). We test for
panel unit root using both common and individual unit root processes. Table 6 shows the results of
such tests, confirming that the panel series are integrated of order 1. Next, we use Johansen Fisher
panel cointegration test, which is characterized by higher power than individual series tests, to test for
cointegration between our variables in their panel form (Larsson, Lyhagen, & Löthgren, 2001; Maddala
& Wu, 1999). The results of Johansen Fisher test in Table 7 indicate the existence of 3 cointegrating
equations, indicating that the cointegration findings of the individual country series remain robust in a
panel settings, and implying the existence of long run relationship between the variables in question.
Finally, once the panel cointegration was uncovered, we use panel causality test with individual
coefficients proposed by Dumitrescu and Hurlin (2012) to test for the causality direction between
our variables of interest.4 The test results in Table 8 indicate that bidirectional panel causality
exists between GDP and energy, giving support to the conclusions we obtained using the Toda and
Yamamoto’s causality method.

4
It is well known that cross-section correlation is likely to be present in panel causality testing and may bias test results.
Hence the panel causality results presented here should be taken as indicative only. Nonetheless, Dumitrescu and Hurlin (2012)
used Monte Carlo experiments to show that their standardized panel statistics have very good small sample properties, even
in the presence of cross-sectional dependence.
 M.A. Al Iriani, M. Trabelsi / Journal of Economics and Business 87 (2015) 35–49 47

6. Conclusion and policy implications

The aim of this paper was to analyze the expected implications of energy subsidy reforms in the GCC
countries. The analysis uses causality analysis to uncover the direction of causality between GDP and
energy consumption during the period 1980–2013, and implications to the effects of energy subsidy
phase-out on the economies of the region. We used the Toda and Yamamoto’s (1995) approach in
testing causality where the VAR is composed of four variables: GDP per capita, an energy consumption
proxy, the ratio of public spending to GDP, and the oil price. We then extended our analysis to panel
causality, which is shown to have more test power given our limited time series sample.
The results of the analysis lend support to the conclusion that GCC countries are not homogeneous
in terms of the relationship between energy and economic growth. Robust results of causality running
from energy to GDP have been uncovered for Oman within and beyond the sample period as per
the variance decomposition test. On the other hand, bidirectional causality has been uncovered for
Bahrain, Qatar, and Saudi Arabia. However, only the results for Qatar and KSA were shown to hold
beyond the sample period. Hence, robust causality runs from GDP to energy for Bahrain. The same
conclusion applies for Kuwait, where causality tests indicates a unidirectional causality running from
GDP to energy within the sample period in that country. Results for UAE do not lend support to the
existence of causality between the two variables.
Implications of the research results on the energy subsidy-phase-out policy can be summarized
as follows: the choice between phasing out subsidies and maintaining the status quo depends on the
expected effects of such a choice on each economy in the GCC. Oman shows a growth hypothesis effect
where abolishing subsidies and the resulting reduction in energy consumption will lead to a negative
impact on GDP in that country. Qatar and KSA follow the feedback hypothesis indicating that other
policies should be adopted to reduce the economy’s energy dependence and to avoid the negative
impact on economic growth resulting from the reduction of energy consumption. The change to less
subsidies should also take into account the feedback effect of GDP on energy consumption in these
two countries. On the other hand, causality results in Bahrain supports the conservation hypothesis
beyond the sample period and feedback hypothesis within the sample period implying the need to
carefully design a phase-out policy that takes into account such feedback effect. In Kuwait, conservation
hypothesis is supported within the sample period. This hypothesis implies that phasing out energy
subsidy may not have significant negative effects on economic growth. Rather, abolishing subsidies
may enhance energy efficiency and increase economic and environmental sustainability.
An interesting observation emerge from the analysis above and is worth mentioning. Because of
the specific results of our econometric exercise, and because of data limitations and the particular
methodology used, these results are only indicative. Phasing out subsidies in the GCC countries is
likely to have different impacts across their economies. Therefore, a decision to phase out subsidies
should be studied further to assess its impact on each country, preferably using disaggregated data at
the economic sector level. Since such data is not available to independent researchers, the suggested
future analysis is feasible only as a governmental exercise, using primary survey data.

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