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Policy Brief Fossil Fuel Subsidies Introduction There is no universal definition of what constitutes a fossil fuel subsidy, although the WTO has developed a general definition of subsidies that is accepted by 153 member states and that forms the Key messages • There is growing consensus that phasing out fossil fuel subsidies is an essential part of the green economy transformation, by sending a right price signal to the market about the true cost of energy and by creating fiscal space that could be used to implement green economy policies across key sectors. • In theory, fossil fuel subsidies have important policy objectives. In reality, they have a negative impact on the environment, absorb substantial fiscal resources, fail to benefit targeted groups and encourage excessive consumption of energy. • Compensation measures for vulnerable households and businesses can help cushion them against the adverse impacts of rising fuel prices following subsidy removal, but they are not a panacea and need to be adapted to a country’s particular circumstances. They also need to be implemented with complementary measures – such as broader energy sector improvements; an effective communication campaign to inform the public about the objectives and expected impacts of reforms; and a supportive administrative apparatus to ensure smooth implementation. • Governments can use the revenues saved from subsidy reform to redirect public investments to clean energy and augment public expenditure for research and development in green technologies. For instance, tax incentives could make investments in clean technologies more attractive while government funds could reduce the risk profile of capital-intensive green technologies. basis for understanding fossil fuel subsidies specifically.1 Among international organizations, there is considerable consensus on what fossil fuel subsidies consist of and how to measure them. Subsidies for fossil fuels2 can take several forms: ÌÌ Direct financial transfer: e.g. fuel vouchers or grants to producers or consumers; ÌÌ Trade instruments: e.g. tariffs on imports of crude oil and petroleum products, which make domestic fuel production more lucrative; quotas and technical restrictions; ÌÌ Regulations: e.g. gasoline prices regulated at below international market levels; regulations that prioritise use of domestic coal for power generation; market-access restrictions; ÌÌ Tax breaks: e.g. favourable tax deductions for depletion or investment in oil and gas fields and coal deposits.; excise exemptions for fuels used in international air, rail or water transport ÌÌ Credit: e.g. loan guarantees to finance energy infrastructure or preferential rates on loans to producers ÌÌ Risk transfers: e.g. insurance or indemnification provided to fossil-fuel producers at below-market levels; limitation of financial liability ÌÌ Below-full cost access to government goods and services: e.g. provision of seismic data for oil and gas exploration. Estimates of the scale of fossil fuel subsidies vary depending on the methodology used, the type of subsidy measured and country coverage. The IEA and the IMF use the price-gap approach, which is the difference between domestic fuel prices and a reference price, in this case international fuel prices. In its latest assessment in 2013, the IEA estimates that US$ 544 billion was spent on fossil fuel subsidies globally in 2012. IMF calculates both pre-tax subsidies – which exist when energy consumers pay prices that are below the costs incurred in supply, which amounted to US$492 billion in 2011 – and post-tax subsidies, which include the cost from environmental externalities such as air pollution and health impacts from fossil fuel use, which amounted to US$ 2 trillion, equivalent to 2.9% GDP and 8.7% of government revenues (see Figure 1). The Organisation for International Cooperation and Development (OECD) uses an inventory approach and measures all the mechanisms used to support fossil fuel consumption and production in its 34 member countries. The organization estimates that between US$ 55 billion and US$ 90 billion was provided to support the use and production of fossil fuels every year between 2005 and 2011. In comparison, US$1,3 trillion a year – or 2% of global GDP – is required to put the global economy on a green economy path (UNEP, 2011), and US$5 trillion is needed for global green infrastructure investment needs.3 UNEP defines a green economy as one that results in improved human well-being and social equity, while significantly reducing environmental risks and ecological scarcities. Figure 1. Global energy subsidies Pre-tax. $492 billion (0.7% GDP, 2.1% revenues) Coal, 7 Petroleum products, 220 Natural gas, 116 Electricity, 150 Post-tax. $2 trillion (2.9% GDP, 8.7% revenues) Coal, 709 Petroleum products, 728 Natural gas, 376 Electricity, 179 ÌÌ Subsidies are a drain on public finances and reduce the funds available for addressing social and developmental objectives. For instance, fossil fuel subsidies in the Middle East and North Africa region amount to 13% of GDP and about 35% of revenues. ÌÌ By sending distortive price signals, fossil fuel subsidies encourage excessive consumption and production of energy, which puts pressure on finite natural resources. In Venezuela, which has some of the highest levels of fossil fuel subsidies in the world, gasoline consumption per capita is 40% higher than in any other country in Latin America, and more than three times the regional average.5 ÌÌ Cheap fossil fuels render low-carbon energy options more expensive and undermine progress towards a green economy. According to the IEA, about two-thirds of the US$1.6 trillion invested in the energy sector worldwide was for fossil fuels, while global investment in renewables and energy-efficiency amounted to US$380 billion a year (Figure 2). Figure 2: Investment in global energy supply, 2000 – 2013 1 800 1 500 1 200 9 00 Source: IMF 2013 Why fossil fuel subsidy reform is needed Governments use fossil fuel subsidies for a number of reasons, including: to protect the poor from fluctuating fuel and commodity prices; to facilitate access to affordable electricity; to boost the competitiveness of domestic industries and to exploit natural resources for the benefit of the citizens of energy-rich countries. However, despite these ostensibly noble objectives, the reality is that fossil fuel subsidies are not efficient in meeting their objectives and often result in a number of adverse, unintended consequences that significantly undermine the arguments for keeping them: ÌÌ Fossil fuel subsidies have significant environmental externalities. According to the Intergovernmental Panel on Climate Change’s 2014 report4, emissions from the energy sector account for 78% of the total GHG emissions increase in the past decade. Continued fossil fuel use in the energy sector intensifies emissions and contributes to global warming while eliminating fossil-fuel subsidies would help to reduce global carbon emissions. ÌÌ Fossil fuel subsidies are highly regressive. In fact, the richest 20% of households receive more than 40% of the benefits from energy subsidies, which is equivalent to 6 times the share of the bottom 20%. 600 300 0 2000 2003 Non-fossil fuel 2006 Power T&T 2009 2013 Fossil fuels Source: World Energy Investment Outlook, International Energy Agency (IEA), 2014 The fiscal space for a green economy UNEP’s 2011 report, Towards a Green Economy, argues that fiscal space for the green economy can be created by shifting public spending from conventional activities towards the creation and maintenance of a new generation of low-carbon assets. Eliminating fossil fuel subsidies can create fiscal space that could be used to implement green economy policies across key sectors. Governments can use the revenues saved from subsidy reform to increase spending on other development priorities such as health care and education. In Ethiopia, for example, energy price reform created additional revenues for public investment in major road and railway projects, such as the Addis-Adama expressway, which was completed at a cost of US$500 million. Reform was also the impetus UNEP launched its Green Economy Initiative in 2008, and is currently supporting over 20 countries around the world in their transition towards a green economy. for a government programme to distribute clean cooking stoves to households without access to electricity, in order to mitigate the spike in biomass use. Overcoming obstacles to reform Reforming fossil fuel subsidies has proved to be challenging, with some countries further ahead than others. Fossil fuel subsidies are difficult to reform because they are often seen as a convenient fiscal tool, requiring little administrative capacity. Citizens may also have a flawed understanding of the effectiveness of the subsidies. In Mexico, for example, a large proportion of the population believed that fossil fuel subsidies were beneficial for all citizens and that the government had an obligation to provide them. In some cases, the public has little confidence in the government’s ability to use the fiscal savings responsibly, which creates distrust and push-back against reform. There are also concerns about the adverse impacts that can arise from reforming fossil fuel subsidies, such as a rise in inflation or a decline in household purchasing power. These fears can be exacerbated if governments fail to communicate adequately with the public. Good practices for undertaking fossil fuel subsidy reform There is a significant body of knowledge about the negative impacts and inefficiencies of fossil fuel subsidies and about how to measure them. However, a remaining challenge is how best to phase out subsidies in a way that maximises the social, economic and environmental benefits of reform. Below are some of the good practices in designing and implementing reforms as outlined by the IMF and the Global Subsidies Initiative. Lessons learned from country experiences with fossil fuel subsidy reform 1. Country experiences show that fossil fuel subsidy reform is best undertaken as part of broader process of energy sector reforms. For example, the government of Ethiopia initiated fossil fuel subsidy reform as a part of its Climate-Resilient Green Economy Strategy elaborated in 2011. 2. Reforming the energy price setting process: This requires allowing full or automatic pass-through so that domestic price fluctuations match international price changes. For example, Morocco, which has ended petrol and fuel-oil subsidies and made big cuts to diesel subsidies, is now indexing energy prices to international benchmarks. Kenya has introduced automatic price adjustment mechanisms for power tariffs in order to depoliticize the setting of energy prices. 3. Communication and Transparency. Public-information campaigns are crucial to overcome obstacles to subsidy reforms. Indonesia for instance, sent text messages explaining the new subsidy policy. The Philippines organised a nationwide roadshow. Jordan successfully implemented a fossil fuel subsidy reform in 2008, thanks in part to a public communication campaign that was undertaken beforehand. The government consulted widely with Parliament, local NGOs, the business community and labour representatives, and emphasized the regressive nature of subsidies as a selling point for reform. 4. Managing the impacts: If reform is done correctly, the negative impacts can be mitigated. It is pivotal for governments to craft mechanisms to compensate vulnerable groups for the higher fuel prices they will face after reform. Governments should study the expected impacts of reform and tailor their compensation mechanisms accordingly. For instance, a study in Ghana showed that the government’s 2013 slashing of subsidies for petrol kerosene, diesel and LPG and the resulting increase in fuel prices would push an additional 395,180 people into poverty. The government therefore expanded its social welfare programme, LEAP, to cover affected households. In Armenia, for example, the government implemented an effective targeted cash transfer as part of its electricity price reform in the mid-1990s. Indonesia chose to use an unconditional cash transfer system for poor households during its 2005, 2008 and 2013 reform episodes, and some countries prefer a universal cash transfer scheme, as Iran adopted. In Iran, the government raised prices on fossil fuel products in 2010 by factors of 2 to 22 and, in compensation, households were given a monthly cash transfer of about US$45 per person regardless of their income level (about US$90 in Purchasing Power Parity dollars). Banks and ATMs were used as a vehicle to transfer the cash pay-outs and were made available in people’s bank accounts soon after the price increases went into effect. While the cash pay-outs were initially successful – there was a perceptible decline in poverty rates and inequality – the government had set the cash transfer price above the level that could be covered by the incoming revenues from the price increases. It started printing money to plug the deficit, which contributed to high levels of inflation. Moreover, external events – namely sanctions imposed on Iran by the United States in 2011, and the devaluation of the rial, the national currency, further increased prices and led to an economic crisis. Reforms were scaled back as a result but under a new administration, a second phase of subsidy reform is underway. The Green Economy Report, published by UNEP in 2011, makes a compelling economic and social case for investing two per cent of global GDP in greening 10 central sectors of the economy. What UNEP is doing Further Reading Fiscal policy is an important tool for the green economy transformation. It entails raising revenue for green activities; government expenditure in support of low-carbon technologies and incentives to shift consumption and production in favour of clean goods and services. UNEP is advising countries on their fiscal policy reforms to accelerate progress towards a green economy. UNEP commissions reports on fiscal policy and the green economy which include analysis of fossil fuel subsidies and broader environmental fiscal reform and the potential impacts on green investment. For instance, studies are underway in Mauritius, Ghana, Kenya and Mozambique. IEA (2014), World Energy Investment Outlook: Special Report, International Energy Agency, Paris, 2014 UNEP also undertakes knowledge sharing and country exchange workshops on topics related to fiscal policy and the green economy. Most recently, it co-organised a workshop on Reforming Fossil Fuel Subsidies for an Inclusive Green Economy, with IMF, GIZ and GSI, in Nairobi, Kenya from 28-29 April 2014. The overall purpose of this technical workshop was to provide a better understanding of the policies that support the production and consumption of fossil fuels, to share countries’ experiences of subsidy reform, and to identify remaining knowledge gaps in terms of data, methodology, and policy guidance. Copyright © United Nations Environment Programme 2015 In addition, UNEP is a founding member of the Green Growth Knowledge Platform (GGKP) and the Green Fiscal Policy Network. Under GGKP, UNEP co-chairs the fiscal policy committee which identifies key knowledge gaps in this area and attempts to fill them by commissioning studies. The Green Fiscal Policy Network is a partnership of UNEP, IMF and GIZ and has developed a web-based platform of knowledge products such as case studies and reports on how fiscal policy – such as reforming fossil fuel subsidies – can accelerate the green economy transformation. These initiatives can help create a global network of practitioners on energy subsidy reform, disseminate knowledge on the topic and help build the capacity and will to achieve results. Clements, B., and D. Coady, S. Fabrizio, S. Gupta, T. Alleyne, and C. Sdralevich, eds. (2013), Energy Subsidy Reform: Lessons and Implications (Washington: International Monetary Fund). Towards a Green Economy, United Nations Environment Programme, 2011 IISD (2013), A Guidebook to Fossil Fuel Subsidy Reform for Policymakers, International Institute for Sustainable Development; Global Subsidies Initiative; http://www.iisd.org/gsi/sites/default/ files/ffs_guidebook.pdf IISD Webpage: Case Studies: Lessons Learned from Attempts to Reform Fossil-Fuel Subsidies, International Institute for Sustainable Development; Global Subsidies Initiative, http://www.iisd.org/gsi/ fossil-fuel-subsidies/case-studies-lessons-learned-attempts-reformfossil-fuel-subsidies Green Fiscal Policy Network website: www.greenfiscalpolicy.org Notes 1 The WTO defines a subsidy as a direct transfer of government funds (e.g. grants, loans) or a potential direct transfer of funds or liabilities (e.g. loan guarantees); government revenue that is otherwise due but is foregone or not collected (e.g. fiscal incentives such as tax credits); or any form of income or price support or relief from normal costs or procedures. 2 Fossil fuels include crude oil, petroleum, natural gas, liquefied petroleum gas (LPG), diesel and coal. Electricity generated from fossil fuels is also sometimes included in the calculation. 3 See The Green Investment Report: The Ways and Means to Unlock Private Finance for Green Growth, World Economic Forum, Switzerland, 2013 4 IPCC (2014), Summary for Policymakers, In: Climate Change 2014, Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge and New York, 2014 5 See study by Davis, L. (2013), The Economic Cost of Global Fuel Subsidies, American Economic Review: Papers & Proceedings 2014, 104(5): 581–585 For information: UNEP DTIE/Economics and Trade Branch 11-13, chemin des Anémones 1219 Châtelaine / Geneva Switzerland T: +41 (0)22 917 82 43 F: +41 (0)22 917 80 76 E: [email protected] www.unep.org/greeneconomy