Download Policy Brief Fossil Fuel Subsidies

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:
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