Energy subsidies and sustainable development

The recent surge in international energy prices has placed energy subsidies at the forefront of the economic policy agenda in many countries, particularly where government interventions are intended to keep prices low to households and industry, or to protect indigenous energy industries from foreign competition. But experience around the world shows that, in many instances, the net overall effects of subsidies are negative, because they distort markets, are costly and open to abuse, and, where they encourage higher energy consumption, harm the environment.

In principle, any measure that keeps prices for energy consumers below market levels or for energy producers above market levels, or that reduces costs for consumers or producers, may be considered a subsidy. Energy is often subsidised through price controls, which keep prices below the full economic cost of supply. They are most common for electricity and natural gas, but are still important in some countries for oil products. The extent of under-pricing is generally bigger in countries where the energy sector is state-owned and where a significant share of production is exported.

Energy subsidies are widespread, but they vary greatly in importance and type by fuel and country. Consumption subsidies – government measures that result in an end-user price that is below the price that would prevail in a truly competitive market which includes all supply costs – are significant in some countries. They have been mostly eliminated in the OECD, but remain large in countries like Indonesia and Venezuela, both in gross terms and net of any taxes. Electricity and household heating and cooking fuels are usually heavily subsidised, though several countries still subsidise road-transport fuels. Production subsidies, usually in the form of direct payments and tax breaks to producers or support for research and development, are most common in OECD countries.

Few studies have attempted to quantify energy subsidies for the world as a whole, because of data deficiencies and the sheer scale of the exercise. The most prominent global study, carried out by the World Bank in 1992, estimated annual fossil-fuel consumption subsidies at around 230 billion US dollars per year. An OECD study the same year estimated global energy consumption subsidies at 235 billion dollars per year, with 254 billion dollars of net subsidies in non-OECD countries offsetting 19 billion dollars in net energy taxes in the OECD.

The economic costs of energy subsidies can be big. Subsidies can place a heavy burden on government finances, weaken foreign trade balances and stunt the growth of economies. Depending on how they work, they can also undermine private and public investment in the energy sector, impeding energy conservation and the expansion of distribution networks. Subsidies to specific technologies can also hinder the development of competing technologies that might be more economic in the longer term. And very often, it is more affluent people who end up with the largest share of subsidies intended for the poor.

Many energy-subsidy schemes are also harmful for the environment. Subsidies that encourage the production and use of fossil fuels inevitably have some harmful environmental effects. By encouraging higher consumption, they lead to higher emissions of air pollutants and greenhouse gases, as well as other forms of environmental damage such as water contamination and spoiling of the landscape. The Kyoto Protocol explicitly requires a reduction of subsidies that encourage greenhouse-gas emissions. But subsidies to fossil fuels can also have a beneficial impact on the environment. For example, encouraging the household use of oil products can reduce deforestation in poor rural areas otherwise dependent on firewood.

Empirical evidence of the net environmental effects of introducing or removing energy subsidies is generally qualitative. This reflects the immense practical difficulties of estimating quantitatively the different effects, expressing them in consistent monetary terms and aggregating them. A number of studies have demonstrated the harmful effects of various types of fossil-fuel subsidies. A recent study by the OECD, for example, shows that global carbon-dioxide emissions would be reduced by more than 6 percent and real income increased by 0.1 percent by 2010 if all subsidies on fossil fuels used in industry and the power sector were removed around the world. Another study by the IEA shows that the removal of consumption subsidies in eight of the largest non-OECD countries would reduce emissions by 16 percent.

Removing subsidies that are both economically costly as well as harmful to the environment would be a win-win policy reform. However, governments are often faced with awkward trade-offs between the economic and environmental benefits of reforming those subsidies and the short-term social costs of higher fuel prices or of lower employment in indigenous energy industries. In some poor countries, including many of those of the former Soviet Union, removing subsidies to modern household cooking and heating fuels has had a dramatic short-term impact on living standards. And removing subsidies to coal can have a devastating effect on employment and incomes in local communities that depend heavily on mining. That is why, in Europe, reform of coal subsidies has often involved redirecting public money towards retraining and other adjustment measures, as well as aid for regional economic development.

Energy-subsidy reform requires strong political will to take tough decisions that benefit society as a whole. Implementing reforms in a phased manner can help to soften the financial pain of those who stand to lose out and give them time to adapt. This is likely to be the case where removing a subsidy has major economic and social consequences. The authorities can also introduce compensating measures that support the real incomes of targeted social groups in more direct and effective ways, where that goal is deemed socially desirable. Experience in Europe shows that redirecting coal subsidies to retraining and regional economic development aid can boost higher-paid, safer and more desirable jobs to replace the jobs lost in the coal industry. Whatever the precise design of reform policies, politicians need to communicate clearly to the general public the overall benefits to the economy and to society as a whole of cutting subsidies, and consult with stakeholders in formulating reforms to counter political inertia and opposition.

Related reading:

International Fuel Prices
International Fuel Prices, the 1st, 2nd, 3rd and 4th editions, edited by the Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ), are available for download at www.internationalfuelprices.com

World Energy Outlook 2006
The World Energy Outlook, an annual publication of the International Energy Agency, produces medium to long-term energy market projections and analysis. The most recent edition, covering 2006, estimates that energy consumption subsidies in non-OECD countries amount to over 250 billion US dollars per year. WEO 2006 notes that “real prices paid by most energy consumers have increased far less than international prices in percentage terms, because of the cushioning effect of taxes and distribution margins and, in some countries, subsidies and a fall in the value in the dollar.” WEO 2006 is available for purchase at:
http://www.worldenergyoutlook.org

International Monetary Fund on the Magnitude and Distribution of Fuel Subsidies
The International Monetary Fund (IMF) published a paper last November that found fuel subsidies to be badly targeted in five of the countries it examined (IMF Working Paper: The Magnitude and Distribution of Fuel Subsidies: Evidence from Bolivia, Ghana, Jordan, Mali, and Sri Lanka). It concluded that in many cases, poor people would be better served by more targeted forms of support than fuel subsidies. “By far the most efficient and effective way to protect the poor is to allocate some of the budgetary savings from the elimination of fuel subsidies to a well-targeted social safety net that has high coverage of poor households and little leakage to nonpoor households,” states the IMF paper. The paper is available for download at: http://www.imf.org/external/pubs/ft/wp/2006/wp06247.pdf