Governments can use weak fuel prices to phase out subsidies

Plunging prices for fossil fuels have given governments a strong opportunity to end subsidies, hasten a shift to renewables, and help meet Paris climate targets, writes Charlotte Middlehurst

On the opening day of the Paris climate summit last December, representatives from 35 governments and hundreds of companies called for an end to what is widely viewed as one of the biggest hidden obstacles to a global transition to low carbon energy.

Fossil fuel subsidies, which are paid in many different forms in dozens of countries, will need to end if governments are able to finance the low carbon shift needed to cap global temperatures at 2C, the Paris statement added.

The subsidies they identified are market interventions – prices caps, tax breaks and direct payments – designed to keep fuel prices artificially low for consumers and keep demand high for oil, gas and coal, thus protecting producers.

A second function is to support industries, many of which are located in economically disadvantaged 'rust belt' areas. Fossil fuel subsidies are therefore a global problem that require local solutions.

This year has been hailed as the ‘year of green finance’ that aims to speed up flows of money to low carbon energy and infrastructure, a transition that will require US$93 trillion over the next 15 years, according to the Global Commission on the Economy and Climate.

However huge subsidies paid for fossil fuels have distorted incentives throughout economies, preventing clear price signals to investors in power generation, energy infrastructure, transport and urban development.

As Norwegian Prime Minister Erna Solberg put it in Paris: subsidies are “negative climate finance”.

Big fossil fuel companies have always benefitted from subsidies. Today, 70% of subsidies go to the petroleum sector, 19% to natural gas and 12% to coal, according to the OECD.

The support they receive gives fossil fuel companies a competitive advantage over renewable energy. The world currently pays roughly four times as much in financial support to fossil fuel industries as it does to energy such as wind and solar.

Society as a whole, however, pays a price. Since being introduced in the 1930s, fossil fuel subsides have driven one third of global carbon emissions, according to New Zealand’s prime minister, John Key. Without a withdrawal of those price supports, the world has no chance of avoiding runaway climate change, stoking up the prospect of economic chaos resulting from floods, extreme temperatures, famines, droughts and increasingly frequent and powerful storms.  

Taxpayers money

According to the International Monetary Fund (IMF), fossil fuel companies benefit from US$5.3 trillion (34.52 trillion yuan) of subsidies a year – more than the total health spending of all the world’s governments.

In the Middle East and North Africa, regions with a high concentration of oil-exporting countries, subsidies account for as much as 10% of annual GDP.

Indonesia – the world’s biggest exporter of thermal coal – was spending 20% of its total budget on subsidies before introducing recent reforms. 

In some Western nations, such as the UK, tax breaks for polluters have risen, according to the Overseas Development Institute, despite promises made at UN climate talks to phase out subsidies.

Japan provides more coal financing that any other country, with over US$20 billion pledged last year. In descending order, China, Korea, Germany, the US and Russia are the next biggest suppliers of public coal finance. In China, coal subsidies alone add up to 35.7 billion yuan (US$5.8 billion).

Window of opportunity

But there is cause for optimism. A sustained fall in global oil prices has opened a window for policymakers to reform the system without risking a backlash from consumers.

Prices for crude oil on the main benchmarks currently trade around US$40 a barrel, up from the 13-year lows below US$30 seen in January. But prices are well below the US$100 prices seen in mid-2014 and aren’t expected to rebound back towards those levels anytime soon.

“Although reducing or eliminating subsidies will increase consumer costs, lower prices mean that the effect of removing subsidies is less dramatic,” said researchers from the International Growth Centre (IGC) in a report in January. Low oil prices ease the pain of adjustment, they add, and will allow governments to implement policy reforms that would otherwise create major political turmoil if oil prices were high.  

Some countries are seizing on the opportunity.

At the end of last year, Saudi Arabia raised its domestic oil price by 40%, bringing it in-line with global market prices. This action had the net effect of a subsidy reform. Traditionally, the kingdom has capped pump prices as a social welfare measure but because of a record budget deficit it was forced to remove them.

But reform is not as simple as removing a price cap. President Joko Widodo’s government in Indonesia has targeted producers by stopping aid for gasoline producers. In 2014, India’s Prime Minister Narendra Modi removed controls on diesel prices. Developing nations have been the first to seize the opportunity to remove subsidies.

The benefits of these reforms include greater fiscal stability, economic growth and the mitigation of climate change, as market distortions are dismantled.

Removal of fuel subsidies will also enable faster and more effective deployment of renewables and stimulate innovation, while benefitting the poorest members of society.

Progress blocked

So why has progress been so slow? One obstacle has been the continuing debate about how to define what a subsidy is. Governments often deny that they subsidise fossil fuels, instead calling them by a range of other names – for example, 'tax breaks' or 'employer incentives'. This ambiguous terminology has made it more difficult to estimate the total value of global subsidies.

For example, the IEA estimates that fossil fuel subsidies in 2013 totalled US$548 billion. Whereas the IMF, which uses different calculations, put the total at US$492 billion.

Another obstacle has been the social welfare argument. In the past, subsidies have delivered what economists call ‘social value’, bringing associated benefits to other sectors of society. 

“Access to basic energy raises living standards for the poor. It also stimulates economic development. Affordable energy is a comparative advantage for manufacturing and construction industries,” said an economic brief from European Commission in March last year.

Subsidies are also seen as a way to distribute resources wealth throughout the population. In European countries specifically, subsidies for coal are an important tool of regional policy and support heavy industry.

However, in the modern era, subsidies appear to be failing to accomplish their main task – to help the poor. In fact, they have proved regressive, benefitting the wealthy more than the needy.

“The myth that only with this type of subsidy can the poor be benefitted [must be dispelled]. It has been interpreted as common practice but high consumption individuals benefit the most, not the poor,” said UN climate chief Christina Figueres at the Paris summit.

Franzjosef Schafhausen, a deputy director for the German Federal Ministry for the Environment, claims that resistance to subsidy reform arises from difficulties in process rather than a lack of recognition of the problem.

“Governments and the public are aware of the magnitude of inefficiency and waste. But implementation of reform is impossible because of vested interests and powerful stakeholders,’ he said.

The roadmap

As China takes over the chair of the G20 for the first time, many eyes have turned to the unfulfilled promise at the Pittsburgh summit in 2009 to phase out fossil fuel subsidies completely.

Ahead of this year’s G20 summit in Hangzhou, there will be a special focus on host nation China – the world’s biggest carbon emitter – on whether it can deliver its promise to move towards a lower carbon economy.

Failure to show progress could cast doubt on the future of the Paris Agreement, whose successful implementation depends on leaving two thirds of the planet’s fossil fuels in the earth.

For some nations, the obstacles are political. The US presidential election in November and the possibility of a Republican in the White House have cast further doubt over whether subsidy reform will be a priority.

In China, the continuing economic slowdown could trigger a new round of economic stimulus for heavy polluting industries. 

Ultimately, the case for reform will come down to a clear choice between a huge restructuring towards low carbon energy, or the status quo of relying on fossil fuels and increasing emissions. 

This article is the first in a chinadialogue series on fossil fuel subsidy reform that will run throughout 2016.