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ESG Explainer: Fossil Fuel Subsidies

A complex web of support measures is slowing the transition to renewables, but tools are available to dismantle wasteful and inefficient policies.

Governments have always used taxation to limit harmful activities and behaviours, such as smoking, and to incentivise those they view more positively. But they have been slow to use their fiscal powers to tilt their economies away from fossil fuel dependence, failing to encourage businesses and households to adopt renewable energy sources, energy-efficiency measures and low-carbon products and services.

In countries hard hit by volatility in the global energy markets, governments appear to be going in the opposite direction, unveiling new schemes to protect consumers from rising fuel bills.

Through a variety of mechanisms, governments are continuing to use the public purse to support the production and consumption of oil, gas and coal. These subsidies, tax breaks and other measures not only skew the economics of the low-carbon transition by making fossil fuels seem more competitive, but they also give investors a false impression of the profit profile of existing carbon-intensive investments, resulting in the misallocation of capital.

As noted by the International Energy Agency (IEA), subsidies, regulated prices and taxes that favour fossil fuels are market distortions representing “a roadblock to a cleaner energy future”.

In this explainer, we attempt to look at the scope of fossil fuel subsidies, their impact on investors and other stakeholders, and the likelihood of reform in light of the Glasgow Climate Pact’s phase-out commitment.

What is the full extent of government support for fossil fuel industries through subsidies?

Much depends on definitions, as these vary widely. To its own advantage, the UK government defines a fossil fuel subsidy as action that “lowers the pre-tax price to consumers to below international market levels”, but the World Trade Organisation regards all public financial support that provides a selective advantage as a subsidy. Increasingly, it is recognised that a wide range of official measures contribute to lowering the cost of producing and using fossil fuels.

Generally, pre-tax subsidies fall into two categories. Consumer subsidies bring energy bills lower than supply costs for industrial, business and domestic users. This includes a wide range of schemes to protect consumers from wholesale energy price volatility, such as the UK price cap introduced in 2019. This type of subsidy is in the news across Europe as governments are under pressure to respond to high wholesale gas prices, fearing a ‘cost of living’ crisis for millions.

Meanwhile, producer subsidies include direct or indirect measures that increase the profitability of fossil fuel production, either through reduction of input costs or increase of output prices. These account for a lot less than consumer subsidies – typically around a quarter of overall support – but can still have a substantial impact in countries, especially but not exclusively where the state has a large and/or controlling stake in energy production.

The International Monetary Fund (IMF) is among the international bodies to have explored the concept of post-tax subsidies, which takes into account efficient levels of taxation factoring in the wider costs of fossil fuel usage to society, including those associated with air pollution and climate change. Among others, this definition could include reduced VAT and the lack of a carbon price on gas and other fossil fuels used for heating buildings, or the lack of VAT or carbon price on aviation fuel. “In most countries, taxes on energy fall far short of the efficient levels,” says the IMF.

Fuel taxes vary widely across countries and have a significant impact on the prices paid by consumers. The IEA includes VAT in its analyses of consumption subsidies, based on the price-gap approach, which compares average end-user prices paid by consumers with reference prices that correspond to the full cost of supply.

Many argue that a high and consistent carbon price would remove these post-tax subsidies over time. Explicit carbon pricing has been slow to evolve, although both of the largest emissions trading markets – Europe and China – are extending their scope, meaning more sectors of industry will pay an explicit carbon price. The UK intends to review the imbalance between gas and electricity prices and examine expansion of the UK Emissions Trading Scheme to extend carbon pricing across more sectors of the economy.

How do producer subsidies and incentives impact fossil fuel and transition economics?

Support for fossil fuel producers varies substantially around the world, with many oil producing nations keen to support domestic exploration and production.

In the UK for example, there are a number of ways in which the government supports oil and gas production financially, which gives a misleading impression of profitability, potentially resulting in a misallocation of capital by corporates and investors.

Upstream oil and gas firms have paid relatively little for extraction licences historically, and the higher tax rates levied in compensation has been eroded over the years. “The UK’s oil and gas fiscal regime is the most generous in the world for developing new large fields. For example, it’s roughly US$2 on the barrel compared to almost US$21 in Norway,” says Daniel Jones, Head of Research and Policy at Uplift, a think tank focused on the UK’s just transition away from fossil fuels.

Critically, new production on the UK Continental Shelf receives 100% capital allowance, effectively enabling firms to generate returns much sooner from projects whose profitability would otherwise have been much more marginal. Further, since 2016 firms have been able to deduct Petroleum Revenue Tax payments against losses incurred during decommissioning. “The combination of large incentives at the beginning of a project and tax relief at the end gets factored into operators’ commercial decisions, leading to extraction that otherwise would not have occurred,” says Jones.

Clearly, current incentives do not sit well alongside the UK’s net zero ambitions. Last March, the UK government published the North Sea Transition Deal, an “ambitious plan” to meet greenhouse gas emissions reduction targets while safeguarding high quality jobs in the oil and gas sector. In December, it consulted on a proposal to align the UK’s licensing regime with its climate objectives. But the UK’s approach is seen as half-hearted at best, and it certainly deviates from the position outlined in the IEA’s Net Zero by 2050 analysis, which says oil and gas exploration must cease after 2021.

“If the government truly believes oil and gas companies really will diversify into renewables, they’ve got to encourage them to allocate capital in ways that are not destructive,” says Jones, noting the disparity in oil majors’ current capex levels.

“There’s also a broader need for the government to send a clear signal about how it intends to manage the decline of the UK Continental Shelf in a way that is just for the workers and fair for the communities impacted. Currently, there is no attempt at leadership on that transition.”

How much do fossil fuel subsidies and incentives add up to?

Due partly to the sheer range of measures that could be considered subsidies, estimates vary widely.

The IMF estimated pre-tax subsidies (both consumer and producer) at US$305 billion in 2015, declining to US$295 billion in 2017, reflecting changes in international energy prices and subsidy reforms. Post-tax energy subsidies were estimated at US$4.7 trillion in 2015 and at US$5.2 trillion in 2017.

The IEA recently calculated fossil fuel consumption subsidies at US$440 billion in 2021, rebounding strongly after the pandemic had reduced them to US$180 billion in 2020.

But an IMF paper released in September 2021 estimated all fossil fuel subsidies globally at US$5.9 trillion in 2020 or about 6.8% of global GDP, forecasting a rise to 7.4% of GDP in 2025. Authors calculated that 8% of the 2020 subsidy total reflects undercharging for supply costs (explicit subsidies), with 92% attributable to undercharging for environmental costs and foregone consumption taxes (implicit subsidies). “Efficient fuel pricing in 2025 would reduce global CO2 emissions 36% below baseline levels, which is in line with keeping global warming to 1.5 degrees,” the paper said. This would also raise revenues worth 3.8% of global GDP and prevent 0.9 million local air pollution deaths.

Despite using a definition which allows it to claim it provides no subsidies, some recent estimates claim the UK pays out as much as US$14 billion annually.

What is being done by governments to end financial support for fossil fuels, including subsidies?

The Glasgow Climate Pact, signed at the end of COP26, committed signatories to phasing out “inefficient fossil fuel subsidies”. Earlier in the summit, 20 countries – including the US and UK – pledged to stop investing in oil and gas projects abroad by the end of 2022.

Also, 11 national and subnational governments, led by Costa Rica and Denmark, formed the Beyond Oil & Gas Alliance (BOGA), to deliver “a managed and just transition” away from oil and gas production. Core members must commit to setting a Paris-aligned date for ending oil and gas production and exploration, while associate members are required to take “significant concrete steps” toward reducing production, including subsidy reform.

So far, the European Union has made a small step. Passed in December, its Eighth Environment Action Programme, which guides climate and environment priorities for the next decade, did not set a firm phase-out date. MEPs called for fossil fuel subsidies to be eliminated by 2025, with other environmentally harmful subsidies dismantled by 2027. But member states balked, as setting a date would trigger a legislative process, committing instead to a termination schedule consistent with limiting climate change to 1.5 degrees Celsius.

According to the European Commission, European governments spent €52 billion on fossil fuel subsidies in 2020, a slight fall from €56 billion in 2019, with both figures influenced by reduced demand during the pandemic.

Also in December, the Climate Change Committee (CCC), established to advise and monitor UK policy, called on HM Treasury to review the role of tax policy in delivering net zero. The CCC said any review should consider tax-based means of achieving a higher and consistent carbon price “given that a low carbon price can be considered a subsidy”.

What’s stopping governments putting an end fossil fuel subsidies to consumers?

By definition, any removal of fossil fuel subsidies has the potential to increase energy costs to end-users. Reducing or eliminating consumer subsidies in particular would hike energy bills, also fuelling inflation and reducing the real incomes of voters, in the short term.

Payments to fuel poor households are a particularly sensitive area. These can only be removed by increasing the heating efficiency of homes, which would be expensive in the short term and politically sensitive due to the potential downsides for already disadvantaged communities.

Studies have found subsidies to be inefficient, ill-directed and counter-productive, with negative impacts on tax rates and government finances. Further, they bake-in our unhealthy relationship with fossil fuels, encouraging excessive consumption, while slowing investment in energy efficiency and cleaner energy sources.

But reform is simply too complex for most governments – or their increasingly sceptical and mistrustful electorates – to contemplate. The process of redirecting money paid out in subsidies toward energy efficiency schemes and targeted support for the vulnerable, as well as investing in a sustainable energy infrastructure for the future, is multi-faceted and lengthy.

How can these political fears and practical complexities be overcome?

While reform is undoubtedly complex, sufficient practical and theoretical work has been done on the subject to ensure that the process of weaning governments, companies and energy users off subsidies is not a mystery. The core ingredients are increasingly well understood; the difficulty lies in getting the policy mix right for local tastes and circumstances.

It’s worth remembering that efforts to tackle subsidies are not new. In its inaugural meeting in Pittsburgh in 2009, the Group of 20 committed to “rationalise and phase out over the medium term inefficient fossil fuel subsidies that encourage wasteful consumption”. Both the Group of Seven and the Group of 20 reiterated their commitments under UK and Italian leadership respectively last year.

The IEA’s Net Zero by 2050 strategy reiterated that subsidy reform should be considered integral to all countries’ climate change policy mix. Recent UN Development Programme (UNDP) research, published as part of its ‘Don’t Choose Extinction’ campaign, calls for “a progressive and gradual response” to reforms. The UNDP offers a ‘toolkit’ for policymakers which outlines a phased approach, including income protection and compensation for less advantaged groups.

The World Bank and Energy Sector Management Assistance Program have developed the Energy Subsidy Reform Facility (ESRF) to provide technical assistance support to developing countries looking to dismantle subsidies. According to a recent blog, the ESRF offers support on various aspects of reform, from identifying and quantifying subsidies, to understanding political and macro-fiscal context, to assessing impacts.

Commissioned by Italy during its recent G20 Preseidency, the IEA and OECD produced a report on the reform of inefficient fossil fuel subsidies. The report shared policy insights, best practice and peer reviews with the aim of further building consensus on the policy tools required, including proposals for how to anticipate and address political challenges.

It is no surprise, perhaps, that the IMF’s own recipe for reform includes “transparent and extensive communication and consultation” alongside comprehensive, multi-sector, multi-year strategies. Following this advice, the Philippines and Indonesia have implemented a system of highly visible cash transfers in conjunction with fossil fuel subsidy reforms.

Researchers have also proposed mechanisms under which forecasted revenues from environmental tax reforms are “distributed to citizens on visible but frozen bank accounts before the environmental tax reform takes place, and the accounts are unfrozen only after the reform has passed”. This approach is hoped to make the benefits of reform more tangible, increasing confidence that cash transfers will be distributed.

How are investors engaging with policy makers on these topics?

Investor representative bodies have made it increasingly clear that they see an end to subsidies as a key policy priority.

When publishing a policy paper on carbon pricing last year, the UN-convened Net Zero Asset Owner Alliance noted that the effectiveness of carbon-pricing schemes was being impaired by exceptions granted to specific industries, including “free allocation of carbon trading permits and counter-running subsidies”.

In response to the announced commitment to end fossil fuel financing for overseas projects at COP26, the Principles for Responsible Investment (PRI) called for all G20 members to “set a clear timeline for the full and equitable phase-out by of all fossil fuel subsidies by 2022”, including the elimination of all subsidies for fossil fuel exploration and coal production, public financing, and commitment to a country peer review.

“The world still needs to see a move away from all forms of fossil fuel production – domestic and international – with just transition plans agreed with workers and communities,” said Edward Baker, Head of Climate Policy at the PRI.

Elimination of fossil fuel subsidies has also been a core element of the policy advocacy activities of the Investor Agenda, which coordinates the climate-focused campaigns of institutional investor networks globally.

Its Global Investor Statement to Governments on the Climate Crisis, signed by 733 investors representing US$52 trillion assets, called on governments to “incentivise private investments in zero-emissions solutions and ensure ambitious pre-2030 action” via measures including robust carbon pricing, the removal of fossil fuel subsidies by set deadlines, and the phase-out of thermal coal-based electricity generation in line with credible 1.5 degrees Celsius pathways.

As institutional investors increase their advocacy and policy engagement efforts to hold governments to their COP26 pledges, it’s likely that fossil fuel subsidies will gain increasing attention.

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