Fuelling controversy

Fossil fuel subsidies act like a negative carbon price

The carbon price is the most efficient way to cut emissions since it allows the market (consumers, businesses and innovators) to decide on the most effective way to respond.

Almost one-quarter of global emissions are covered by some form of carbon pricing; 17% via an emissions trading scheme (ETS) with some 6%-8% of GHG emissions covered through a carbon tax.1

There is another form of government policy that often work directly in competition with carbon markets. Fossil fuel subsidies encourage the production and consumption of oil, gas and coal and lead to an increase in emissions.

Fossil fuel subsidies can be thought of as a ‘negative price of carbon’.

As this article shows, government expenditure on fossil fuel subsidies dwarfs the revenue generated by carbon taxes and emissions trading schemes by a factor of 15.

Let’s look at those subsidies used to support production first. ‘Capex’ related subsidies are often targeted at writing-off capital costs against taxable income, reducing costs associated with exploration, research and development, and feasibility studies, in addition to providing funding for infrastructure (ports, roads and pipelines, etc.). Meanwhile, ‘opex’ subsidies such as tax breaks, reduced royalty payments and inadequate environmental regulations enable a fossil fuel company to increase its profitability.

Governments also frequently subsidise the consumption of fossil fuels, regulating consumer prices at below market levels and providing direct cash transfers to consumers. In normal times, fossil fuel resource rich nations, particularly those with autocratic governments, often provide access to cheaper energy as a way of providing a visible example of the benefit of the country’s resource wealth. Following Russia’s invasion of Ukraine, many governments set energy price caps and direct transfers to consumers.

Subsidies encourage the inefficient production fossil fuels, locking-in future carbon emissions by enabling the economic extraction of fossil fuel deposits, and discouraging investment in infrastructure (renewable energy in particular), while inducing higher levels of consumption and numbing consumers response to higher prices. In either case, the implication is an increase in greenhouse gas emissions.

Once subsidies are in place, they are also extraordinarily difficult to remove.

Production subsidies are often used to support state-owned companies, while companies with close relationships to the country’s leaders also benefit. Well-connected businesses tend to be very adept at lobbying for subsidies to continue, especially given the ‘sunk cost’ nature of capital invested in fossil fuel infrastructure. Meanwhile, citizens who are accustomed to administratively established food and energy prices tend to hold their government responsible in the event that prices rise sharply, often triggering a political backlash against the ruling political party.

However, removing subsidies for fossil fuel production and consumption will be crucial to decarbonising the global economy and keeping global warming below 1.5 degrees. As we’ve seen, they act as a negative carbon price, increasing the incentive to emit carbon dioxide and other greenhouse gases into the atmosphere.

What is the potential carbon benefit from removing fossil fuel production and consumption subsidies, and how much progress have the major economies made towards phasing them out?

Lets dive in.