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Fossil fuel subsidies are not the answer to the energy crisis

Written by Archie Gilmour

People around the world face hardship and privation due to the energy crisis and its effects on the cost of living. Governments are under huge pressure to support their citizens, but many of their responses do not sufficiently target those who most need the help. To make matters worse, these responses will soon lead to huge fiscal and environmental challenges that governments must eventually confront. As governments in countries of all levels of income prepare to face another difficult year in 2023, reforms to energy subsidies could reduce costs, support net zero transition and better protect those struggling with the rising cost of living.

Intervention is expensive

Subsidising the cost of energy for consumers seems an obvious choice. After all, driving the cost-of-living crisis are oil and gas prices, which have sky-rocketed since the Covid-19 recovery and Russia’s invasion of Ukraine. However, while the drive to support the vulnerable is welcome, intervention in energy markets is debilitatingly expensive and prohibits public welfare spending elsewhere.

The cost of support for fossil fuels was on the rise even before the current crisis, and while collapsing demand during lockdowns did mean that subsidies were comparatively low in 2020 across the G20, they still reached an eye-watering $147 billion for production and consumption. The following year, government responses to the Covid-19 crisis led to a surge in subsidies, growing by 130% to $190 billion. These benefited fossil fuel producers more than ever, to the tune of $64 billion – the highest ever tracked by the OECD.

Subsidies in 2022 will undoubtedly eclipse those of previous years. Many are linked to fluctuating energy prices, so spiking oil and natural gas prices will have automatically triggered billions of dollars in subsidies for fossil fuel consumption. In some cases, they are delivered through lower rates of tax – as in the UK for the use of domestic energy and heating. With higher prices, the country foregoes billions in revenue that it could spend on other forms of support. In other cases, subsidies require more direct expenditures. Indonesia, for example, provides electricity, diesel and kerosene below market price, which means the taxpayer must make up the shortfall.

These existing subsidies, vast as they are, are totally outmatched by the energy price caps recently imposed or proposed in many European countries. Portugal, Spain and the UK have already implemented caps, setting the price paid by consumers and paying the difference to suppliers. Meanwhile, the EU has agreed to implement a cap but is still debating its range. The precise cost of such unprecedented measures will depend on future fossil fuel prices, but it will clearly be astronomical – at least tens of billions of dollars in each country.

Governments – or more specifically, taxpayers – must foot the bill. These billions of dollars squeeze ‘fiscal space’ – in other words, governments have less money to spend on policy areas such as health, education, infrastructure and net zero transition. This is especially important in lower- and middle-income countries, where subsidies often make up a higher portion of government spending and borrowing money may be harder. Nigeria will spend an estimated 4 trillion naira ($9.3 billion) on fuel subsidies, almost 10 times higher than the 443 billion naira ($1 billion) initially projected and equivalent to 23% of the 2022 budget, exceeding the combined total spending on health and education. The costs are therefore high, especially if the support is poorly optimised.

The UK provides a great example of poorly optimised support. Introduced in April 2022, the Energy Profits Levy is a temporary windfall tax on fossil fuel producers which is intended to help fund additional support for the cost of living. However, fearing that a new tax would discourage investment, the government included a tax saving of 91 pence for every pound invested in new fossil fuels. This was short-sighted, since new investment in fossil fuels is incompatible with reaching net zero by 2050. Nor will such investment be realised in time to assuage the energy crisis. The policy also presented multinational corporations with a giant loophole to exploit: Shell, for example, will pay no tax on the levy at all this year, on the back of £685 million in net credit claimed from the UK government between 2015-2021. The levy, which was supposed to contribute £5 billion to supporting the cost of living, will not only fall short of reaching this target; it has also incentivised the exploration of unsustainable fossil fuels.

The problem with subsidies

Beyond their fiscal cost, fossil fuel subsidies may have devastating impacts on the climate and the broader economy. Subsidising energy is a huge boost to fossil fuels and continues to skew incentives in their favour when the world needs to swiftly transition away. Subsidies encourage excessive consumption in wealthier households and businesses by distorting markets, shielding people from price signals and making renewables less competitive.

The UK’s Energy Price Guarantee, which started in October and is due to run until April 2024, caps the unit price of electricity and gas. Small regional variations exist and the cap will rise from an average of £2500 to £3000 in April 2023; otherwise, the guarantee applies equally across all income tiers, with additional, one-off payments to support pensioners and those on benefits. But this is not enough. Support should more explicitly and comprehensively target the poor and vulnerable, while those who can afford the higher price of energy should bear the cost. This will serve as a powerful incentive to consume less energy more efficiently. As it stands, this subsidy encourages consumption at great cost to the taxpayer.

Fossil fuel subsidies may also accelerate inflation. While some suggest that a well-designed price cap can help curtail inflation domestically because indices measure the price for consumers rather than the total price including subsidies, subsidies could actually contribute to higher global inflation. Indiscriminate subsidies can encourage demand by making consumption cheaper; since there is a limited supply of fossil fuels, any increasing demand risks driving global prices higher.

Inflation is already a huge problem. The response of central banks around the world has been to pump the brakes on the economy by increasing interest rates, threatening recession and making life harder for many. This is especially the case for lower-income countries: with debt denominated in US dollars, the rising exchange rate means it is more expensive to service their debt in their national currencies. At the same time, Europe’s willingness to pay for scarce energy resources is driving up costs around the world, pricing out many poorer, energy-importing countries.

A better way

Indiscriminate subsidies are the least efficient way to deal with the energy crisis. Instead, blanket fossil fuel subsidies should be eliminated in line with the global climate commitments made at COP26 in Glasgow and reaffirmed at COP27 in Sharm el-Sheikh. Responses should instead target the poor and most vulnerable through sustained cash transfers or focused price caps.

Ideally, these subsidies should be offset by taxes on higher-income consumers for energy and carbon use and by permanent windfall taxes on the excess profits of fossil fuel extractors, helping to limit public debt. There is also a strong case that renewables should not be subject to windfall taxes even if their prices rise unfairly on the back of fossil fuel energy inflation, because this increases investor risk in renewables at a time when investment is much needed.

This would free up resources to support households with the upfront costs of end-use energy efficiency such as home insulation and the switch to cleaner forms of energy (e.g. heat pumps). The UK government has recently announced an additional £6 billion from 2025 for energy efficiency over six years, but this is too little and very late. Knowledge campaigns should encourage efficiency and lower consumption, enforced if necessary with energy rationing. Such sacrifices would not be easy. But these policies would accelerate the transition to net zero while also carrying us through the energy crisis and making sure nobody is left behind.