Some Unpleasant Energy Arithmetic
What's the right price of fossil fuels? And what price are we willing to pay?
This post is inspired by an online exchange with my friend Fabio Ficano, a brilliant entrepreneur and energy expert. Fabio and I always enjoy disagreeing, and I encourage you to follow his perspectives directly.
In past blogs I have expressed my dissenting views from the climate change consensus (see here and here on how climate science is far from settled; here for the hypocrisy on the transition costs.) I know the debate on renewables vs fossil fuels can get heated, so let me make a couple of things clear from the start:
1. I do believe we should keep increasing the renewables’ share of energy, for a number of reasons: reduce pollution, undermine the geopolitical power of some of the West’s key adversaries, and help mitigate climate change.
2. The key question however, one which is almost never addressed, is what economic cost we are willing to pay to achieve specific green transition goals over a specified time horizon.
The magnificent 7 (trillion $)
Western governments have deployed a wide array of subsidies to accelerate the adoption of solar and wind power. Critics argue that governments are giving a fiscally unsustainable price advantage to green energy solutions that would not otherwise be viable. Supporters of renewables counter that fossil fuels benefit from even more generous government subsidies.
The latter view has been bolstered by a research paper released last summer by the International Monetary Fund, which added fuel to this already fiery debate. The paper estimated that governments around the world subsidize fossil fuels to the tune of $7 trillion, or about 7% of global GDP. Armed with this shocking headline figure, many have rushed to conclude that
1. Renewables would already be hugely more competitive if fossil fuels did not benefit from such massive subsidies; and
2. If only governments stopped subsidizing the fossil fuel industry, we could quickly enjoy cleaner and cheaper energy.
The first conclusion — that renewables would already be hugely more competitive if only we had a level playing field — is based on questionable and somewhat disingenuous IMF estimates of “subsidies”. The second conclusion — that removing fossil fuel subsidies would quickly give us cheaper and cleaner energy — is flat-out, dangerously wrong.
What do you mean by “subsidies”?
Take a closer look at the IMF numbers. When you hear that governments are subsidizing fossil fuels to the tune of $7 trillion, you envision policymakers handing out gigantic amounts of cash to the likes of Exxon Mobil and Shell. This is not at all the case.
Less than one-fifth of the $7 trillion are explicit subsidies, actual government outlays to keep prices below production costs. And the IMF itself notes that these explicit subsidies were temporarily more than doubled by a geopolitical spike in energy costs and will most likely revert to their previous level of “just” $500 billion.
The vast majority of the $7 trillion therefore — or 82% to be precise — consists of supposed implicit subsidies: mostly the estimated cost of global warming and air pollution, plus traffic congestion and foregone tax revenues. (Side note to IMF: traffic congestion depends on the number of cars, not on whether they are gasoline-powered or electric vehicles…). Once explicit subsidies revert to baseline, over 90% of the fossil fuel “subsidies” the IMF talks about reflect estimated externalities.
Now, attempting to account for externalities is exactly the right thing to do if you want market prices to reflect the true economic cost of a resource or activity. But here we have a huge uncertainty problem: the bulk of these estimated implicit “subsidies” are “based on assessments of the least-cost global carbon price trajectory that would be consistent with limiting global warming to 2°C.” In other words, the subsidy estimated by the IMF is the difference between the current price of fossil fuels and the price that climate models say is needed to reduce global emissions to within the +2°C global warming limit.
I have two problems with this. The first is that climate models have a double level of huge uncertainty. (a) great uncertainty on what impact a given price hike would have on fossil fuels consumption; and (b) great uncertainty on what impact a specific reduction in fossil fuel consumption and emissions would have on global temperatures.
The second is that this is not the right way to account for externalities. What one should do is estimate the “discounted global (economic and environmental) damages from current CO2 emissions.” The IMF tells us that using such a methodology would balloon fossil fuel subsidies estimates to about $11 trillion, or 11% of global GDP. Why not take this estimate, since it is methodologically more correct? If you want to price externalities, then go ahead and price the externalities. But perhaps between two very shaky estimates the IMF decided to go with the one that sounded less implausible.
the subsidy estimated by the IMF is the difference between the current price of fossil fuels and the price that climate models say is needed to reduce global emissions to within the +2°C global warming limit.
Who gets the subsidies?
Now let’s take a look at the explicit subsidies:
About half are for natural gas, and the rest is split between electricity and petroleum products, mostly diesel and gasoline. Electricity subsidies are included because the majority of electricity generation still comes from fossil fuels, mostly coal and gas. Who gets these explicit subsidies? When you hear that governments are massively subsidizing the fossil fuel industry you expect policymakers to be handing out money to “big oil” companies. Instead…
Nearly all explicit subsidies go to consumers (96%), to make energy access more affordable.
So no, governments are not handing out $7 trillion to oil companies; they are giving $0.5-1 billion to consumers to help them pay for gasoline, diesel, natural gas and electricity because for many these are still the only options to heat their homes and drive their cars, trucks and tractors.
Nearly all explicit subsidies go to consumers (96%), to make energy access more affordable.
You want me to pay how much?
Now we come to the crunch. Let’s set aside for a moment my misgivings with the IMF’s estimates of “subsidies” and take them as given at $7 trillion. What happens if we eliminate these $7 trillion in “subsidies”, in order to level the playing field between fossil fuels and renewables? Well, obviously we will face a massive increase in the global price of energy .
Think about it: remove the explicit subsidies, and consumers will immediately have to pay more for gasoline, diesel, natural gas and electricity. As the report notes, “Raising energy prices can be politically challenging.” No kidding. Of course, as the IMF correctly points out, some of the existing subsidies could be repurposed as targeted help to low-income households, a much more efficient (and equitable) solution.
But explicit subsidies are the least of it. What about the implicit “subsidies” that constitute most of these $7 trillion? To clarify, that’s not money currently in the governments’ coffers — hence their implicit nature. To remove those implicit '“subsidies” means imposing new energy taxes to the tune of nearly $6 trillion. If you want to trigger a massive global depression, jacking global energy prices up by about 6% of global GDP looks like a perfect move — especially if at the same time you reduce consumer subsidies by an additional 1% of global GDP. Again, remember how those implicit subsidies are estimated: they represent the price hike needed to drastically curtail fossil fuel consumption so as to stay within the +2°C global warming target. Remove those subsidies, and by definition you will get a massive plunge in the consumption of fossil fuels, which account for over 80% of global energy supply.
Governments could take this revenue and convert it in explicit subsidies for renewable energy. But we do not have anywhere near enough renewables to replace the massive contraction we would see in fossil fuels consumption. Not even close. Case in point: when Europe faced a sharp jump in natural gas prices following Russia’s invasion of Ukraine, we did not see a sudden rise in wind and solar energy — we saw a sudden rise in fossil fuel subsidies, and Germany fired up its — very dirty — coal plants.
No solutions, only trade-offs
As I said at the beginning, the key questions are costs and timing. Raising fossil fuel prices to account for externalities would accelerate the shift towards renewables — and spur other energy-saving innovations. It would get us to cleaner energy quicker. But not overnight — the technology is just not there yet, and we do not have anywhere near enough renewable energy to make up for a massive reduction in fossil fuels. Again: fossil fuels account for four-fifths of global energy generation.
The immediate impact therefore would be much higher energy prices, much lower energy consumption, much lower economic growth. And there is more. Look at where the subsidies are being given:
The vast majority, about two-thirds, are in emerging markets, with only one-third in high-income countries. (The split is about the same for both explicit and implicit subsidies.) So two-thirds of the effort would have to come from emerging markets, where sacrificing near-term economic growth is a lot more painful, since many more people are still mired in poverty. If emerging markets are not on board with this, no amount of sacrifice and emission reduction in the West will make an iota of difference to climate change.
Let’s be clear about this. Talking of “fossil fuel subsidies” can be quite misleading when we are mostly referring to hazy indirect estimates of externalities. Let’s be honest and say that we think we should impose massive taxes on fossil fuels to combat climate change. If we truly believe that the actual cost of fossil fuel consumption is $7 trillion higher than we are currently being charged, then we should absolutely start imposing these huge taxes. Clearly, there will be substantial long-term gains as we transition to cleaner energy. Equally clearly, there will also be staggering near-term costs. The hard question is how much we as a global population are willing to sacrifice now — in terms of lower standards of living and slower poverty reduction — in order to accelerate the green transition.
As Thomas Sowell said, “there are no solutions, only trade-offs.”
Thank you for this useful critical appraisal of the fossil fuel subsidy discussion. I agree with you that the distinction between actual monetary outlays and what’s imputed on the basis of estimates of the associated externalities hasn’t been as clear as it should have been. However, conceptually it is correct: not accounting for the externalities (by pricing carbon right) is a subsidy. (To take into account the uncertainty about the social cost of carbon, it would have made sense to present a range of estimates.) Whether you prefer to call it a tax hike on fossil fuels is a question of messaging. In terms of practical policy, nobody is recommending we instantly raise the price of fossil to the SCC: it is clear that it will have to be gradual. And the IMFs recommendation is that this should be done in a revenue neutral way, i.e. the carbon tax proceeds be recycled to the private sector. The point is to induce a substitution effect without the income effect. Which is why it’s economically irrelevant that the subsidies are paid to consumers: they lower the price of fossil fuels and thus increase consumption. The ultimate incidence of the subsidy is with producers, as the consumer spending is profits for them.
Finally, in terms of practical policy the uncertainty about the SCC is a red herring: when the current global price of carbon is - if we’re lucky - 20 dollars, the issue is not whether the SCC is 100, 200, or 300. We know what we need to do: raise the price of carbon! And absolutely, we need to do it in an equitable way.
Thanks for this thoughtful piece though, I will write up my thoughts in a more structured way in my own Substack.