Time is of the essence: can Indonesia phase out energy subsidies without hurting the poor?

Subsidies were not reaching the poorest
Subsidies were not reaching the poorest

Today’s post is by Maroussia Klep of the OECD Environment Directorate

Indonesia enacted a major reform recently. On 1 January, President Joko Widodo followed through with his electoral promise to cut decades-long subsidies for energy products. Many leaders had tried before him, but retreated in the face of fierce resistance from the people. Thanks in part to low oil prices, the newly-elected President got the reform through without much trouble. The true challenge will be how to support poor households when prices start rising again.

If the President holds strong on this reform, benefits can be great for Indonesia. Fossil-fuel subsidies introduced by the government in the 1970s recently hit nearly $20 billion a year. This amount, which represents 20% of the public budget, could be used for development and poverty alleviation if the reform succeeds. Removing the subsidies was even more justified as they were not reaching the poorest households who can neither afford electricity, nor consume products such as gasoline.

A new OECD publication supports these claims. The study highlights notable economic and environmental benefits of phasing out fossil-fuel subsidies in Indonesia. Interestingly, the study is based on the context that pertained until mid-2014, when international oil prices where high and before the recent phase-out of subsidies by the government. With a total removal of subsidies, it is estimated that up to 0.7% GDP growth and 1.6% welfare gains for consumers could be generated by 2020 through a more efficient allocation of resources.

The report also highlighted potential environmental benefits from such reforms, which would incentivise a decrease in energy consumption and thereby a reduction in greenhouse gas (GHG) emissions and local air pollution. Other uncertain environmental impacts may follow, which could be positive such as the development of new renewable solutions, or less desirable such as an increase in deforestation coming from substituting wood for kerosene.

But next to the overall impacts for the country as a whole, a sudden increase in energy prices due to the removal of subsidies may have significant effects on households. As highlighted by OECD Secretary General Angel Gurria: “for this [the removal of fossil-fuel subsidies] to succeed, we need well-targeted, transparent and time-bound programmes to assist poor households and energy workers who might be adversely affected in the short-term.”

The new report aims to answer this key question: what redistribution scheme could be put in place in order to make sure that the reform favours low-income households? Three possible scenarios are explored.

Under a first scenario, the reform is compensated by unconditional cash payments paid by the government to every household. This type of programme is not easy to implement but could help reduce relative inequalities.

A second possibility for the government would be to provide payments to households in proportion to their labour income. However, in Indonesia, poor people often work in the informal sector and would therefore not be eligible for the transfers. Thus such a policy could mostly benefit the wealthy.

Finally, a third option would be to translate savings from the reform into new subsidies, for example for food products. This policy would primarily benefit the poor given their proportionally higher spending on food. However, at the economic level, this option appears less efficient.

As often in OECD reports, no single policy recommendation can be drawn. This is because several compensation policies should probably be combined together for achieving best results. Besides, while the three scenarios identified are common options, there are of course other ways to ensure a fair and efficient subsidy phase-out. The government may for example decide to use savings from the subsidy cuts for expanding public services and investments in education or health care.

Time is now of the essence for the President. When the government reflects on how to best reallocate resources, external events may well play a decisive role in the success of recent reforms. If a new surge arises in international oil prices, the shock will be much harder to bear for poor households in the absence of solid and sustainable compensation programmes. Today, Indonesia has the opportunity to demonstrate that economic welfare and environmental protection can also benefit the poor.

Useful links

OECD work on fossil fuel subsidies

The IEA’s interactive fossil fuel subsidy world map

A call for zero net emissions

OECD climate and carbon report
OECD climate and carbon report

Today’s post is from OECD Secretary-General Angel Gurría and is co-published by the World Economic Forum, meeting in Davos.

Our leaders must get to grips with the huge risk that carbon dioxide emissions pose to the economy and the environment. As we know, carbon dioxide is a long-lived gas. It hangs around. Of every tonne of CO2 emitted this year, some will still be around thousands of years from now. Even small ongoing emissions will continue to add to the atmospheric concentration.

This is already having a serious environmental impact.

The Intergovernmental Panel on Climate Change’s 2013 report finds it extremely likely that human influence has been the dominant cause of global warming since the mid-20th century. Many countries are taking these findings seriously. However, mounting evidence suggests that a stronger approach is needed.

At the 16th session of the Conference of the Parties (COP 16) to the United Nations Framework Convention on Climate Change in Cancun, Mexico, countries agreed to limit the increase in global average temperature to below 2°C above pre-industrial levels. However, UNEP estimates that country pledges to reduce emissions by 2020 get us only between a quarter and half way to our goal of maintaining a two degree ceiling on the global average temperature increase.

This is why I am making a strong call for governments to put us on a pathway to achieve zero net emissions from the combustion of fossil fuels in the second half of this century. Unlike the financial crisis, we do not have a “climate bailout” option up our sleeve. Nothing short of a transformation of the energy economy will suffice. But we face significant obstacles towards meeting this goal.

Ending our reliance on fossil fuels was never going to be easy. Two-thirds of electricity generation and nearly 95% of the energy consumed by the world’s transport systems relies on fossil fuels.

Several factors compound the challenge of weaning ourselves off this energy source. First, we have recently moved from a world of threatened scarcity to one of potential abundance, due to the exploitation of unconventional fossil fuel deposits such as shale gas in the United States. Second, investments in carbon intensive technologies remain more profitable and attractive than those in low-carbon technologies, in many cases. Third, oil and gas rents account for a considerable share of total government revenue in many countries. Given this “carbon entanglement”, it is not surprising that cash-strapped governments worldwide are hoping to find and exploit new reserves of oil and gas.

There is currently a credibility gap between what governments are saying about climate change and the policies they have in place. Most businesses do not take governments seriously when it comes to climate, primarily because many governments have inconsistent and incoherent policies and then often keep changing them, sometimes retroactively. This makes businesses reluctant to invest in greener technologies.

I propose the following action agenda to reverse this trend.

Action 1: Put a price on carbon. This can be done through a carbon tax or an emissions trading system (ETS). Here, governments have made important progress, with more than 40 countries having implemented some form of carbon tax or emission trading scheme. The “flexibility” of ETS’s makes them politically attractive, although their design and implementation can be improved. However, not all governments have shied away from explicit carbon taxes. There are some strong success stories of introducing carbon taxes smoothly and incrementally over time.

Action 2: Reform fossil fuel subsidies. We have to reconsider our approach to subsidies. The OECD recently inventoried support to fossil fuel consumption and production in our Member Countries. The support we uncovered is in the range of US$ 55-90 billion per year. This is in addition to the US$ 544 billion provided as subsidies to fossil fuel consumers in developing and emerging economies estimated by the IEA. Urgent reform is needed in all countries to phase out fossil fuel subsidies that encourage carbon emissions. While the subsidies are often used to fight poverty, their poor targeting makes them an inefficient way of achieving this goal. Fossil fuel already has a huge advantage as the energy resource of choice. It doesn’t need more help.

Action 3: Address incoherent and inconsistent policies. Governments need to stand back and consider the entire range of signals they are sending to consumers, producers and investors. A key question is whether non-fossil energy investments can currently compete with fossil fuels in terms of their risk-return profile with the policy settings in place domestically and internationally. To help get a consistent picture and to compare country’ performances, carbon pricing and climate policies will soon be a key element of our OECD Economic Surveys. Thus, by mid-2015 we will have a good idea of the progress and remaining challenges in both OECD countries and key emerging economy partners.

The actions outlined above will help to create a clear, long-term signal that the price of emissions will only go one way – up – and put us on a trajectory towards zero emissions. The transition to a zero emissions economy will not be costless, and governments must be frank about the cost of the transformation. But building a post-carbon world will offer some incredibly exciting economic opportunities.

At the same time, inaction also entails huge consequences. For instance, Hurricane Sandy cost the US about 0.5% of the country’s GDP. Recent analysis suggests that the annual costs to deal with flood exposure in coastal cities may increase to over US$ 50 billion by 2050. Typhoon Haiyan, which hit the Philippines, was a stark reminder that developing countries are most vulnerable to the impacts of climate change.

We are on a collision course with nature. Now is the time for us to take bold decisions. Cherry-picking a few easy measures will not do the trick. There has to be progress on every front, particularly with respect to carbon pricing. I feel confident that leaders will rise to this challenge with a stronger commitment to tackle climate change and seize the economic opportunities that a post-carbon world has to offer.

Useful links

The climate challenge: Achieving zero emissions Full text of the OECD Secretary-General’s speech at an event in London in October 2013, co-organised with the London School of Economics and the Climate Markets & Investors Association (CMIA),

OECD work on climate change

Reducing fossil fuel emissions isn’t enough: We must aim for their complete elimination by the second half of the century

Click to download the report
Click to download the report

Today’s post is from OECD Secretary-General Angel Gurría who this morning is presenting a major address on the Organisation’s analysis of climate change, investment and energy policies at an event in London co-organised with the London School of Economics and the Climate Markets & Investors Association (CMIA),

We need to come to grips with the risk of climate change. While many countries have announced ambitious targets to reduce fossil fuel emissions by 2020, and even mid-century, further efforts are needed. UNEP estimates that current pledges will only get us between a quarter and half way of the goal to limit the increase in global average temperature below 2oC. To combat climate change, reducing emissions will simply not be enough! We need instead to eliminate them altogether.

“Zero net emissions” might sound extreme. Why not just simply reduce them? The problem is accumulation. Carbon dioxide is a long-lived gas: almost half the CO2 emitted this year will still be around 100 years from now. Carbon dioxide concentration, and its warming potential, will therefore increase over time, unless the rate of accumulation falls to zero.

Ending our reliance on fossil fuels was never going to be an easy task. Two-thirds of all the electricity generated and 95% of the energy consumed by the world’s transport systems still rely on fossil fuels. The good news is that the bulk of fossil fuel emissions are energy-related and could be completely eliminated using existing technologies. Carbon pricing is a powerful tool to encourage this transformation, either through taxes or by means of emissions trading schemes.

For these efforts to bear fruit, the whole range of price and non-price measures that can be put in place by governments must be mutually supportive and consistent. This is not the case now. For example, coal releases far more CO2 per unit of energy than oil or gas but is taxed at lower rates than most fuels used to generate electricity. Diesel, which emits around 18% more CO2 per litre of fuel than gasoline, is taxed in OECD countries on average a third less than gasoline. Likewise, many countries have tax breaks to support biofuels, even though in most cases these are costly and often of questionable, if not negative, environmental value.

Even worse, some countries still engage in “negative carbon pricing”, more commonly known as subsidies. The IEA estimates that subsidies to fossil fuel in developing and emerging economies totalled $523 billion in 2011. Approximately $55- $90 billion per year are spent in support of the consumption and production of fossil fuels in OECD countries. The net effect of this massive misallocation of resources is to tilt the playing field in favour of a continued reliance on fossil fuels.

A coherent approach to carbon pricing is thus needed to ensure that price signals sent to consumers, producers and investors alike are consistent and facilitate a gradual phase-out of fossil fuel emissions.

Pricing carbon is also essential to encourage the development of alternative technologies, including for carbon capture and storage (CCS). Progress in this area is badly needed. Even if all currently planned CCS capacity were to be built today, only 90 Mt of CO2 would be captured per year, which represent less than 1% of the current power sector CO2 emissions in 2012.

The building of a post-carbon world will offer new economic opportunities, but the transition will not be costless. Governments must be frank about this fact. The commitment to limit the increase in global average temperature below 2oC will require expensive mitigation and adaptation investments. This is a manageable and affordable target, and certainly much less costly in human and economic terms than the alternative of unmitigated climate change

Thus, the goal for governments is to develop a policy mix that, over time, remains credible given the scale of the transformation needed. In doing so, governments should address four key policy challenges:

First, the lack of strong, consistent carbon pricing signals. Up to now, when carbon prices have been imposed, exemptions and carve-outs have combined with very low prices to make the overall impact of pricing marginal at best.

Second, there is an urgent need for fossil fuel subsidy reform. One would imagine that twenty years into the climate debate, countries would at least have made progress in removing subsidies to fossil fuels that encourage carbon emissions. Unfortunately, subsidies continue to exist, not only for consumers (which often end up benefiting higher income households), but also in the form of official support to oil and gas companies for the exploration and exploitation of new fossil reserves.

Third, government needs to avoid mixed messages and stop-go policies in supporting renewable energy. What is required are consistent and coherent signals to encourage greater investor confidence, which in the past has been badly shaken.

Finally, governments need to tackle regulatory and market rigidities which continue to favour the use of fossil fuels in the electricity sector. Thus, governments should encourage demand-side options and increased consumer choice over energy sources.

Tackling these challenges is as much a political issue as an economic one. Businesses simply don’t believe that governments are committed, and their investment choices reflect this lack of confidence, perpetuating activities that bring fossil fuel to the market.

We are neither on track to achieve internationally agreed goals nor managing to execute existing policies in a cost-effective way. Every government needs to take a hard look at its policy mix and determine if it is consistent with a path that eliminates emissions from fossil fuels sometime in the second half of the century.

It will not be enough to cherry-pick a few easy measures, there has to be progress on every front, but notably in respect to carbon pricing. The OECD is committed to assist countries in this process, in order to design, promote, and implement better policies for better lives!

Useful links

The climate challenge: Achieving zero emissions Full text of the OECD Secretary-General’s speech

OECD work on climate change

Fossil fuel subsidies: billions up in smoke?

Click to read the report online
Click to read the report online

On a visit to Scotland in 1435, Aeneas Sylvius, the future Pope Pius II, saw many marvellous things, but as he wrote in his journal, the most astonishing was how “the poor, who almost in a state of nakedness begged at the church door, depart with joy in their faces on receiving stones as alms!” Like most Europeans at the time, the pre-Pope didn’t know what coal was, but once he heard the explanation, he saw that the monks were doing a good deed by helping the poor to heat their hovels.

These days, he may have been astonished to learn that often it’s the other way round. German taxpayers for instance gave 2 billion euros to coal producers in 2011. Poland’s coal producers got 7 billion euros over 1999-2011. These are just a couple of examples of the 550 measures that support fossil-fuel production or use in the OECD’s 34 member countries.  These measures had an overall value of $55 to $90 billion a year in 2005-2011 according to a new OECD report, Inventory of Estimated Budgetary Support and Tax Expenditures for Fossil Fuels 2013.

Despite the many benefits for the environment and public finances of reforming fossil-fuel subsidies, lack of information regarding the amount and type of support measures in place makes it difficult to design and apply policy efficiently. Usually, lack of data is associated with developing counties, but in this case the culprits include OECD members. The International Energy Agency (IEA) has been producing data on fossil-fuel consumer subsidies in emerging and developing countries for several years using an estimation approach known as the “price-gap” method. This measures the extent to which a policy keeps domestic fuel prices below an international reference price. According to the IEA’s 2012 World Energy Outlook, fossil fuel subsidies amounted to $523 billion in 2011, up almost 30% on 2010 and six times more than subsidies to renewables.

However, the IEA approach does not capture support to producers and tax concessions to producers and consumers. The new report does, and you can download the data for each country or consult a country overview here.

Lack of data isn’t the only difficulty facing reform. There is a problem of political economy you’ll find in many other cases too. Those who stand to lose from the reform may be significantly worse off and feel the impact immediately. Benefits on the other hand may be more long term and not amount to much when spread over the whole population. Moreover, those seeking to block reform are often better informed and better organised than the reformers.

That said, there are a number of examples of successful reform. The figure of 2 billion euros to the German coal industry actually represents a significant drop from the 5 billion the industry got in 1999. Much of the money Poland is now paying is associated with historical liabilities, and since 2011 the country has to follow EU regulations that only authorise state aid for the purpose of closing mines, treating damage to miners’ health, and addressing environmental problems from past mining.

The OECD report cites a number of other examples of successful reforms, and identifies a number of common characteristics of programmes that work. First, improve the availability and transparency of support data. Apart from informing the debate, this helps to identify where support is helpful and where it’s not. (The report itself insists that  it “does not analyse the impact of specific measures or pass judgement on which ones might be usefully kept in place, and which ones a country might wish to consider for possible reform or removal.)

Second, some people are going to suffer from subsidy removal, so provide them with financial if needed.

Third, where possible, integrate the subsidy reforms into a package that includes broader structural reforms.

And finally: “Ensuring credibility of the government’s commitment to compensate vulnerable groups and, more generally, to use the freed public funds in a beneficial way.” So announcing that you’re cutting pensioners’ heating allowance to help pay bankers’ bonuses may not rally the support you need.

Useful links

Taxing Energy Use: A Graphical Analysis provides the first systematic statistics of effective tax rates – on a comparable basis – for each OECD country, together with “maps” that illustrate graphically the wide variations in tax rates per unit of energy or per tonne of CO2 emissions.

Joint report by IEA, OPEC, OECD and World Bank on fossil-fuel and other energy subsidies: An update of the G20 Pittsburgh and Toronto Commitments” prepared for the G20 Meeting of Finance Ministers and Central Bank Governors (Paris, 14-15 October 2011) and the G20 Summit (Cannes, 3-4 November 2011)