Naked Budgets: A fiscal argument to save the climate

Two news stories this week, emerging from either side of the Atlantic, encapsulate the climate change conundrum.

The message coming from hundreds of civil society organizations, scientists and policy-makers gathered at the climate change conference in Marrakech (COP 22) has been the fact that, in order to keep climate change within 2 degrees, three quarters of the known reserves of oil, gas and coal need to stay in the ground.

At the same time, U.S. Geological Survey announced what could be the largest deposit of untapped oil ever discovered in America.

Therein lies the question: will countries continue exploring and extracting new oil, gas and coal despite the existential risk of climate change, or will they leave fossil fuels in the ground? To a great extent, the answer lies with economics, including the role of subsidies to the fossil fuel production industry.

In every country that IISD has examined, governments afford subsidies to the extractive industry, as they have done for decades. But the world is changing: climate change is a reality, and fossil fuel companies are no longer the key taxpayers they once were. It is high time to rethink how fossil fuels are taxed and to stop subsidizing them—for the benefit of national budgets and the global climate alike.

Stripped of Tax Revenues

Against the backdrop of low commodity prices, fossil fuel companies have seen their earnings plummet. Over the past two years, the world’s leading coal producer, Peabody Energy, filed for bankruptcy, as have over 100 oil and gas companies in North America alone. Even assuming that global energy commodity prices rebound, other factors—such as the enhanced role of renewables and energy efficiency, the high cost of extraction, recent oil sand fires and explosions, attacks on operations, oil spills and other accidents—will continue to eat into the margins of oil, gas and coal producers.

Extractive companies do not own oil, gas and coal reserves. These reserves are owned by governments that license companies to extract oil, gas and coal in return for royalty and other tax payments. If these payments fade out, the fiscal rationale for the industry’s existence comes under question. Of course, there are other reasons, too, that governments may want to prop up the sector—energy demand, energy security, jobs, trade balance, for example. But for each of these needs, fossil fuels are not the only answer.  

Fossil Fuel Subsidies—A Vicious Circle

Every year, the oil, gas and coal extracting industries receive at least USD 100 billion in government subsidies globally (of which USD 70 billion are national subsidies in G20 countries). Low commodity prices have led to more subsidy demands over the past two years. In the U.K., the cabinet responded in 2015 with a package of tax breaks for North Sea production. In Indonesia, the government found itself under pressure from coal-mining companies lobbying for an increase in domestic coal price to cushion their losses from reduced demand in China and India.

Beyond the jobs and energy security arguments, one of the reasons why governments may favourably view demands for more support to the extractive industry are hopes to recoup these subsidies as tax revenues in the future. Experts and decision-makers in the area of natural resource taxation conventionally think in terms of rents and repeat that tax and royalty breaks are “incentives” and not subsidies.

Because fossil fuel companies operate globally, governments often grant subsidies to extractive industries under the banner of tax competitiveness. And, as a result, there emerges a vicious circle, a “race-to-the-bottom” where, to attract international investment, some countries seek to grant more subsidies than others. The result is that subsidies increase and revenue back to government decreases—a losing proposition.  

New Fiscal Policy—A Virtuous Circle

The need to deeply decarbonize our economies is incompatible with fossil fuel subsidies. Three quarters of fossil fuel reserves listed by the extractive industry are already “unburnable” and have to stay in the ground if we want to keep climate change within the 2 degrees scenario. Policies that encourage production and consumption of fossil fuels are inconsistent with this climate goal.

Global as well as national-level studies for Canada, Norway and Turkey demonstrate that, in most cases, the phase-out of subsidies to fossil fuel producers not only generates greenhouse gas emissions savings, but is neutral or slightly positive in macroeconomic terms.

While the phase-out of upstream subsidies can be difficult politically, there are several reasons why it stands a good chance of success. First, heads of state have repeatedly committed to fossil fuel subsidy reform within G7, G20, APEC and other forums. Second, within national legislation, these subsidies are framed as deviations from the normative taxation, which eases the political case for their reform. Third, there are encouraging examples of governments phasing out domestic support to fossil fuel producers in Germany, China and Canada as well as restricting overseas support to fossil fuels.

Finally, fossil fuel producer subsidy reform can build on lessons learned from consumer subsidy reform.  For a long time, consumer subsidies appeared irreversibly entrenched. Yet, from 2014 to 2016, dozens of countries, including such “lead subsidizers” as India, Indonesia and Saudi Arabia, have reformed their consumer subsidies. The resources that are freed up by both consumer and producer subsidy reform, in their turn, create fiscal space for governments to fund “green” development and reduce their dependence on fossil fuels. This virtuous circle is the future of fiscal policy.

Cross-posted from the Global Subsidies Initiative's Subsidy Watch Blog.