What exactly is a fossil fuel subsidy?

Half a trillion dollars? Two trillion dollars? “Only” 85 billion? Widely-differing numbers have been cited in recent years for global fossil fuel subsidies, making policy evaluation and consensus-building on reform challenging. Different definitions for subsidies, the boundaries of review, and the methods for calculating subsidies are responsible for the large differences and have contributed to the confusion. Despite a broad consensus that most fossil fuel subsidies are inefficient, reduce public funds for critical social spending, and slow transitions to sustainable energy development, achieving consistency in definitions and valuation methods remains a work in progress.

What do subsidies cover?

Our recent paper provides a review of different approaches to defining and quantifying fossil fuel subsidies—including price gap, hidden cost, and inventory methods. The paper defines a fossil fuel subsidy as a deliberate policy action by government that specifically targets oil, gas, coal, or fossil-fuel-based electricity or heat, with one or more of the following effects:

1. Reducing net cost of energy purchased
2. Reducing cost of production or delivery of energy
3. Increasing revenues retained by energy suppliers

There is a judgment call in using this definition to quantify subsidies. For example, how specific is “specifically targets…”? What if 55 percent of a certain tax concession is captured by the oil industry? And what is the baseline against which prices, supply costs, and fiscal payments are compared? If there is a tax concession, what is the baseline tax year? Upstream fiscal terms may have changed many times over the years. In determining the reference price for electricity, what technical and commercial losses are assumed “normal”? Analysts have not always addressed these types of issues in the same way, resulting in material differences in which interventions are included in each study. Even when there is definitional agreement, technical constraints may limit data on certain types of subsidies—loan guarantees, for example, can be challenging to value.

Unaccounted externalities

The treatment of unaccounted externalities is the largest contributor to different subsidy values across global studies. The divergence is wide, from exclusion to broadly including all unaccounted externalities that are in any way associated with fuel production or consumption as fuel subsidies. Many such externalities cause significant environmental and health damage, and environmental economists have long argued for charging corrective taxes as a means of internalizing externalities. Doing so is appealing from one point of view, but apart from the challenge in attributing particular types of damage to fuels alone, inclusion of uninternalized externalities in subsidies poses difficulties, including reconciliation with how practitioners in other sectors understand the concept of subsidy. The World Bank, the International Energy Agency (IEA), and the OECD all exclude unaccounted externalities from subsidy valuation. By contrast, the IMF estimates include them, attributing all calculated externalities to fuels, which adds another $1.5 trillion over and above the $0.5 trillion computed by the IEA.

Three methods to choose from?

Having defined subsidies, how do practitioners quantify them? The price-gap approach estimates the gap between free-market reference prices and the prices charged to consumers. It is widely applied in multi-country reviews, although serves as a lower-bound estimate of total support. High costs from inefficiency may make prices approach reference prices, hiding subsidies. And price gaps do not capture many producer subsidies.

The hidden-cost approach is used primarily for electricity, natural gas, and district heating. It captures deviations from reference costs based on efficient operation. Excess costs from over-staffing, high system losses, or tariff under-collection are all examples of hidden costs. Although financially important, these losses are not generally counted as subsidies as defined in our paper.

The inventory approach draws up a list of various forms of support provided to consumers and producers, although analysts may differ on the subset labeled as a subsidy.

Do practitioners need to first pick a method from this menu of options? Thankfully, no. While a particular approach may best suit available data or policy needs, the methods are complementary and form parts of a unified, comprehensive framework for producer and consumer support estimates.

Toward a unified framework

Lack of data has been the primary impediment to adopting the unified framework globally, driven in turn by resource constraints. How to prioritize data collection and calculation depends on the immediate objectives. Price gaps cause distortions throughout the economy and quantification is needed to improve pricing policies. If utilities are in poor financial health, or tariffs are high because of high costs, identification of hidden costs may be the most immediate need. If a pressing policy question is efficiency of budget allocation and execution, a subsidy inventory would be useful.

Subsidy tracking is a continuous process of adjustment. In the agricultural sector, decades of work have led to a common understanding of terms and standardized calculation methods to assess subsidies. Agriculture is close to having adopted a unified framework for subsidy calculations. Not so with energy—not yet. Working toward a common framework and definitions, while intensifying data collection and sharing, would greatly facilitate subsidy comparison across countries and sectors, assessment of policy efficacy, and benchmarking pricing.

This article originally appeared on The World Bank’s Let’s Talk Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Masami Kojima is a Lead Energy Specialist in the Oil, Gas, and Mining Unit, Sustainable Energy Department.

Image: An employee fills a test tube with mineral oil. REUTERS/Ilya Naymushin.