3 essential steps towards ending fossil fuel subsidies

• Fossil fuel subsidies persist despite the climate crisis.

• They distort the energy market by keeping fossil fuel prices artificially low.

• Removing these subsidies must be accompanied by social programmes that will reduce the impact on the poorest household.

At their latest meeting in May, the environment ministers of the G7 agreed to phase out government funding for fossil fuel projects. These commitments come not a moment too soon – fossil fuel subsidies are the dirty secret of today’s energy policy.

A total of around $650 billion is spent every year worldwide on subsidizing energy sources. Given the broad consensus that the impending climate catastrophe is the greatest challenge facing mankind, you might assume that these massive investments are being made into renewable energies. Wrong: About 70% or $450 billion is spent on fossil fuels such as coal, oil and gas, while little more than a quarter (about $170 billion) goes to renewables. The rest supports nuclear energy. This raises two questions: How can this still be the case? What can be done about it?

One explanation for the persistence of fossil fuel subsidies can be found by looking at the states involved. Countries such as Iran, Kuwait, Saudi Arabia and Venezuela top the list – so-called "petrostates" where high fossil fuel subsidies are an expression of the close interlinkages between the oil industry and the state. But such petrostates only top the list when the relative size of the subsidies – i.e. as a percentage of GDP – is considered.

In absolute terms, the picture looks different. The five largest donors account for 44% of all fossil fuel subsidies – and among these five are China (number 2) and India (5). The ten largest donors account for 63% of subsidies, including Indonesia (6), Egypt (8) and the UK (9). Finally, Italy, France, Brazil and the USA also appear in the top 15. Fossil fuel subsidies are thus by no means only a petrostate problem.

In developing countries such as India and Indonesia, subsidies often play a primarily sociopolitical role: Cheap fuels for cooking, heating and transportation are a means to secure the livelihoods of the poorest. By contrast, subsidies in developed countries appear to be paid primarily through a lack of transparency, enabling interest groups to secure advantages for themselves under the radar of the critical public. Therefore, and in contrast to the developing world, it is rather the producers than the consumers of energy who benefit here.

The effect is nevertheless fatal: Efforts to reduce CO2 emissions through higher prices are thwarted. This results in distorted markets, for example in financing the transition to climate neutrality; investments into renewables become less attractive when compared with subsidized alternatives and the result is a suboptimal allocation of capital. Fossil fuel subsidies therefore lead not only to more climate-damaging emissions today, but also tomorrow.

There are only a handful of countries that seem really determined to abolish these subsidies, with the US the most prominent example. But in the case of the US, this mainly reflects the unwillingness to introduce proper carbon pricing. Reducing fossil fuel subsidies is the ersatz way of placing the social cost of carbon on carbon producers. Even in countries where the political will exists, the abolition of subsidies by the "cold turkey approach" is unlikely to produce the desired results, as the examples of Ecuador – which saw social unrest in 2019 after the abrupt end of subsidies – and France with its Yellow Vest protests in 2018/19 show.

What is needed, therefore, is a well thought-out, three-pronged approach that ultimately makes fossil fuel subsidies superfluous.

First, by supporting the adoption of cost-effective alternatives. From e-scooters in Jakarta to solar panels in rural India, mass expansion of renewable energies is happening fast, and the past few decades have clearly shown how essential economies of scale are in this area. With a doubling of capacity, electricity production costs generally fall by about a third. As a result, generating electricity from renewables becomes cheaper than from coal or oil today.

Second, to accelerate the transition to climate-friendly energy supplies, subsidies for producers presently active in the fossil fuel sector should be steered into lowering emissions. Energy producers can keep their subsidies – but only if they devise transition plans in accordance with the 1.5-degree goal and follow through on them. If targets are missed, subsidies can be clawed back.

Third, and most importantly, fossil fuel subsidies must be made redundant for social policy reasons. This is all the more urgent in the aftermath of the COVID-19 crisis, which has exacerbated existing inequalities. Abolishing fossil fuels subsidies for energy consumers could even help create a more equal society, since the biggest beneficiaries of these subsidies are those who consume the most energy – usually not the poorest households.

As things stand, abolishing subsidies would place the brunt of costs on poorer households, who spend twice as much of their income on energy-related expenditures as richer households. Targeted social programmes are needed to counter this. By using subsidies “saved” from richer households, such programmes could even become self-financing to a certain extent. However, these measures should not only provide ad hoc assistance, but address the root cause of poverty. The most promising way to do so is through investing in children, which delivers gains across every sphere: education, health, employment and wealth. The Biden administration’s "American Families Plan" could serve as a blueprint here. In general, climate policy must ultimately be embedded into a fundamental renewal of the social contract.

Fossil fuels subsidies are a nuisance and are diametrically opposed to modern climate policy. At the same time, they are an expression of deeper social and political fault lines. Simply abolishing them for climate policy reasons is therefore not a sustainable solution. Their causes must be eliminated, too. The new pledge of the G7 countries is a welcome start, but a global strategy is needed, one which includes developing and emerging countries. The next step should be the adoption of the “Naples Declaration” on stopping fossil fuel subsidies by the environment, climate and energy ministers of the G20 on their meeting on 23 July in Naples.