Making Fossil Fuel Subsidies Obsolete

In early 2012, the Nigerian government drastically cut diesel and petroleum subsidies, causing local fuel prices to more than double overnight. Violent public protests broke out in response, leading the government to quickly reinstate the subsidies.

While this case is extreme, it illustrates a common challenge facing many countries: Despite the recognized benefits of fossil fuel subsidy reform, including climate change mitigation, the reality of subsidy removal can be a political nightmare.

The hidden costs of «cheap» energy

Estimates of global fossil fuel subsidies range from USD 300–500 billion [1] to USD 5.3 trillion [2] per year. Such numbers certainly grab headlines – especially when juxtaposed with estimates for support for low-carbon technologies (about USD 120 billion) or Green Climate Fund targets (USD 100 billion) – but they also risk masking the complexity of fossil fuel subsidy reform.

These numbers also cannot reveal the effect these subsidies have on distorting public investments and creating political and social vulnerabilities as state budgets drain. Indeed, many cases of national subsidy reform occur in times of major fiscal imbalance, when international organizations, such as the IMF, step in with substantial loans and make their lending conditional on the recipient country removing its fossil fuel subsidies. However, in times of crisis, a government often has limited capacity to manage the negative impact of removing these subsidies – particularly on the poor and vulnerable members of its population.

Unsustainable appeasement strategies

Reducing fossil fuel subsidies to a single number may also give the impression that reforming fossil fuel subsidies means simply reducing this sum. To date, subsidy reform has been synonymous with subsidy removal – or taking away a negative distortion. As a result, much work on fossil fuel subsidy reform has analyzed the political power balances involved in subsidy removal, and concludes that subsidy phase-out should be coupled with an appeasement strategy to win buy-in from affected stakeholders. One common strategy therefore proposes a partial redistribution of the fiscal savings from the subsidy reductions to compensate stakeholder groups perceived as particularly powerful in opposing reform. Such approaches to subsidy reform are not only fiscally unsustainable, but also can only be a superficial solution to a much deeper socio-technical problem.

Shifting the focus to the underlying system

While the ultimate goal should be to reduce fossil fuel subsidies, strategies for achieving this goal need to better target the underlying energy systems that create the demand for cheap fossil fuels. Ultimately, it is this system that generates the economic and political rents that make fossil fuel subsidy reform difficult and short-lived. Combining reform with policies that incentivize technological change can thus help make subsidy reform more sustainable.

In parts of Indonesia, for example, technology-oriented policies helped enable the reduction of kerosene subsidies for cooking. Alongside kerosene subsidy reduction, the government enacted policies that incentivized a significant amount of consumers to switch to alternative cookers running on cleaner liquefied petroleum gas. These technology-oriented policies provided a cost-effective alternative for users, thereby reducing their dependence on – and thus their opposition to the removal of – kerosene subsidies. Such an approach could also work for other sectors such as transport, industry and electricity generation.

Reframing economic reforms

Hybridizing fossil fuel subsidy reform with technology-oriented policies also critically reframes the political economy of reform. Rather than a one-sided focus on removing a financial flow in an often already investment-starved economy, these hybrid approaches seek to build advocacy for subsidy reform by creating real economic activity.

In the electricity sector, for example, policies that support emerging fossil-free technologies open the typically monopolistic sector to new independent power producers. Renewable energy technologies also can create local jobs in construction, maintenance and manufacturing. The emergence of these low-carbon actors entrenches new “green” interests in the sector, thus altering the political balance of power in subsidy debates. In many cases, low-carbon technologies are already cost-competitive, and diversifying the technology mix decreases the vulnerability of a country and its consumers to future fuel-price shocks.

It should also be in the interest of international organizations (such as the IMF) to advocate for and, where necessary, financially support hybrid policies. These approaches provide an opportunity for international organizations to move from being the scapegoat for driving up energy prices, to enablers of new, job creating alternatives.

This blog post is a shortened version of an earlier external page article by Tobias Schmidt and Tyeler Matsuo published in the Diplomatic Courier.