9.2.1.2 Reducing Subsidies in the Energy Sector

Empirical and theoretical studies indicate that no regrets policies can result from the removal of subsidies from fossil fuels or from electricity that relies on fossil fuels. The UN Framework Convention on Climate Change (UNFCCC article 4.2e (ii)) calls for Annex I Parties “to identify and periodically review its own policies and practices which encourage ... [greater emissions] than would otherwise occur”. The Kyoto Protocol calls for such Parties to “implement … measures ... such as ... progressive reduction or phasing out of market imperfections, fiscal incentives, tax and duty exemptions and subsidies in all greenhouse gas emitting sectors that run counter to the objective of the Convention …”.

The extent of the impact of reducing subsidies will depend on the specific characteristic of each country, the type of subsidy involved, and the international co-ordination to implement similar measures. Most countries introduce subsidies in order to accomplish several policy objectives. In the case of energy, these are usually in order to:

• secure domestic energy supplies;
• ensure that power supply is sufficient to meet demand;
• provide access to energy for low-income households;
• maintain or slow the loss of employment in mining communities; and
• retain the international competitiveness of domestic industry.

Coal subsidies have encouraged high production of coal in a number of industrial countries and high coal consumption in numerous developing and transition economies (OECD, 1997c). For example, a complete measure of the total support to producers can be estimated in the form of the producer subsidy equivalent (PSE), which has been calculated annually by the International Energy Agency (IEA) for several countries since 1988 ( IEA, 1998b). DRI (1994) used revised versions of the IEA’s coal PSE estimates (shown in Table 9.2) to model the effects of removing subsidies. These subsidies tend to increase GHG emissions and more general pollution.

Table 9.2: Producer subsidy equivalents for coal production in OECD countries in 1993
	PSE per tonne US$/tce	Total PSE MUS$	Budgetary support	Price support Mtce	Subsidized production
France Germany Japan Spain Turkey UK US	43 109 161 84 143 15 0	428 6688 1034 856 416 873 0	100% 40% 12% 37% 100% 2% 0	0% 60% 88% 63% 0% 98% 0	10.0 61.5 6.4 10.2 2.9 57.4 0
Note: PSE is Producer Subsidy Equivalent; tce = tonne of coal-equivalent; Mtce = million tce. 1 tce = 29.308 GJ Source: OECD (1997c).

In recent years many countries have changed their energy policy, from a focus on energy self-sufficiency, to broader policy objectives, oriented towards encouraging economic efficiency and taking into account environmental problems. Subsidies are currently under review by many countries, and in some cases reforms have already taken place. Nevertheless, large subsidies remain in both Annex I and non-Annex I countries.

In theoretical terms, polluting activities, such as coal mining and coal burning, could be taxed in order to achieve economic efficiency. Economic theory indicates that the optimal policy would be to replace those production and consumption subsidies with optimal taxes. According to global studies, even without adding new taxes, removing the subsidies and trade barriers at a sectoral level would create a win-win situation, improving efficiency and reducing the environmental damage (Burniaux et al., 1992; Hoeller and Coppel, 1992; Larson and Shah, 1992, 1995; Anderson and McKibbin, 1997). It is a well-established finding that removal of these subsidies would result in substantial reductions in GHG emissions, as well as stimulating economic growth. Local studies also indicate that removing support to the production and use of coal and other fossil fuels can result in substantial reductions in CO₂ emissions in the main coal-using countries, at the same time as reducing the cost of electricity production (DRI, 1994; Shelby et al., 1994; Golub and Gurvich, 1996; Michaelis, 1996; OECD, 1997c, Appendix A). Table 9.3 is a review of the quantitative results of these case studies, along with the global studies. Note, however, that these analyses adopt different methodologies, so that the figures are not directly comparable.

In spite of these results, it is not wise to generalize about the environmental and economic effects of removing subsidies in the energy industry (OECD, 1997c). For example, the effect of removing subsidies to coal producers depends heavily on the type of subsidy removed and the availability and economics of alternative energy sources, including imported coal. Removing some electricity sector subsidies may have very little effect on GHG emissions or may even increase emissions, for example, when subsidies to electricity supply industry investment are supporting the use of less polluting energy sources. Finally, there may be cases where removing a subsidy to an energy-intensive industry in one country would lead to a shift in production to other countries with lower costs or environmental standards, resulting in a net increase in global GHG emissions (OECD, 1997c). The issue of carbon leakage is addressed in greater detail in Chapter 8.

9.2.1.3 Sectoral Impacts of the Kyoto Mechanisms

The effects of the Kyoto Mechanisms at the sectoral level are complex. The available studies have looked at the effect of international emissions trading, but there have been no comprehensive studies on the sectoral effects of the Clean Development Mechanism (CDM) or joint implementation (JI). Countries buying assigned amount units (AAUs), or funding CDM and JI projects, may have less need to reduce fossil fuel consumption. Therefore, the sectors in these countries that depend on fossil fuel production or use may experience smaller economic impacts (Brown et al., 1999). This would also reduce the impact on fossil fuel producers, both at the domestic and international level. However, countries selling credits, or hosting JI and CDM projects, will have to generate these AAUs or Certified Emission Reductions (CERs) through either reduction of GHG emissions or enhancement of sinks. The economic impact on sectors within those countries will vary depending on the source of the credits. Some sectors will benefit, while others may see reduced rates of growth. Until the rules for implementation of the Kyoto mechanisms have been decided, sectoral impacts of their use will remain speculative.

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