13.2.1.5 Subsidies and incentives

Direct and indirect subsidies can be important environmental policy instruments, but they have strong market implications and may increase or decrease emissions, depending on their nature. Subsidies aimed at reducing emissions can take different forms, ranging from support for Research and Development (R&D), investment tax credit, and price supports (such as feed-in tariffs for renewable electricity).^[21] Subsidies that increase emissions typically involve support for fossil fuel production and consumption. They tend to expand the subsidized industry, relative to the non-subsidy case. If the subsidized industry is a source of GHG emissions, subsidies may result in higher emissions. Subsidies to the fossil fuel sector result in over-use of these fuels with resulting higher emissions; subsidies to agriculture can result in the expansion of agriculture into marginal lands and corresponding increases in emissions. Conversely, incentives to encourage the diffusion of new technologies, such as those for renewables or nuclear power, may promote emissions reductions.

One of the significant advantages of subsidies is that they have politically positive distributional consequences. The costs of subsidies are often spread broadly through an economy, whereas the benefits are more concentrated. This means that subsidies may be easier to implement politically than many other forms of regulatory instruments. Subsidies do tend to take on a life of their own, which makes it difficult to eliminate or reduce them, should that be desired.

The International Energy Agency (IEA) estimates that in 2001 energy subsidies in OECD countries alone were approximately 20–80 billion US$ (IEA, 2001). The level of subsidies in developing and transition economy countries is generally considered to be much higher. One example is low domestic energy prices that are intended to benefit the poor, but which often benefit high users of energy. The result is increased consumption and delayed investments in energy-efficient technologies. In India, kerosene and liquefied petroleum gas (LPG) subsidies are generally intended to shift consumption from biomass to modern fuels, reduce deforestation and improve indoor air quality, particularly in poor rural areas. In reality, these subsidies are largely used by higher expenditure groups in urban areas, thus having little effect on the use of biomass. Nevertheless, removal of subsidies would need to be done cautiously, in the absence of substitutes, as some rural households use kerosene for lighting (Gangopadhyay et al., 2005).

OECD countries are slowly reducing their subsidies to energy production or fuel (such as coal) or changing the structure of their support to reduce the negative effects on trade, the economy and the environment. Coal subsidies in OECD countries fell by 55% between 1991 and 2000 (IEA, 2001).^[22] (See Chapter 7 for additional information.)^[23] About 460 billion US$ is spent on agricultural subsidies, excluding water and fisheries (Humphreys et al., 2003), with OECD countries accounting for about 318 billion US$ or 1.2% of the GDP. These subsidies result in the expansion of this sector with associated GHG implications (OECD, 2001, 2002).

Many countries provide financial incentives, such as tax credits for energy-efficient equipment and price supports for renewable energy, to stimulate the diffusion of technologies. In the USA, for example, the Energy Policy Act of 2005 contains an array of financial incentives for various advanced technologies; these financial incentives have been estimated at 11.4 billion US$ over a 10-year period.

One of the most effective incentives for fostering GHG reductions are the price supports associated with the production of renewable electricity, which tend to be set at attractive levels. These price supports have resulted in the significant expansion of the renewable energy sector in OECD countries due to the requirement that electric power producers purchase such electricity at favourable prices. The US Public Utility Regulatory Policy Act of 1978 requires electric utilities to buy renewable energy at “avoided cost”. In Europe, specific prices have been set at which utilities must purchase renewable electricity – these are referred to as ‘feed-in tariffs’. These tariffs have been effective at promoting the development of renewable sources of electricity (Ackermann et al., 2001; Menanteau et al., 2003). As long as renewables remain a relatively small portion of overall electricity production, consumers see only a small increase in their electricity rates. Incentives therefore have attractive properties in terms of environmental effectiveness, distributional implications and institutional feasibility. The main problem with them is cost-effectiveness: They are costly instruments, particularly in the long-run as interests and industries grow to expect the continuation of subsidy programmes. See Chapter 4.5 for a more extensive discussion.