Chapter 6. Mitigation and Fuel Pricing in Developing Economies*
Author: Mr. Michael Keen
Language:
English
Keywords:
BOOK; emission; firm; price; revenue; SCC; low income; price fluctuation; emission price; fuel price movement; developing economy; Non-renewable resources; Greenhouse gas emissions; Consumption; Energy subsidies; Global; mitigation cost
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Abstract

Low- and lower-middle-income countries contribute only about 12 percent of global carbon dioxide (CO2) emissions, though this share is increasing (and they account for a larger share of other greenhouse gases).

Key Messages for Policymakers

  • Low- and lower-middle-income countries contribute only about 12 percent of global carbon dioxide (CO2) emissions, though this share is increasing (and they account for a larger share of other greenhouse gases).

  • Several large, lower-middle-income countries are already important sources of CO2 emissions; for them, much of the guidance developed in other chapters of this volume is relevant.

  • Developing economies that are low emitters of CO2 nonetheless have a critical role in finding an effective and efficient global response to the challenges from climate change: ways need to be found both to prevent “carbon leakage,” as mitigation measures in high-emitting countries cause emissions to shift there, and to exploit the relatively cheap opportunities for emissions reduction there.

  • Contrary to a standard mantra, an efficient approach to global mitigation does not require that developing economies charge emissions at the same rate as high-emitting countries.

  • Good tax policy in these countries calls for applying to fuel use both excises (applying to both businesses and households) that at least reflect environmental damage arising at local and national levels and, on top of that, VAT or some other form of sales tax on use by final consumers.

  • Fossil fuel subsidies are almost always bad policy, even apart from the increase in emissions they cause, since there are generally better ways to help the poor; transparency and the development of social support systems are key to exiting from them.

  • The problems of weak administration and poor compliance that pervade many developing economies argue for robust taxation of energy use.

  • Offset schemes, whatever their intrinsic strengths and weaknesses as strategies for mitigation—which are likely to become more important in the coming years—are potentially a useful source of additional revenue for many developing countries.

This chapter considers fiscal policies toward mitigation, and those bearing on the use of fossil fuels more generally, in developing economies. It also considers, more briefly, the implications for them of mitigation measures adopted in more advanced economies. The central argument of the chapter is straightforward. The course of emissions in most, though not all, developing economies—by which we mean those in the low-income and lower-middle-income categories of the World Bank classification (see the Appendix, Table 6A.1)—is relatively immaterial to future warming. The case for them to bear substantial mitigation costs to limit emissions in the near future is correspondingly weak, even leaving aside the argument that they bear little responsibility for the cumulative stock of greenhouse gases (GHGs) and so have little duty to act. But ways need to be found both to exploit possible low-cost opportunities from mitigation there, with financial flows from developed economies having an important role, and, if need be, to avoid excessive leakage from aggressive schemes adopted in more advanced economies. Moreover, even setting climate concerns aside, there is in many developing economies—in terms simply of their own self-interest—scope for significant improvement in fiscal policies toward fossil fuels. And these will, in many cases, act in the direction of reduced emissions.

The chapter starts by looking at current and prospective contributions to global CO2 emissions in developing economies, and then at current levels of consumption and production of fossil fuels and GHG emissions, focusing on the distribution across countries categorized by income level. The next section discusses tax design for products and activities that result in GHG emissions, recognizing both efficiency and equity concerns. This is followed by a comparison of the principles that emerge with current policies in low- and lower-middle-income countries. The next two sections address how to deal with any unwelcome equity consequences of the reforms this comparison suggests, and offset schemes, which are a source of revenue for developing economies that is currently very limited but seems likely to grow in importance.

Mitigation for the Collective Good?

Low-income and lower-middle-income countries account, collectively, for only about 12 percent of global CO2 emissions (though a higher share of other GHGs, as seen below), and their per capita emissions are barely one-tenth of those in high-income countries (Figure 6.1). Individually, all low-income and most lower-middle-income countries have only negligible emissions. These emissions can, of course, be expected to grow, both absolutely and in percent of the total, but they will still have only a relatively modest impact on global emission totals for decades.1 A handful of lower-middle-income countries emit significant quantities of GHGs: Five of them—India, Indonesia, Pakistan, Ukraine, and Uzbekistan—accounted for 75 percent of the total emissions of the 50 lower-middle-income countries in 2009, and 10 countries accounted for 90 percent. Efforts to curtail emissions or slow emissions growth in these countries can make a real contribution to reducing climate damage—and much the same analysis of issues and methods discussed elsewhere in this volume applies to these countries.

Figure 6.1.
Figure 6.1.

CO2 Emissions, 2009. (Left) Global share; (right) emissions per capita (kilograms).

Source: Energy Information Administration (http://www.eia.gov/countries/data.cfm) and authors’ estimates.

The focus here, however, is on low-income and the low-emitting lower-middle-income countries. What happens to their emission makes relatively little difference to atmospheric GHG concentrations. Even though many of them stand to suffer most from climate change, their inability to affect the climate outcome gives them little incentive to undertake unilaterally measures specifically to curtail emissions. To the extent that mitigation measures are costly for them, the case for them to adopt, for climate reasons, aggressive mitigation strategies—in the sense of some form of carbon pricing at levels comparable to those appropriate in high-emitting countries—is correspondingly weak both in terms of their own self-interest and in terms of the wider good. There are, however, two caveats:

  • Mitigation measures may be needed in these countries to avoid “leakage” from aggressive measures adopted elsewhere; that is, to avoid an increase in emissions there caused by the relocation of emitting firms or by the reduction in fossil fuel prices induced by the actions of others. This risk would be lessened if those implementing aggressive policies were to adopt border tax adjustments that impose corresponding charges on their imports from countries not imposing comparable emission prices—which, by the same token, will increase the self-interest of these countries in adopting similar measures.

  • To the extent that, as will often be the case, it is cheaper to reduce emissions in these countries than in more advanced ones, efficiency (and, hence, potential gain to all) requires finding some way to realize those opportunities, quite likely involving some form of international transfer.

It may then be that pricing to reflect the global damages from GHG emissions in many developing economies need not be a priority in coordinated efforts to reduce global warming. Fiscal policies toward fossil fuels in these countries can then be driven by narrower notions of self-interest. And here, as discussed later, there is substantial scope for improvement. Before turning to this, however, it is helpful to take a closer look at patterns of fuel use and GHG emissions in these countries.

Fossil Fuel Consumption and the Distribution of CO2 Emissions

Trends in Consumption and Emissions by Income Level

The consumption of fossil fuels is heavily concentrated in high-income and upper-middle-income countries. In 1980, these two groups accounted for 96 percent of total energy consumption (Table 6.1). This share decreased to 89 percent by 2008, with a faster-than-average rate of increase in the consumption by upper-middle-income countries more than offset by the slower-than-average growth in consumption in high-income countries (43 percent). The extremely rapid increase in energy consumption in lower-middle-income countries accounts for all of the reduction in the share of consumption in the two higher income groups, with 80 and 90 percent, respectively, of the increase in this share coming from the 5 and 10 largest emitters in the group. The shares of the bottom 45 and 40 emitters in this group were only 1.2 and 0.5 percentage points, respectively.

Table 6.1.

Consumption of Energy and CO2 Emissions, 1980–2008

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Source: Energy Information Administration (http://www.eia.gov/countries/data.cfm) and authors’ estimates.

Percentage change for level and percentage point change for share.

By any metric, low-income countries have not been significant contributors to CO2 emissions.2 Indeed their share of CO2 emissions has even decreased, even though their share of energy consumption has remained constant. This result stems—at least in part—from the fact that the income groupings are defined based on current income levels. A number of countries that have grown rapidly—for instance, China and India—have moved into middle-income categories, increasing the rate of growth in energy consumption and CO2 emissions in these categories and reducing the rate of growth in the low-income category. Again, the few large consumers/emitters among lower-middle-income countries accounted for almost all of the 7.4 percentage point increase in the share of this group.

The rate of growth in emissions largely mirrors the growth in energy consumption. However, the overall rate of emissions growth is slower, reflecting an average reduction in emissions per unit of energy consumed. This reflects primarily a shift in the composition of energy sources toward fuels that are less carbon intensive on average. Globally, there has been a shift away from petroleum and toward coal, natural gas, and other nonemitting energy sources such as nuclear power and renewables (Table 6A.2, in the Appendix), with a concomitant shift in emissions sources (Table 6.2). The result has been a net increase in emissions intensity (Table 6.3), although the shift to coal, which has the highest emissions intensity, partly offset the gains from the shifts to natural gas and renewables. High-income countries have shifted from petroleum and coal into natural gas and other energy sources, while middle-income countries, especially upper-middle-income countries because of China, have shifted into coal. Low-income countries, on the other hand, have seen an extreme shift out of coal into primarily natural gas, most likely due to the increased availability of this energy source.

Table 6.2.

Distribution of Emissions Sources, 1980–2008

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Source: Energy Information Administration (http://www.eia.gov/countries/data.cfm) and authors’ estimates.

Percentage change for consumption and percentage point change for share.

Table 6.3.

Emissions and Energy Efficiency, 1980–2008

article image
Source: Energy Information Administration (http://www.eia.gov/countries/data.cfm) and authors’ estimates.

Note: Btu = British thermal unit; PPP = purchasing power parity.

Percentage change for consumption and percentage point change for share.

In short:

  • Low-income and the vast majority of lower-middle-income countries have contributed very little to either the level or the growth in global emissions, primarily because slow growth has constrained the growth in their energy consumption.

  • In addition, low-income countries—but not lower-middle-income countries in general—have shifted away from coal and toward cleaner hydrocarbon energy sources, again mitigating their contribution to CO2 emissions.

Stringent mitigation measures by low-income countries and most lower-middle-income countries are, thus, not a necessary condition for reducing global CO2 emissions.

Trends in Energy Efficiency

A somewhat different picture emerges if one looks instead at the efficiency with which low- and middle-income countries use energy, both in terms of emissions and energy consumption. This picture is, however, somewhat different depending on how GDP is compared across countries.

Using market exchange rates (in the upper part of Table 6.3), the worldwide carbon intensity of production fell by 12 percent between 1980 and 2008. This stemmed entirely from improved efficiency in high- and low-income countries, with a very small contribution from low-income countries to the aggregate. Moreover, almost all of the increase in efficiency has stemmed from a reduction in the quantity of energy used to produce output. Energy efficiency fell for middle-income countries, as evidenced by the increase in Btu3 per U.S. dollar of GDP for both subgroups. Measuring GDP in purchasing power parity terms (lower part of Table 6.3)—which adjusts, for example, for labor-intensive nontradable services being cheaper in poorer countries—generally leads to higher GDP numbers and therefore to lower emission and energy intensity.4 Now (almost) all of the increase in energy and emissions efficiency occurs in high-income countries, but the level of efficiency in other income groups seems, relative to those countries, much higher. The broad qualitative pattern of changes is much the same, except that emissions intensity in upper-middle-income countries falls on a purchasing power parity basis, but rises when market exchange rates are used.

The lesson here is that even though low-income and many lower-middle-income countries account for a very small share of global energy use and global emissions, they have room for increases in efficiency that will be of value if and when these countries achieve sustained growth—and which the offset schemes that we will now discuss attempt to exploit.

Other Greenhouse Gases

Methane and nitrous oxide are the next two most important anthropogenic GHGs after CO2. The levels of these GHGs, measured in CO2 equivalent, are significant, although less in aggregate than CO2 emissions (Table 6.4). Low- and lower-middle-income countries account for a much larger share of these emissions. Discounting the incomplete data for 2005, the share of emissions in low-income countries is on the order of 10 percent for the two GHGs combined, while lower-middle-income countries account for roughly one-quarter.

Table 6.4.

Combined Methane and Nitrous Oxide Emissions, 1990–2005

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Source: World Resources Institute (http://earthtrends.wri.org/) and authors’ estimates.

Data for 2005 are fragmentary. We assume growth rate for missing countries is equal to the average growth rate for countries in the same income class for which data are available.

Agriculture and livestock cultivation are the most important sources of anthropogenic methane and nitrous oxide. Consequently, low- and lower-middle-income countries could become a larger source of these GHGs as, for instance, widespread use of nitrogen-based fertilizer is adopted in more poor countries. These emissions should, in principle, be subject to pricing that reflects their contribution to the buildup of GHGs. In practice, however, they do not lend themselves to the same methods of taxation or cap-and-trade that are the focus of this volume and chapter, lacking an analogue to the possibility for relatively upstream monitoring of the use of fossil fuels to which CO2 emissions are very mechanically related. For the foreseeable future, the primary mitigation instrument in this area, at least in lower-income countries, is thus likely to be support for efficient agricultural and husbandry techniques.

Tax Design Considerations

Low-emitting developing economies face two key questions: Should they nonetheless price carbon emissions and, if so, at what level? How do other considerations affect how they should tax fossil fuel use?

Should Energy Taxes in Developing Economies Reflect Climate Concerns?

It is a standard mantra that a globally efficient approach to mitigation requires that all countries apply the same charge to CO2 emissions. Even leaving aside the practical consideration above that emissions from many developing economies are tiny, this mantra is incorrect as a matter of principle for two reasons.

First, the mantra applies only if issues of income distribution among countries are either immaterial or adequately addressed by transfers from richer countries to poorer. Neither of these conditions seems a reasonable assumption on which to base policy. And when it fails, a strong case can be made on equity grounds—and this is quite independent of the “responsibility” argument—for taxing emission at a lower rate in poorer countries. Indeed, given the low level of their emissions noted above, a carbon charge of zero—or at least low enough to avoid significant leakage—might well be reasonable on these grounds.

Second, the mantra ignores the interaction of CO2 emissions charges with the rest of the tax system (and, potentially, other market imperfections, too, such as local pollution, discussed below). The implications of this can be complex. In some cases, it may point to corrective charges on CO2 emissions being lower than would otherwise be the case because the good they do in correcting environmental damage is offset, in part at least, by the damage they do to the government’s wider revenue-raising objective by reducing the level of economic activity. In other cases, however, these interactions may point to taxation at a higher rate than otherwise—perhaps as a response to informality, as discussed further below. The key point here is that carbon charges need to be seen as part of countries’ wider revenue-raising systems and in light of country-specific challenges in these areas. It is to these that we turn next.

Climate Aside, How Should Fossil Fuels Be Taxed in Developing Economies?

The same general principles apply as in developed economies, as discussed elsewhere in this volume—but with some potentially important differences in application.

Looking beyond climate damage, the use of fossil fuels may be associated with adverse external effects at the local or national level that policymakers can and should address. These might include, for instance, the congestion associated with vehicle use, local noise pollution, or SO2, NOx, and particulate emissions. Such externalities can call for the use of “corrective” taxes—intended to change behavior rather than to raise revenue. To avoid unintended distortions, these should be targeted as closely as possible to the source of the externality. So it is only carbon-related externalities that call for correction in the form of carbon charges. Congestion, for instance, is better handled by explicit congestion charging (per-mile tolls rising and falling during the course of the rush hour), as is beginning in some cities in the developing and emerging world. (Indeed, over the longer term, congestion pricing is a promising source of own finance for lower-level governments.) The potential to fine-tune corrective taxes in this way, however, is constrained both by limited administrative capacity in many developing economies, which may have higher priorities, and by limited knowledge of the magnitude of the relevant external costs in developing economies. A broad-based carbon tax could go a long way to addressing these local externalities; early work for Pakistan, for instance, suggested that a carbon tax in the order of US$25 per tonne of CO2 would be more than warranted solely in these terms. Failing that, fuel taxes, in particular, are likely to retain for some time a potentially important role as proxying corrective charges on congestion and other underlying sources of harm associated with vehicle use.

Importantly, such charges intended to correct for externalities associated with fuel use should be charged at the same rate (in the absence of good reasons to do otherwise) on use by both businesses and final consumers—the damage is the same in either case. There should be no exemption, for instance, for fuels used in road haulage, and congestion charges, if applied, should not be remitted for business travel. So far as is practicable, the rates applied to different petroleum products should differ to reflect differences in the externalities generated; motor fuel taxes, for instance, should reflect congestion and accident externalities (which are relatively large), while fuel oil for power generators or oil for home heating should not.

Externalities aside, taxes on energy use have a role as one among many devices for meeting a government’s revenue needs. If the government can effectively implement a full range of taxes on consumption (a big “if” that is returned to below), then this revenue-raising motive requires (in contrast to the environmental motive) that only use by final consumers be taxed, not use as a business input. The reason for this is that taxes on input used by businesses will typically lead them to make choices (their mix of inputs and degree of vertical integration of their activities) that differ from those that would be driven by the underlying prices that matter for social costs and benefits. So taxing intermediate use effectively reduces the aggregate level of output and thereby makes raising whatever revenue is needed more costly for society. Thus, looking only to revenue considerations, fuels should typically be subject to whatever tax a country levies on final sales; in practice, this typically means the value-added tax (VAT), which effectively excludes business use from taxation by giving registered businesses a credit or refund of taxes charged on their inputs. So, for instance, VAT should apply to all electricity consumption (residential, industrial, and commercial), but credits or refunds would be provided to industrial and commercial users to ensure that the tax really only bites for residential use.

When externalities are present and revenue is a concern, these considerations point to two distinct charges on fuel use: An excise (in “specific” tax form—that is, as a fixed monetary amount—since the damage does not itself vary with the price of the good) and a charge imposed—on the price including the excise5—as part of the wider VAT system. The excise itself might, in principle, be somewhat lower or higher than the marginal environmental harm, as noted above, to best take account of interactions with the wider tax system—but in practice, this may be a subsidiary consideration.

The question then is what rates of taxation should be applied to final consumption of fuels. The first general principle here is that items of final consumption should be taxed at a higher rate the more their use is associated with “leisure” (in the sense of untaxed activity)—to limit the overall distortionary impact of the tax system, a condition that is closely associated with the familiar “inverse elasticity rule”; that is, that tax rates should be higher on goods in more inelastic demand. The second general principle is that the tax rate should be higher, all else equal, the more its consumption is concentrated among the better off in order to meet equity goals.

There are some insights from this that are of fairly general applicability. Domestic transport fuel, for instance, is likely to be a candidate for relatively heavy taxation on the first efficiency criterion. But the full implications will depend on each country’s own circumstances; it matters for instance, whether individuals use fuel mainly for leisure or mainly for work-related travel. And these, moreover, are often issues on which empirical evidence is weak, and hence, so too is the case for charging differential tax rates (even leaving aside the implementation costs of doing so, which can be considerable). On the second, equity criterion, one general lesson is that differentiating rates of taxation across items of final consumption is rarely the best way of pursuing distributional objectives. This is most clearly the case in more advanced economies, with a range of income-related and other instruments available to help the poor. Even in lower income countries, however, the poor may benefit more from targeted health and education spending, tax subsidies for work, or the development of simple social safety nets (as discussed below) than they would from reduced tax rates on particular items. And indeed, the rationale offered for reduced rates—or, as discussed later, outright subsidies—is often more fundamentally flawed. For example, some developing countries have sought to address concerns that taxes on household electricity use, in particular, would have adverse distributional effects by introducing a reduced VAT rate for low levels of usage; but, as with fuel subsidies more generally, the concern is often misplaced—the poorest households in many developing countries, for instance, are unlikely to have any access to electricity.

In practice, the case in principle for applying differential rates of VAT to fuel products is, thus, often weak. Add to this the administrative and compliance problems that such rate differentiation creates—likely to be especially evident in lower-income countries, and a presumption emerges in favor of applying a single rate of VAT.

The challenges of revenue administration in many developing economies may also be important in setting the level of excises on petroleum fuels in particular and fossil fuels in general. They likely tilt the balance still further in favor of relatively heavy taxation of energy use in general and hydrocarbons in particular, for two reasons:

  • First, fuel taxes—the excises in particular—are, or should be, among the easiest taxes to administer and with which to comply. Charges can be applied at mine mouth, import, or refinery gate—meaning there are relatively few points that the authorities need to control (see Chapter 2). National oil companies can also provide a natural point of control. The relative ease of taxing fuels compared with, for instance, personal incomes, argues for greater reliance on this source of revenue than would otherwise be the case.

  • Second, the implication of the large informal sectors—businesses that are less than fully tax compliant—in many developing countries is that the government cannot tax households’ final consumption or businesses’ profits as it would like. In this case, there is a strong case for taxing that consumption and those profits indirectly by taxing inputs used in their production. And for many enterprises, energy is one such input. Taxes on fuel use then have particular appeal in substituting for missing taxes on the sales and profits of noncompliant enterprises.

However, these arguments should not be pushed too far. Heavy energy excises also bear on compliant firms,6 for instance, and labor market distortions can amplify potentially adverse effects on employment (as has been identified as a concern in South Africa, for instance). They do, nonetheless, reinforce the case for vigorous taxation of energy use in developing economies—combined, if need be, with measures to protect the poorest along lines discussed below.

Pricing of Hydrocarbon Products in Low- and Lower-Middle-Income Countries

Clearly, developing economies, like others, should set the prices of hydrocarbon products to consumers and businesses at least at the levels that the tax policy criteria discussed previously imply would be appropriate in the absence of the GHG global externality. Addressing climate change would then require setting those prices still higher, to an extent reflecting considerations also raised above. Abstracting from this latter concern, this section asks whether developing economies already set tax rates at or above the levels that would be in their own self-interest, in the absence of climate concerns, for efficient revenue mobilization and to address local externalities.

Gasoline and Diesel Prices

There is no comprehensive database on hydrocarbon prices similar to the data on energy production and consumption and GHG emissions used above. However, GIZ, the German agency for international development, does collect the prices (including taxes) of gasoline and diesel in over 170 countries biennially (see Table 6A.3 for a summary of trends). Based on these data, there is little evidence that low-income countries significantly subsidize gasoline and diesel. The average price of gasoline in low-income countries in December 2010 was US$1.26 per liter. Prices ranged from US$0.80 per liter in Myanmar to US$1.71 in the Central African Republic and Malawi (Figure 6.2). The average price was slightly lower for countries that export petroleum.

Figure 6.2.
Figure 6.2.

Gasoline Prices in Low-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Source: GIZ (http://www.gtz.de/en/themen/29957.htm).

The tendency for oil exporters to place a low price on or even subsidize petroleum products is more pronounced for lower-middle-income countries (Figure 6.3): within this group, the average price for oil exporters in December 2010 was US$0.28 per liter lower than for nonexporters. This difference cannot be completely explained by transportation costs since a number of exporters of crude oil have no or insufficient refining capacity and must import at least some of the petroleum products they use. Even nonexporters in the lower-middle-income group had prices lower than the global average, and their overall average was the lowest among the four groups (although oil-exporting countries in the upper-middle-income category had a lower average than exporters in the lower-middle-income category).

Figure 6.3.
Figure 6.3.

Gasoline Prices in Lower-Middle-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Source: GIZ (http://www.gtz.de/en/themen/29957.htm).

For completeness, the distribution of gasoline prices among upper-middle-income and high-income countries is presented in the Appendix (Figures 6A.1 and 6A.2). The range in prices is very wide, with high-income European countries—including those that export oil—at the high end. Other oil-exporting countries in these categories tend to be at the low end of the distribution.

Prices of Other Hydrocarbon Fuels

As noted, the data on the pricing of other hydrocarbon fuels are less comprehensive. For natural gas, what subsidies persist appear to be in the former Soviet Union and, perhaps, in domestic markets of some other producers; low-income countries are primarily importers. More generally, and especially for fuels used to generate electricity, the problem seems to be less with the pricing of the fuel than with the pricing of the electricity.

Electricity and Public Transportation Subsidies

Direct price subsidies for coal—and, for that matter, subsidies for other fuels used to generate electricity—are less of a problem than the subsidies on electricity itself. For instance, Business Insider (May 25, 2011) reported that in China:

The State Grid Corp of China warned [in May 2011] that it would shut down some generators over the summer, reducing output by as much as 40 gigawatts, according to Global Times. Power companies are struggling as coal prices have risen 75 percent since 2007, while electricity prices have risen only 15 percent. China’s five biggest coal power businesses have posted combined losses of $9.23 billion since 2008. Energy analyst Li Chaolin tells Global Times: “Many coal plants have shut down their generators because the more they produce, the bigger the losses they will suffer.”

An editorial in the Oriental Times complains: “The coal industry is in a market economy, but the power industry is still in a planned economy.”

A number of low-income countries subsidize electricity, creating significant budgetary problems. The electricity is often produced by a public enterprise, and the subsidies can remain hidden until they must be recapitalized. Several countries have had electricity subsidies costing more than 2 to 3 percent of their GDP.

Subsidies for public transportation can also contribute to the overuse of petroleum products even in the absence of mispricing of gasoline and diesel. As with electricity, countries often subsidize public transportation by allowing public enterprises to endure significant losses on their operations. Some studies for advanced economies have found high operating subsidies for mass transit in major cities to be warranted by various scale economies and the reduction of auto externalities (which are high in congested cities). Where the balance of considerations lies in pricing public transport needs assessment on a case-by-case basis.

Addressing Unwelcome Consequences of Subsidy Reform

Reforming Subsidies

The benefits of universal fuel subsidies commonly accrue, in practice, to the highest income groups—making them an extremely costly approach to protecting the welfare of poor households. For example, taking the poorest 20 percent of households as the target “poor” group, the cost to the budget of transferring one dollar to this group via gasoline subsidies is commonly found to be about $33 (i.e., $1/0.03). This reflects the fact that over 97 out of every $100 of gasoline subsidy “leaks” to the top four quintiles. Even for kerosene, which is widely used for heating and cooking in poor households, this (budgetary) cost-benefit ratio is generally around $5 (i.e., $1/0.19).

Such high leakage of subsidy benefits means that there is likely to be a high return to developing more effective ways of protecting the real incomes of poor households. For example, if $15 out of every $100 allocated to a safety net program is absorbed by administrative costs and 80 percent of the remaining $85 in beneficiary transfers reaches the poor (or 68 percent of the total budget), then the (budgetary) cost-benefit ratio for such a program is $1.5 (i.e., $1/0.68), which is substantially lower even than for kerosene subsidies.7 In addition, the extent of protection that can be given to the poor via kerosene subsidies without severely disrupting fuel markets is very limited. Relatively low kerosene prices result in substitution of kerosene for diesel (legally or illegally) and often lead to shortages for rural households and smuggling to neighboring countries with higher prices.

However, since eliminating fuel subsidies can still have a sizeable adverse impact on poor households, reform strategies should include measures to address equity concerns. Where an effective social safety net exists, expanding the budget for these programs can address concerns for poverty while containing the fiscal cost. For countries that do not have access to effective safety net programs, a more gradual reform approach is desirable if fiscal conditions allow. This could involve maintaining kerosene subsidies over the short term and using existing programs that can be expanded quickly, possibly with some improvements in targeting effectiveness (for instance, school meals, reduced education and health user fees, cash transfers to vulnerable groups, or subsidies for consumption of water below a specified threshold).

Similarly, other public expenditures, such as on education and health expenditures, as well as infrastructure expenditures such as roads and electrification schemes, could be expanded.

Increasing retail prices to reduce fuel subsidies is always politically difficult. At the most fundamental level, support for such subsidies can indicate a lack of faith in government: In oil-exporting countries in particular, there can be a sense that they are a way for the citizenry to enjoy benefits from their common resources in a way that sidesteps empowering government. Dealing with subsidies can be a key adjunct of wider governance reform.

An effective and credible public information campaign can be a key (indeed likely indispensible) way to increase public support for price increases by informing the potential beneficiaries (consumers and taxpayers) about the drawbacks of existing subsidies and the benefits of reform. This could, in particular:

  • Highlight the fact that subsidies provide incentives for inefficiently high levels of fuel consumption and that the associated fiscal costs can be detrimental to growth and poverty reduction. Eliminating subsidies will encourage more efficient energy consumption and thus reduce the impact of future international price increases on the economy. In addition, subsidy reform will contribute to fiscal sustainability and economic growth, which are crucial for sustained poverty reduction. A growing economy will also enhance households’ capacity to absorb price shocks for key commodities and can be the most effective approach to limiting the adverse impact of general price increases.

  • Highlight the fact that higher income groups benefit the most from fuel subsidies and that neighboring countries with higher prices are often substantial beneficiaries through cross-border smuggling. The evidence clearly shows that most of the benefit from lower fuel prices goes to higher income groups. When relevant, governments should also highlight that subsidies promote smuggling, shortages, black market activities, and corruption.

  • Highlight the fact that retail price changes reflect fluctuations in international prices beyond the government’s control. All countries face price fluctuations and need to adjust to this reality. Passing higher international prices through to domestic prices provides the appropriate incentive to consumers to reduce fuel consumption and thus limits the adverse impact on the economy as a whole. If the domestic prices of exporters do not adjust, they bear the opportunity cost of reduced exports and the efficiency costs of mispricing.

  • Educate the population about the importance of fuel tax revenues in financing priority public expenditures. This should highlight the importance of revenues for financing a range of high-priority public expenditures such as improvements in education, health, and physical infrastructure. During times of relatively high price increases, it can help to clearly identify the decreases in other priority expenditures that would have to be made if subsidies increase. Not least, it is essential to transparently record subsidies on-budget to ensure that they have to compete with these other sectors for available financing.

Avoiding the recurrence of fuel subsidies requires a new approach to fuel pricing in many countries. In countries with fuel subsidies, the government’s control of domestic prices creates the impression that price changes simply reflect government policy, rather than international factors, with political pressure to avoid passing through increases in international prices but, on the other hand, to pass through decreases. The need for effective communication is neverending. Preventing the recurrence of subsidies can be just as difficult as eliminating them in the first place until the public becomes used to the implications of international prices for domestic prices.

Improving Pricing Mechanisms

The first best approach to petroleum pricing is to implement a fully liberalized regimen, accompanied by appropriate regulation to ensure competition. As an interim measure, however, governments can adopt automatic pricing mechanisms. But this cannot be relied on to solve the problem. Many countries have abandoned such mechanisms, or abandoned subsidy reform programs, in times of sharp increases in international prices. For example, Ghana adopted an automatic mechanism in January 2002 only to abandon it in January 2003. The increasing fiscal cost of incomplete pass-through led to the reinstatement of the mechanism in February 2005, but it was again abandoned in early 2008 when international prices increased sharply, and domestic prices remained fixed from May to November 2008. Similarly, Indonesia began a subsidy reform in 2005 with the intention of eliminating subsidies and fully passing through increases in international prices. However, this policy was abandoned by the end of 2007. So both governments that control prices and those with automatic pricing mechanisms have struggled to fully pass-through prices during periods of sharp increases in international prices. Consistent with this, median pass-through exceeded 100 percent at the end of 2006, but decreased substantially thereafter.

The fragility of automatic price adjustment mechanisms often reflects the reluctance of governments to fully pass-through sharp international price increases that they believe may be temporary. If, however, such price increases are persistent, this “wait-and-see” approach can result in escalating subsidies, and substantial increases in domestic fuel prices are eventually required. Since the public is likely to be more concerned about large price increases, reform becomes more difficult, and subsidies become entrenched. To make automatic pricing adjustments more attractive, smoothing mechanisms can be incorporated. These smoothing rules can: lessen, in the short term, the magnitude of retail price changes compared to full pass-through; ensure full pass-through of price changes over the medium term; and avoid long periods of fixed prices that eventually necessitate large retail price increases if international price increases turn out to be persistent.

Especially where smoothing rules are not in place, pressures can arise to change tax rates on fuels so as to avoid large movements in energy prices. Even leaving aside the difficulty of distinguishing temporary from permanent price shocks, the issue is a complex one. Ad valorem taxes, such as the VAT (taxes charged as a proportion of the price), actually amplify the underlying effects of fuel price movements on final prices to consumers: With a 20 percent VAT, for instance, a $1.00 increase in underlying fuel prices translates into a $1.20 increase in fuel prices at the pump. Whether this amplification is appropriate is by no means clear. Box 6.1 looks at these issues in more detail and suggests that an appropriate response—again, environmental considerations aside—may be to adjust taxes on fuels in response to a permanent increase in oil prices in such a way that total tax falls as a percent of the fuel price but rises as a monetary amount per gallon.

How Should Taxes Vary with Oil Prices?

To see the rationale for the strategy set out in the text, suppose first that it was decided in response to an increase in oil prices to hold the tax constant as a monetary amount per unit (which would mean reducing any ad valorem component). In this case, with a reduction in demand consequent upon the increase in price, tax revenue will fall. But this is unlikely to be optimal; and to recover this revenue loss, at least partly, means raising tax rates on all commodities—including fuels. So an optimal response likely involves increasing the monetary amount of the tax per unit.

But can it be optimal to increase the monetary amount by so much as to leave it unchanged as a proportion of the oil price? Almost certainly not, because then tax revenue would increase (assuming, as is reasonable, that the elasticity of demand is less than unity)—and that too cannot be optimal if the original level of revenue was seen as appropriate. So the tax should increase by less than this amount.

For the environmentally motivated element of the charge, the question is whether the change in total demand induced by a change in oil prices materially affects the marginal environmental damage from oil use that this element is intended to reflect. In many cases it will not, in which case, no change is needed on these grounds.

Source: Authors.

Promoting Transparency

Fuel subsidies are often difficult to measure and evaluate, partly because of definitional and measurement issues. In some cases, fuel subsidies do not appear in the fiscal accounts at all, making them difficult to track, quantify, and assess. And even when they are reflected in the fiscal accounts, they can be hidden in broader aggregates. The inability to identify properly the costs of petroleum product subsidies, and the winners and losers they create, hinders efforts to assess them properly and, hence, the ability to undertake reforms.

Fuel subsidies should be recorded transparently in government accounts. Where appropriate, they should be recorded in the budget and explicitly identified. Off-budget subsidies should be identified and recorded in separate accounts. This may require improvements in the budget classification systems. Arrangements whereby international or national oil companies provide subsidies to consumers without explicit budget support should be clearly defined and described in budget documents.

Transparency is especially important for oil exporters where the opportunity cost of fuel subsidies is the revenue foregone by not charging international prices domestically. Oil producers that record fuel subsidies explicitly in the budget include Indonesia, Iran, Malaysia, Sudan, and Yemen. Some countries have implemented specific subsidy reporting systems designed to help raise public awareness.

Financial Flows (and Other Effects) from Developed Economies

Sometimes overlooked is the possibility that developing economies can attract finance from abroad to finance mitigation and other climate-related actions. There are three potential sources of revenue:

  • First, some have argued for a global cap-and-trade scheme, with allocations of emissions rights to developing economies sufficient to ensure that they would be net sellers to other countries.

  • Second (as discussed in Chapter 7), under the Copenhagen Accord, developed economies have committed to provide finance to developing economies to help meet costs of adaptation and mitigation “in the context of meaningful mitigation actions,” suggesting that some effort is indeed expected of developing economies themselves.

  • The third potential source is from offset schemes—provided for in the Kyoto Protocol, and no doubt to be included in other and successor agreements—by which public and private entities in developed economies facing binding emissions commitments can meet those obligations in part by investing in projects in developing economies that are certified as implying a corresponding emissions reduction there. The primary vehicle for this is the clean development mechanism (CDM), although there are other possibilities too, including voluntary schemes. Such schemes are attractive to investors to the extent that the costs of emission reduction in developing economies are lower than those in developed economies. This can often be the case—given both the use of relatively dirty technologies in developing economies and the increasing difficulty of cutting emissions in developed economies—as requirements become more demanding.

Such schemes can yield revenue to governments in developing economies in two ways, although these revenues are, to some degree, offset by the costs of mitigation. They are a direct source of revenue when government entities operate the emissions reducing project. And they can be a source of tax revenue from private projects, too, in so far as tax is chargeable on various aspects of such projects. This latter point raises a range of detailed issues as to how the host country should treat these projects for tax purposes—whether VAT and/or stamp duties should be charged on the transfer of credits, for instance, and how to tax the profits associated with such projects. Practice seems to vary: Some countries offer preferential tax treatment for such schemes, while others do not. But the appropriate policy line seems clear: Except to the extent that such projects generate local externalities of the kind stressed above, there is no particular case for taxing them differently from any others.

The sums raised by CDM projects have so far, however, been relatively limited and have accrued to just a few of the larger developing economies. To a large extent, this reflects recognized limitations of the CDM process, including high transaction costs associated with the verification that emissions reductions are indeed additional (that is, would not have occurred without the supported project). The problem of establishing the counterfactual is a serious difficulty with offset schemes: What would have happened in their absence? This is a key reason why avoided deforestation is not covered by the CDM. Arguably, the counterfactual issue renders the offset approach problematic as an approach to efficient mitigation. What matters for present purposes, however, is simply that offset schemes offer some potential for welfare gains in developing economies. As the CDM process becomes smoother and more encompassing in the coming years—and the need to make it so is widely recognized—the opportunities that offset schemes present for developing economies will, it is to be hoped, become more evident.

As yet little noted, however, is the potentially adverse impact of aggressive carbon pricing in large emitters on the increasing number of lower-income oil exporters. By reducing demand for and hence the world price of oil, such policies would reduce the resource rents that these countries can enjoy. There has, as yet, been little recognition of this issue, let alone any discussion of possible measures to reduce the impact.

Conclusion

Given the importance of low-emitting developing economies to the climate negotiations, surprisingly little attention has been given to the question of what mitigation policies they should follow.

The analysis in this chapter stresses that their own emissions are a relatively small part of the global problem (at least for CO2) and—as a distinct point, reflecting their low-income levels—that appropriate carbon charges in these countries may well be lower than in advanced economies. At the same time, however (and beyond the element of realpolitik in the expectation of mitigation action to secure climate finance from developed economies), their inclusion in the wider architecture for dealing with climate change is needed both to avoid undoing emission reductions elsewhere and to exploit some of the cheapest options for mitigation. The latter, in particular, could be an opportunity for these countries to mobilize additional resources. Not the least important consequence of considering mitigation policies in these countries, however, is that it places attention on their current systems for taxing energy and fossil fuel use—which, in many cases, can offer them scope for significant gain, even apart from the climate benefit to the wider world.

Appendix: Additional Tables and Charts

Table 6A.1.

Country Income Classification

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Source: World Bank (http://data.worldbank.org/about/country-classifications/country-and-lending-groups).Note: OECD = Organization for Economic Cooperation and Development.
Table 6A.2.

Distribution of Energy Sources, 1980–2008

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Source: Energy Information Administration (http://www.eia.gov/countries/data.cfm) and authors’ estimates.

Percentage change for consumption and percentage point change for share

Table 6A.3.

Unweighted Average Gasoline Prices, 1998–2010

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Source: GIZ (http://www.gtz.de/en/themen/29957.htm) and authors’ estimates.

Markups are measured as of 2010 and held constant in percentage terms in other years.

Figure 6A.1.
Figure 6A.1.

Gasoline Prices in Upper-Middle-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Source: GIZ (http://www.gtz.de/en/themen/29957.htm).
Figure 6A.2.
Figure 6A.2.

Gasoline Prices in High-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Source: GIZ (http://www.gtz.de/en/themen/29957.htm).

References and Suggested Readings

Useful data on energy prices and use are in:

A useful source for emissions projections and assessment of other trends is:

Organisation for Economic Cooperation and Development, 2011, OECD Environmental Outlook to 2050 (Paris: OECD).

That global efficiency does not require uniform carbon taxes in the absence of international transfers is shown in:

Chichilnisky, G., and G. Heal, 1994, “Who Should Abate Carbon Emissions? An International Perspective,” Economic Letters, Vol. 44, pp. 443–449.

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For experience with fuel subsidies and the development of better-targeted support mechanisms:

  • Arze del Granado, Javier, David Coady, and Robert Gillingham, 2010, “The Unequal Benefits of Fuel Subsidies: A Review of Evidence for Developing Countries,” IMF Working Paper 10/202 (Washington: International Monetary Fund).

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  • Coady, David, Robert Gillingham, Rolando Ossowski, John Piotrowski, Shamsuddin Tareq, and Justin Tyson, 2010, “Petroleum Product Subsidies: Costly, Inequitable, and Rising,” IMF Staff Position Note No. 10/05 (Washington: International Monetary Fund).

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  • Grosh, Margaret, Carlo del Ninno, Emil Tesliuc, and Azedine Ouerghi, 2008, For Protection and Promotion: The Design and Implementation of Effective Safety Nets (Washington: World Bank).

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  • IMF, 2008a, “Food and Fuel Prices—Recent Developments, Macroeconomic Impact, and Policy Responses” (Washington: International Monetary Fund). Available at www.imf.org/external/np/exr/foodfuel/index.htm.

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  • IMF, 2008b, “Fuel and Food Price Subsidies: Issues and Reform Options” (Washington: International Monetary Fund). Available at www.imf.org/external/pp/longres.aspx?id=4293.

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On how to assess proper levels of fuel taxation, with application, see the following:

Parry, Ian, and Kenneth Small, 2005, “Does Britain or the United States Have the Right Gasoline Tax?” American Economic Review, Vol. 95 (September), pp. 1276–1289.

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For a framework for thinking about tax design to address local pollution, carbon, and motor vehicle externalities, with rough calculations of the relevant externalities (including in some developing countries):

Parry, Ian, John Norregaard, and Dirk Heine, forthcoming, “Environmental Tax Reform: Principles from Theory and Practice,” Annual Review of Resource Economics.

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There are relatively few studies of carbon pricing design and impact outside more advanced economies. Important exceptions—the first a very early analysis focused on Pakistan and including assessment of the impact on local externalities, the second stressing the importance of labor market distortions—are:

  • Shah, Anwar, and Bjorn Larsen, 1992, “Carbon Taxes, the Greenhouse Effect, and Developing Countries,” Policy Research Working Paper WPS 957 (Washington: World Bank).

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  • Devarajan, Shantayanan, Delfin Go, Sherman Robinson, and Karen Thierfelder, 2009, “Tax Policy to Reduce carbon Emissions in South Africa,” Policy Research Working Paper 4933 (Washington: World Bank).

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For general issues in VAT design and implementation:

Ebrill, Liam, Michael Keen, Jean-Paul Bodin, and Victoria Summers, 2001, The Modern VAT (Washington: International Monetary Fund).

*

We are grateful to David Coady, Shanta Devarajan, Philip Daniel, Stephane Kallegatte, Adele Morris, and Ian Parry for many helpful comments.

1

Projections allowing a breakdown by income group readily comparable with these and later figures for current and past emissions do not seem to be available. For the set of countries other than Brazil, China, India, Indonesia, and Russia that are not among the advanced economies, however, the Organization for Economic Cooperation and Development projects a broadly unchanged share (at about 26 percent) of total GHG emissions from 2010 to 2050.

2

Low-income countries, for instance, have accounted for about 2 percent of cumulative CO2 emissions since 1850.

3

Btu stands for the British thermal unit, which is a measure of energy expended.

4

Efficiency levels for high-income countries are not greatly affected since the United States is taken as a benchmark in the purchasing power parity calculations.

5

This sequencing—VAT charged on the price including the excise—ensures that changes in the general rate of VAT do not discriminate across goods in the sense that they do not affect their relative prices.

6

In principle, a higher VAT rate on energy use might for this reason be preferable to a higher excise: It would have the same effect on firms not complying with their VAT obligations, but not for the compliant (which would be entitled to credit or refund of the tax). Differential VAT rates can, though, add considerably to the difficulties of implementing and complying with a VAT, so that few countries do this in practice.

7

A full comparison between price subsidies and alternative ways of supporting the poor would also consider their incentive impacts and those of the tools used to finance them.

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Cover Fiscal Policy to Mitigate Climate Change
Fiscal Policy to Mitigate Climate Change
A Guide for Policymakers
Author: Ruud A. de Mooij, Mr. Michael Keen, and Ian W.H. Parry
ISBN:
9781616353933
Publication Date:
10 Sep 2012
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781616353933.071
Pages:
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  • View in gallery

    CO2 Emissions, 2009. (Left) Global share; (right) emissions per capita (kilograms).

  • View in gallery

    Gasoline Prices in Low-Income Countries, December 2010

    (U.S. cents per liter, oil exporters in red)

  • View in gallery

    Gasoline Prices in Lower-Middle-Income Countries, December 2010

    (U.S. cents per liter, oil exporters in red)

  • View in gallery

    Gasoline Prices in Upper-Middle-Income Countries, December 2010

    (U.S. cents per liter, oil exporters in red)

  • View in gallery

    Gasoline Prices in High-Income Countries, December 2010

    (U.S. cents per liter, oil exporters in red)

CO2 Emissions, 2009. (Left) Global share; (right) emissions per capita (kilograms).

Gasoline Prices in Low-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Gasoline Prices in Lower-Middle-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Gasoline Prices in Upper-Middle-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)

Gasoline Prices in High-Income Countries, December 2010

(U.S. cents per liter, oil exporters in red)