June 12, 2024

By Steven van Weyenberg, Minister of Finance (The Netherlands), Juan Carlos Vega, Minister of Finance (Ecuador), Jeppe Bruus Christensen, Minister for Taxation (Denmark) and Marcela Bensión, Ministry of Economy and Finance (Uruguay)

Through the Coalition of Finance Ministers for Climate Action, a diverse group of finance ministers and senior officials came together to exchange views and experiences on the opportunities and challenges countries face in transitioning away from carbon-intensive fuels. One key barrier to reform is the existence and persistence of fossil fuel subsidies. Their prevalence and pervasiveness mean that the production costs of these carbon-emitting fuels are systematically not being reflected in fuel prices, that is, we have been making it significantly cheaper to consume fossil fuels than they cost to produce, even before environmental and climate costs are considered.

Jointly addressing the topic resulted in a rich and candid exchange of experiences between high-level representatives from the Netherlands, Ecuador, Uruguay and Denmark. In this article, they share some key insights with the wider public.

The excessive cost of fossil fuel subsidies

Fossil fuel consumption is the largest contributor to global climate change, responsible for over 70% of greenhouse gas emissions. According to IMF Deputy Director of Fiscal Affairs Ruud de Mooij, “despite the clear negative environmental and fiscal impacts, most countries around the world continue to subsidize fossil fuel consumption. Between 2020 and 2022, total explicit fossil fuel subsidies across 177 countries more than doubled to USD 1.3 trillion, prompted in large part by surges in global energy prices after the COVID-19 pandemic. That is approximately 1.3% of global GDP. If we add implicit subsidies, reflecting the external costs such as global warming, pollution and damage to public health, we reach a staggering USD 7 trillion, or 7% of global GDP.”

Minister Vega from Ecuador highlighted the fiscal costs of fossil fuel subsidies: “Our subsidy bill amounted to over 3% of GDP in 2023. This is the equivalent of our total health spending, 70% of our spending on education, and three times the amount of spending on cash transfers to the poor.”

Measurement is the first step

A sound methodology for measuring both explicit and implicit subsidies provides the foundation for understanding the extent of the issue and the price adjustment that is needed. Quantification and publication of data on subsidy expenditure can also help raise public awareness of the size of the government subsidy bill. However, the methodology really matters. Minister van Weyenberg identified the Netherlands’ challenges with subsidy measurement: “We carried out three measurements between 2018 and 2023, with different methodologies, which yielded widely varying figures. The outcomes ranged from EUR 4 billion for the first one, to almost EUR 46 billion for the most recent and extensive one. This was much higher than we initially expected and illustrates the impact of the specific methodology that is used. But good measurement is key: if you don’t know how big the issue is, it is hard to build a case for reform. The Coalition of Finance Ministers for Climate Action is uniquely placed to help promote comparability across countries.”

Prepare the public for reform

Subsidy reforms are likely to come under significant public scrutiny, even if great efforts are taken to explain the benefits of the reform. Targeting or reducing a subsidy normally means increasing prices for some. Those who will face higher prices could become very vocal in their opposition of subsidy reforms, especially since certain benefits of reform are diffuse and many will only become evident over a longer time horizon. This dynamic poses a real challenge for policy makers. Having experienced multiple episodes of extreme social unrest following its attempts at subsidy removal earlier this decade, Minister Vega shared a key lesson: “Strong public communication of measures and their benefits is important. However, it is no guarantee of success, since the benefits are perceived over longer-term horizons, but the costs are felt immediately.”

A gradual approach to subsidy removal, combined with complementary measures to support vulnerable households and firms can also help to weather both the social and the macroeconomic impact of the reform. Marcela Bensión, Director of Economic Policy at the Ministry of Economy and Finance of Uruguay shared: “In Uruguay, a key determinant of policy success was our phased approach, allowing the government to get buy-in from the public and from businesses.”

Protect the poorest

As explicit subsidies in most countries are provided to all income groups, the benefits of subsidies tend to accrue disproportionately to higher income households as they tend to consume more in absolute terms. To protect vulnerable consumers, a portion of the revenues previously directed towards subsidies could be used to compensate low-income households for higher energy prices through targeted cash transfers. If needed, support could also initially be provided to energy-intensive firms to help ease the transition.

Marcela Bensión explained how the authorities in Uruguay have sought to protect low-income households when adjusting fuel prices. “Rather than direct support, we have focused on bus ticket prices. Since our buses mostly run on gasoline, bus ticket prices have been kept low, cross-subsidized by other fuels. Recently, we have put in place new incentives to substitute fossil-based buses with those based on clean technologies, something that will gradually reduce the level of subsidies.”

However, this is not always easy. Ecuador’s Minister Vega pointed out that “understanding potential impacts in households and firms is critical. One should be very mindful of the interconnectedness of value chains and the relative weight of fossil fuels. Strong analytical work is necessary to anticipate those effects and find ways to compensate people who need to weather new conditions. Those at the top of the income distribution do not need compensation but groups in the middle or poorer households do.”

Beware of cross-border spillover effects

Minister Vega from Ecuador also spoke of the impact on demand for smuggled fuel when price differentials exist across borders. “In Ecuador, fuel prices are up to ten times lower than in neighboring countries, with the resulting smuggling of fuel to other countries further adding to the government’s subsidy expenditure”. As Minister Bruus Christensen of Denmark explained, this is also an issue in Europe: “The spillover effects to neighboring countries depend heavily on the differences in the price of petrol and diesel between countries. For instance, Sweden reduced their tax on diesel and biofuels requirements in 2024, which moved a significant amount of fuel demand from Denmark to Sweden.” Regional and international coordination would be very useful in solving these collective action problems, another important area the Coalition of Finance Ministers for Climate Action can contribute to.

In the same vein, a number of fossil fuel subsidies are locked in through international treaties, and as such cannot be phased out by any individual country. Minister Van Weyenberg explained the situation in the Netherlands. “During our last inventory, we found that around half of our fossil fuel subsidies – around EUR 20 billion – are enshrined in international treaties, such as for the international aviation sector. Joint international action is required to abolish them.”

Fossil fuel pricing: what’s next?

Getting the pricing of fossil fuel products right is critical to meeting the Nationally Determined Contributions (countries’ national climate plans) under the UN Paris Climate Agreement. The distortion of price signals resulting from both implicit and explicit subsidies can promote inefficient allocation of an economy’s resources. This encourages overconsumption of fossil fuels at artificially low prices, and discourages investment in cleaner alternative sources of energy, ultimately hindering growth and increasing global warming and air pollution.

And while challenging, removal of explicit subsidies is only the first step – this alone will not allow us to reach global climate goals. The issue of implicit subsidies is next on the agenda. Only 47 countries have some form of carbon pricing in place, covering 25% of global GHG emissions at a carbon price of around $22/ton of CO2e. As of November 2023, 50% of global emissions remain explicitly subsidized. In contrast, measures equivalent to a global carbon price of at least USD 85 on almost all global emissions would be needed to achieve 2°C goals, and higher for 1.5°C.

Finance ministries play a central role in setting the right price for fossil fuel products. They can repurpose subsidies and additional revenues to generate much needed fiscal space for green investment and social spending to ensure an orderly and just energy transition. Subsidy reform and carbon pricing can be politically and socially unpopular. It is important to take concerns seriously, as the reforms are critical to achieving global climate goals. The experiences of these four countries suggest that correctly pricing fossil fuel products needs to be part of comprehensive policy package that is socially equitable, politically acceptable, fiscally as well as macroeconomically sound, and well communicated to the public.

The Coalition of Finance Ministers for Climate Action will continue to drive the topic of fossil fuel subsidy reform, including by sharing lessons learned from its member countries, and supporting members to measure, reform and phase-out fossil fuel subsidies. Furthermore, the Coalition will work with member countries and Institutional Partners on the compatibility and comparability of methodologies for the measurement of fossil fuel subsidies, and facilitate peer exchanges on the specific, practical barriers to phase out subsidies and how to overcome them, including in regional and international fora. Finally, the Coalition will also seek to facilitate further dialogue across countries to enable the removal of subsidies enshrined in international treaties, and possible regional coordination of carbon pricing in order to mitigate spillover effects.