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On Energy Subsidies and Externalities

Energy subsidization is an area of intense debate simply because it artificially promotes some technologies over others. In practice, a high degree of subsidization implies that the energy sector (the very foundation of our modern civilization) is shaped by politicians rather than by scientists and engineers. And yes, it does not really take a rocket scientist to figure out that this can only end one way – badly.

To further complicate matters, debate is intensifying about the so-called external costs (externalities) of various energy technologies. The most common mention of externalities in the energy debate is related to the negative effects resulting from fossil fuel combustion, and the failure to internalize these externalities in the selling price can be viewed as an indirect subsidy.

This article will take a closer look both at direct and indirect forms of subsidization.

Direct subsidies

The IEA estimated fossil fuel subsidies at $523 billion and renewable energy subsidies at $88 billion in 2011. Given that fossil fuels provide 87% of global energy and subsidized renewables contributed 1.7% in that year (BP statistical review), direct subsidies to renewables were 8.6 times greater per unit energy than direct subsidies to fossil fuels.

However, there is an important difference between the subsidization of renewables and fossil fuels: renewable energy subsidies allow energy to be sold below the cost of production, while this is rarely the case for fossil fuels. As shown below, fossil fuel subsidies are primarily related to oil and shows a high degree of proportionality to the oil price. This is because the bulk of these subsidies are in oil-producing countries which can still extract oil from their conventional oil fields at very low prices and continue to pass these low prices on to local consumers.

Fossil fuel subsidies IEA

The breakdown of fossil fuel subsidization per country is given below. It is clear that the list is dominated by fossil fuel producing developing nations. These nations simply prefer the economic growth provided by selling fossil fuels closer to the local cost of extraction over the increased profits resulting from selling more of their product at international market prices.

Fossil fuel subsidies by country

Yes, to developed world citizens, this might appear to be a wasteful and selfish practice, but we have no right to prevent these developing nations from enjoying the full economic advantages of their fossil fuel resources. People born in the developed world enjoy one order of magnitude greater material affluence than people born in the developing world because of one century of $20/barrel oil and $20/ton coal. It will not be politically possible to tell the developing world that they do not deserve to derive similar advantages from the fuels they can still extract at or below these prices.

Forcing the Middle East (which can still extract oil for $20/barrel or less) to sell this oil locally at $100/barrel would be similar to forcing a solar farm in Mexico to sell electricity at the same price as that required by a solar farm in Greenland. The only reason why the lower oil prices in MENA nations are labelled as a subsidy is because the highly concentrated liquid nature of oil makes it highly suited for international trade. If oil was less suited for international trade (like solar power), the subsidies reported in the above figure would be much smaller.

In fact, if energy subsidization was defined as the total amount of direct government support given to close the gap between high production costs and lower selling prices (such as is the case for renewables), fossil fuel subsidies would amount to an enormous negative number due to the large revenues governments in fossil energy producing countries derive from profits on fossil fuel exports. The figure below illustrates this for a number of OPEC member states based on data on the official OPEC homepage.

OPEC percentage of budget revenues from oil

It is therefore clear that the direct subsidization of fossil fuels (in the sense that the product is sold closer to local extraction costs) is not going away any time soon. No developed world citizen living in a world of material affluence built almost entirely through cheap fossil energy has the right to complain about this form of subsidization.

Indirect subsidies (externalities)

When talking about externalities, it is important to distinguish between long-term global and short-term local externalities. As this section will strive to explain, short-term local externalities of fossil fuels such as poor air quality (negative) and rapid economic development (positive) should arguably be of much less concern to policymakers than long-term global externalities such as climate change.

Short-term local externalities

The good thing about short-term local externalities is that citizens experience the negative and positive externalities in a fairly equitable manner, thereby enabling them to weigh these positives and negatives with reasonable accuracy. For example, if the negative effects of air pollution from coal-fired power plants begin to outweigh the positive effects of cheap and reliable electricity, citizens will start to resist further coal-fired plants or demand that existing plants be upgraded with pollution control mechanisms. Naturally, this implies a trade of more expensive energy for cleaner air, but, since both the electricity price and the air pollution are short-term local effects, this will be a reasonably well-informed trade.

Citizens in the rich world have been making this trade-off for quite some time now. The sharp drop in US air pollution caused by increasingly strict legislation on coal-fired power plant emissions (below) offers a good example.

US emissions reduction

As is evident from the above figure, improved technology can greatly reduce the air pollution effects of coal-fired power plants. This technology is also not very expensive, but will only be implemented when the population becomes sufficiently affluent that effects such as cleaner air are valued above very cheap and reliable power. For example, one study found that the non-CO2 externalities of coal-fired electricity can be reduced from 10.3-28.4 €cent/kWh to 1.6-3.0 €cent/kWh through levelized plant capital costs amounting to only about 0.7 €cent/kWh. A further 1.4 €cent/kWh in levelized capital costs can reduce the externality to only 0.5-0.8 €cent/kWh through a 99% reduction in SOx emissions and a 75% reduction in NOx emissions.

The air pollution externality also depends greatly on the country of interest. For example, the oft-quoted study of Epstein et al. determined the air pollution externality of coal in the USA to be 9.3 $cent/kWh – more than triple the CO2 externality at $30/ton. This value comes from assigning a price tag of $187 billion to 24475 excess deaths in 2005 (this out of date number is about double current estimates). If this valuation was used for the 444000 Americans killed by smoking every year, it can be calculated that cigarettes cost the US almost a quarter of its entire GDP. This very high externality is therefore more indicative of the enormous healthcare expenses created by the typical western pattern of destroying the body through unhealthy consumption habits and sedentary living before being bankrupted by the degenerative diseases that inevitably arise from such poor lifestyle choices. The figure below compiled from Wikipedia data on healthcare expenditures and life expectancy proves this point.

LIfe_expectancy_vs_healthcare_expenditures

In developing nations such as China and India where air pollution in the big cities often reaches truly shocking levels, the air pollution externality is generally calculated as being much lower. One study for China found that the externalities related to SO2, NOx and particulates are substantially smaller than the externality of CO2 at $50/ton. Another study came to a similar conclusion for a large Indian city. In comparison to the 15 $cent/kWh non-CO2 externality calculated for the US in the Epstein study, the Indian study calculated only 1 $cent/kWh for all non-CO2 externalities (coal mining, coal transport, human health and agriculture).

It is therefore clear that negative short-term local externalities in the two countries accounting for 76% of the 1400 GW of coal-fired power plants currently being planned globally and 58% of current global coal consumption are still perceived to be substantially smaller than the positive short-term local externality of rapid economic development. If you have lived in a developing nation and directly observed the horrible vicious cycles of poverty in action, this will be very easy to understand. Those who have lived their entire lives in fossil-fuelled western luxury should try to live on $2/day for a few weeks to gain some perspective.

Poverty and coal in China

According to the World Bank, the coal-driven Chinese economic miracle has reduced the number of people living below $1.25/day from 84% in 1981 to only 13.1% in 2008 (energy data in the graph above is from the BP Statistical Review). As of 2008, there remains 1.3 billion people living below $1.25/day and 2.5 billion living below $2/day. The vast majority of these people would gladly trade high levels of air pollution for economic development.

It is therefore clear that including non-CO2 externalities to the tune of $0.15/kWh into the price of coal-fired electricity in the biggest coal consuming nations is a matter of complete impossibility. As nations develop, the population will naturally demand a shift to cleaner energy sources as the negative short-term local externalities begin to outweigh the positives. Thus, while headlines such as those created by the Epstein study will continue to fuel intense debate for many years to come, it is highly unlikely to lead to any meaningful practical implementation.

To make the debate more balanced, it would be useful to not only monetize the external costs of fossil energy, but also the economic impacts of the recommended price increases and the external costs of the recommended alternative energy sources. For example, the financial crisis caused in part by a quadrupling of oil prices cost the US substantially more than the $345 billion (2.2% of GDP) calculated by Epstein et al. (the bust cut $16 trillion from household wealth, only 45% of which has been recovered to date). Also, one gets twice the number of Google hits for “protest wind” than for “protest coal” even though wind supplies only about 3% of the energy supplied by coal on a global basis. Such a more complete approach is sorely needed at this stage of the debate.

Long-term global externalities

This category of externalities (predominantly climate change) is completely different. In this case, there is a very poor connection between the negative externality of climate change and the positive externality of rapid economic development – a discrepancy which definitely should be corrected. For example, the 17% of people living in developed nations are currently enjoying the material affluence granted by 76% of cumulative CO2 emissions up to 2002, while the negative effects of these emissions will have a disproportionate effect on the lives of developing world citizens.

While this global nature of climate change is a serious concern, the primary problem with the climate change externality is its long-term nature. This means that the world as a whole can easily pass the buck to future generations, something which we are very good at as illustrated by the US budget projection below.

USA projected budget deficit

Thus, a very strong case can be made for internalizing the climate change externality simply because those who experience the positives are separated by many years and thousands of miles from those who experience the negatives. Whether this will in fact happen is of course a completely different story…

Conclusion

Developed world citizens should be careful not to distort the facts about energy subsidization through subjective bias or ignorance in an effort to vilify the very energy source that made their fortunate positions in life possible. Energy subsidization is a very important and sensitive subject and the proliferation of ideologically attractive, but unbalanced opinions can end up doing much more harm than good by perpetuating political stalemate and increasing market uncertainty.

Relatively speaking, the direct subsidization of fossil fuels is very small and is arguably the right of the energy-exporting developing nations where these subsidies are predominantly implemented. On the topic of indirect subsidization, it is recommended that studies of the short-term local externalities of fossil fuels monetize not only the negatives, but also the positive effects in terms of rapid economic development and the negatives of alternative energy sources at high penetration levels. This approach will much better reflect the continued real-world dominance of fossil fuels in the global economy.

Arguably the only fully legitimate case for unjustified fossil fuel subsidization is in the form of the long-term global externality of climate change. Citizens reaping the benefits of cheap and reliable fossil energy are separated by many years and thousands of miles from those that must face the consequences. This is a clear market failure and must be corrected through a scientifically derived price on CO2. All other commentary around direct subsidization and short-term local externalities of fossil fuels can be seen as a very unfortunate distraction pulling focus from this matter of central importance.

Schalk Cloete's picture

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Clayton Handleman's picture
Clayton Handleman on August 28, 2013

 

In referring to CO2 you make the following point in your summary of this post.

“This is a clear market failure and must be corrected through a scientifically derived price on CO2.”

When?  It seems like this has been studied pretty extensively and still nothing approaching consensus.   

In an earlier post you suggested that in a fair market renewables will not make a significant difference for at least half a century.  Oddly you did not include in your discussion of a fair market that part of a fair market would include monetization of externalities.  What was your reasoning behind excluding externalities? 

You mention only CO2.  Why do you exclude analysis of the long term impacts of habitat destruction such as the 100,000 square miles in Alberta from extraction of oil from tar sands?  And similarly destruction of the Appalachians from mountain top removal?

 

 

 

 

 

Paul O's picture
Paul O on August 29, 2013

Schalke can speak for himself, but I have to say that from my point of View, CO2 is the cause of the great Global Devastation we are all concerned about, so why is it not sensible to talk about CO2 especially?

I also take issue with your (I think) rather expansive extention of externalities without also considering the  Contra- Externalities (my terminology).

What would the Costs have been to Humanity and the Planet, had fossil fuels not been used. If there had never been oil and coal use, would we even have any forests left? How much money should the existence of forrests accrue to the FF industries?

If there had never been Coal, would  we have electrified cities and homes? What would the costs of the lack of electricity have been?

What would the costs of lack of Airplanes and Jet travel, Diesel driven ships have been to the human experience and to civilization?

What are the savings that should accrue to the benefit of  fossil fuels in terms of Agriculture, Health, lifespan increase, business and commerse?

We can drag this on to no end, but I rather feel that groups bent on calculating  externalities do so in ways that foster their intended points and biases.

George Stevens's picture
George Stevens on August 29, 2013

Tremendous article!

How often do we hear “fossil fuel receives 10x the subsidy of renewable energy globally” when in reality the opposite is true. We obviously need to clean up energy, but hearing from yuppies that have benefitted their entire lives from fossil fuels that we need to immediately replace fossil fuels with wind and solar is just annoying.

If the impacts of global warming are to be limited only a solution which can approach the comprehensive price of fossil energy can work, which is exactly what the people at the forefront of the climate issue have concluded.

Schalk Cloete's picture
Schalk Cloete on August 29, 2013

You are quite correct in that we are still a long way from putting a consistent price on CO2. The long-term global nature of climate change not only makes it a very worrying ecological/ethical problem, but also a daunting political challenge. 

When it comes to short-term local externalities, a population choosing to pay for reducing such external costs (e.g. through cleaner fossil fuel plants) will directly enjoy the benefits (e.g. cleaner air). However, any country implementing a CO2 price in isolation will only hurt its own international competitiveness and get no direct benefit in return. It is because of this political conundrum that I think we will only implement a CO2 price when a sufficiently large portion of the electorate starts to experience direct and clearly attributable effects of climate change sometime within the next decade or two. 

About the previous post, the CO2 externality was omitted primarily for the sake of simplicity. I did, however, work with a relatively high coal-fired electricity price ($0.06/kWh – the biggest coal consuming countries generate coal-fired electricity for close to half this price) in order to avoid any bias towards coal. 

But the conclusion of that post was that intermittent renewables are still are about one order of magnitude from challenging coal in the electricity market. A 50% increase in the price of coal-fired electricity from CCS will not significantly change this outlook.

 

About the tar sands and mountaintop removal, well, that is just a tradeoff between the positives of economic growth and the negatives of environmental destruction. If enough people value nature preservation above fossil fuel money, this will stop. Until humanity has evolved to that point, however, we will keep to the status quo. 

Schalk Cloete's picture
Schalk Cloete on August 29, 2013

Very good point. Had it not been for fossil fuels, Malthus would have been proven right a long time ago through very unpleasant outcomes such as large scale war and famine. The fossil fuel driven industrial revolution has given humanity the chance to evolve to the point where many countries now desire family sizes below the rate of replenishment. This is the first requirement of a sustainable society. 

The next level of evolution will have to be the denouncement of the highly erroneous perceived link between excessive material consumption and happiness. I am confident, however, that this jump will be made over the coming decades (mostly forced by external circumstances).  

Ironically therefore, the amazing technological advances facilitated by fossil energy has given us the opportunitity to attain true sustainability (as opposed to the adaption – exponential growth – stagnation – death cycle of simple-minded populations in a closed environment). It is essential that this mindset is translated to the billions of poor people still populating this planet and, at this stage, fossil fuels remain by far the most practical way in which to do this. 

That being said, however, climate change has the potential to rob humanity of the highly attractive ideal of true sustainability. Many uncertainties on this topic remain, but my feeling is that, if we do not handle this challenge in good time, Malthus could be proven right after all…

Schalk Cloete's picture
Schalk Cloete on August 29, 2013

Thanks for the link. It is interesting to see that, even though China is now easily the greatest emitter, it still is responsible for only about a third of the emissions of the US on a cumulative basis. 

Schalk Cloete's picture
Schalk Cloete on August 29, 2013

The IMF used a price of $25/ton of CO2, implying that I agree with about $0.9 trillion of the $1.9 trillion in the report. The remaining $1 trillion (direct subsidies and short-term local externalities) are more debatable though. 

Schalk Cloete's picture
Schalk Cloete on August 29, 2013

You raise some good points about the complexity of these matters. As mentioned in a comment above, the fact that any country implementing a CO2 price in isolation will only hurt its own competitiveness while seeing virtually no direct benefits will continue to delay climate action. Climate skeptisism also does not help. 

Regarding externalities, it is probably best to tax fossil fuels at the source (coal mine or gas/oil well). In this way, the external costs will be translated throughout the economy in the most equitable manner whether the fossil energy is used for electricity, transportation or general industrial uses. 

Gary Tulie's picture
Gary Tulie on August 31, 2013

Regarding the assertion that a country implementing a CO2 price would harm its international competitiveness, it would seem to me that this depands on how it is done, and the nature of the nation’s economy.

Take the following example  

A country taxes CO2 at $25 per ton adding something like $0.015 per kWh to the cost of coal fired power generation. 

The country then ringfences this revenue to subsidise the cost of energy efficiency upgrades – giving companies tax breaks to better insulate their buildings, install LED lighting, upgrade their air conditioning systems to more efficient up to date technology, and to encourage the use of more fuel efficient company vehiclesand providing grants to householders to take similar actions. 

In this scenario, it seems to me that reduced power consumption, cuts in heating energy demand, and a more efficient vehicle fleet will soon offset the 5 to 10% rise in per kWh energy cost making trhe country more competitive rrather than less.

Also, a country like Switzerland with cheap hydro-electricity, high GDP and low emissions per $ GDP would be far less affected by a carbon tax than a poor country living off heavy industry. 

Schalk Cloete's picture
Schalk Cloete on September 1, 2013

International competitiveness is most directly determined by two factors: the cost of labour and the cost of energy. In total, these two things represent the cost of getting things done in any specific country.  

Imposing a CO2 price will raise the cost of getting things done in any specific country from day one. This, in turn, will hurt export industries (because their products will become more expensive internationally) as well as industries producing goods & services for local consumption (because imports will become relatively cheaper). In total, this will lead to a slowdown in economic activity in the country in question, making it politically infeasible to use the CO2 revenues for the purpose of long-term investment. 

Yes, in theory, many countries can benefit greatly from smart energy investments, but, due to mounting debts and unfunded liabilities, very few countries can afford the short-term growth reduction impacts of such investments. The situation you describe is therefore definitely technically feasible, but the mechanisms described above (and real-world evidence) suggests that the political feasibility is highly questionable.

About the Switzerland example – yes, countries with a low carbon intensity will be less affected by a CO2 price, but, from a global perspective, a little bit of further decarbonization in such countries will have very little impact. What we need is for China, the US and India (responsible for half of global emissions) to implement such measures. 

Marcus Pun's picture
Marcus Pun on September 2, 2013

Interesting and nicely done. However your analysis misses the biggest externality of all, the costs of war. We don’t go to war over coal but much of US foreign policy is shaped by keeping oil from the Middle East available to markets here.  A lot of money over the post Cold War years was spent on maintaining naval and land forces in the area or nearby in EuropeThe first Gulf war, while costing the US $61 Billion at the outset, ended up at $7 Billion due to contributions from other countries.

We are not so fortunate in the Iraq Afghanistan wars. According to a Harvard study, the total costs of the two front war will be between $4 Trillion and $6 Trillion dollars, with taxpayers underwriting the cost of medical care of wounded veterans and expensive repairs to a force depleted by more than a decade of fighting [ Bilmes, Linda J. “The Financial Legacy of Iraq and Afghanistan: How Wartime Spending Decisions Will Constrain Future National Security Budgets.” HKS Faculty Research Working Paper Series RWP13-006, March 2013.]

Note:I do not think this study takes into account the economic impact of having a  population of veterans that are dependents rather than producers (crudely put as their service trumps all producers as far as I am concerned.)

 

Marcus Pun's picture
Marcus Pun on September 2, 2013

In response to Paul O., the benefits (contra externalities as you call them) are already figured into the market with the price people are willing to pay for the energy. In terms of broad societal benefits, given the wars fought over resources, the cost in horrific human misery and countless lives, I think at the very best it is a wash.

Schalk Cloete's picture
Schalk Cloete on September 5, 2013

Although I in no way want to underplay the cost of war, I think the $4-6 trillion is the total over the time-period between 2000 and 2050 (although it is hard to find an explicit breakdown of this headline figure in the report). The cost of wars which might have an oil connection is therefore large, but not dominant. 

Also, the claim that these wars were fought primarily because of oil is highly contestable. Yes, it is certainly possible that oil interests played a part, but the primary motivations for both the Iraqi and Afghan wars were definitely terrorism and weapons of mass destruction. This means that only a small portion of the total costs of war can be seen as an oil externality. 

But yes, it is hard to understand why the US allowed itself to become so dependent on foreign oil that it can be seen as a motive for war. If the US consumed oil more frugally like Europe, it would not have to import anything. This is now slowly changing as people are forced to drive less and buy more efficient cars, but the urban sprawl of American cities will make this transition very slow indeed. 

Marcus Pun's picture
Marcus Pun on September 5, 2013

This has a long history and deep roots. Having studied this since the 1970’s it is very easy to see why we are so dependent on ME oil. It provided a cheap source of oil for multinational oil companies to sell in the US at a fairly high profit. Much of our political and intelligence maneuvering mid 20th century revolved around having nations friendly towards these companies. These are the roots fo the terrorism you describe.  Iran is  a classic example. The quick version is that in 1951 Iran Prime Minister Mohammed Mosaddeq received the vote required from the parliament to nationalize the British-owned oil industry. The reaction from Britain and the US was to set up a coup that overthrew Mossadeq. The resulting autocracy, having gotten the message, entered into agreement with an international consortium of foreign companies which ran the Iranian oil facilities for the next 25 years splitting profits fifty-fifty with Iran but not allowing Iran to audit their accounts. So basically the oil companies looted the country blind. On the cultural side, very important, there was a rapid westernization that went along with modernization. Having the typical top down rule the economy became more stratified with the man on the street not getting the benefits of the oil boom. So much discontent added to conservative religious followers’ dismay at the direction Iran was going led to the initial rise of Ayatollah Khomeni in 1963, his imprisonment, and subsequent intense radicalization of his followers. Simply put this led to much of the rising cultural/political tide of Islamic radicalism. US post Iraq War presence in Saudi Arabia,  considered Islam’s Holy State, assisted binLaden’s rise to power, the creation of his racial following and the terrorist attacks on American interests and soil. The upshot, modern Islamic terrorism has everything to do with oil.That’s the short story on terrorism. VERY short.

On the US demand side, post WW2 and post Depression, we went from frugality to where consumption became a cultural right. Oil was considered an unlimited resource except by a few and as long as the ME spigots remained open as domestic production declined, this was the state by which American energy policy was made. 27 cent a gallon gas.  Think about it. In Europe it was 4 times that. Initial controls on car exhaust helped to establish the EPA under Nixon but CAFE standards were not implemented until 2 years after the Arab Oil Embargo in 1973.  There was much political resistance among car manufacturers and oil companies. Big cars made more profit and sold more gas. Hence CAFE standards made little headway until recently. Initially it was 18 mpg for passenger cars in 1978 and then 26-27mpg by the mid-80’s and then it was stuck there for the next 25 years(!!!). It’s now at 30mpg. The other side is home and business usage of energy. Few states went outside the Federal government in terms of controlling energy usage. The most effective has been California, which uses half the carbon per dollar of economic activity than the rest of America. In terms of alt energy production it is the leader although states like Kansas and Texas have more wind power.This was the result of a very successful energy conservation program started under the Jerry Brown administration in 1978. Upshot is that since the start of the program the energy savings to businesses and consumers amounts to $74 billion dollars. There’s now a very aggressive generation program. Solar, as an example has gone from 1GW last August to 2.5GW today. In a few years it could easily top 10GW.

If you want to know why Exxon and Koch Industries have spent hundreds of millions on climate science denial, they are afraid of the competition from diffuse energy sources whose output is controlled by nature, not by governments or business.

As for the breakdown of the recent I-A wars I think the estimate for military spending and replacement of assets funds about 1.8 trillion. The additional 3-5 trillion is the Veterans Administration’s estimates of what it will take to care for the veterans of these was for the next 50 years.

 

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