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Putting the IMF Externalized Cost Report in Perspective

Highlights

  • Authors at the IMF recently released a working paper in which very high fossil fuel externalities are reporte  
  • The magnitude of these costs may well be substantially over-estimated
  • Serious economic consequences can result from the proposed large fossil fuel price increases 
  • Most importantly, the proposed price controls will stifle developing world growth, thus damaging global sustainability

Introduction

Authors at IMF have recently published a working paper (not necessarily reflecting the views of the IMF as detailed in this disclaimer) in which they detail surprisingly large "post-tax" energy subsidies of fully 6.5% of global GDP. These subsidies are attributed primarily to environmental effects of fossil fuel combustion and have therefore enjoyed a great deal of oft-sensationalist reporting by various green news outlets.  

IMF externalities

As always, however, such dramatic numbers contain many questionable assumptions under the surface. This article will describe what I deem to be the most important of these.

Questionable assumptions

Very high estimates for local air pollution costs

On a global level, the report calculates externalized costs of $317/ton for coal, $35/barrel for oil and $2.6/MMBtu for gas. Details on these numbers are referred to another IMF report which is not open access or included in the extensive scientific literature database to which I have access. When looking specifically at the large externality estimate related to coal, the report breaks it down into $78/ton for climate change and $239/ton for local air pollution. When considering a cheap and simple coal power plant operating at 35% efficiency combusting coal with a heating value of 23 GJ/ton, this is equivalent to costs of $35/MWh for climate change and $107/MWh for local air pollution. A search of the scientific literature on the subject revealed the following estimates for developing nations to which the bulk of coal damages are attributed. CC = climate change, LAP = local air pollution.

India (2012) - CC: $35/MWh, LAP: $15/MWh

China (2015) - CC: $18/MWh, LAP: $54/MWh

Poland (2012) - LAP: $26/MWh

Chile (2013) - CC: $13/MWh, LAP: $5/MWh

Bosnia (2011) - LAP: $5-10/MWh

China (2007) - CC: $54/MWh, LAP: $36/MWh

Global (2007) - LAP: $16-30/MWh

On average, these peer-reviewed studies report $29/MWh for climate change and $24/MWh for local air pollution. The climate change estimate is in line with that of the IMF working paper, but the local air pollution estimate is 4.5 times lower.

Attributing congestion and traffic accidents to oil

More than half of the externalized costs related to oil consumption is attributed to costs related to traffic accidents, congestion and road damages. Naturally, these costs should be associated with the vehicles themselves and not with the fuel they consume. In other words, these post-tax subsidies are vehicle subsidies, not energy subsidies. If they are to be internalized, this should happen through e-tolls on congested roads and through vehicle sales and ownership taxes, not by taxing gasoline.

Over-simplified welfare gain calculation

The report calculates global welfare gains from the implementation of "efficient energy pricing" (all post-tax subsidies removed) to amount to 2% of global GDP. The breakdown of these welfare gains between regions is given below. This number was calculated based on a simple linear model, implicitly assuming that such large energy price increases leading to large reductions in energy consumption (from 10% natural gas to 25% coal) will not have any non-linear negative effects on the broader economy.

IMF welfare gains from efficient pricing

Firstly, it should be acknowledged that GDP scales exponentially with energy consumption as an economy grows and energy intensive manufacturing gradually gives way to less energy intensive services. The development of the US economy over the past 50 years is given below as an example.

US GDP vs energy

As such, large reductions in energy consumption caused by large taxation of energy products can seriously disrupt the foundation of the economy and can have undesired ripple effects, further accentuated by the highly leveraged state of the global economy. Expressed another way, a large increase in energy costs will cut the overall energy surplus available to the economy, thereby disrupting high-value services at the top of the pyramid below. Hierarchy of energy needs

Secondly, the practical implementation of such very large taxation (~6% of global GDP) will be a very inefficient and costly endeavor. The report acknowledges that such policies will lead to large welfare shifts with large winners and losers. Trying to implement this in practice will be a very costly process likely taking decades to implement. The very slow political process surrounding climate change (which accounts for only a quarter of the externalities calculated in the report) presents a good example.

Thirdly, if we actually manage to implement such large taxes, it will lead to a rapid shift in the world's long-term capital stock and associated workforce, bringing large costs in terms of capital writedowns and labour force restructuring. Even though such a shift must take place in the long-term, forcing this transition to happen rapidly through a global tax of the magnitude recommended by the IMF working paper will lead to large economic and labour market inefficiencies.

Lastly, and perhaps most importantly, imposing such large energy taxes, particularly on coal, will have large negative impacts on developing world growth. This topic is further discussed below.

Cheap energy and economic development

Maximizing developing world growth is arguably the most important goal in overcoming the sustainability challenges we face in the 21st century. Achieving this goal is vitally important for two main reasons: 1) Economic development is the most effective morally acceptable way to limit and eventually reverse population growth. Large families simply become uneconomic as societies develop, thus leading to very natural and ethically sound population control. 2) Economic development is mandatory to get environmental issues anywhere near the top of the priority list of the average member of society. People living in poverty have much more basic and pressing concerns than fossil fuel emissions - something which can probably only be fully understood by people who have seen true poverty first hand.

As shown in the graphic below from the previous BP Energy Outlook, almost all major economies kickstart their development with coal after which a natural diversification occurs. Imposing large additional energy taxes will hamper this natural process, thereby stifling the development of poorer nations and hurting the global mission towards long-term sustainability.

Dominant fuel transition

Take China for example - a region where the report estimates external energy costs of a whopping 15% of GDP. Let's say that China decided to heavily tax all negative effects from coal and oil consumption starting 25 years ago. Even though coal and oil would probably still have been the primary drivers of growth (see a comparison of coal scaling to other options in this article), the clear incentives to build more complex and costly state of the art coal plants and industries together with up-market fuel efficient vehicles would have retarded Chinese growth significantly.

The very rapid Chinese energy buildout would have been impossible, as would their very successful export driven growth model due to substantially more expensive "made in China" products. All-in-all, even a conservatively estimated reduction from 10% growth to (a still very rapid) 7% growth rate would have cost them half of their GDP today - much more than the 15% of GDP pollution-related estimate of the IMF working paper. The graph below illustrates this point.

China growth 7 pc vs 10pc

Luckily, this was not the case. As a result, China is now a true industrial superpower capable of rapidly cleaning up its coal fleet, successfully completing  truly gargantuan hydropower projects, easily leading the world in terms of nuclear power deployment, and also leading the way in terms of clean energy investment. None of this would have been possible without decades of unchecked coal-driven economic development.

There are many other developing nations that must be allowed to carry out a similar rapid industrialization to that achieved in China. A good look at the global wealth pyramid below should make this abundantly clear. Imposing large energy taxes on developing nations will greatly retard this vital process, thereby making our sustainability challenges in the 21st century even more daunting than they already are.

For some perspective, it can be estimated that the total resource consumption required to double the size of an economy growing at 7% will be about 25% greater than it would be for an economy growing at 10%. The 6 billion (and counting) developing world citizens will require several doublings in economic output before we can approach anything close to a sustainable global society.

2014 global wealth pyramid

Short-term local vs. long-term global externalities

In an earlier article, I distinguished between short-term local (primarily air pollution) and long-term global (climate change) externalities, arguing that the former should be left to the free market to handle, while the latter needs clear policy intervention. This argumentation strongly applies to the present discussion as well.

Short-term local externalities (which make up three quarters of the external costs reported in the IMF working paper) are felt directly by the population which benefit from the associated cheap and practical fossil energy. Thus, as living standards rise and people start valuing clean air above rapid economic development, policies to make this happen will naturally be put in place.

Existing cheap and dirty coal plants will be retrofitted with scrubbers, emission standards will be put on the vehicle fleet, industry will face stricter environmental regulation and cleaner energy will be subsidized. The graph of US coal plant emissions shown below illustrates just how rapidly this can happen.

US emissions reduction

Closer analysis of the data in the report reveals that a large part of reported welfare gains in fact comes from retrofitting coal plants with emission control technology (coal usage falls by 25% while externalities fall by more than half in the modelled scenario with "efficient prices"). This is an important finding, but is seriously underplayed in the report. However, it should be stressed again that trying to achieve this favourable outcome with large price controls will be much less efficient than simply stepping back and allowing the economy to handle these short-term local externalities in a natural manner.

Overall, it just makes all the sense in the world that a nation should first achieve rapid development with cheap and practical energy after which it can leverage the built up infrastructure, skills and productive capacity to rapidly reduce adverse effects and diversify its energy supply. This natural development process will only be hampered by the large energy price interventions advocated in the report. 

Yes, the damages from fossil fuel emissions are large and real, but the damages from poverty in terms of preventable deaths and wasted human potential are just much, much greater. In addition, every year of sub-optimal growth in a developing country represents a tremendous waste of time and resources in our quest towards a sustainable global civilization. On the other hand, long-term global externalities (climate change which accounts for the remaining quarter of externalities calculated by the IMF working paper) requires strong policy intervention.

People benefiting from the associated energy consumption can be separated by thousands of miles and numerous decades from those paying the price. Obviously, this is something that cannot be naturally handled by our economic system and needs to be corrected via the implementation of an "efficient price" as advocated in the report.

Conclusion

The viewpoint presented here conflicts with the central message of the IMF working paper that energy prices should be much higher (especially coal which should be 5 times more expensive). Firstly, coal externalities may well be much lower than reported, while more than half of the  subsidies attributed to oil are not energy subsidies at all. Secondly, more detailed analysis on the impact of the proposed very large policy interventions on the broader economy is needed. Finally, and most importantly, the impacts of large energy taxation on the growth prospects of developing nations should be seriously considered.

In summary, the proposed very large taxation on short-term local externalities will be detrimental both to the global economy and to global sustainability. These costs are best left to the free market, while environmental groups focus on implementing a meaningful policy framework for long-term global externalities (climate change).

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IMF disclaimer related to the working paper discussed in this article: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

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