Removal/reform of subsidies to end-user energy prices and on energy supply

The removal/reform of inefficient subsidies on end-user energy prices aims at changing energy consumption patterns towards reduced or more efficient energy use and ending costly and inefficient spending of public funds. By reforming subsidy schemes that push energy prices below market level, energy subsidy removal/reform profoundly changes incentive structures for end-users and producers alike, thus giving energy saving behaviour and energy efficiency investments the financial value they deserve. By this, private investors will see the same value and benefits of energy efficiency as the national economy as a whole.

Worldwide implementation status
At their summit meeting in Pittsburgh in 2009, the leaders of the Group of Twenty (G-20) countries agreed to phase-out inefficient fossil-fuel subsidies over the medium term (cf. www.bigee.net/s/61f6gv). However, when reviewing those commitments, independent studies have found little progress made in terms of real action (cf. Koplow 2010; G20 Research Group & G8 Research Centre 2010; Koplow 2012). Reported efforts had been initiated prior to the commitments and information on the scale of existing subsidies has suffered from serious underreporting. Still, it can be seen that many developing countries and emerging economies are also taking action to reduce energy subsidisation.

Governance level
Since direct or indirect subsidies on end-user energy prices and on energy supply are being implemented at all levels of government (international, national, regional and local), their removal/reduction likewise occurs on all levels.

Depending on the incidence of a subsidy, all sectors (industrial, commercial, residential and public) are potential targets.

Related sectors

• services
• residential
• industrial

In principle the technological focus is unlimited.

Related target groups

• User: The target group of the policy is all energy end-users and suppliers that currently seem to benefit from subsidies bringing energy prices below market level but actually suffer from too small returns on energy efficiency improvements.

Overall, society benefits from a decrease in inefficient spending of public funds and - very likely - also private funds, due to decrease in energy wastage.

Direct beneficiaries

• Governmental actor

  The reform of subsidies on end-user energy prices and/or on energy supply directly benefits governments, which gain additional financial leeway against the backdrop of budget-austerity and reduce their dependence on volatile energy markets.

Indirect beneficiaries

• Energy Service Company

  Energy efficiency service companies and consultants may benefit due to increased demand for their products and services.

• Manufacturer

  By increasing the cost of energy consumption and production, the reform of inefficient energy subsidies stimulates demand for energy efficient solutions and thus indirectly benefits manufacturers, retailers, property development companies, system suppliers, architects, engineering consultants and installation contractors offering such solutions.

Relevant barriers

• Economic and financial barriers: A reform of inefficient energy subsidies raises energy prices and/or the cost of production, which then more accurately reflect the social cost of energy use and production. As a consequence, investments in energy efficiency become financially more attractive to end-users and suppliers since these not only offer a way to cope with higher energy prices but also promise considerable savings in the long run.
• Lack of interest and motivation in energy efficiency-improvement: By raising the cost of energy use, the reform of inefficient subsidies on energy consumption directly affect end-users “where it hurts”, i.e. their disposable income. Consequently, the policy raises awareness within society regarding the real (i.e. the social) cost of energy use, putting the topic of energy efficiency and energy saving on the public agenda.

Relevant incentives

• Saved energy costs: As a result of higher energy prices, private and industrial end-users will earn higher savings on energy efficiency and energy-saving behaviour and therefore become more aware of technological and behavioural options to decrease their energy use and thus reduce associated costs.
• Directly increasing earnings or profits for actors on the supply side: Energy efficiency consultants, as well as manufacturers and retailers that supply energy efficient solutions within the appliances market, may experience increasing turnover and profits due to higher demand for their products.

If due to market failure energy prices still do not reflect the social cost after a subsidy reform, it should be complemented with other fiscal measures such as energy taxation. Moreover, besides setting negative incentives for more efficient energy use and production, a policy package should comprise regulatory measures such as Minimum Energy Performance Standards (MEPS) for products and processes, financial incentives for energy-efficient appliances where useful, and additionally provide information (e.g. via labels or campaigns) and consultancy on how to improve energy efficiency.

The implementation of subsidy reform may require the development of institutional, administrative and sometimes physical capacity in order to gather and process information on subsidy incidence and the economic, social and environmental impact of subsidy reform, and to administer the process in a transparent manner.

• Review of country-specific subsidy patterns with regard to beneficiaries as well as scope, type, accuracy and overall efficiency of subsidies with regard to original targets.
• Execution of an ex-ante impact assessment for different reform scenarios with regard to environmental, social and economic efficiency.
• Consultation with stakeholders and scientific experts in order to increase acceptance for the policy.
• Development and execution of a sound information strategy in order to inform people about the social and environmental impact and the economic costs of inefficient subsidies for society, i.e. the benefits of removing them.
• Gradual implementation of subsidy reform combined with targeted assistance to negatively affected energy consumers, particularly low-income households. This could include both direct balancing payments for the increase in energy costs, and technical and financial support for energy efficiency improvements. It could also include broad-based energy efficiency programmes for all sectors.
• Monitoring and evaluation of reform outcomes using ex-ante specified indicators (s. Monitoring and Evaluation).

Quantified target
Removal/reduction of inefficient subsidies can aim at quantified budgetary and energy savings. The scope and likelihood of emergence however are largely dependent on national circumstances with regard to subsidy patterns and the corresponding reform design.

Co-operation of countries
Multilateral agreements on reforming national energy subsidies can legitimise the policy within the public discourse and have an important signal effect to opposing domestic stakeholders. Moreover, internationally co-ordinated action can prevent competitive disadvantages for national industries and energy suppliers, as well as transnational shifts in consumption.

Monitoring
For the purpose of evaluating the removal of energy subsidies, a broad database of factors that influence energy consumption is necessary, which should be built parallel to the introduction of the policy. It is similar to monitoring and evaluating the introduction of an energy tax. Best evaluation practice has shown that for the assessment of energy consumption on a household level, monitoring of data not only on total energy consumption, but also on the use of appliances, general behavioural patterns, type of household by size and income are most useful, while on an industry level data on the overall consumption of different sectors is sufficient (cf. INFRAS 2007, p. 19). For the tertiary sector, the type of business or building should also be monitored.
Furthermore, both the actual energy prices after subsidy reform and the level of subsidy before and after intervention should be monitored as a basis for evaluating their impact on energy prices.

Evaluation
In order to evaluate the different impacts of a policy-induced change in energy prices, the use of Computable General Equilibrium (CGE) models and other econometric approaches such as time series analyses - before and after introduction of the schemes - to evaluate energy price elasticities of energy demand and to calculate the energy savings using these, but also Input-Output-Analyses, have proven to provide sound and meaningful results. Overall, rather than the choice of method, the availability of relevant data is crucial in this respect. With regard to timing, impacts on the energy demand side should be evaluated within 1-3 years after the introduction of the instrument while structural impacts require a longer period of 5 years to emerge (cf. INFRAS 2007).
Impacts that should be considered are, on the one hand, the additional costs to energy consumers from the increase in energy prices but also from energy efficiency investments induced. On the other hand, there are the financial savings from energy savings, reduced social security cost or reduced other taxes, or direct compensation payments or financial incentives received for energy efficiency investments that the state pays out of the budget savings from reduced energy subsidies.
Energy (cost) savings from such incentive programmes for energy efficiency can be evaluated directly using bottom-up methods.
For the overall economy, savings on energy supply and from reduced unemployment can be evaluated, but also wider changes in GDP. Reduced greenhouse gas emissions are another important benefit that should be evaluated.
In addition, it is useful to quantify the impact on the state’s budget. This includes not only the tax or auctioning revenue and its use, but also secondary effects from reduced unemployment or increased VAT on energy efficiency investment.

Relevant individual dynamics and side-effects

• Dynamic market transformation and/or innovation: Removing inefficient subsidies on energy use and production provides a strong price signal to end-users and energy providers. Assuming utility maximizing behaviour and rationality, consumers and producers of energy products will adapt to higher energy costs depending on the specific demand elasticity. If demand for an energy product is inelastic (i.e. is not substitutable), end-users will tend to opt for more energy efficient solutions, thus promoting technological innovation OR they will choose cleaner energy sources. This will contribute to market dynamics on energy efficient products and solutions. This effect can be enhanced a lot with dynamic sector-specific energy efficiency policies. If demand for an energy product is elastic, the removal of inefficient subsidies may nonetheless alter consumption patterns and hence lead to an overall reduction of energy use.
• Avoiding lost opportunities: By raising the cost of energy production and consumption, a subsidy reform stimulates energy saving behaviour and provides incentives for investments in energy efficient solutions. This way it may help to avoid lost opportunities such as the purchase of less energy efficient appliances or equipment.
• Minimising rebound effects: By raising the cost of energy use to a level that reflects the social costs of production, the gradual removal of energy consumption subsidies can help to minimise rebound effects in consequence of energy efficiency improvements.
• Minimising snap-back effects: Maintaining a correct price signal after the first removal of energy subsidies will contribute to continued awareness and action for energy efficiency and thus reducing snap-back effects.
• Minimising free-rider effects: One characteristic of inefficient energy subsidies is their lack of accuracy, which results in free-riding from energy users, such as high-income groups, which are not part of the original target group. By reforming such subsidies, policy can contribute to the minimisation of the free-rider problem in the energy sector and promote a more efficient use of public funds and energy. With regard to free-ridership on energy efficiency action, this is equivalent to the share of energy efficiency actions that consumers adopted even before removal of energy subsidies. This will depend on the level of energy subsidies and the type of action. We do not see any options to minimise such free-rider effects that are specific to the policy of removing energy subsidies.
• Creating Spill-over effects: As the policy affects all energy consumption, there are no spill-over effects in the classical sense. However, these effects may be enhanced a lot if the subsidy reform is combined with sector-specific energy efficiency policies to a policy package for energy efficiency. Furthermore, market dynamics for appliances induced by removal of energy subsidies are likely to create economies of scale for these technologies and solutions. This will reduce their costs and increase demand for them, and thereby create spill-over effects.

Sustainability aspects
Within a successive process of reforming inefficient energy subsidies, policy-makers should first focus on cutting fossil-fuel subsidies in order to promote energy efficiency and also renewable energy sources. This can help the transition towards a sustainable energy supply system. Moreover, by removing subsidies on primary energy, the policy may provide incentives for more efficient energy conversion and thus improve resource efficiency.

Co-benefits
The reform of subsidies on carbon intensive energy sources reduces their competitiveness vis-à-vis renewable and low-carbon energy sources, which provides society as a whole with public health benefits due to air quality improvement.

The following barriers are possible during the implementation of the policy:
Attempts at reforming financial entitlements such as energy subsidies are likely to create fierce political opposition from current beneficiaries. In addition, fear of negative economic consequences and social distortions may further shape the public discourse towards maintaining the status quo. Moreover, in practice there is often a lack of adequate information on the incidence of energy subsidies and the scope of associated negative externalities, which hampers policy-makers’ ability to point out the positive outcomes of their reform and argue in favour of the policy. Subsidy reform may also fail due to a lack of institutional and administrative (and sometimes even physical) capacity to collect and disseminate accurate data as well as to administer the reform process in a transparent and effective manner.

The following measures can be undertaken to overcome the barriers:
In order to overcome political resistance, stakeholders and scientific experts should be consulted to increase the acceptance of the policy among those affected. Also, the proceeding should be accompanied by a sound information strategy, in which policy-makers clearly communicate the social and environmental impact and the economic costs of inefficient subsidies for society, namely the benefits of reforming them.
To overcome problems with regard to the process of effectively implementing subsidy reform, the development of institutional and administrative capacity is crucial. In this instance, drawing on the technical expertise of independent organisations is recommendable.
In order to address fear of negative economic consequences, reforms should be introduced in a gradual, programmed fashion. This alleviates the financial burden on current subsidy beneficiaries and reduces adjustment costs for affected consumers. Also the choice of an opportune moment within a favourable market (e.g. low inflation, low fuel prices) and political condition (e.g. shortly after an election) can promote the successful implementation of subsidy removal/reform and may alleviate economic concerns. Furthermore, combining the energy subsidy reform with energy efficiency programmes funded from the budgetary savings can increase the acceptance of the subsidy reform.
Finally, with regard to concerns about social distortions, saved funds should be used to provide targeted assistance to low-income households in order to keep energy bills affordable. This could include both direct balancing payments for the increase in energy costs, and technical and financial support for energy efficiency improvements. It could also include broad-based energy efficiency programmes for all sectors.

According to a study by IEA et al., phasing out the lion’s share of subsidies on fossil-fuel related consumption could lead to a 5.8% reduction in primary global energy demand by 2020 compared to a business-as-usual scenario (cf. IEA et al. 2010). Also, in the same study, global CO₂ emissions are estimated to decrease by 6.9% (equal to 2.4 GT of CO₂) over the same period due to implementation of the policy.

Implementation costs for governments may arise in the context of institutional and administrative capacity development necessary to collect and disseminate accurate data on subsidy scope and incidence as a prerequisite for successful subsidy reform. In the short term, formerly subsidised consumers are likely to face higher costs related to energy efficiency improvements in order to cope with higher energy charges.

In a review on studies analysing the effects of fossil-fuel subsidy reform, the Global Subsidy Initiative (GSI 2010) concluded that removing fossil-fuel subsidies will result in an average yearly growth of 0.1% in GDP in OECD and non-OECD countries by 2010 and of 0.7% by 2050. Moreover, theoretically governments could save up to US$ 409 billion (data for 2010) in consumption subsidies (cf. IEA 2011) and up to US$ 100 billion (data for 2009) in fossil fuel related production subsidies (GSI 2010).