2. Designing reform of support for fossil fuels: a methodology for a robust sequential approach in OECD and G20 countries
Chapter 2 proposes a methodology for a sequential approach to designing fossil-fuel subsidy reforms in OECD and G20 countries, to assist governments assess and address the effects of support measures and their reform, and spur enduring change. Sections 2.1 and 2.2 present the rationale for a sequential approach, and provide an overview of possible steps and associated tools. Section 2.3 considers how governments might identify support measures, document their objectives and estimate their budgetary cost, as a crucial first step towards reform. Section 2.4. addresses how to isolate measures that result in the most significant changes to economic decision-making and environmental performance across different segments of the fossil-fuel value chain, to establish priorities for reform. Section 2.5 identifies analytical tools to inform on possible economic and social effects of reform. Section 2.6 examines how reform measures may be accompanied by complementary policies to alleviate any negative effects of reforms and channel fiscal savings to more productive uses. The chapter concludes with a discussion of how the OECD can support governments in applying the sequential approach and possible forward work priorities.
Progress towards achieving the international commitments that countries have taken in the G20, G7 and APEC forums to phase out support for fossil fuels has been mixed, as Chapter 1 demonstrates. However, the case for sharper global focus on reform of fossil-fuel support has been strengthened by mounting climate ambition, fiscal pressure resulting from the COVID-19-induced recession and increasingly vocal calls to “build back better” as governments devise and implement economy recovery packages. In addition, the need for reform has been underlined by evidence that energy sector support in response to the COVID-19 crisis has been weighted in favour of incumbent fossil-fuel industries.
Comprehensive guidance to support reform processes tailored to OECD and G20 countries’ circumstances has not previously been developed, despite the challenge involved to unwind government support for fossil-fuel production and consumption. Previous OECD studies of the effects of fossil-fuel support and their reform have generated qualitative tools to guide users in identifying environmental benefits of reform. An early look at the implications of fossil-fuel support under the umbrella of environmentally harmful subsidies produced a checklist for determining the likelihood of environmental benefits from reform (OECD, 2005[1]). An integrated assessment framework was later introduced to map out the objectives, cost-effectiveness, and incidental and long-term consequences of reform (OECD, 2007[2]). This work was presented to the G7 as part of a report produced at the request of Italy to support discussions in the environment stream of its 2017 G7 Presidency (Jésus et al., 2017[3]).
To fill the gap in comprehensive guidance and encourage reform – including in the context of COVID-19 recovery packages – this chapter sets out a sequential approach.1 It offers a toolkit for each step along the reform trajectory to help governments assess and address the effects of fossil-fuel support measures and their reform. This approach builds on the latest research and accommodates the diversity of tax systems across OECD and G20 countries, to help each government build the evidence base it needs for its specific national context and reform process. The tools recommended vary in their level of ambition, difficulty, and data and resource intensity. But being modular by construction, the sequential approach enables different steps to be undertaken in isolation as countries identify specific needs and as their capacity to conduct analysis becomes available.
Countries can scale up the breadth and depth of their analysis at their own pace. Unavailability of resources to complete any one step does not preclude policy makers from proposing and proceeding with a reform agenda. The sequential approach can be viewed as a comprehensive research programme with which to gauge the depth and breadth of any given evaluation process. It can also help assess gaps in the evidence base that could be a source of weakness in designing reform. Carrying out a full suite of assessments in designing reform measures should minimise the risk of political backlash and backsliding that too often accompanies reform.
The sequential approach to analysing government support measures proposes four steps of analysis with associated tools (Table 2.1). The tools vary in their level of ambition, difficulty, as well as data and resource intensity.
Countries should heed the broader policy environment as they deploy these assessment tools. Policy interactions should not be neglected; complementarities and redundancies should be identified and addressed along the way. The proposed multi-step approach takes into account the complexity and challenges that confront policy makers seeking to implement reform. Potential distributional and competitiveness implications can act as deterrents to reform and may warrant accompanying compensatory measures. The differentiated effects of support measures may also mean that some will not be a priority for reform as they are important for achieving a government’s social or investment objectives, with no viable alternatives. The widespread use of tax expenditures in OECD and G20 countries to provide preferential treatment to the use and production of fossil-fuel requires deployment of specific tools suitable for studying their role in influencing economic decisions and environmental outcomes along the fossil-fuel value chain, as integral to the effective design of reform packages in these countries.
Moreover, because energy plays such a central role in OECD and G20 countries, the economic, social and environmental effects of fossil-fuel support typically spread far beyond the energy sector and its consumers. Reform of fossil-fuel support therefore requires a whole-economy approach, with careful consideration of potential adverse effects. Reform should be conceived within a country’s national development plans, especially for developing G20 countries. The cross-cutting nature of fossil-fuel support, compared with support to specific sectors like agriculture and fisheries, means that understanding its effects on economic decisions and environmental outcomes can be a daunting task.
Similarly, government efforts to respond to the COVID-19-induced recession, enhance fiscal discipline and increase climate ambition should be conceived as part of a broader policy landscape. Efforts to integrate environmental considerations in the budgeting process have multiplied over recent years, both internationally and at the country level. The Paris Collaborative on Green Budgeting (PCGB), launched at the One Planet Summit in 2017, is a multilateral initiative to institutionalise the tracking and evaluation of public expenditure to ensure it is better aligned with climate goals and other environmental goals. The more recently formed Coalition of Finance Ministers on Climate Action has lent further support to the PCGB, as it encourages countries to take climate change into account in their macroeconomic and fiscal and budgeting planning. In 2019, France, as a founding member of the PCGB, proposed a framework that would be used to deliver a green budget statement as an annex to the general budget, starting with the 2020 fiscal year. The first green budget statement was duly delivered in 2020. Ireland commenced green budgeting practices in 2019 and has identified, tagged and estimated climate-related expenditure for the 2019, 2020 and 2021 budgets. Climate-related expenditure is defined as any expenditure that promotes, in whole or in part and directly or indirectly, Ireland’s transition to a low-carbon, climate-resilient and environmentally sustainable economy (OECD, 2021[4]). Such undertakings can improve governments’ understanding of the short- and long-term implications of budgetary decisions on climate and other environmental outcomes.
Spending reviews are widely used as a budgeting tool in OECD member countries to improve spending efficiency and reprioritise expenditures to align them better with government policy and fiscal objectives (OECD, 2019[5]). Since direct budgetary transfers and tax expenditures in support of fossil fuels result in forgone revenue, they might be evaluated as part of a country’s spending review. The Netherlands’ use of spending reviews to effect important reforms can be viewed as good practice (Box 1). The scope, frequency and evaluation methods of spending reviews vary from one country to another. Some countries undertake annual reviews of spending programmes in a specific policy area, such as Denmark, Ireland and the Netherlands (Elgouacem and Journeay-Kaler, 2020[6]). Others carry out comprehensive policy reviews every few years, such as the United Kingdom and, again, Ireland. As fossil-fuel support is delivered through different policy instruments (i.e. both through – tax and non-tax measures – and with different policy objectives in mind, single reviews are less likely to result in a comprehensive evaluation of support than broader policy review mechanisms.
Periodic evaluation has proven to be an important driver for policy reform in the Netherlands. As the budgetary process requires government spending schemes to be evaluated every four to seven years, ministries have the opportunity to review policies and reform those they deem no longer effective or relevant. Evaluations can be carried out for specific policy areas, through an impact assessment of an individual measure or a cost-benefit analysis.
In addition to policy reviews of individual schemes, the government carries out interdepartmental policy reviews (interdepartementale beleidsonderzoeken or IBOs). IBOs are forward-looking as they identify options for policy adjustments and, unlike the targeted policy reviews, they are not confined to a specific policy area as defined in the budget law. This allows them to address broader social problems. Some ministries can choose to combine an IBO with a policy review, in which case both backward-looking and forward-looking evaluations are undertaken.
An OECD/IEA review of efforts to phase out and rationalise support for fossil fuels in the Netherlands, presented to the Dutch parliament in September 2020, found that policy reviews had resulted in the elimination of several measures providing preferential tax treatment to specific fossil fuels or end users. The measures had been found to be ineffective in reaching their policy objectives (Elgouacem and Journeay-Kaler, 2020[6]). Nevertheless, the review recommended that the government consider broadening the scope of tax and non-tax measures addressed in policy reviews, to help the country achieve its climate targets. For example, it suggests that the government consider expanding the scope of a planned 2020 evaluation of energy taxation to cover “all those support measures that confer a benefit to the use and production of fossil fuels”, to provide a more complete and informed view of the situation. The initial scope of the evaluation excluded several measures related to the upstream oil and gas sector – in some instances because they were subject to review in separate evaluation rounds – including measures falling under the purview of the EU Energy Taxation Directive, tax expenditures related to fuel excise duties, and compensation to certain companies for the indirect costs arising from the EU Emissions Trading System.
Reporting individual support programmes and their associated fiscal costs is a crucial first step towards reforming support for fossil fuels. Government policies can benefit fossil fuels through four different transfer mechanisms:
3. Induced transfers (e.g. through market price support that results in observed domestic energy prices lower than international reference prices);
These policies can target different parts of the fossil-fuel supply value chain, changing the cost structure for producers and the price for end users.
The OECD Inventory approach provides an organising framework for tracking a wide and comprehensive range of government support for fossil fuels.2 In the Inventory, individual government policies are classified not only by how public resources are transferred to their beneficiaries but also by the formal incidence of the measures along the fossil-fuel value chain, i.e. whether they benefit producer output returns, enterprise income, cost of intermediate inputs, factors of production, or final consumer prices and incomes (OECD, 2015[7]).3 International efforts to develop a methodology to help track the SDG indicator for phasing out inefficient fossil-fuel subsidies (SDG 12.c.1.) have adopted the OECD Inventory approach to estimating support for fossil fuels (UN Environment, OECD and IISD, 2019[8]).
The key to building an inventory of support measures is to start by creating a comprehensive list of government policies and programmes that could be providing preferential treatment or benefits to fossil-fuel consumers and producers using a transfer mechanism taxonomy. The OECD Inventory represents an excellent resource in this respect for the 50 economies it covers. The inventory can then be populated with the corresponding estimates using readily available information and internationally established methods. Where no budgetary estimates are available for measures, reporting is still beneficial as it enhances transparency on government policies and can serve as a basis for future improvements.
The most straightforward government programmes to identify are direct spending programmes. These are well documented, revised on a budget cycle, and subject to legislative and executive branch scrutiny. Tax expenditures, however, are underreported in many jurisdictions. Only 26 of the 44 OECD and G20 economies included in the OECD Inventory produce tax expenditure reports that record the revenue forgone from providing tax benefits. In addition, the scope of what constitutes a tax expenditure can be substantially different from one jurisdiction to another. Tax expenditures are not subjected to regular evaluation procedures and therefore they remain opaque; this is a main reason explaining the lack of estimates of tax expenditures, in contrast with budgetary programmes.
Nevertheless, tax expenditures as well as direct spending programmes are the more readily identifiable forms of government support for fossil fuels in OECD and G20 economies and thus should be a priority in the reform process.4 The OECD Inventory focuses on government support provided through these mechanisms because data for other forms of support are generally much more difficult to obtain or technically arduous to calculate (see below).An inventory of budgetary transfers and tax expenditures, as the first building blocks towards mapping the policy landscape of support, helps to understand how governments use fiscal instruments to implement energy, social and economic development policies.
2.3.1. Estimating the cost of direct spending and tax expenditures
The level of difficulty in measuring government support varies across the different transfer mechanisms. It ranges from the ease of quantifying the cost of direct spending programmes, to the estimation of induced transfers due to government regulation and the revenue forgone from providing tax benefits, to quantifying the support element of transferring risk to the government through concessional finance or loan guarantees. The estimation of support measures other than direct spending hinges on measuring the difference between applied tax rates, regulated price, interest rate and realised equity return, and their reference counterparts. Among the OECD and G20 economies whose tax expenditures are reported in the Inventory, a third do not have estimates for the incurred revenue forgone.
Estimating the cost to government of preferential loans and loan guarantees is particularly complex.5 Government support through the financial system remains underreported despite its scale and its potential for affecting the allocation of capital across sectors and technologies. Tracking the value of potential support associated with concessional loans or risk transfers comes with much more demanding data requirements, as they need to be measured at the project level. For example, there exists no official government reporting of concessional loans and below-market equity to fossil-fuel related projects, with the exception of the OECD Development Assistance Committee (DAC)-reported grant equivalent of overseas development assistance (ODA) flows (OECD, 2021[9]). (OECD, 2018[10]) proposes a method to overcome methodological difficulties and quantify the support element of government credit assistance, but the Inventory does not yet cover this type of support.
Given that they do not encompass financial support estimates, the USD 178 billion value of the more than 1 300 individual direct transfers, induced transfers and tax expenditures documented in the 2020 OECD Inventory, as well as the more global OECD-IEA estimate of government support for the production and consumption of fossil fuels discussed in Chapter 2 (USD 478 billion in 2019), should therefore be understood as lower-bound estimates.6
2.3.2. Understanding the rationale for government support measures
It is not enough to estimate the fiscal cost a government incurs through a support measure. Part of the stock-taking exercise is also to understand the objective of each measure and its intended beneficiaries. Such information is important to help assess the relevance of the measure and to identify alternative measures that could meet the same policy objectives in a more efficient, equitable and environment-friendly manner. Unlike direct budgetary transfers for which evaluation processes exist on a periodic basis to inform the effectiveness of different spending programmes in reaching their goals and beneficiaries, tax expenditures often go unassessed, with minimal to no adjustments to their original provisions during their lifetime.
The economic rationale for government intervention is often to correct for market failures, such as imperfect competition, public goods, externalities, incomplete markets or informational asymmetries. Additional arguments are made for government intervention particularly when market outcomes do not deliver socially equitable income distribution, even if Pareto efficient (i.e. resulting in optimal overall welfare). Therefore, it is important to identify which market failure or distributional motivations are behind support measures and consider alternatives that are more cost-effective and efficient in addressing these objectives.
Countries can engage in a self-review or peer-review process to identify, quantify and evaluate their support measures for fossil fuels. Several countries have pursued peer reviews under the auspices of the G20 and APEC as part of their commitment to phase out inefficient fossil-fuel subsidies that encourage wasteful consumption; the Netherlands recently completed a “G20-style” peer review (see Chapter 1). These peer reviews culminate in reports by a reviewing panel comprised of representatives from different countries, international organisations and non-governmental organisations. Peer reviews discuss the energy, economic and overall policy environment in the country, enumerate support measures, their objectives and their effectiveness, and propose reforms.
A review and inventory of government support measures for fossil fuels are useful starting points for analysing their economic, environmental and distributional implications, and alternative policies that could deliver the same policy outcomes. Identifying measures with the biggest effects on economic decision-making and environmental performance can orient reform efforts to prioritise the most economically and environmentally distortive measures. The following sections propose analytical frameworks to examine how government interventions affect different segments of the fossil-fuel value chain: from the upstream and midstream sectors (exploration and development, production, processing, refining and transportation) to industrial, commercial, transport and residential end users.
By changing the cost structure for upstream investments, lowering input costs for consuming industries and distorting relative prices for other end users, support for fossil fuels induces behavioural responses that modify economic, social, and environmental outcomes. Producer support measures encourage excessive development of resources and shore up carbon-intensive production processes. This locks in CO2-intensive capital in sectors that might otherwise make different choices with a view to long-term competitiveness, and slows the uptake of less carbon-intensive technologies. Support to end users often leads to wasteful consumption since it brings end-user energy prices below cost recovery or market prices, or confers preferential treatment to a select group, with the lower prices sometimes extending outside their intended target beneficiaries. As a result, support for fossil fuels facilitates lock-in of emissions-intensive infrastructure and slows down the transition towards a greener economy. Distortions are defined in this chapter as economic or environmental outcomes that result from government support and deviate from a benchmark case with no support instruments. Decisions that are influenced by government policies targeting fossil fuels in the upstream and downstream sectors are examined first, followed by a discussion of distortions emanating from household behavioural responses.
2.4.1. Evaluating support to the upstream fossil-fuel sector: effective tax rate analysis
Countries use several forms of government support, including tax incentives, concessional finance or direct budgetary transfers, to attract domestic and foreign investment. Investments in the fossil-fuel extractive sector can be important drivers for economic growth but are generally inconsistent with countries’ commitments to reduce carbon emissions to net zero by 2050. Government support to the upstream fossil-fuel sector can erode a government’s ability to fund public services and investments of higher priority. As well as tilting the playing field towards fossil-fuel energy sources, support for fossil fuels can crowd out investments in other industries.
Thus far, policies to limit climate change and to rein in government expenditure on fossil fuels have generally focused on demand-side policy instruments that aim to reduce greenhouse gas emissions and fossil-fuel use. Little has been done to explore opportunities for supply-side policies, despite governments’ plans to change energy markets to integrate less emitting sources. However, the increasing number of economies committing to achieve net-zero emissions by 2050 including the European Union, France, Japan, Korea and the United Kingdom, will force further action in this area. Several experts, have called upon policy makers to consider policies that restrict fossil-fuel supply as part of climate change mitigation policy packages (Green and Denniss, 2018[11]) (Piggot et al., 2018[12]) (Faehn et al., 2017[13]). Several countries have committed to cut fossil-fuel supply by phasing out coal power generation (including the signatories to the Powering Past Coal Alliance), close uncompetitive coal mines (via the EU Council decision 2010/787/EU and Spain’s “Framework Plan for Coal Mines and Mining Communities 2013-2018”) and halt new exploration for oil and gas (including Costa Rica, Denmark and New Zealand, and Canada via its moratorium on Arctic oil and gas work). Carbon Tracker is leading a consortium to develop a Global Registry of Fossil Fuels intended to bring together standardised and government-vetted data on fossil-fuel reserves, licensed resources, and historical and projected production, to provide a baseline of fuels “known, estimated and planned for extraction” and enable assessment of related lock-in of emissions (Herr, 2020[14]).
This section provides a method for quantifying the influence of tax incentives and support measures on investment decisions in the upstream fossil-fuel sector compared with a reference benchmark fiscal system, i.e. that applied to the broader economy not benefitting from preferential tax treatment (Box 2). Given the diversity in fiscal measures (including tax incentives and other support measures) used to raise revenue from the sector (Elgouacem et al., 2020[15]), a synthetic indicator is proposed, via analysis of effective tax rates (ETRs), which allows for comparison across different fiscal regimes in an international context. ETRs differ from statutory tax rates depending on the access firms have to various forms of preferential tax treatment. Larger gaps between effective and benchmark tax rates are a measure of distortion in the sense that uniform treatment under the benchmark system would be more efficient.
For producers of fossil fuels, the user cost of capital plays an important role in allocating their investments for exploration, development and production. It represents the marginal product of capital (or return) that a firm needs to earn to pay the return required by investors and the marginal tax on its income, and to offset depreciated capital. Analysing how the user cost of capital is affected by changes in a fiscal regime enables inference of the degree of distortiveness of fossil-fuel support. Building on the concept of user cost, the effective marginal tax rate (EMTR) exposes the extent to which a fiscal regime affects firms’ user cost and therefore investment and production incentives. It represents the wedge between the pre-tax return and the post-tax return of capital as a share of the pre-tax return.
The EMTR can be used to study how fiscal regimes affect investments at the margin – investments for which the return on capital is just sufficient to cover economic cost of investment. Therefore, this indicator reveals the effect of the fiscal regime on investments related to projects that are already in place, rather than investment in new projects.
The choice of a benchmark fiscal regime is essential for the evaluation of different government spending programmes. The benchmark is a fiscal regime against which to measure behavioural responses of producers to different government incentives.
From an economic efficiency perspective, a neutral fiscal regime – whereby investment decisions at the margin are not impacted by the prevailing fiscal regime – represents a useful benchmark. Under such a system, oil and gas producers are liable for taxes, a combination of corporate income tax (CIT) and a resource rent tax (RRT), levied on their net profits. For such a system to be neutral, this RRT is only levied once a project has recovered all its exploration and development expenditures and reached a minimum rate of return. At that point, the project pays a high marginal tax rate.
A neutral benchmark fiscal regime is considered to be symmetrical, i.e. its marginal tax rate on income is the same as its marginal tax reduction rate on all costs related to the different phases of production in the oil and gas sector. (Daubanes and Andrade de Sá, 2014[16]) and (Gaudet and Lasserre, 2015[17]) lay out the conditions under which an RRT is neutral vis-à-vis the firm’s investment decisions. The economic efficiency of this profit-based tax might be compromised if the government, as the resource owner, has the objective of raising the requisite revenue to ensure that it is compensated for the opportunity cost it incurs from extracting an exhaustible resource. (Conrad, Hool and Nekipelov, 2018[18]) underline this divergence in incentives between the producer and the resource owner and propose that a royalty could capture the scarcity value of the resource.
The opportunity cost of depleting an exhaustible resource cannot be ignored when constructing a benchmark system as it characterises the economic trade-offs facing this sector and the welfare implications for intergenerational equity. It is therefore useful to show whether the government, as the resource owner, recovers the asset value of the in situ resource through its tax system to ensure that future generations are taken into account. In the same spirit, the opportunity cost of the environmental implications of production can also be integrated into a benchmark fiscal regime, to reflect the constraints facing producers.
An alternative and widely used approach to designate a benchmark fiscal regime is to take the prevailing corporate tax system as the benchmark against which to compare the fiscal regime applied to the fossil-fuel sector. Such a benchmark abstracts from the economic efficiency discussion of the fiscal system and focuses on the preferential tax system applied to the sector using the country-specific baseline.
EMTRs can account for most of the incentives granted to corporations, including those in the upstream fossil-fuel sectors. (McKenzie and Mintz, 2011[19]), for example, apply the method to measure the extent to which the fiscal regime encourages investments in Canada’s upstream sector at the provincial level and find that on aggregate, oil and gas production in Canada is still discouraged by the overall fiscal regime (positive EMTR). But they find that exploration and development are benefiting from a negative EMTR, and that the fiscal regime provides more benefits than levies taxes on these activities. Their paper falls short of showing how the aggregate EMTR for the oil and gas industry in Canada compares with the EMTR in other sectors, to ascertain whether the prevailing fiscal regime for oil and gas confers a preference for investment in this sector relative to other sectors.
When measured against a benchmark fiscal system – or EMTRs facing other sectors – the EMTR can be used to quantify the magnitude of the distortion emanating from a specific fiscal design relative to others. One study, using available data in the United States on the cost of debt and equity financing, shows that it is straightforward to derive the cost of finance, (i.e. the required return for investors) for different sectors. Taking a ratio of the pre-tax and after-tax cost of finance only (a component of the user cost of capital) for each sector shows that different fiscal industries, through their choice of the mix of equity and debt financing, have substantially different tax costs of finance (Figure 2.1). Although it is not clear from this exercise why those industries have adopted different finance mixes, the result is that the tax cost of financing investment in oil and gas production and exploration is among the lowest in the sample of sectors.
EMTRs can also be used for cross-country comparison to identify fiscal regimes that favour more than others the expansion of the extractive industry, circumventing some of the challenges associated with cross-country comparisons based on tax expenditure estimates. However, as noted above, EMTRs are limited to marginal investment decisions and are indicators of the scale of an investment; they are not indicators of the impact of taxation on the discrete choice of where to locate a new investment.
Another ETR indicator that can be used to complement the information delivered by a marginal analysis – or as a stand-alone indicator – is the effective average tax rate (EATR). Unlike the EMTR, the EATR is concerned with discrete investment decisions about where to locate project development. It uses cash flow analysis to shed light on whether the tax system encourages new investment to occur in the first place, i.e. at the extensive margin. More specifically, the EATR relies on a project-level internal rate of return, which ensures that the project is viable over the course of its lifespan. It is expressed as a share of the project’s economic profits and gives the percentage of economic profit that is taxed away (Dressler, Hanappi and van Dender, 2018[20]).
The EATR indicates how a fiscal regime can facilitate investment in new fossil-fuel projects, but it requires assumptions about the level of profitability that is representative of the industry. Because such assumptions can differ dramatically from one oil field or coal mining project to another, the EMTR, which only requires measuring the user cost of capital, might be less sensitive to such specifications. The EATR, on the other hand, has the potential to better reflect investment decisions in the resource sector because it summarises tax incentives for investments that earn an economic profit, or a return that is greater than the normal return required on a marginal investment.
The OECD uses fiscal models to calculate economic indicators such as EATR and EMTR. Building on OECD efforts in documenting and modelling economy-wide corporate effective tax rates, effective tax rates in the electricity sector and R&D tax subsidies, there is scope to expand these models to account for specificities of fossil-fuel extractive industries.7 Also, the International Monetary Fund provides an open-source tool, the Fiscal Analysis of Resource Industries (FARI) model, to generate EATR and EMTR as well as other outcomes such as government revenue raised under different fiscal regimes. These OECD and IMF tools remain partial, however, as they take production and investment paths as exogenous parameters.
2.4.2. Other tools available to evaluate distortiveness in the upstream sector
Modelling production of oil and gas, using an optimal extraction model such as the one developed by (Anderson, Kellogg and Salant, 2018[21]), can be highly complementary. Optimal extraction models can provide a more comprehensive evaluation of the distortiveness of different fossil-fuel fiscal regimes as they can quantify production volumes. For example, (Daubanes and Andrade de Sá, 2014[16]) and (Gaudet and Lasserre, 2015[17]) study the impact of different tax provisions on exploration and extraction outcomes, though not quantitatively. (Anderson, Kellogg and Salant, 2018[21]) model the drilling decisions of firms and under simplifying assumptions, as in (Metcalf, 2018[22]), it is possible to analytically derive the additional drilling activity and production induced by preferential tax treatment.
The impact of fiscal regimes on trade can be inferred. For instance (Metcalf, 2018[22]) constructs a simple model of an oil and of a gas market and calibrates it to reproduce a future global oil price provided by different forecast scenarios. The study draws on the literature of supply and demand elasticities to provide a back-of-the-envelope calculation of the impact of tax preferences on macroeconomic outcomes such as global prices, domestic and international supply, and domestic demand. As for the environmental implications of such incentives, the resulting excess production can be converted into CO2-equivalent quantities and the associated welfare loss can be derived using the social cost of these emissions.
2.4.3. Evaluating distortions from fossil-fuel support for industrial end-user sectors
A focus on firms’ decisions in response to government support measures allows analysis of one of the more relevant concerns for OECD and G20 countries over reform of support for fossil fuels: the potentially deleterious consequences of reform on domestic energy-using industries. Tax expenditures on energy used by industries are the main support instrument that directly affects their use of fossil fuels. Economic theory can help guide discussion on how support for fossil fuels causes distortions in the investment, production and consumption decisions of industrial firms.
As with the method proposed for the upstream sector, distortions generated by support measures for fossil-fuel users can be captured by evaluating how fiscal regimes might reduce the user cost of capital in a given sector. An ETR for end-user industries indicates the extent to which support creates incentives for investment in fossil-fuel consuming industries through preferential tax treatment of their energy inputs. Industry-country specific ETRs can also point to industries that benefit the most from government support and thus reveal the potential impacts of reform across sectors. The OECD’s Taxing Energy Use (TEU) and Effective Carbon Rates (ECR) databases provide effective tax rates for energy use, including for industrial users (OECD, 2019[23]; OECD, 2018[24]). Data therein show that 76.5% of emissions are priced below EUR 30/tCO2, with at least 80% of industrial emissions completely unpriced (OECD, 2018[24]).8 The integration of information on tax expenditures for energy inputs could strengthen the capacity of the TEU and ECR databases to inform on capital-related distortions created by the fiscal regime (Hanappi, 2018[25]).
Another approach to measuring the direct impact of fossil-fuel support on resource allocation for end users is through modelling behavioural responses of end-user industries to government support measures. Given the prevalence among OECD member countries of tax expenditures for energy-intensive industries, a modelling framework similar to that used in (Fullerton and Heutel, 2007[26])and (Heutel and Kelly, 2016[27]) would be suitable to derive and analyse the effect of different types of support measures commonly used to benefit downstream industries. This type of framework provides analytical expressions for the impact of distortionary support measures on output and the allocation of factors of production across two sectors: an energy-intensive sector and a non-energy-intensive one.
The model is in a closed-economy setting but can be extended to take into account trade effects. In the model, the energy-intensive sector is one that uses energy as a factor of production in addition to labour and capital; the second sector employs only non-energy factors of production. The model is flexible enough to evaluate the role of different support mechanisms benefiting end-user industries, a fossil-fuel excise tax reduction being one of them. Additionally, results from such a model enable estimation of the environmental implications of government support through a conversion of energy-use into burnable emissions.
Countries that provide tax expenditures on energy products for their industrial sectors often claim that these measures are necessary to maintain their domestic industries’ international competitiveness and prevent relocation of polluting industries to less environmentally stringent countries. Several empirical studies on differential energy price impacts on firms’ performance find that this impact is smaller than others.9 Modelling behavioural responses of end-user industries could complement insights from these empirical studies to further reveal the impact of tax expenditures and other transfers on end-user industries performance.
Another advantage to using the modelling framework proposed in (Fullerton and Heutel, 2007[26]) and (Heutel and Kelly, 2016[27]) is that the functional form of supply and demand equations need not be specified, and the data needed to calculate the impact of tax reductions on production decisions are available. Energy, capital and labour use at the sector level are available for OECD and some partner economies. Factor shares and factor expenditure shares in total sector income can also be measured. Elasticities of substitution between inputs and outputs can be informed by the vast literature dedicated to their estimation.
There are limitations, however, to the use of the proposed modelling framework. Since its equilibrium outcomes are derived from a linearised approximation of the underlying model, it is only considered robust enough for measuring small changes in tax rates, up to 10%. It is also too simple to derive precise point estimates for effects, although it can provide a robust indication of the direction of the impacts.
2.4.4. Evaluating distortions resulting from fossil-fuel support to end-use consumption outside the industrial sector (residential, transportation, commercial)
Underpricing fossil-fuel products relative to market prices or cost recovery by regulating domestic prices or reducing tax rates, and hence end-user prices, increases consumption of fuels relative to an efficient pricing counterpart. (Coady et al., 2017[28]) provide analysis on the fiscal, welfare and environmental distortions caused by underpricing fossil fuels. Their analysis uses a stylised long-run comparative static framework to provide insights on the potential gains from correcting the underpricing of fossil fuels, to reflect the social cost of carbon.10 Similarly, (Davis, 2014[29]) and (Davis, 2017[30]) measure the effect of underpricing road fuels on consumption and the resulting costs to society, or “deadweight loss”, by taking into account the private cost of fossil fuels (as set by international markets or cost recovery), the cost of externalities, end-user prices, and demand and supply elasticities. (Jacobsen et al., 2016[31]) offer another way to measure the deadweight loss of second-best energy policies (i.e. opposed to direct pricing of carbon) for internalising the external costs. Their proposed method demonstrates that regression results of the externality on the policy instrument can have welfare implications provided that certain conditions are met. Rather than relying on demand or supply elasticity estimates, this method requires data on the distribution of the externality (e.g. carbon emissions) and the policy instrument used (e.g. effective energy prices).
2.4.5. Evaluating the incidence of fossil-fuel support
It is not always straightforward to ascertain the incidence of government support measures because those who are directly targeted or eligible for support are not necessarily those who benefit from it; the statutory incidence and the economic incidence of support are not always the same. Fossil-fuel taxes are important fiscal instruments deployed to raise revenues and to internalise negative externalities associated with the use of fossil fuels. The price pass-through of such instruments is highly dependent on the market structure and its price-setting behaviour. When the market is competitive, firms shift the burden of energy taxes completely onto consumers; in imperfectly competitive settings, the pass-through of price changes to consumers can be more or less proportional to the changes in tax rates (Fullerton and Metcalf, 2002[32]) and (Flues and Thomas, 2015[33]).
At the same time, tax expenditures that reduce the prevailing statutory tax rate on energy products for some consumer classes, such as agricultural and manufacturing sectors, are pervasive among OECD and G20 countries. It is important to understand the implications of these tax expenditures for household income and consumption to gauge the extent to which the benefits are passed on to consumers, including across income-levels, and potential equity issues. Micro-simulation models that use household surveys with data on income and expenditure are specifically designed to study such questions.
In emerging and less developed countries, consumer price support is a policy tool that has been used, among other objectives, to extend energy access and affordability as well as alleviate poverty, particularly in resource-rich countries. Several country studies have shown that the underpricing of energy products disproportionally benefits richer households (Arze del Granado, Coady and Gillingham, 2012[34]) and (Lustig et al., 2013[35]). Tools to analyse the distribution of such support across income groups are widely available within the OECD and externally; Commitment to Equity (CEQ) Institute and the IMF, among other entities, have built publicly accessible toolkits to this end.
2.4.6. Prioritising fossil-fuel support measures for reform
This last step towards assessing the distortiveness of support measures for fossil fuels is to develop indicators on different outcomes – ETRs, production, investment, consumption, environmental and welfare – that capture the impact of one measure versus another. The analytical tools discussed above indicate that a cost-effective way to ascertain distortions is to measure the support measures against the reference fiscal regime. The ratios between the reference case and the case with a given support policy can be used to rank support measures along different dimensions.
In the case of ETR analysis, the difference between the ETRs delivered through a chosen reference fiscal regime can be used as the baseline to gauge the effects of different tax provisions on the allocation of capital across sectors. The EMTR differential between the oil and gas sector and the reference fiscal system, for example, reveals the relative treatment of the concerned industries and thus the relative incentives offered for incremental investments. Differences in EATRs between the reference case and the tax regime that includes a support measure would indicate the relative incentives delivered to new investments (i.e. at the extensive margin). Investment distortions can be analysed with reference to several dimensions: timing, asset types, jurisdictions, and sectors (Mckenzie, 2016[36]). The effective tax analysis, while comprehensive in terms of the tax provisions it can assess, stops short of delivering insights on the relative impact of different support measures on other behavioural outcomes of interest.
Partial equilibrium models by (Anderson, Kellogg and Salant, 2018[21]) and general equilibrium models by (Heutel and Kelly, 2016[27]) are examples of analytical frameworks that can shed light on how different support policies deliver different production, investment and consumption outcomes, and environmental and welfare implications compared with a reference fiscal regime. Eventually, the different policies can be ranked according to their impact along these different dimensions. Policies that create the largest deviations from a reference fiscal regime could be put forward for reform.
The analytical frameworks described above are useful for identifying the most distortive measures that can be considered good candidates for reform. However, they provide a limited assessment of the consequences of reform. By not taking into account the forward and backward linkages between upstream fossil-fuel producers and downstream industrial consumers and other end users (e.g. transport and residential users), they reveal little about the implications of reforms.
The phasing out of fossil-fuel support may have some unwanted economic and social effects that could hamper the political acceptance of reform and jeopardise reform processes. These possible effects should be anticipated by assessing the distributional consequences of reform and likely implications for the performance of firms and industries of increasing energy and capital costs. The analytical tools discussed in this section can shed light on possible impacts of reforms and help identify potential winners and losers.
Adverse effects of reforming fossil-fuel support can be direct or indirect. Direct effects result from behavioural responses of individuals and firms targeted by the specific government support. Indirect effects result from price changes for inputs and outputs throughout the fossil-fuel value chain that shift consumption and production patterns and can induce macroeconomic and trade effects. Two approaches are widely used to evaluate the impacts of reforms: empirical and modelling-based methods.
2.5.1. Econometric studies using micro-data
Econometric studies that examine distributional consequences of policies provide precise information on the effect of reform on consumption demand – or more generally their welfare implications – by studying the erosion of household income or firm competitiveness. They often rely on surveys with highly detailed data, at the firm or the household level, on expenditures and incomes. Econometric studies using household or firm surveys can provide important information on the groups affected by the phasing out of fossil-fuel support and the magnitude of this impact. The micro-data provided by the survey allows for precise assessment of distributional effects of reforms, including effects on poverty or inequality. Survey-based tools may also prove useful to simulate alternative compensation measures accompanying reform (an increase of means-tested benefits, for instance).
The OECD has used household budget surveys to investigate effects of energy tax reform across different income and demographic groups (Flues and Thomas, 2015[33]). Other institutions have also developed open-source modules to help policy makers understand the distributional impacts of reforms based on household surveys. The IMF developed a tool for analysing the distributional impacts of fuel subsidy reforms emanating from both direct and indirect effects of price changes on household income (Fabrizio, Goumilevski and Kpodar, 2016[37]). The Commitment to Equity (CEQ) Institute developed a framework to analyse the incidence of taxes and benefits and applied it to a range of low- to medium-income countries (e.g. (Enami and Lustig, 2018[38])).11
However, survey-based studies suffer from limitations. Their coverage is restricted to a country, region or sector, which weakens the general validity of their conclusions. They cannot account for spillover effects that fall outside the scope of the analysis and may not allow for dynamic responses to an initial policy change, as they often provide only short-term information on the incidence of reforms and do not capture behavioural responses.
2.5.2. Structural and computable general equilibrium models
Structural models provide additional insight into the possible impacts of reforms since their outputs are more complete and they can enable dynamic and long-term predictions of responses to initial policy shocks. These models, which posit a partial assessment (sectoral) or a general equilibrium assessment (at the country or global level), simulate the reform considering a set of equations defining the relationships between economic agents, and compare the results thus obtained to a business-as-usual scenario. Sectoral models are useful to precisely assess impacts for the energy sector or other specific industries, though computable general equilibrium (CGE) models are usually favoured at the country or global level, as they provide more complete information on macroeconomic variables and greenhouse gas emissions. CGE models can be dynamic and introduce markets’ responses to a policy reform and transition, and structural changes for the medium and long term. They are also modular and can be extended to account for more indirect and feedback effects of households on upstream sectors.
The OECD uses CGE models tailored to specific policy areas that can be used to study potential adverse impacts of fossil-fuel support reform processes. The OECD ENV-Linkages CGE model is used to study climate change mitigation policy; the OECD Trade model METRO (ModElling TRade at the OECD) has been developed to explore the economic impact of changes on policy, technology and other factors. The ENV-Linkages model was used to examine the macroeconomic, environmental and distribution consequences of energy subsidy reforms applied to Indonesia (Durand-Lasserve et al., 2015[39]). The model was extended to account for households’ income distribution since its generic form limits the analysis to a single representative household type. By accommodating household heterogeneity, the CGE model delivers insights on how the effects are felt by different groups in the population. In the same vein, the METRO model is undergoing an extension to accommodate distributional effects by mapping the information from household budget surveys to the model’s structure (OECD, 2021[40]).
Several universities and research institutions have energy-specific models, such as the University College London Energy Institute’s suite of energy models, ranging from a bottom-up model, BUEGO, which captures project-level oil and gas extraction information, to an integrated assessment model, TIAM-UCL-IAM, which aims to capture the complexity of the climate system (UCL, 2021[41]).
The main modelling tools used to evaluate the effects of reforming fossil-fuel support can provide much information (Table 2.2). They still have shortcomings, however. They are data and resource-intensive and often rely on fixed parameters (for instance, the proportion of income saved by households), which may change over time. These parameters are often determined by empirical studies, the results of which may be hard to extrapolate. Computing capabilities also limit the extent to which particular industries and countries (or regions) can be singled out, thus narrowing the range of questions that models can address. As a consequence, structural models should not be considered as precisely predictive, but as a tool to anticipate likely effects. They can also be complemented with insights from survey-based analysis.
Since fossil-fuel support programmes are diffused throughout the economy, affecting economic, social and environmental outcomes, their reform should be accompanied by alternative measures that not only alleviate any negative effects of reforms, but also channel the resulting fiscal savings to more productive uses. In that sense, an inclusive fossil-fuel support reform necessitates a whole-economy approach and should be pursued as part of broader energy transition agendas that have at their heart the aim of protecting vulnerable populations from harm.
Given the diversity of countries providing support for fossil fuels, country-specific reform packages, including alternative policy measures, should be designed to ensure a low-emissions energy transition that enables economic growth and social inclusion. Fossil-fuel capital assets and reserves run the highest risk of becoming stranded as governments put mitigating and adapting to climate change at the forefront of their policy agendas. Transition programmes for concerned sectors, as in the case of coal, should be anticipated, especially as pressure mounts for countries to phase out coal-fired power plants.
An organising concept used in economics to evaluate alternative policy options is the criterion of Pareto or near-Pareto improvements, whereby policy reform increases welfare compared with a situation without reform. Despite the considerable scope for reducing distortions from fossil-fuel support, there can be trade-offs between economically efficient policies, “equitable” income distribution and better environmental outcomes. When existing policies are poorly designed, their reform can worsen both efficiency and distributional outcomes. In other cases, the prospect of reform can pose difficult political choices. Therefore, designing alternative policies requires a balancing act among these different goals. Clearly stated policy objectives, which harness synergies among seemingly disparate policy areas, can facilitate designing a Pareto-improving reform agenda.
Insights from empirical and simulation work into the distributional effects of reforms across households and firms will help identify the groups that would be most affected by reform and alternative strategies to alleviate adverse effects. OECD work and the broader literature have shown that economic and distributional improvements, as well as emissions reductions, tend to result from better-targeted fuel subsidies or means-tested cash transfers rather than from broader consumer price support, i.e. government regulation that lowers domestic prices relative to market prices. The OECD’s Going for Growth work stream, which looks at structural reforms in policy areas identified as priorities to boost income, inclusiveness and sustainability in OECD and selected partner economies, identifies reform priorities for each country addressed. It does so in an integrated way, so as to provide reform packages that account for the synergies and trade-offs among policies to mitigate adverse effects (OECD, 2019[42]). For example, in the case of reforming fossil-fuel support, a combination of increasing energy taxes on firms and lowering labour costs has been identified as an alternative measure to reduce the “deadweight loss” from support, while mitigating the impact of higher energy-input costs. For countries and regions dependent on the revenues from fossil-fuel resources, opportunities for economic development outside the sector should be part and parcel of a reform programme, particularly as unsubsidised coal becomes an unviable source of energy (Morris, Kaufman and Doshi, 2019[43]).
Reform of support for fossil fuels is often identified as a priority for a country’s fiscal consolidation efforts and for climate action to align financial flows with low-carbon pathways. Implementation remains elusive for many countries, however, as they face seemingly irreconcilable policy agendas of economic growth and sustainability, coupled with potential political backlash against austerity and rising costs. The COVID-19 crisis and resulting recession present an opportunity to reform support for fossil fuels as part of efforts to alleviate mounting fiscal pressure and achieve a more efficient and sustainable path as part of economic recovery packages.
The sequential approach set out in this chapter provides analytical tools to underpin a well-informed reform process, including as part of COVID-19 recovery packages, drawing on the OECD’s longstanding experience in measuring support measures for fossil fuels. The Inventory sheds light on over 1 300 support measures for fossil fuels, often rooted in complex fiscal legislation. Deploying the tools highlighted in this chapter can help policy makers identify the most distorting government support measures and alternative or complementary policies that deliver desired objectives more efficiently and effectively. The OECD Secretariat stands ready to support countries interested in applying the sequential approach to obtain evidence-based recommendations for reform. In addition, the chapter has highlighted a number of information and analytical gaps along the different steps for reform, suggesting several areas for further work, including analysing effective tax rates and measuring the relative distortiveness of support measures.
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Notes
← 1. This chapter is adapted from a 2020 OECD Environment Working Paper by Assia Elgouacem. For further detail and technical discussion, see (Elgouacem, 2020[49]). The chapter focuses on G20 and OECD member countries, consistent with the bulk of the countries reflected in the OECD Inventory.
← 2. A comprehensive discussion of the taxonomy of support measures can be found in Chapter 2 of the OECD Companion to the Inventory of Support Measures for Fossil Fuels 2015 (OECD, 2015[44]).
← 3. Formal incidence (de jure incidence) is to be distinguished from economic incidence, which takes into account supply and demand elasticities and looks at de facto final beneficiaries of a measure, and is therefore much more difficult to establish. The OECD Inventory approach builds on the OECD’s PSE-CSE accounting framework for measuring support to particular industries, used to measure support for the agriculture sector since the mid-1980s and the fisheries sector since the late 1990s.
← 4. Depending on how transparent or systematic a country is in its budgetary reporting processes, many if not most induced transfers will be captured in direct budgetary transfer reporting.
← 5. See, for example, OECD work on aluminium sector subsidies (OECD, 2019[45]).
← 6. In addition, the combined OECD-IEA estimates do not include producer support estimates for largest fossil-fuel exporting developing countries, because the IEA price gap methodology that covers these countries does not pick up policies that support fossil-fuel production but do not directly impact on end-user prices. Further, governments are funnelling major additional resources to fossil-fuel industries as part of COVID-19 recovery packages, with preliminary estimates in the order of at least USD 235 billion.
← 7. (Hanappi, 2018[25]), (Dressler, Hanappi and van Dender, 2018[20]).
← 8. The EUR 30/tCO2 benchmark represents a conservative estimate of the social cost of carbon.
← 9. (Flues and Lutz, 2015[46]), (Garsous and Kozluk, 2017[47]), and (Dechezleprêtre, Nachtigall and Venmans, 2018[48]) are among studies tackling the issue of competitiveness and carbon leakage.
← 10. For the IMF, under-pricing of fossil fuels is measured relative to an efficient price level that comprises environmental and health externalities.
← 11. These tools have been mostly used to study the impacts of fuel price reforms on household incomes in developing countries.