EIA calls for new approach: Throwing carbon prices into the mix to unveil fossil fuel subsidies

It is no secret that fossil fuel subsidies are seen as roadblocks in the transition to clean energy sources and many options have been presented in pursuit of their removal. In line with this, the International Energy Agency (IEA) has outlined a new price gap-plus approach that could bring carbon prices and environmental costs into the equation.

Previously, the IEA came up with a methodology known as a price gap approach where it established a market reference price and then compared it with the price paid by consumers. When the end-user price is lower than the reference price, it is counted as a subsidy. The results of the International Energy Agency’s most recent analysis show a startling rise in such subsidies in 2022.

However, this approach does not capture all the fossil fuel subsidies that are out there, as there may be government interventions that tip the playing field in favour of fossil fuels but that do not affect end-user prices and production subsidies are a case in point, which is why the IEA works closely with the OECD – which tracks other types of subsidies – to produce a broader joint assessment.

In its latest report, the IEA considers whether it might be possible to incorporate environmental aspects into the calculation of fossil fuel subsidies, as the price gap approach does not reflect the environmental costs of fossil fuels such as carbon prices. To this end, the report suggests a price gap-plus approach, which explores whether, and how, it might be possible to incorporate environmental aspects into the calculation of fossil fuel subsidies.

Furthermore, the analysis indicates that global fossil fuel subsidies for end-users reached more than $1 trillion  – by far the largest value that the IEA has ever seen – which is five times higher than in 2020, a year in which countries saved on subsidy outlays due to the historically low fuel prices during the pandemic.

The International Energy Agency points out that governments face conflicting priorities when it comes to energy prices, as they are keen to avoid or mitigate the effects of price shocks and volatility, as these can have damaging effects on economies, households and businesses, with the worst effects often concentrated among poorer and more vulnerable communities.

On the other hand, there is widespread recognition that prices should reflect not only market value but also the externalities associated with the underlying product, such as pollution and detrimental health impacts, thus, in the case of fossil fuels, this points towards introducing carbon pricing.

The IEA claims that such carbon prices are already implemented in a variety of ways with about 23 per cent of global emissions covered by carbon price schemes explicitly while countries impose general levies or specific charges on the use of fossil fuels. According to the IEA, these may not be directly linked to the carbon content of the fuels but instead encourage efficiency and fuel substitution in favour of less polluting sources of energy, thus, giving a push in the same direction as carbon prices.

“The conceptual idea behind a revised price gap-plus approach is to incorporate an allowance for carbon prices in the reference price, and therefore to apply a higher and more sustainable benchmark for global end-user prices,” explained the IEA.

As there are no internationally agreed disciplines regarding appropriate levels of energy taxation or carbon prices, which co-exist in practice with other energy taxes, the addition to the IEA’s reference price can be covered in practice by a variety of levies or charges that may or may not have an environmental purpose.

As for the level of carbon prices to apply, practice around the world offers a huge range with some 68 carbon pricing initiatives implemented in different countries with the price levels in these initiatives ranging from $1 to $130 per tonne of carbon dioxide (USD/t CO₂), and the median value is around $30 t CO₂. Many countries focus on a carbon price that is consistent with their emissions reduction goals.

Moreover, the IEA conducted an analysis of six countries that are the negotiating parties for a new international Agreement on Climate Change, Trade and Sustainability (ACCTS) – Norway, Iceland, New Zealand, Switzerland, Costa Rica and Fiji – taking two approaches to the level of carbon price examined. While the first distinguishes between different economic profiles, the second imposes a uniformly high level.

For the first, the IEA followed the tiered pricing in a recent International Monetary Fund study, which assumed a carbon price of $75 t CO₂ for advanced economies, $50 t CO₂ for high-income emerging economies (China, etc.) and $25 t CO₂ for low-income emerging economies. Therefore, a carbon price of $75 t CO₂ is assumed for Norway, Iceland, New Zealand and Switzerland in the first approach. For Costa Rica and Fiji, it is assumed to be $50 t CO₂. In the IEA’s second approach, a carbon price of $100 t CO₂ is uniformly applied to all six countries.

Based on the IEA’s findings, getting price signals right is “essential for clean energy transitions,” creating incentives to use polluting fuels efficiently, to switch to cleaner ones, and to invest in efficient and low-emissions technologies. In line with this, “governments need to harness these market signals effectively and supplement them with regulation and standards to enable more sustainable choices,” says the IEA.

The International Energy Agency’s analysis underscores that adding a carbon price to the reference price is more likely to reveal fossil fuel consumption subsidies, because the benchmark, that is the reference price, becomes higher with the addition of the carbon price, even though there are no agreed standards for carbon pricing. This issue becomes more sensitive during periods of high and volatile fuel prices, when governments opt to take actions to protect consumers.

While the analysis was conducted on fuel prices in 2021, the IEA believes that doing the same exercise for 2022 would reveal even more strains, especially if it encompassed natural gas markets where prices have been extremely high during the global energy crisis.