Blog Post

The IMF Takes on Energy Subsidies

Apr 16, 2013 | Joel Darmstadter

It has long and widely been accepted that subsidies that promote the production and consumption of energy – thereby disguising its real cost to society – do little to benefit mankind. On the output side, second-guessing the market distorts firms’ decisions about optimal investment strategies. Among users, access to below-cost energy encourages waste, with environmental stress an added by-product. Even subsidies directed primarily to “clean” energy sources deserve to be carefully designed. Measures to enable, say, wind power to compete more effectively with coal-based electricity invite an outcome that is the worst of both worlds: coal combustion continues, even as wind power subsidies benefit developers while adding to budget woes.

The International Monetary Fund (IMF) has just released a report that presents an exhaustive account of worldwide energy subsidies. Although concern with energy may not immediately be associated with the Fund’s ongoing involvement in international monetary and fiscal-policy issues, it would be a mistake to view energy subsidies as extraneous to those traditional areas of responsibility. Thus, the extent to which energy subsidies can non-trivially warp the pursuit sound fiscal policy is just one useful insight to be drawn from this report.

The IMF’s estimate of global energy subsidies comes to an annual total of $1.9 trillion – hardly a negligible sum in the context of worldwide GDP of around $60 trillion. That figure is composed of two elements. The first is well grounded empirically and, for the most part, can be sharply defined. The IMF defines the subsidy for a commodity as the benchmark international price (adjusted for transport and distribution costs) minus the cost charged the energy consumer. The second category is well honed conceptually but less robust in its quantitative dimensions. It treats as a subsidy the estimated spillover costs (also called “negative externalities”) in both energy production and use that inflict damages on society.

The IMF reckons that, in aggregate, subsidies that underprice energy to users relative to market levels come to an annual global level of around $480 billion. As an iconic example, there’s the case of Venezuela where, most recently, the price per gallon of gasoline equaled about 10 cents (US). With a world gasoline price averaging around $2.75 per gallon (and three times as much in countries with high fuel taxes), it gives you a sense of how the Venezuelan government deprives its nation of about $2.50 a gallon in income that could be deployed to meet any number of social and infrastructural needs (including the long-neglected modernization of the oil industry itself); and it produces gridlock and pollution that tangibly compound the economic distress of a misguided pricing system. While such a manifest degree of subsidization is especially prevalent in oil-producing developing economies, the problem is more widespread. Consider India’s recurrent power blackouts where underpriced electricity robs investors and producers of the wherewithal and incentives to improve power generation and the grid.

The $480 billion ascribed to under-pricing is more solid than the estimate of implicit subsidies attributed to the exclusion, in energy prices, of various negative externalities associated with energy production and utilization. That second component of subsidies, estimated at $1.4 trillion, is based on a number of speculative and even heroic assumptions laid out in the body of the report and appendix materials.

In terms of energy categories, the comparison between subsidies from below-market pricing with those attributed to externalities is quite striking. For one thing, underpricing, as noted, is much more a feature of the developing world than of advanced countries. Externalities, on the other hand, are concentrated in advanced industrial countries. In terms of particular energy resources, coal is a relatively insignificant offender in the first category but, not surprisingly, a conspicuous contributor to the second category, as is clear from the accompanying table. (I should note that, in the case of electricity, externalities associated with fuel inputs, such as coal, are tabulated on lines for those fuels rather than electricity.)

Subsidies ascribed to:

Underpricing Externalities
Petroleum Products $212bn $667bn
Electricity $150bn $6bn
Natural Gas $112bn $187bn
Coal $6bn $533bn

Arguably, a precipitous removal of subsidies could invite political turmoil in a number of countries. Moreover, there are situations where equity demands attention to the regressive burden that some energy costs can impose on low-income households. But that ought not to feed a populist frenzy for cheap energy; more often than not, distributive justice is more effectively achieved through targeted income support than widespread subsidization of society at large. Indeed, the very proceeds (say, through oil royalty payments) to governments embracing sound energy and fiscal policies can finance such earmarked assistance to its needy citizens.

The IMF study is a an important wake-up call that the prevailing pattern and magnitude of energy subsidies is a major impediment to rational energy, environmental, and – not least – sound economic policy-making.