Beyond the Paris Agreement: 3 Economic Tools to Cut Global CO₂ Emissions
Ending subsidies on fossil fuels is all about incentives.
Humans love borders. Ever since the Treaty of Westphalia established our modern concept of sovereignty, we’ve collectively dismissed the idea of one world government. And in keeping with the human tendency for unnecessary escalation, we’ve taken that distaste a step further with conspiracy theories like the New World Order and Illuminati.
But the problem of climate change recognizes no borders, which puts the nations of the world in a bit of a pickle. How do we protect the most vital public good of all — Planet Earth — without traditional governance and enforcement? Fortunately, we are beginning to see a buildup of political will and sense of mutual accountability, as evidenced by the 2016 Paris Climate Agreement. Paris was the first time that every UN Member State agreed to an emissions reduction accord, and it’s a promising first step. Still, its enforcement potential is weak.
You may be surprised to learn that much of the world is still actively subsidizing the fossil fuel industry, including the United States. The International Monetary Fund puts that number at $5.2 trillion, or 6.5% of the global GDP. Instead of trying to mandate the removal of these subsidies, what if the UN created an incentive structure that favored reducing emissions? With the proper economic levers, traditional punitive measures may not be necessary.
Currently, political incentives align with bolstering petroleum, coal, and natural gas energy producers in developed and developing economies alike. These subsidies are deeply entrenched in political economies around the world, making them very difficult to undo. Despite the fact that the U.S. also subsidizes renewable energy, embedded in our tax code is continued support for fossil fuel production. In the United States, this is mostly due to the absence of campaign finance reform and a spread of disinformation that depresses constituent demand for clean energy (though it is rising!). Meanwhile, authoritarian regimes subsidize fuel to keep energy prices low enough to buoy the middle class, thus preventing popular uprising.
It’s important to define what it actually means to subsidize fossil fuels. Conventionally, energy subsidies are associated with “pre-tax” price supports. To put it simply, the government lowers the price of energy by paying suppliers to produce more. Because supply then exceeds demand, the price drops.
However, when the IMF and some environmental economists talk about fossil fuel subsidies, they are also referring to the failure to price fossil fuels at their true cost to society, or “post-tax” subsidies. In addition to the monetary cost of extracting fossil fuels and converting to usable power, their combustion has dire consequences for ecosystems, human health, infrastructure, food security, conflict stabilization, and more. The social cost of harmful greenhouse gas emissions is much higher than the actual price of fossil energy, so any governments that do not tax CO₂ are effectively subsidizing the industry.
There’s little argument for maintaining these subsidies from an economic perspective. Perhaps counterintuitively, they’re regressive policies. In 2013, the world’s wealthiest 20% of households captured 43% of fossil fuel subsidies’ energy savings, while the bottom quintile enjoyed only 8% of the benefits. Fossil fuel subsidies rarely stimulate job growth or lower fuel prices in any meaningful way, instead stifling economic competition and distorting price signals. They also exacerbate fuel price volatility by dampening demand response to price changes. Subsidizing fossil fuels rarely spurs the growth necessary to offset the cost of its inefficiency and, unlike renewable energy subsidies, they are not an investment in the future.
The solutions below address pre-tax subsidies — government expenditures that support the production or consumption of fossil fuels. Because there is such a wide range of fossil fuel subsidies (direct vs. indirect, production vs. consumption), it is difficult to measure the corresponding reduction in global carbon emissions. Some estimates put the global emissions reduction as high as 18% after the full elimination of pre-tax subsidies. One thing, however, is clear: subsidizing fossil fuels harms the planet, and we can do better than waiting around for government reforms.
1. Compensation: Subsidy Reduction Fund
The international community could set up “subsidy reduction funds” for eliminating oil or coal subsidies. This plan is loosely based on Australia’s Emissions Reduction Fund, which uses an auction mechanism where businesses propose emissions reduction schemes, and funding is allocated to the most cost-effective proposals.
A similar fund for global subsidy reduction, like the one proposed by Jakob and Hilaire, has one key difference. Rather than an international institution funding the program from its own coffers, it would compensate subsidy reduction using the projected savings of fuel importers. Governments are looking to minimize the burden of meeting their Paris Agreement commitments. Cutting fossil fuel subsidies is a relatively easy way to make progress on emissions reduction, but the perceived political benefits of doing so need to outweigh the costs.
Here’s how the subsidy reduction fund works:
- Countries A, B, C, D, and E, which are net fossil fuel exporters and heavy subsidizers, cut their oil or coal subsidies. Oh no! Producers are irate. Consumers in these countries worry about their electric bills.
- Oil and coal prices actually fall on the global market.* As consumers in Countries A–E see their energy prices rise in the absence of subsidies, they consume less fuel, and demand for fossil fuels falls substantially. This causes a temporary decrease in global fuel prices as supply remains constant. As a result, net importing countries F, G, H, I, and J begin saving on their fossil energy imports.
- Countries F–J want to earn easy credit toward their emissions reductions commitments under Paris. They recycle a portion of their savings into the subsidy reduction fund, which in turn compensates Countries A–E. Countries F–J keep some of their savings.
Yes, we are paying exporters not to subsidize, which seems like an economic inefficiency. But the true benefit of the subsidy reduction fund is that it helps relieve all actors in the global fossil fuel market of the political pressure to subsidize those industries. Ironically, the former subsidizers are the big winners here. They can invest their fund money in domestic programs, but they also enjoy a net welfare gain because their governments are saving on subsidy expenditures. For net importers, as more of them join the scheme, they each get to keep a higher percentage of their savings.
The subsidy reduction fund doesn’t work indefinitely. Ideally, the world’s largest economies use this mechanism only as they transition away from fossil energy entirely. The world’s oil, coal, and gas trade should diminish over time such that the reduction fund is no longer practical or needed.
*This model assumes a 5% decrease in the global market price of oil as predicted by Schwanitz et al., which would require 100% subsidy elimination in the top 5 exporting countries.
2. Access to Capital: Subsidy Phase-out and Reform Catalyst (SPARC) Bonds
UN member states could create a mechanism for buying a new type of “subsidy phase-out and reform catalyst” (SPARC) bond. The international development community already uses a type of green bond to fund energy efficiency projects in developing markets. SPARC bonds take this concept and add a layer of political cover for fossil fuel-subsidizing governments.
Multilateral development banks, which are commissioned by two or more governments, could issue bonds to private investors on behalf of a government that subsidizes fossil fuels. In the model proposed by Hale and Ogden, governments could use SPARC bonds to raise capital that can fund any domestic projects of their choosing — including compensating oil and coal producers. SPARC bonds would have to be repaid with savings from removing subsidies, and would therefore be proportional to the subsidy amount that a country is willing to cut. For example, if a petroleum-subsidizing country pledges to cut subsidies over 10 years valued at $20 billion, investors would purchase bonds from that country with a maximum net present value of $20 billion. That’s a huge upfront cash flow.
Why would the subsidizers agree to use SPARC bonds? They provide capital at below the market rate, which is attractive to developing nations in particular. For private investors, SPARC bonds are a socially responsible financial instrument. They satisfy the concerns of the carbon divestment movement, and because they are backed by multilateral financial institutions, they come with a AAA bond rating. If governments, rather than private investors, chose to buy SPARC bonds, the interest earned from the bond sale could supplement tax revenue in supporting domestic clean energy projects and renewables industries.
The key benefit to any type of development loan, rather than a binding agreement, is flexibility — the friend of political opportunity.
3. Game Theory: Subsidy Reduction Trading Club
Governments can negotiate a “club” framework for incentivizing fossil fuel subsidy abatement, in which members have collective rights and obligations. This solution, based on the “climate clubs” model of emissions trading popularized by Nobel prize-winning economist William Nordaus, uses game theory to eliminate subsidies.
The idea is that club members may freely trade fossil fuels with each other, but membership is contingent upon phasing out fossil fuel subsidies. Any exporters who refuse to participate in subsidy reduction, including existing members who violate the subsidy reduction terms, face a tariff when trading oil, coal, or natural gas products with club members. Thus most fossil fuel exporters — most of whom are also subsidizers — are incentivized to join.
Climate clubs may sound similar to something we already have: the Paris Climate Agreement. Paris is the first universally agreed upon framework, but it’s still light on incentives. Specifically, it falls victim to the free-rider problem. Remember our discussion of how climate change sees no borders? It’s not easy to attribute emissions reductions to specific interventions by a Member State, so the accountability system is weak.
Game theory predicts that in order to maximize participants in the club scheme, the required subsidy phase-out rate should hit some determined goldilocks zone (e.g., phase out 60% of fossil fuel subsidies to qualify). The club system should have a more stable equilibrium than a loose coalition because it guards against free-riding off other members’ emissions reductions. The club can also employ public shaming; by publishing a list of club membership violations, members could discourage non-members from voluntarily trading with offenders. If the club includes most of the world’s largest economies, non-members might be particularly discouraged from cozying up to violators on the club’s “block” list.
Of course, the club strategy poses challenges. It depends on the political will of the founding club members, and its preferential trade policy could cause headaches in the World Trade Organization. A common critique of the original Nordhaus model is its failure to distinguish between clean and dirty energy products, because it could have a chilling effect on renewables trade. For that reason, this version of the club would only apply tariffs to oil, coal, and gas products.
As with the subsidy reduction fund, this model exists only as long as there is a significant global market for fossil energy products. Ideally, the world’s largest economies will decarbonize to the point of exiting the market entirely.
You may be skeptical of any solution that requires international cooperation. How can we trust that governments will accurately report their subsidy reductions? How is it possible to deploy any comprehensive policy plan on a global scale without a world government?
We don’t need the entire world to agree to one scheme, and we can design them in a way that is largely self-enforcing. Fuel subsidies today are a political phenomenon, and the right economic incentives can change a government’s political calculus pretty dramatically.
It’s true that all three of these solutions pose startup and implementation challenges, but at this stage of the climate crisis, we need to think big. Gone are the days when the world could avoid major economic disruption and still keep global warming below 2℃. The most effective decarbonization policies will be those that shake up status quo political and financial systems, like taking apart a jigsaw puzzle. And maybe, if we succeed in realigning incentives, we won’t need — or want — to put those same pieces back together.
