Applying Pigouvian charges

A recent article in the Guardian argues that fossil fuels receive about $5 trillion per year globally of unseen benefits, representing some 6.5% of global GDP. The journalist concludes that this must point to a dim future for this energy source. The discussion stems from a paper that has been recently published in the journal, World Development, but is originally a piece of work by two analysts who work for the IMF that surfaced prior to COP21 in 2015. The same authors are involved with the current article.

The new version of the paper classifies these benefits into two types,

  • ‘‘pre-tax subsidies”— these arise when consumer prices paid by fuel users are below the opportunity costs of fuel supply (e.g., many oil producers in the Middle East and North Africa traditionally set domestic prices below international prices). This is the definition that leaders had in mind at the 2009 G20 Pittsburg meeting when they called for a phase out of energy subsidies (IEA, OPEC, OECD, & World Bank, 2010).
  • ‘‘post-tax subsidies”— these arise when consumer prices are below the cost of supply when a ‘‘Pigouvian” charge (1) is included to reflect environmental damages. Economic efficiency requires that the prices of goods and services reflect not only supply costs but also (i) (most importantly) environmental costs like global warming and deaths from air pollution and (ii) taxes applied to consumer goods in general.

A visit to the IEA website on energy subsidies shows that the value of pre-tax consumer price subsidy worldwide totaled $493 billion in 2013, falling to $322 billion by 2015 as oil prices fell globally. This is equivalent to ~$25 per tonne of oil equivalent, or $3.50 per barrel. By comparison, these amounted to $390 billion in 2009 (in 2014 dollars), the year the G20 and APEC commitments were made. The value of these estimates has fluctuated from year-to-year in line with reform efforts, the consumption level of the fuels in question, international prices for fossil fuels, exchange rates and general price inflation. IEA decomposition analysis reveals that, while movements in world prices typically have the greatest impact from year-to-year, policy interventions have played an important role as well. These subsidized prices are primarily focused on oil and electricity and in many cases, are a mechanism for distribution of benefits to very low income segments of the national population. For example, India subsidized oil, electricity and natural gas in 2015 for its consumers for an amount of nearly $20 billion, but is not a recognized oil producer.

However, the focus of the Guardian article is the lack of charges for externalities in relation to fossil fuel use. By applying a series of Pigouvian charges to fossil fuels, covering issues such as carbon dioxide emissions and air pollution, they argue that fuels are under-priced by some $5 trillion per annum. The additions made also cover issues related to fossil fuel use, but not directly caused by them. An example is road traffic congestion and safety which the article specifically mentions. These would also be externalities in a transport system powered by electricity. In total, these missing post-tax charges for coal amount to $2.5 trillion, oil is $1.5 trillion and natural gas about $400 billion. Pre-tax price subsidies for coal hardly exist, amounting to just over $1 billion per annum globally per the IEA.

Applying this methodology to fossil fuels also opens the debate for other goods and services. For example, many governments offer direct help to farmers and subsidise food prices. The production of rice and beef contributes some 6 billion tonnes of carbon dioxide equivalent to the atmosphere in the form of methane, which alone amounts to an externailty of $250 billion per annum or roughly $1.30 per kilo in the case of beef (vs. a US average ground beef price of $7 per kilo).

A robust and comprehensive application of Pigouvian pricing across the economy incorporating all externalities would likely touch every single product or service in use today, excluding any energy penalty related to fossil fuels. Environmental damage and health issues remain widespread in the world, despite great efforts to address them at every level of society. Many are simply a function of the vast scale on which manufacturing operates, which in turn results in some environmental degradation. In March 2014, the Guardian reported on the social and environmental costs associated with the production of rare earth metals, which have become critical in the manufacture of a multitude of electronic products today, including renewable energy systems. The article raised questions on cancer rates, which in turn links human mortality costs with these products.

In the case of fossil fuels, the simplest and most effective way of confronting this issue is to introduce a carbon price, ideally at a level that reflects the social costs of use. The World Development article uses a figure of around $40 per tonne of carbon dioxide. While this wouldn’t address every aspect of fossil fuel use, it would nevertheless go a long way towards addressing the concerns of the authors.

(1)  This refers to the work of Arthur Cecil Pigou, a University of Cambridge economist who published The Economics of Welfare in 1920. In this book, Pigou introduced the concept of externality and the idea that external problems could be corrected by the imposition of a charge. By ‘externality,’ Pigou meant an indirect economic impact of an activity that happened outside the immediate system where the activity was underway. The externality concept remains central to modern welfare economics and is at the heart of environmental economics. In the case of climate change, the externality is the release of carbon dioxide into the atmosphere and the future social and economic impact caused by the consequent increase in the surface temperature of the planet. Externalities can be both positive and negative, but in the case of carbon dioxide emissions, it is considered negative. Pigou argued that the activities associated with a negative externality should be penalized to the extent of the impact, such that their real economic value can be assessed. This penalty is widely known as a Pigouvian Tax. Alcohol taxes are Pigouvian; so are taxes on cigarettes.