Getting Energy Prices Right : From Principle to Practice

Ian Parry, Dirk Heine, Eliza Lis, and Shanjun Li

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2014
• eBook ISBN: 9781484388570

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Chapter 1. Summary for Policymakers

Many energy prices in many countries are wrong. They are set at levels that do not reflect environmental damage, notably global warming, air pollution, and various side effects of motor vehicle use. In so doing, many countries raise too much revenue from direct taxes on work effort and capital accumulation and too little from taxes on energy use.

This book is about getting energy prices right. The principle that fiscal instruments must be center stage in “correcting” the major environmental side effects of energy use is well established. This volume aims to help put this principle into practice by setting out a practicable methodology and associated tools for determining the right price. The book provides estimates, data permitting, for 156 countries of the taxes on coal, natural gas, gasoline, and diesel needed to reflect environmental costs. Underpinning the policy recommendations is the notion that taxation (or tax-like instruments) can influence behavior; in much the same way that taxes on cigarettes discourage their overuse, appropriate taxes can discourage overuse of environmentally harmful energy sources.

Background

Energy use is a critical ingredient in industrial and commercial production, and in final consumption, but it can also result in excessive environmental and other side effects, with potentially sizable costs to the economy. For example,

• If left unchecked, atmospheric concentrations of carbon dioxide (CO₂) and other greenhouse gases (GHGs) are expected to raise global temperatures by about 3–4°C by the end of the century (IPCC, 2013). Temperature changes of this magnitude are large by historical standards and pose considerable risks.
• Outdoor air pollution, primarily from fossil fuel combustion, causes more than 3 million premature deaths a year worldwide, costing about 1 percent of GDP for the United States and almost 4 percent for China (National Research Council, 2009; World Bank and State Environment Protection Agency of China, 2007; World Health Organization, 2013).
• Motor vehicle use leads to crowded roads, accidental death, and injuries. Drivers in the London rush hour, for example, impose estimated costs on others that are equivalent to about US$10 per liter ($38 per gallon) of the fuel they use through their contribution to traffic congestion, and traffic accidents cause an estimated 1.2 million deaths worldwide (Parry and Small, 2009; World Health Organization, 2013).

The Need for Fiscal Policies

Given the seriousness of the problems associated with fuel use, addressing them with carefully designed policy instruments is critical. Ideally, these policies should do the following:

• Be effective—exploit all opportunities for reducing environmental harm and mobilizing private investment in clean technologies
• Be cost-effective—achieve environmental objectives at lowest cost to the economy
• Strike the right balance between the benefits and the costs of environmental improvement for the economy, thereby maximizing the net benefits.

All three features are important for balancing trade-offs between environmental protection and economic growth and enhancing prospects for sustaining and scaling up efficient policy. Fiscal instruments—environmental taxes or similar instruments (primarily emissions trading systems with allowance auctions)—can fully meet these criteria (in conjunction with complementary measures, such as research and development and investment in transportation infrastructure).

Fiscal instruments targeted directly at the sources of environmental harm promote the entire range of possibilities for reducing that harm. They can also produce a substantial revenue gain and, so long as this revenue is used productively—for example, to reduce other taxes that distort economic activity—environmental protection is achieved at lowest overall cost to the economy. Finally, and not least, if these instruments are scaled to reflect environmental damage, they avoid either excessively burdening the economy or, conversely, forgoing socially worthwhile environmental improvements.

Getting Prices Right

“Getting prices right” is convenient shorthand for the idea of using fiscal instruments to ensure that the prices that firms and consumers pay for fuel reflect the full costs to society of their use, which requires adjusting market prices by an appropriate set of “corrective” taxes. In practice, many countries, far from charging for environmental damage, actually subsidize the use of fossil fuels. For many others, energy taxes—if currently implemented at all—are often not well targeted at sources of environmental harm, nor set at levels that appropriately reflect environmental damage. Clearly there is much scope for policy reform in this area, but there are also huge challenges, both practical and analytical.

From a practical perspective, higher energy prices burden households and firms and, even with well-intentioned compensation schemes, can be fiercely resisted. These challenges—not to understate them—are largely beyond the scope of this book; however, a complementary volume (Clements and others, 2013) distills lessons to be drawn from case studies of energy price reforms. Moreover, getting energy prices right need not increase the overall tax burden; higher fuel taxes could partially replace broader taxes on income or consumption (or environmentally blunt taxes on energy), broadening support for the policy. Where new revenue sources might be needed, corrective energy taxes are an especially attractive option because, unlike most other options, they improve economic efficiency by addressing a market failure.

The main focus here is on assessing the analytical challenges, that is, the pricing that needs to be put into practice. For the vast majority of countries, there has been no attempt to measure the magnitude of environmental damage across fossil fuel products—yet these measures are critical for actionable guidance to be given on how countries can get energy prices right.

The corrective energy tax estimates presented in this book should be treated with a good deal of caution, given data gaps, and controversies—for example, about the valuation of climate damage and the link between air quality and mortality risk. Nonetheless, the estimates provide a valuable starting point for dialogue about policy reform, scrutiny of the key uncertainties, and cross-country comparisons estimated on a consistent basis.¹ Moreover, the impact of alternative assumptions on corrective tax estimates can be derived from accompanying spreadsheets.² Although tax assessments may change significantly as evidence evolves and data improve, the basic findings—most notably, the strong case for substantially higher taxes on coal and motor fuels in many countries—are likely to remain robust.

Defining an Efficient Set of Energy Taxes

From the perspective of effectively reducing energy-related CO₂ emissions, local air pollution, and broader side effects from vehicle use, energy tax systems should comprise three basic components:

• A charge should be levied on fossil fuels in proportion to their CO₂ emissions multiplied by the global damage from those emissions (alternatively, the charge could be levied directly on emissions), though there are reasons why some governments (e.g., in low-income, low-emitting countries) may not wish to impose such charges.
• Additional charges should be levied on fuels used in power generation, heating, and by other stationary sources in proportion to the local air pollution emissions from these fuels but with credits for demonstrated emissions capture during fuel combustion, given that net emissions released are what determine environmental damage (another possibility again is to charge emissions directly).
• Additional charges for local air pollution, congestion, accidents, and pavement damage attributable to motor vehicles. Ideally, some of these charges would be levied according to distance driven (e.g., at peak period on busy roads for congestion), and doing so should become increasingly feasible as the technology needed for such programs matures. Until then, however, reflecting all of these costs in motor fuel taxes is appropriate and is the approach taken here.

In practice, there are complex political reasons why the bases and rates of energy taxes may diverge from the ideal, and why regulatory instruments are often the preferred approach. But a necessary first step for understanding the trade-offs involved between all the policy choices, and how political constraints might be met with minimal compromise to environmental, fiscal, or other objectives, is to provide some quantitative sense of the corrective energy tax system for different countries, which provides a benchmark against which alternative policies should be evaluated.

Methodology

The techniques used for assessing various types of environmental damage are straightforward conceptually, although they require extensive data compilation.

Climate Damage

The volume does not add to the contentious debate on climate damage but simply uses an illustrative damage value of $35 per metric ton of CO₂ (US Interagency Working Group on the Social Cost of Carbon, 2013), combined with data on the carbon content of fuels, to derive carbon charges for all countries. (The implications of different damage assumptions, including zero damage for low-income, low-emitting countries, are easily inferred.)

Air Pollution

The major problem from local air pollution is elevated mortality risks for exposed populations. For coal plant emissions, damage is assessed by first estimating how much pollution is inhaled by people in different countries based on combining data on power plant location with data indicating how many people live at different distance classifications from each plant (smokestack emissions can be transported over considerable distances). This pollution intake is then combined with baseline mortality rates for pollution-related illness and the latest evidence on the relationship between exposure and elevated risks, though substantial uncertainties surround this relationship. Health effects must then be monetized, which is a contentious exercise, but is done for illustrative purposes using evidence on how people in different countries value the trade-off between money and risk from numerous studies analyzed in OECD (2012). Finally, damage is expressed per unit of energy content or fuel use using country-level data on emission rates. The same approach is used to measure air pollution damage from natural gas plants. Damage from vehicle and other ground-level sources (which tend to remain locally concentrated) is extrapolated from a city-level database on pollution intake rates.

Congestion and Accidents

Traffic congestion costs imposed by one driver on other vehicle occupants are approximated by using a city-level database to estimate relationships between travel delays and various transportation indicators and extrapolating the results using country-level measures of those same indicators. Travel delays are monetized using evidence about the relationship between wages and how people value travel time. Accident costs are estimated based on country-level fatality data and assumptions about which types of risks drivers themselves might take into account versus those they do not, and extrapolations of various other costs, such as those for medical expenses, property damage, and nonfatal injury.

Chapter 2. Energy Systems, Environmental Problems, and Current Fiscal Policy: A Quick Look

Overview of Energy Systems

Although insofar as possible this volume presents results for 156 countries, a focus on 20 countries is used to illustrate how corrective taxes and their impacts vary with per capita income, fuel mixes, population density, road fatalities, and so on. This section provides some basic statistics for these countries for 2010 (or the latest year for which data are available).

Figure 2.1 shows primary energy consumption (i.e., the energy content of fossil and other fuels before transformation into electricity...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Foreword
• Acknowledgments
• Abbreviations
• 1 Summary for Policymakers
• 2 Energy Systems, Environmental Problems, and Current Fiscal Policy: A Quick Look
• 3 Rationale for, and Design of, Fiscal Policy to “Get Energy Prices Right”
• 4 Measuring Pollution Damage from Fuel Use
• 5 Measuring Nonpollution Externalities from Motor Vehicles
• 6 The Right Energy Taxes and Their Impacts
• 7 Concluding Thoughts
• Glossary
• Index
• Tables
• Footnotes