Case Study for Fuel Trading
I. Executive Summary
Getting fossil fuel prices right is critical for efficiently allocating an economy's scarce resources and
investment across sectors and activities- the efficient price includes both the supply and
environmental costs of fuel use. Underpricing leads to overconsumption of fossil fuels, which accelerates global warming and exacerbates domestic environmental problems including losses to human life from local air pollution and excessive and road congestion and accidents. This has long been recognized, but globally countries are still a long way from getting energy prices right.
This updated analysis for 191 countries finds:
Gaps between efficient prices and user prices for fossil fuels remain large and pervasive. No country is fully pricing all fuels in line with their full supply and environmental costs. The largest price gaps are generally for coal, followed by natural gas, diesel, and gasoline (Figure ES1).
Figure ES1. Gaps between efficient prices and user prices for fossil fuels by country, 2020
Source. IMF staff.
Globally, fossil fuel subsidies are were $5.9 trillion or 6.8 percent of GDP in 2020 and are expected to increase to 7.4 percent of GDP in 202S as the share of fuel consumption in emerging markets (where price gaps are generally larger) continues to climb (Figure ES2). Just 8 percent of the 2020 subsidy reflects undercharging for supply costs (explicit subsidies) and 92 percent for undercharging for environmental costs and foregone consumption taxes (implicit subsidies).
Figure ES2. Global Fossil Fuel Subsidies Over Time
Source. IMF staff.
Note. 2019 and 2021 onwards use projections for fuel use and fuel prices, respectively.
Underpricing for local air pollution costs is the largest contributor to global fossil fuel subsidies (Figure ES3), accounting for 42 percent, followed by global warming costs (29 percent), other local externalities such as congestion and road accidents (15 percent), explicit subsidies (8 percent) and foregone consumption tax revenue (6 percent).
Figure ES3. Global Fossil Fuel Subsidies by Component, 2020
Source. IMF staff.
Efficient fuel pricing by 2025 would reduce global carbon dioxide (CO2) emissions 36 percent below baseline levels, equivalent to a 32 percent cut below 2018 levels. This is in line with keeping global warming to 'well below' 2 degrees and towards 1.5 degrees (Figure ES4).
Figure ES4. Global CO2 Pathways for Temperature Targets
Source. IMF staff and IPCC (2021).
Note. Warming pathways assume energy-related national CO2 emissions are reduced in proportion to total greenhouse gas emissions. NDCs = Nationally Determined Contributions.
Efficient fuel pricing would raise substantial revenues, worth 3.8 percent of global GDP (Figure ESS), while averting 0.9 million premature deaths per year from local air pollution.
Figure ESS. Global Fossil Fuel Subsidies by Component, 2020
Source. IMF staff.
II. Introduction
Getting fossil fuel prices right is critical for efficiently allocating an economy's scarce resources and investment across sectors and activities. The right price is the socially-efficient price that reflects the full societal costs of fuel use-not just the supply costs (e.g., labor, capital, and raw materials) but also the environmental costs, including carbon dioxide (CO2) emissions, local air pollution, and broader externalities associated with fuel use (e.g., road congestion), as well as general taxes applied to household products. Underpricing fossil fuels not only undermines domestic and global environmental objectives but is a highly inefficient policy for helping low-income households and has a sizable fiscal cost-too little revenue is raised from fuel taxes, implying other taxes or government deficits must be higher or public spending lower.
Fossil fuel price reform could not be timelier. All 191 parties to the Paris Agreement are submitting revised mitigation pledges ahead of COP26 in November 2021-many have made substantial commitments for 2030 and have specified emissions neutrality targets for mid-century (Table 1, third and fourth columns). Meanwhile, local air pollution concentrations remain stubbornly high, often far above safe levels recommended by the World Health Organization
(PM2.5 below 10 µg/m3), and air pollution causes substantial premature mortality in many countries (Table 1, fifth and sixth columns). Government debt. moreover, is now at historically high levels-mostly around 50-100 percent larger (relative to GDP) in 2020 than in 2007 (Table 1, seventh and eighth columns).
The principle that fossil fuel prices should be set efficiently, and that fiscal instruments must be central in 'correcting' the major environmental side effects of fossil fuel use, is well established. Underpinning the policy recommendations is the notion that taxation (or tax-like instnuments) 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. Putting this principle in practice, however, requires a practical methodology and associated tools for quantifying the efficient price, fuel by fuel, and country by country. This methodology can then be used to assess the:
Extent of price changes needed to reach their efficient levels through corrective taxes;
Environmental, fiscal, health, and economic impacts of price reform; and
Magnitude of current fossil fuel subsidies, which helps to inform and sharpen domestic and international dialogue on the need for fuel price reform.
Although environmental costs are subject to uncertainty and controversy, they are a key component of the societal costs of fossil fuel use and therefore it is important to factor an unbiased estimate of them into fuel prices. A transparent and practical methodology enables individual governments to infer efficient fuel prices, understand their key determinants, and perhaps use their own judgement about some of the underlying parameter values.
Table 1. Climate, Air Pollution, and Fiscal Background, Selected Countries
Sources: UNFCCC {2021). IMF (2021), IMF staff calculations.
In a series of previous reports, IMF staff developed such a methodology by compiling, from various sources, extensive country-level data on fuel prices, taxes/subsidies, fuel use, and a diverse range of parameters underlying environmental costs (e.g., local air pollution emissions rates, local population exposure to pollution). The first report (Parry and others 2014) found that most fossil fuel products, in most countries, were underpriced, with the degree of underpricing generally most severe for coal.
Subsequent papers (Coady and others 201 S, 2019) updated data sources, refined the methodology, and provided country, regional, and global estimates of fossil fuel subsidies. Importantly, Coady and others (2015) introduced the concepts of narrow or 'pre-tax' subsidies and broad or 'post-tax' subsidies where the former reflected (most importantly) underpricing for supply costs and (less importantly} subsidies for fossil fuel producers, while the latter also included underpricing for (most importantly} environmental costs and (less importantly} general consumption taxes. Coady and others (2019), for example, put global post-tax subsidies at a striking $4.7 trillion in 2015, or 6.3 percent of world GDP, with only S percent of this figure reflecting pre-tax subsides. This paper uses a slightly different terminology, referring to explicit subsidies as undercharging for supply costs and producer subsidies (i.e., pre-tax subsidies), and implicit subsidies as undercharging for environmental costs and general consumption taxes (i.e., post tax subsidies less pre-tax subsidies).
In principle, fine-tuned instruments can more effectively address some of the environmental costs of fossil fuel use, compared with a per unit fuel charge - for example, fees on local air emissions from coal plants promote use of end-of-pipe abatement technologies as well as switching from coal to other fuels, while coal taxes promote only the latter response. Institutional capacity constraints (e.g., for monitoring emissions} may however limit the viability of fine-tuned instruments. In the interim, raising fuel prices provides a 'second-best' response and, moreover, may be combined with other measures (e.g., rebates for coal plants with abatement technologies} to better mimic the effects of fine-tuned instruments.
Increasing fossil fuel prices is also difficult politically, not least because of the burden it imposes on vulnerable groups. A comprehensive strategy, for example with measures to assist low-income households, displaced workers, trade-exposed firms/regions, and the use of revenues from price reform to boost the economy in an equitable way, can improve acceptability. Most likely however, countries will need a balance between higher fossil fuel prices and reinforcing sectoral measures that are less efficient but avoid significantly higher energy prices (e.g., feebates to alter the relative price of clean/polluting vehicles or activities}. Again, however, having some sense of the efficient set of fuel prices can guide the setting of implicit prices in these reinforcing instruments and it provides a benchmark for assessing the trade-offs involved in alternative packages of pricing and sectoral measures.
This paper provides a comprehensive update of: (i} efficient fossil fuel prices by country; (ii} fossil fuel subsidies at the country, regional, and global level; and (iii) the environmental, fiscal, and economic impacts of fuel price reform. Selected results are presented below, while a full set of country-level results is available from accompanying spreadsheets. Besides utilizing all the latest data, the paper improves over prior methodologies by:
Using more refined, country-specific estimates of fuel prices and supply costs, including prices disaggregated by end-use sector, more granular, country-specific import and export-parity prices (with less reliance on international reference prices), and additional fuels such as liquified petroleum gas (LPG);
Making use of new of methodologies for quantifying local air pollution damages by country that account for meteorological factors affecting local air quality;
Integrating the analysis into the Carbon Pricing Assessment Tool (CPAT)-see Annex A-which enables future projections of efficient prices, fuel consumption, and impacts of subsidy reform (projections have greater salience for prospective policy reforms); and Expanding coverage to 191 countries.
The main results of the discussion can be summarized as follows:
Underpricing of fossil fuels is still pervasive across countries and is often substantial, especially for coal. Coal has high carbon and local air pollution damages (though the latter vary considerably across countries). At the global level, 99, 52, 47, and 18 percent of coal, (road) diesel, natural gas, and gasoline consumption is priced at below half of its efficient level in 2020, respectively.
At the global level, total (explicit plus implicit) fossil fuel subsidies are $5.9 trillion in 2020, or 6.8 percent of GDP. Assuming current policies, projected (total) subsidies rise to 7.4 percent of GDP in 2025 with the growing share of global fossil fuel consumption in emerging market economies (EM Es}, where local pollution costs tend to be larger. Explicit subsidies were $0.45 trillion in 2020 (and are larger than reported in prior IMF studies due to methodological improvements) but implicit subsidies remain by far the most important component accounting for 92 percent of the total.
Underpricing for local air pollution and climate damages are the two biggest sources of subsidies, accounting for 42 and 29 percent of the global total in 2020, respectively. Other components include undercharging for broader externalities (15 percent}, supply costs (8 percent), and general and consumption taxes (6 percent).
The power generation sector is the largest recipient of subsidies, receiving 61 and 33 percent of coal and natural gas subsidies, respectively. Electricity subsidies are evenly split across industrial and residential users (due to retail prices that are below cost-recovery levels).
By region East Asia and the Pacific accounts for 48 percent of total energy subsidies. And by country, China remains the biggest subsidizer in absolute terms, followed by the US, Russia, India, and the EU.
With efficient fuel prices in 2025, projected global CO2 emissions are reduced 36 percent below baseline levels, fossil fuel air pollution deaths 32 percent (saving 0.9 million lives annually), tax revenues are higher by 3.8 percent of global GDP, and there are net economic benefits (environmental benefits less economic costs) of 2.1 percent of global GDP.
The rest of the paper is divided into two main sections, the first covering conceptual and measurement issues and the second presenting the main findings.
III. Conceptual and Measurement Issues
This section first provides a brief recap of efficient fuel prices and fossil fuel subsidies from a conceptual perspective, and then discusses the measurement of environmental costs. Computational procedures and other data are discussed in Annex A and B.
A. Conceptual Issues-a Quick Recap
(i) Defining Efficient Fuel Prices
The efficient price per unit of a fossil fuel product is given by:
([unit supply cost] + [unit environmental cost]} x (1 + general consumption tax rate, if applicable]
Each component is discussed below.
Supply costs. For a non-tradable product (which is largely the case for electricity), the supply cost is the domestic production cost, inclusive of any transportation, processing, distribution costs, and margins. In contrast, for an internationally tradable product the supply cost is the opportunity cost of consuming the product domestically rather than selling it abroad-this is measured here by the import- or export-parity price (for fuel importing and exporting countries respectiveIy), wIm adjustments for domestic margins.
Environmental costs. The environmental costs of coal, natural gas, and liquid fuel combustion include global climate and local outdoor ('ambient') air pollution damages. For all fuels, the climate damage is the fuel's CO2 emissions factor times the damage per unit of CO2 emissions. CO2 emissions factors for a given fuel vary only modestly across countries when expressed per unit of energy, though the emissions factor is about 25 and 45 percent lower per unit of energy for liquid fuels and natural gas than for coal, respectively.
The major local air pollutants from coal include: (i) directly emitted fine particulate matter, with diameter less than 2.5 micrometers (PM2.s), which is small enough to enter to the lungs and bloodstream; (ii) sulfur dioxide (502) and nitrogen oxide (NO,), which react in the atmosphere to form PM,.s indirectly; and (iii) (low-lying) ozone formed, for example, from volatile organic compounds (VOCs) like benzene. The local pollution damage per unit of fuel use is the fuel's emissions factor for each pollutant, times the damage per unit of emissions, and aggregated over all pollutants. Emissions factors can vary substantially across countries depending on the use of end-of-pipe control technologies and fuel quality (e.g., bituminous coal has higher sulfur content than lignite and anthracite). Burning natural gas produces only one local pollutant, NO,.
For road fuels, CO, emissions per liter are about 16 percent higher for diesel than for gasoline--for both fuels CO2 emissions can be moderately reduced by blending them with biofuels (our data accounts for this but not for partially offsetting land-use CO2 emissions). Combusting gasoline and diesel can also produces direct PM,.s, 502, NO, and voes and again emission rates vary across countries depending on the stringency of (new and used) vehicle emission rate standards and fuel quality-emission rates are generally much lower for gasoline than diesel.
More broadly, use of road fuels in vehicles is associated with other externalities, most importantly traffic congestion and accidents and (less importantly) wear and tear on the road network (the nature of these externalities is discussed below). In principle, all three externalities are most efficiently addressed through various km-based charging systems (e.g., km-based fees rising and falling over the rush hour on congested roads or that vary with driver/vehicle accident risk), however until such systems are comprehensively implemented (which no country has done to date) fuel taxes remain a valid (albeit blunt) second-best instrument. Efficient fuel taxes are however lower to the extent tax-induced reductions in fuel use come from improvements in fleet average fuel economy and shifting to electric vehicles (EVs), rather than reduced vehicle km travelled. Externalities for non-road uses of other oil products and LPG (e.g., for home heating, off-road vehicles, petrochemicals) are limited to CO2 and local pollution and are calculated separately. For oil product consumption that could not be allocated to one of the four oil products analyzed-gasoline, on-road diesel, LPG and kerosene-the local air pollution and climate externalities are assumed to be equal to the average of the four oil products, weighted by consumption.
