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Future Investment: A Toolkit for a Fair Energy Pricing Reform

The world is spending billions of dollars on fossil fuels subsidies while hundreds of millions of people live in poverty. Priorities must shift if we want humanity to survive and our planet to be protected. An average of USD 423 billion dollars are spent annually to subsidize fossil fuel consumption – oil, electricity, gas and coal – which is four times the amount committed by developed countries to help poor countries tackle the climate crisis. The extent to which fossil fuel subsidies drives inequality is staggering: half of the total amount benefits the richest 20 percent of the population. A new UNDP analysis shows that the total amount spent on these subsidies could wipe out global energy poverty four times over, or pay for COVID-19 vaccinations for every person in the world. Instead these funds, paid for by taxpayers, end up deepening inequality and impeding action on climate change. History has shown us that fossil fuel subsidy reform is difficult and often fails – because these subsidies are intended to protect consumers’ purchasing power from price volatility by keeping the prices of energy lower than the supply cost – with the impact of reforms often affecting the incomes of poor and vulnerable groups. The price of energy is a highly volatile and political issue – as shown currently by the rise in energy prices across Europe, and how citizens and governments are responding to it. To help countries successfully undertake transformational energy reforms, UNDP has released a primer which provides analysis and guidance to help governments seeking to ending their dependence on fossil fuels and transitioning to a green economy through well-designed energy pricing reform in a way that is fair and equitable. The global pandemic has shaken the world, but it also provides a unique opportunity to re-imagine the future. Which is why, rather than go back to “business as usual”, UNDP is urging people all around the world to seize this moment to ensure a just and green transition, to invest in people and planet, and to ensure we collectively meet the ambitions of the Sustainable Development Goals (SDGs.)

Why tackle fossil fuel subsidies?

On August 9 the Intergovernmental Panel on Climate Change (IPCC) released its much anticipated sixth assessment report. The bottom line was clear: climate change is here and it’s the crisis that is defining our era. It’s intensifying, it’s accelerating, and it’s caused by our use of fossil fuels – about 90 percent of global carbon dioxide (CO2) emissions comes from fossil fuels and industry. "The alarm bells are deafening, and the evidence is irrefutable", said the UN Secretary-General António Guterres, who noted that the report was nothing less than "a code red for humanity". But there is still time to avert the worst impacts of climate change, IPCC experts said. Strong and sustained reductions in CO2 emissions and other greenhouse gases, could quickly make air quality better, and in 20 to 30 years global temperatures could stabilize. However, despite knowing the goal, we are still dragging our feet on the way to a planetary crisis. As the energy sector, powered by fossil fuels (coal, oil, gas), is the main contributor to climate change, the only way out of the climate crisis is to transition away from fossil fuels. This is a monumental challenge. In industrialized nations, coal and oil have been the primary source of energy for centuries. Our modern economies have been built on fossil fuels, and they are still heavily embedded in our production and consumption patterns. Overtime, as access to cheaper energy became commonly viewed as a key for reducing poverty, improving human development indicators, and promoting industrial development, governments have introduced mechanisms to subsidize both the production and consumption of fossil fuels. As a result, our entire energy system is mis-priced and artificially skewed towards fossil fuels—and cheap fossil fuel-based energy has become the norm in many countries. Governments use public funds to implement direct transfers or induced transfers in the form of price supports: annually, when negative externalities such as adverse environmental, climate, and public health impacts are included, the ‘true’ costs of fossil fuels could reach almost US$ 6 trillion annually, or a staggering US$11 million per minute. All of this is happening during an economic reversal.

Given the weight of the energy sector in carbon emissions, current subsidy practices have become a major contributing factor to the planetary crisis – which hits the poorest and most vulnerable the hardest – and to wider problems such as air and water pollution which are felt acutely. Air pollution alone is currently estimated to cause 7 million premature deaths globally each year, 90 percent of which are in developing countries. Fossil fuel subsidy reforms would thus benefit human health and well-being. They would also contribute to reduce CO2 emissions: In a study of 26 developing countries, subsidy reversal was found to potentially reduce emissions by an average of 6.4 percent by 2025 compared to business as usual. Repurposing fuel subsidy reforms is a first step towards correctly pricing energy to reflect the ‘true’ and full cost of using fossil fuels to society and the environment. But such reforms can also be harmful for poor and vulnerable households if they are poorly designed. While fossil fuel subsidies are regressive –and thus constitute an unequalising tool, they also represent a significant share of the incomes of the poor that otherwise would be paid for energy consumption. This is why UNDP has prepared a toolkit for fair energy pricing reform with income protection and compensation schemes for least advantaged groups –that align incentives for a green and just energy transition, and that are crafted with a broad inter-sectoral engagement. Energy pricing reform: a monumental challenge

We must dispel the myth that there is a choice between climate and the economy. Climate action is both an economic requirement and an opportunity. It creates jobs - more than 30 million jobs could be created in clean energy, energy efficiency, and low-emissions technologies by 2030. Economies that do not invest in becoming climate resilient now may end up paying a high price for it soon. It is estimated that a business-as-usual, fossil-fuel dependent trajectory will cut global wealth in half by the middle of this century. And it will cost the global economy US$ 551 trillion in climate-induced damages. Amid the COVID-19-induced shock and the continued urgency of the climate crisis, “Green recovery” and the opportunity to “Build Back Better” are much more than buzzwords. Extensive research shows that most countries would be better off from implementing mitigation policies consistent with achieving the Paris Agreement targets. The energy transition offers sizable local development benefits, including better health through cleaner air, sustainable growth and employment, and strengthened public finances. For instance, the International Labor Organization estimates that limiting climate change to 2°C would create approximately 24 million jobs at the loss of approximately 6 million jobs in carbon-intensive industries, producing a net increase of 18 million jobs by 2030. However, at the time of writing, as part of their COVID-19 recovery packages G20 countries are committing more money to fossil fuels than to clean energy, with fossil fuels accounting for 40% of all public money committed to the energy sector and clean energy for 37%. This is largely because energy pricing reform – whether it is gradually removing subsidies or introducing carbon pricing measures -- is a highly politically sensitive issue. Industrial and consumer groups which are most affected by energy pricing decisions often have powerful political influence. Removing fossil fuel subsidies without aligning the right incentives across sectors and at different levels of government and without investing in social protection, compensation mechanisms, and clean energy would incur job losses, add pressure on households, and potentially led to civil unrest. Many governments still harbor an economically short-term view of the future, bound by the need for re-election, and are as such incentivized to stick to the status quo. COVID-19 has showed that many governments have the political capital to introduce strong measures in times of crisis. But the ongoing crisis has equally showed how critical it is for such measures to be accepted as effective by their populations. Governments can act and mitigate the harmful impacts of these crises—and now more than ever, they must seize this historic opportunity to invest in a sustainable, better future for all. Many energy pricing reforms have failed because they have been designed, planned, timed or communicated poorly. Implementing such reforms successfully requires understanding the political, social and policy factors intertwined. If done well, addressing the underpricing of fossil fuels would be a decisive step forward in a just transition towards green economies.

UNDP’s Policy Toolkit For A Fair Energy Pricing Reform

In "Future Investment: a toolkit for a fair energy pricing reform", UNDP advocates for a two-step reform, in which sequencing is key. The first step is to identify ways to repurpose fossil fuel subsidies reforms in a way that is progressive, not poverty-increasing, socially just, and economically fair. Another key step is to introduce carbon pricing measures that are most adapted to national contexts. UNDP’s research across two studies provides analysis and guidance to help governments move toward ending their dependence on fossil fuels and transitioning to a green economy through well-crafted energy pricing reforms. The toolkit highlights experiences and best practices in energy pricing reform by comparing outcomes and drivers in five case study countries, selected to illustrate the impact of different implementation choices across divergent social, economic, and political settings. It also offers a comprehensive analysis of carbon pricing tools and guidance as to which tools are best suited to specific national contexts.

Step 1: Phase out fossil fuel subsidies

Reforming energy subsidies through a well-designed mechanism for their gradual removal -- itself a significant undertaking -- is an important first step towards implementing carbon pricing in many developing countries.

UNDP’s research highlights that: Ensuring social and political acceptability is a key enabler of successful energy pricing reform. Beyond being environmentally impactful, such reforms must be socially and economically fair. Such acceptability is influenced by broader social, economic and political trends, including the level of public trust in governmental institutions. Political economy factors are key to successful implementation – and in contexts dependent on fossil fuel extraction, a clear understanding of the politics of resource revenues allocation and the governance of resources is critical. Strengthening social protection systems and developing fair compensation schemes to protect against price increases is central to promoting more socially and politically acceptable outcomes. Such reforms should focus initially on extending and reinforcing existing social provisions, including in relation to cash transfer mechanisms. Many of the paper’s case studies show that technical and capacity constraints weaken implementation of complementary measures. Reinforcing and extending social programmes require broader efforts to develop institutional and technical capacity. Effective public communication and deep stakeholder engagement are also key to successful subsidy reform. In Chile for instance, at the end of 2019 an increase in public bus and metro fares due partly to fuel costs triggered protests because it was borne by the capital city’s poorest populations. This was the starting point for broader civil unrest on other social issues partly related to wealth and political power concentration, which eventually led to a change of the constitution.

Step 2: Put a price on carbon

Introducing a carbon tax or other carbon pricing mechanisms is often seen as an environmentally effective but highly politically sensitive policy tool. As the selection of these tools depends on countries’ specific socio-economic and political contexts, the toolkit provides a comprehensive analysis of carbon pricing tools and guidance as to which tools may be best suited.

UNDP’s research highlights that:

Policy options for imposing an explicit carbon price include a tax, an emissions trading system (ETS) or measures combining features of both. Taxes can be levied on energy production, consumption, or trade, for example. Alternatively, policy makers can control the volume of emissions under an ETS. Finally, so-called “hybrid” measures combine facets of both these policies by setting a cap on emissions but, for example, limiting the range within which prices can fluctuate.

Carbon pricing measures aim to increase the cost of polluting fuels and technologies. But if mis-planned or mis-designed, carbon taxes can lead to civil unrest.

Carbon pricing measures are effective in terms of greenhouse gas emissions reductions and revenue raising opportunities. Unlike other policy instruments such as energy efficiency regulations or subsidies for low carbon technologies, carbon pricing has the potential to mobilize billions of USD in additional fiscal revenues annually which could help support the Sustainable Development Goals (SDGs). Overall, these could address often chronic funding issues faced by many developing countries.

International momentum on carbon pricing is gathering pace. Globally, more than 60 carbon pricing initiatives have been implemented. 96 of 146 Nationally Determined Contributions (NDCs) currently refer to carbon pricing as a policy option. However, current policies require extending, reinforcing and coordinating to achieve current and future emissions reduction goals.

Step 3: Redirect money towards investments that are in-line with the SDGs

UNDP harnessed its policy experience and expertise as well as worldwide on-the-ground presence to create the Future Investment: Toolkit for a Fair Energy Pricing Reform. Its key insights and policy recommendations aim to guide governments to introduce energy pricing reforms in an environmentally impactful, economically viable and socially fair way. The Don't Choose Extinction campaign is UNDP’s response to this monumental challenge. Launched ahead of the COP26 UN Climate Summit in November 2021, the campaign is calling for an end to fossil fuels as a crucial milestone in the journey towards an inclusive, green recovery from COVID-19. This will be a critical step to accelerate a global transition towards sustainable, green economies that leave no one behind.