Promoting Responsible Energy Pricing

“If we do nothing, we face a future that is grim indeed. Our fortunes will melt with the ice, evaporate like water under a relentless sun, and wither away like sand in a desert storm. And the planet’s poorest and most vulnerable people will be the first to feel the pain.”

GLOBE-Net, July 31, 2014 –  These are not the apocalyptic predictions of a doomsday individual or group. On the contrary, they are part of a sobering assessment of an emerging global environmental crisis by Christine Lagarde, Managing Director of the International Monetary Fund (IMF) speaking at the Center for Global Development.

IMF Managing Director Christine Lagarde

The global environmental crisis “is shaping up to be one of the greatest crises facing our generation and our century”, and the issue upon which future generations will judge us, said Lagarde. “As a matter of utmost urgency the international community must come together and take action to push back against these threats to our environment,” she said.

Her speech coincided with the release of a new IMF book: Getting Energy Prices Right: From Principle to Practice, the fulfillment of a commitment she made two years ago that the IMF would provide practical guidance – “a kind of toolkit” – to help members ensure that they are pricing energy responsibly.

Environmental issues and the IMF 

The IMF is concerned about the environment for one simple reason said Lagarde. A degraded environment leads to a degraded economy. Environmental damage has macroeconomic implications, and implications for the design and impact of fiscal policy.

“So where environmental damage is “macro-critical” it must also be “mission-critical” for us,” she said.

There are no simple solution notes Lagarde. Protecting the environment involves a multitude of moving parts: research and development, infrastructure upgrades for power and transportation systems, and appropriate tax and regulatory regimes for extractive industries.

But fiscal policy must take center stage she stressed. “The message is simple: to get it right, price it right. Make sure that prices reflect not only the costs of supplying energy, but also the environmental side effects.”

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The core premise of the IMF book is that while carbon-based energy has been the engine of economic growth over the past century, it has come with considerable costs.

The solution is to target the sources of the environmental harm arising from fossil fuel energy and to make sure that charges on different fuels are proportional to emissions from those fuels. We need to get the relative prices of dirty, intermediate, and clean fuels right to ensure that environmental damage is properly factored into energy prices, she said.

Smarter taxes not higher taxes 

The IMF has long been pushing for the elimination of energy subsidies, which it claims are bad for the planet, bad for the economy, bad for the budget, and bad for social equity. But the need for reform goes beyond the elimination of direct cash subsidies. Energy tax systems around the world must properly reflect environmental side effects, argues the IMF. 

“On this point, let me be crystal clear: we are generally talking about smarter taxes rather than higher taxes,” said Lagarde. “This means re-calibrating tax systems to achieve fiscal objectives more efficiently, most obviously by using the proceeds to lower other burdensome taxes. The revenue from energy taxes could of course also be used to pay down public debt.”

According to the report, getting energy prices right involves extending fuel taxes, which are already well established and easily administered in many countries, to other fossil fuel products, such as coal and natural gas, or their emissions, and aligning the rates of these taxes with environmental damage.

“Fuel tax reforms can yield substantial health, environmental, and fiscal benefits,” said Vitor Gaspar, head of the IMF’s Fiscal Affairs Department.

“According to our estimates, moving from existing to efficient fuel prices, at a global level, would reduce pollution-related deaths from fossil fuel combustion by 63 percent, mostly from reduced coal deaths, reduce energy-related carbon emissions by 23 percent, and raise revenues equal to 2.6 percent of GDP,“ he added.

Fiscal instruments, such as environmental charges on fuel use, have a powerful incentive effect on economic behavior, notes the IMF report. These instruments are:

• The most effective at exploiting opportunities (shifting to cleaner fuels, using more fuel-efficient vehicles, conserving on use of air conditioners, and so on) for reducing the harmful health and environmental side effects associated with energy use—so long as they are directly targeted at the right base (e.g., emissions rather than electricity consumption);
• Can achieve environmental protection at the lowest overall cost to the economy—so long as environmental tax revenues are used productively (e.g., to lower the burden of broader taxes in the fiscal system or fund socially valuable spending); and,

• Can strike the right balance between environmental benefits and costs—so long as tax rates are aligned with environmental damages.

 Not all taxes are bad 

The world’s finance ministers should recognize they have some fairly potent tools at their disposal says Ian Parry, Technical Assistance Advisor in the IMF’s Fiscal Affairs Department.

“Let’s face it, taxes can be a powerful way to point consumers and firms away from certain products—look at what’s happened with cigarettes in many countries over the past 50 years. Environmental taxes or similar pricing instruments can help in getting prices right, that is, reflecting environmental side effects in energy prices.”

Countries need not wait on international action to move ahead with energy price reforms, says Parry, given the large domestic environmental and fiscal benefits.

“Finance ministers have a central role to play in all this, both in administration, and in restructuring the tax system away from taxes that are likely to be most harmful for efficiency and growth, such as income taxes, in favor of carefully designed energy taxes,” he adds

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 CO emissions multiplied by the global damage from those emissions

• 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

• 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).

For Canada, the IMF says gasoline taxes should be around $0.55 (U.S.) a litre instead of the current 36 cents, and road diesel at about $0.64 per litre, versus the current 42 cents, roughly a 52-percent increase for each.

Coal should be taxed at a $4.90 per gigajoule. Currently it is not taxed. Natural gas should be taxed at $2.20 per gigajoule, in lieu of receiving subsidies that currently exists.

Notes the report, coal is pervasively undercharged, not only for carbon emissions, but also for the health costs of local air pollution. Air pollution damage from natural gas is modest relative to that from coal, but significant tax increases are still needed to reflect carbon emissions.

“We do not expect energy price reform to happen overnight,” said Lagarde. “It will require education about why substantially higher fuel prices are needed—and indeed unavoidable—to deal with mounting environmental challenges.”

“We know where we need to go and how to get there, so let us start the journey,” she concluded.