Mapping of environmentally damaging subsidies for future reporting

Recent years have witnessed increased interest in subsidies with potentially negative effects on the environment and climate. An example is subsidies on fossil fuels. These subsidies may contribute to increased combustion of fossil fuels and thus lead to increased emissions of greenhouse gases. Internationally, OECD, IMF, Eurostat and the UN, among others, have been concerned about such subsidies. Nationally, environmentally damaging subsidies have been a topic in debates about the tax regime and in connection with the government's plans to cut CO₂ emissions.

Environmentally damaging subsidies are defined quite broadly. They include subsidies that in various ways have a negative effect on climate or the environment. Fossil fuel subsidies are a subgroup among environmentally damaging subsidies. There is often talk of potentially environmentally damaging subsidies, because it is not always clear how large effect these subsidies have on the environment.

Neither nationally nor internationally is there agreement on what is to be considered an environmentally damaging subsidy. One reason for this is different interpretations on what a subsidy is, what an environmentally damaging activity is, as well as what the connection is between a subsidy and the effect on the environment or climate.

In this article we explain some common interpretations, definitions and calculation methods. This article is part of a pilot project on developing statistics on environmentally damaging subsidies. The project is supported by Eurostat.

No agreed definition

There is currently no internationally agreed definition of potentially environmentally damaging subsidies. Several approaches are in use at international institutions, such as the OECD and the IMF. The lack of a common definition is partly due to the fact that different actors have different purposes for presenting environmentally damaging subsidies.

One issue is regarding what to include as a subsidy. There are many ways to arrange a subsidy, and there are differences between countries when it comes to how transfers and other financial instruments are set up.

In the national accounts, subsidies are defined as "current unrequited payments which general government or the institutions of the European Union make to resident producers." (ESA2010). This is support from state budgets that can be identified in general government accounts.

When it comes to fossil fuel subsidies and other environmentally damaging subsidies, a broader definition of subsidies is used than in the national accounts. First, other transfers that are not considered subsidies in the context of national accounts are often included. Further, other instruments that are not registered as financial transactions but may be regarded as alternative instruments, are included. Examples of the latter are exemptions from paying environmental taxes, or beneficial investment deductions. In order to separate between subsidies as defined in the national accounts and other subsidies, the terms direct subsidies are used for what is included in the definition of national accounts and indirect subsidies for other types of subsidies.

Within environmental statistics, an international framework called the System of Environmental Economic Accounting Central Framework (SEEA CF) is applied. This framework describes potentially environmentally damaging subsidies as subsidies and similar transfers that support activities that are considered environmentally damaging. In some definitions, this measure also includes so-called implicit (or indirect) subsidies, such as preferential tax rates. A definition of potentially environmentally damaging subsidies is not included in the SEEA.

There is international consensus that activities with a negative environmental effect are to be regarded as damaging to the environment. It is relatively easy to state that activities that lead to CO₂ emissions have such a negative environmental effect. It is somewhat more difficult to identify other negative environmental effects than CO₂ emissions from fossil sources. The challenge is to identify the environmental impact of different activities. Examples of activities or products that may have such negative effects are agriculture, transport, construction of buildings, roads, wind turbines or other devastation of nature.

As more and more activities and industries move towards more environmentally friendly alternatives, it becomes more difficult to define entire activities, products or industries as environmentally damaging. This means that one must use a detailed level of information to identify the activity, on a level where the data may be weaker. One might also see an activity or a product as both environmentally friendly and environmentally damaging at the same time, depending on which dimension one considers the activity along.

Fossil fuel subsidies are more clearly defined than other environmentally damaging subsidies. Fossil fuels are directly related to greenhouse gas emissions and thus easier to define. Fossil fuel subsidies are various forms of subsidies that can potentially stimulate increased combustion of fossil fuels. In 2018 and 2019, 77% of Norwegian CO₂ emissions derived from the consumption of fossil fuels.

Proposed national approach

Fossil fuel subsidies are included in indicator 12.c.1 in the UN's sustainable development goal (SDG) 12 on responsible consumption and production. The indicator is to measure fossil fuel subsidies that potentially increase the consumption of fossil fuels. In this context, direct transfers, price support and tax benefits are considered subsidies. The indicator shall measure fossil fuel subsidies as a share of GDP.

Currently, there are no national calculations of environmentally damaging subsidies or fossil fuel subsidies for Norway. Only the IMF and OECD have estimated figures for fossil fuel subsidies for Norway. It is the IMF's calculations for Norway that currently form the basis for the SDG indicator 12.c.1.

Over the past year, Statistics Norway has been working on a pilot project in order to prepare for possible new statistics on environmentally damaging subsidies. The work has consisted of examining different definitions and methods used by international organizations and other countries. Potential data sources and methodologies that suit Norwegian conditions have also been investigated. International comparability has particularly been emphasized. A proposed approach is to distinguish between fossil fuel subsidies and other environmentally damaging subsidies, and then allocate them according to the following setup:

1. Direct budget transfers
2. Indirect subsidies in form of tax reduction
3. Other implicit support measures

Furthermore, an overall definition of fossil fuel subsidies has been proposed:

"A fossil subsidy is a direct subsidy, a tax expense or other financial support from public authorities that makes the production, sale or consumption of fossil fuels more favorable to the producer, sales link or end user than it would be without the subsidy."

Direct budget transfers are identified by evaluation of each individual expenditure in the state budget and classifying them as either environmentally damaging or not. Environmental expenditures has already been mapped through the statistics for environmental protection expenditure in general government and environmental subsidies.

Indirect subsidies in form of tax reductions could have similar effects as a direct transfer. The difference from a transfer is that a traceable transfer of funds is not carried out by a tax reduction. However, there are several ways to calculate an indirect subsidy.

Indirect subsidies – different methodologies

There are several ways to calculate fossil fuel subsidies. The methods have their advantages and disadvantages and are suitable for different purposes. The two most mentioned methods are the revenue foregone method and the effective carbon rate (ECR). The former method is most suitable for analyzing revenue consequences for the general government. ECR is more suitable for assessing competitiveness effects, carbon leaks and for international comparisons of tax regimes.

Tax expenditure arise from full or partial exemption or refund from a tax where at normal rates, additional tax revenue should accrue to the state. In our context, a tax expenditure calculated on the basis of (partial) exemption or reimbursement for environmental taxes imposed on fossil fuels. The subsidy thus consists of the amount that should accrue to the state in the absence of an exemption or refund. It is assumed that a change in the tax rate does not affect the consumption of fossil fuels. The OECD uses this method in its calculations of fossil fuel subsidies. The Ministry of Finance's calculation of tax expenditures, which are published in the tax bill for each state budget , is calculated in the same way. Mathematically, it can be shown as follows per tax:

(1)

where FS = total fossil fuel subsidies (NOK), A_i = ordinary tax rate (NOK / liter) on fossil fuels i, RA_in= reduced tax rate (NOK / liter) for industry n on fossil fuels i and FB_in = quantity fossil fuels in industry n (liters).

Equation (1) shows that the fossil fuel subsidy (FS) is the difference between the general tax (reference) and the reduced rate (A_i  – RA_in) multiplied by the amount of fossil product used (FB_in) summed up for all industries and products.

A drawback with this method is that countries with a high level of CO₂ tax will, with a tax exemption, receive relatively high indirect subsidies compared to a country with a low or no CO₂ tax. It can thus be an advantage to price CO₂ emissions low in this context, in order to be able to point to low fossil fuel subsidies.

With the ECR method, all environmental taxes an industry pays for the use of fossil fuels will be taken into account. The effective carbon rate (ECR) is calculated for each fossil fuel by summing the specific taxes levied on fossil products: CO₂ tax, energy taxes and emission permits.

The carbon rate is calculated in detail per industry and/or institutional sector to take into account different tax rates, exemptions and reimbursement schemes. The ECR method thus takes into account a more complex tax system, where, for example, an exemption from a tax is sometimes granted because another tax is paid instead. Note that general taxes, such as VAT, will not be included as part of the ECR, although most consumers will have to pay full VAT on fossil fuels.

A reference price is used to calculate the actual subsidy by the ECR method. This reference price may, for example, reflect an internationally or nationally determined CO₂ price or a price target. This contrasts to the tax expenditure calculation, where the reference price often chosen is the general tax rate. The subsidy is calculated as the difference between the carbon price and the reference price, multiplied by the amount of consumption of fossil fuels for the relevant industry/institutional sector.

Mathematically, this can be shown by the following equations:

(2)

 

(3)

where CO₂ price * = Calculated CO₂ price (NOK/tonnes CO₂) per industry (n) and per fossil fuel (i), A = tax rate (NOK/liter), t_i = density (kg/liter) per fossil fuel i, u_i = emission factor (kg/kg) per fossil fuel i, U_in = tonnes CO₂ emissions per industry per fossil fuel i, i = product/tax, n = industry, FS = fossil subsidy (NOK/tonnes CO₂), RP = reference price (NOK/tonnes CO₂) and K = price for emission permits (NOK/tonnes CO₂).

The advantage of the ECR method is that it is more comparable between countries than estimated tax expenditures. The reason is that one can use the same reference price instead of national tax rates, which may vary between countries. It also takes into account the potential absence of environmental taxes.

International consensus seems to be that ECR in that sense is a more appropriate method, not least because international comparisons are a main purpose of statistics on fossil fuel subsidies. At the same time, there is no international agreement on what the reference price should be.

Not always an easy solution

Removing environmentally damaging subsidies could have positive effects on the environment and climate. It will also provide increased revenue to the state. However, while it may be an international objective to get rid of fossil fuels and environmentally damaging subsidies, for example by removing exemptions and refunds for various environmental taxes, it may have other, undesirable implications nationally. There may be good reasons why certain industries receive exemptions or reimbursement schemes for environmental taxes.

Carbon leakage is one such example. Carbon leakage entails the danger of industry being moved to countries with less strict climate policies. In other words, climate policy can lead to activity moving abroad and emissions going down in the area one moves from, but correspondingly up in the area one moves to. Here, too, the production processes can be more polluting than in the "home country". Free emission permits or reduced taxes are examples of measures to prevent carbon leakage. In the European Emissions Trading System (EU-ETS), companies in sectors considered to be particularly vulnerable to carbon leakage receive free emission permits. The largest recipients of free emission permits are steel and cement production, as well as oil refineries. Oil and gas extraction are also high on the list.

Nevertheless, the visibility of such subsidies could help to remove or shift support to instruments that have a less environmentally damaging character, or create new instruments that offset this effect. For example, the EU is discussing the introduction of a Carbon Border Adjustment Mechanism (CBAM) on goods from countries with less strict climate policies.

 

The content of this article represents the views of the authors only and is their sole responsibility. The European Commission does not accept any responsibility for use that may be made of the information it contains.

This article was funded by the European Union.