By any measure, fossil fuel subsidies are immense. Combined estimates from the Organisation for Economic Cooperation and Development (OECD) and the International Energy Agency (IEA) put explicit fossil fuel subsidies across 82 major economies at $1.5 trillion in 2022[i] The International Monetary Fund (IMF) has estimated explicit and implicit subsidies combined at $7 trillion across 170 countries for the same year.[ii]
As these subsidies are increasingly likely to be reduced, reforms threaten to lower the net present value of oil and gas companies by decreasing their profit margins – and, by extension, value to investors.
Subsidies, in general, may be economically efficient when they address market failures – for instance, when they support firms generating positive externalities such as knowledge spillovers[iii] or environmental benefits. Subsidies may also be temporarily justified when they support infant industries that will eventually become competitive due to declining average costs, particularly when the benefits of establishing the industry accrue to the many and not the few.
Through this lens, subsidies for oil and gas are economically inefficient and distortionary, artificially boosting demand for a product whose end use generates significant negative environmental and health externalities. These subsidies also typically worsen public debts, exacerbate social inequalities, and divert public funds away from uses where government support may be economically justified. For countries reliant on the oil and gas sector for a significant portion of state revenue, subsidies also represent a notable barrier to shifting the economy away from fossil fuel dependence, reinforcing state exposure to energy transition risks – discussed further in our report PetroStates of Decline.
Fossil fuel subsidy reform has historically been hard
Recognising the impacts of fossil fuel subsidies, governments worldwide have agreed to phase down these subsidies to an extent. The Group of 20 (“G20”) and the Asia-Pacific Economic Cooperation (“APEC”) group committed to phasing out and rationalising “inefficient” fossil fuel subsidies as early as 2009,[iv] while parties to the Glasgow Climate Pact at COP26 similarly agreed to phase out “inefficient” fossil fuel subsidies in 2021.[v] Yet, despite this consensus, only a few subsidy reform measures have succeeded to date, with fossil fuel subsidies continuing largely for political reasons.
Consumption subsidies (e.g., pricing energy below the market rate) can help politicians in low-income countries to deliver on the social contract. Citizens of oil- and gas-abundant countries may also feel a birthright to inexpensive fossil fuels, bringing leaders to provide consumers with generous subsidies.
Production subsidies (e.g., producer tax breaks, subsidised credit, risk guarantees) enable politicians to repay the fossil fuel companies that have vastly contributed to campaign finance and lobbying and ensure ongoing financial support. In the United States alone, where a Senate seat typically costs over $10 million to attain, the energy and natural resources industry spent $4.5 billion on lobbying from 1998 to 2014.[vi]
Once subsidies are in place, they are often deeply unpopular to remove. Politicians that remove consumer subsidies often face widespread public backlash. Those that remove producer subsidies are at risk of losing an important source of campaign finance and may face resistance from local communities whose livelihoods are tied to the industry. Producer subsidies are also largely inconspicuous, allowing them to be administered without drawing heavy scrutiny.
However, rapid renewables growth paves the way for reform…
Despite the historical obstacles to reform, the tide may be turning. As renewable energy capacity expands, governments are increasingly able to reform subsidies without jeopardising energy security or affordability. As the physical impacts of climate change become increasingly real, policymakers are also likely to have a growing mandate to act on subsidies. Reforms are also important for addressing soaring public debts.
The question then becomes: when are reforms likely to be enacted?
On the producer side, public sentiment for increasing corporate taxation (or subsidy removal) is greater during periods of high commodity prices and associated corporate profits – as observed across the EU, the UK, and India with the implementation of windfall taxes in 2022.[vii] Governments looking to accelerate the transition may seek to enact lasting reforms in the short- and medium-term before average commodity prices decline.
A shift in public administration may further accelerate production subsidy reforms. The UK Labour Party, for instance, is expected to scrap a cut in fuel duty in its first Budget once the discount was found to solely benefit producers/corporate profits.[viii]
National climate commitments may also drive reforms, as countries with a legal obligation to reduce emissions take action to meet 2030 emissions targets. For example, Ireland effectively ended commercial peat harvesting (and associated subsidies) by 2023 due to the EU’s binding emissions reduction targets.[ix]
On the consumer side, governments may phase down consumption subsidies in the near term by removing subsidies gradually to avoid price shocks, and pairing subsidy reforms with redistribution measures to ensure basic energy needs are met. Such approaches have proven effective in cases such as the decontrolling of diesel prices in India and fuel prices in Ghana.[x]
In the long term, the commodity price declines that are expected to occur as the energy transition unfolds may help reinforce consumption subsidy reforms. Lessons from India, Indonesia, and Ghana suggest that low commodity prices help states remove consumption subsidies without exposing consumers to unduly high energy prices, improving public reception to reform.[xi]
Beyond explicit subsidies (i.e., production and consumption subsidies), implicit subsidies are increasingly likely to be reformed through carbon pricing mechanisms, which would likely negatively impact the welfare of both producers and consumers. The EU’s carbon border adjustment mechanism (CBAM), for instance, will take full effect by 2026, putting a price on carbon for certain emissions-intensive sectors. The UN Principles for Responsible Investment’s Inevitable Policy Response (IPR) forecast believes that the US may follow suit, and that all major industrial economies may utilise carbon pricing in the long term.[xii]
…increasing the exposure of oil and gas companies and their investors to transition risks
As the energy transition unfolds, investors in oil and gas should recognise the risk that fossil fuel subsidy reforms (e.g., removal of lucrative production tax breaks, decreasing demand for fossil fuels due to removal of consumption subsidies) pose to their returns on investment. Specific financial impacts could include:
- A decrease in revenues and profitability from existing projects
- Lower revenue and profitability forecasts for potential new projects (with negative impacts to project financing availability as well)
- Associated reductions in share price, in turn decreasing value to shareholders
Emergence of subsidy reforms calls for investors to engage further with corporates
Considering these risks, investors in oil and gas should request the following information from corporates to identify and address specific areas of risk exposure related to subsidy reform:
- Value of fossil fuel subsidies provided to the company.
- What is the value of tax breaks, exports loans/guarantees, and other production subsidies received by the company?
- To what extent is consumption of the company’s products subsidised within different markets?
- Sensitivity analyses identifying the potential financial impacts of subsidy reform.
- How is the company forecasting its forward-looking risk exposure to subsidy reform?
- How would reforms of implicit and explicit subsidies impact demand for the company’s oil and gas products? For instance, would the company’s returns meet the hurdle rate?
- Business strategy and production plans in the event of subsidy reforms.
- What subsidy reform scenario is the company planning on when devising its production and investment plans?
- How does the business strategy prepare the company for potential subsidy reforms?
Additionally, investors with a mandate to act to reduce the climate impact of investees companies should request information on subsidy-related lobbying activities. Such lobbying threatens not only the removal of production and consumption subsidies but also the introduction of an appropriate carbon price, undermining international efforts under the Paris Agreement to limit global warming to well below 2°C. The following are key questions on such lobbying to ask all companies, with company-specific questions included within our oil and gas company profiles:
- Does the company lobby against subsidy reform (including carbon pricing) either directly or indirectly (i.e., via industry or trade associations)?
- What corporate governance controls are in place to ensure any lobbying related to subsidies does not contravene the goals of the Paris Agreement?
Equipped with information on risk exposure and mitigation, as well as corporate actions on lobbying, investors can more effectively engage with oil and gas companies around the impacts of fossil fuel subsidy reform. Investors left unsatisfied with corporate response must then consider whether they can reasonably continue to hold such investments within portfolios or continue to finance their business activities. As with many other transition-related risks, change can take a while to happen, but when it does, it can be surprisingly rapid with potentially significant consequences.
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[i] https://web-archive.oecd.org/temp/2023-12-06/670493-cost-of-support-measures-for-fossil-fuels-almost-doubled-in-2022-in-response-to-soaring-energy-prices.htm
[ii] While the layperson may assume production subsidies are a form of implicit subsidies, the IMF classifies both production and consumption subsidies as “explicit” subsidies. In contrast, the IMF considers undercharging for externalities and foregone consumption tax as “implicit” subsidies.
The IMF’s total subsidies estimate would be closer to $11 trillion if it were to use a higher social cost of carbon.
https://www.imf.org/en/Topics/climate-change/energy-subsidies
[iii] Knowledge spillovers generally refer to the unintentional and uncompensated exchange of insights or innovations between individuals or firms.
[iv] https://www.imf.org/en/Topics/climate-change/energy-subsidies
[v] https://www.imf.org/en/Topics/climate-change/energy-subsidies
[vi] https://practicalactionpublishing.com/book/2642/ending-fossil-fuel-subsidies
[vii] https://www.ft.com/content/bab495e0-ec4d-4026-a13d-1aad9fcc0805
[viii] https://www.bbc.co.uk/news/articles/cm2nrneym82o
[ix] https://practicalactionpublishing.com/book/2642/ending-fossil-fuel-subsidies
[x] https://practicalactionpublishing.com/book/2642/ending-fossil-fuel-subsidies
[xi] https://practicalactionpublishing.com/book/2642/ending-fossil-fuel-subsidies
[xii] https://www.unpri.org/inevitable-policy-response/the-inevitable-policy-response-2021-policy-forecasts/7344.article
