Removing fossil fuel subsidies reduces emissions with limited impacts on economic activity and household incomes

New ESRI research examines how removing eight fossil fuel subsidies would impact both the economy and carbon emissions. It finds that simultaneously removing seven of them — all but the household fuel allowance — would have a modest adverse effect on real GDP and household income. However, doing so would have a sizeable impact on reducing economy-wide emissions.

The research also finds that increasing the carbon tax at the same time as removing the subsidies would slightly increase the adverse economic impact but lead to a more substantial decline in emissions. However, these emissions reductions would be insufficient for Ireland to meet its 2030 emissions targets, in the absence of other policy tools.

The results are based on new research using the ESRI’s Environment, Energy and Economy (I3E) model for Ireland.

Eight fossil fuel subsidies accounted for €2.44 billion forgone government revenue in 2014. These subsidies fall into three categories: 1) transportation, electricity and peat production sectors to lower the cost of production, 2) reductions of excise tax rates on diesel fuel oil and kerosene and 3) means-tested fuel allowances of households for electricity, gas and fuel to lower the cost of home heating.

The research finds that if the subsidies, except for fuel allowances of households, are removed in 2020, real GDP will decline by 1.24% and the economy-wide CO2 emissions will decline by 20% by the year 2030, compared to a business-as-usual scenario. If the subsidies are removed and the government increases the carbon tax by €6 annually starting from 2020, real GDP in 2030 will be 1.8% lower while CO2 emissions will decline by 31%, relative to a business-as-usual scenario.

The research shows that the removal of subsidies lowers the level of economic output of the subsidised sectors, particularly for the air transportation and peat sectors. Removing the excise tax subsidies on diesel has the highest adverse impact across all commodity-related subsidies.  Electricity production and transportation are hit the hardest, but the impacts on sectoral value-added are less than 3% in 2030. If all subsidies, except fuel allowances, are removed simultaneously, value-added of the transportation, mining, and electricity production sectors decreases in real terms, whereas the impacts are negligible for other sectors.

With the exception of energy allowances for households, the subsidy removal policy has negligible impacts on the real disposable income of households. Incomes would decline in line with the declines in real GDP, and the effects are almost uniform across households. However, as energy allowances of households are means-tested transfers, the poorest two income quintiles (i.e. lowest 40%) in urban and rural areas are affected negatively. Excluding these allowances from removing fossil fuel subsidies does not affect the macroeconomic aggregates and emissions results but it is important for preventing a negative impact in terms of income inequality.

One of the ESRI report’s authors, A. Mert Yakut commented: “Lowering the cost of fossil fuels via subsidies encourages excess consumption of these commodities and accelerates climate change. Removal of fossil fuel subsidies would directly improve our emissions performance plus provide substantial fiscal headspace for the government to use for other climate and social policies. Furthermore, the research finds removal of fossil fuel subsidies, except fuel allowances of households, causes a substantial reduction in country’s emissions without adversely altering the income distribution. Increasing the carbon tax, in addition to the removal of subsidies, would lead to more substantial reductions in emissions with relatively minor decline in household incomes”.