All Hands On Deck To Confront The Energy Crisis

The current energy crisis illustrates once again the importance of reliable, diversified and affordable energy sources. Strong price increases inflict heavy economic damages: if coal, oil and gas retain their recent high prices, global spending on energy will reach 13% of GDP in 2022 – doubling in just one year. This is equivalent to the oil shocks in the late 1970s, which were followed by a deep global recession.

Energy price shocks also inflict a severe hit on vulnerable households. A survey in mid-September found that more than 1.7 million UK households were planning to stop paying their energy bills. In the United States, 20 million households are behind on utility invoices. This could lead to social discontent and political unrest. Governments are therefore stepping in with consumer subsidies to soften the hit, but at a great cost for the public finances.

Energy markets need to be reformed

None of this is new. Energy shocks already struck in the mid-1970s, eary-1980s, mid-2000s – and will keep on striking without fundamental change. Deep reforms are needed to secure a more reliable, diversified and affordable energy system. What to aim for is well known: we need to shift away from fossil fuels, increase the supply of alternative energies, and achieve a diversified energy mix less prone to sudden shocks.

Unfortunately, after more than five decades of procrastination, fossil fuels still represent 83% of global primary energy consumption. The rise of emerging market economies with strong oil and coal demand partly explains it. But advanced economies have seen little change either: fossil fuels still account for 81% of their primary energy consumption, and renewable energies have only progressed marginally. In the United States, as an illustration, wind power today accounts for only 4% of consumption and solar power for a mere 1.7%. The share of nuclear power is more significant (8%) but is on the decline.

Source: BP Statistical Review (2022)

 

The global energy mix must change much faster. A gradual energy transition, as currently planned, will not suffice. Nothing short of an “energy revolution” is needed. To do this, all hands must be on deck. Rather than focusing on a limited set of policy tools, governments must use all available instruments to accelerate the pace of reform.

The United States has launched initiatives to improve its energy mix

The United States recently provided an example of how to improve the energy mix. The Inflation Reduction Act (IRA) approved by Congress, and signed into law by President Biden in August, funnels US$369 billion over 10 years to lower the country’s heavy reliance on fossil fuels. Large tax expenditures will support wind farms, solar panels, nuclear plants, and green hydrogen. The IRA will also lower the cost of electric and zero emission vehicles and provide generous subsidies to individuals who upgrade the energy efficiency of their homes. Unfortunately, the IRA does not increase taxes on fossil fuels, apart from a charge on specific types of methane emissions.

According to estimates by Princeton’s REPEAT, the IRA will lower oil consumption by 13% and natural gas consumption by 9% in 2030 compared to a baseline with existing policies. The bulk of this decline will be in the power sector, which is expected to switch massively to renewable electricity. New wind power capacity is projected to double, and that of solar power to increase five times. This is a welcome package, which will result in a more diversified and thus more secure energy mix.

Nonetheless, IRA will not be sufficient to reach net zero carbon emissions in 2050. Without further reforms, fossil fuels will remain the main source of energy in heavy industries, commercial and residential buildings, and transport. Reducing the consumption of fossil fuels in these sectors will require larger investments and more spending on research and development. High levels of carbon pricing would provide financial incentives to make these investments worthwhile in the private sector.

However, fossil fuels face extremely low taxes in the United States. Gasoline and diesel fuels are subject to federal and state-level taxes equivalent to only $14.32 per tCO₂. California’s carbon market trade at around $28 per tCO₂. Both prices are well below levels that are deemed necessary to encourage switching away from fossil fuels, and other fossil fuels remain largely untaxed.

Several attempts have been made to pass carbon pricing legislation in Congress. More than 10 carbon pricing bills were submitted, both by Republican and Democratic lawmakers, with initial carbon rates ranging from $15 to $59 per tCO₂. Model-based simulations found that all these initiatives would have been efficient instruments to reduce fossil fuel consumption, slash carbon emissions, and improve the energy mix.

Unfortunately, Congress has not approved these bills. While this is in line with the established narrative of broad opposition to a carbon tax among US citizens, a closer look paints a different picture. Indeed, according to a new OECD study, only 17% of Americans oppose a carbon tax that is used to fund environmental infrastructure, and only 22% oppose a carbon tax that is used to reduce personal income taxes. The OECD study shows that a majority of households support a carbon tax if the revenue is recycled appropriately. OECD work also suggests that energy pricing should start with the industrial, residential and agricultural sectors – rather than the politically-sensitive gasoline tax – hence facilitating the task of lawmakers.

In addition to carbon pricing, improving the energy mix will require eliminating US fossil fuel subsidies. The federal government provides financial support to the oil and gas sectors to encourage domestic energy production, and tax benefits to support exploration and drilling operations. Eliminating these subsidies is easier said than done. Congress has made several attempts to curb their generosity and reduce their distortive effects, but without finding a majority. Powerful lobbying pressures make it difficult to progress. Instead of removing these supports, they could be rechannelled to encourage a more rapid transformation of the energy sector. Major oil and gas firms have expertise, technology and know-how required for a new energy mix – they should be encouraged to invest heavily in renewable energies, while keeping the door open to new players.

All of the above

With 15.5% of fossil fuel energy consumed in the world, the United States is important to the global energy transformation. Also crucial is a rapid reversal of fossil fuel consumption in China (26.6%), India (6.5%) and Russia (5.6%). In these countries, and around the world, carbon pricing is within the reach of policymakers if attention is paid to cost efficiency, inclusiveness, and political acceptability.

Timing is essential: higher carbon prices are off the table in the current crisis, but this will change as soon as global energy prices fall back towards their previous levels. Informing consumers about future policies ahead of time is critical so that they can prepare for upcoming changes.

Carbon pricing is vital to encourage private investment in renewable energies. Other policy instruments also have a role to play. Direct subsidies can help improve the energy efficiency of consumers and the fast transformation of producers. Tax expenditures can help to accelerate innovation. Public investments can provide public goods such as extended and strengthened electricity network. Regulation can close the gaps when other instruments are not available. Multiple forums are available internationally where government officials can exchange experience about these policy interventions and learn how to devise successful country-specific packages.

All instruments and, crucially, all hands must be on deck.