Hybridizing low-carbon technology deployment policy and fossil fuel subsidy reform: a climate finance perspective

Under the paradigm of shared global responsibility to address climate change, all Parties of the Paris Agreement have set nationally determined emissions reduction targets. As countries begin to translate these targets into concrete mitigation actions, climate finance can play an important role in shaping the direction of climate action (Newell and Bulkeley 2016). Given the scarcity of their financial resources, international climate finance providers aim to support national mitigation actions that can demonstrate not only their direct emissions reduction impact, but also their potential for self-sustained implementation and 'transformational change' (Winkler and Dubash 2015). At present, one key reality that threatens these principles in many climate finance recipient countries is the pervasiveness of fossil fuel consumption subsidies, estimated at 493 billion USD in 2014 (IEA 2015b).

These subsidies impede climate goals directly, by encouraging consumption of and reliance on fossil fuels, and indirectly, by economically and politically undermining mitigation actions. Consequently, the reform of perverse fossil fuel subsidies is increasingly climbing the climate policy agenda, including among international financial institutions looking to support low-carbon development (Rentschler and Bazilian 2016). While fossil fuel subsidy reform (FFSR) has been proposed to be developed as a national-level climate policy (Schmidt et al 2012, Merrill et al 2015), moving this rhetoric into reality has proven challenging for two reasons.

Firstly, emissions reductions from FFSR are difficult to measure, report and verify (MRV) (Wooders et al 2016). Ex-ante mitigation estimates are derived from economic models that predict decreases in fuel consumption as domestic prices increase to the international level (Burniaux and Chateau 2014, Schwanitz et al 2014). Such methodologies are problematic given that fuel price elasticities are low in the short-term and uncertain in the long-term (Ellis 2010). These difficulties are compounded by the uncertainty in world fuel prices (McCollum et al 2016). Furthermore, ex-post attribution of emissions reductions specifically to the FFSR policy is difficult, as disentangling the policy effect from other drivers of fuel consumption may prove infeasible (Okubo et al 2011, Fouquet 2016). Thus, while environmental arguments are a key motive behind international ambition to support reform (Lockwood 2015), justifying climate finance flows to national FFSR policies will likely require more robust MRV approaches.

Secondly, on top of these methodological challenges lies the national political challenge accompanying any FFSR effort (Victor 2009, Lockwood 2015). Historically, the national political will to introduce reform has often arisen from the urgent need to correct fiscal imbalances (Rentschler and Bazilian 2016). This context gave international lending institutions such as the IMF significant leverage in coercing subsidy removal, but also forced fiscal tightening at a time when social grievances were high and already weak national institutions were ill-equipped to manage the negative distributional repercussions of FFSR (Wamukonya 2003). Many of these reforms spurred public protest, leading to the reintroduction of subsidies and a perception of international involvement in FFSR policies as politically insensitive to national contexts.

Since the end of 2014, the drop in global fuel prices has renewed the national political will to introduce FFSRs (Rentschler and Bazilian 2016). Although low fuel prices soften the immediate societal impact of reducing subsidies, the persistence of these reforms is questionable if and when fuel prices rebound. Given that economic and environmental benefits of FFSR are realized over longer terms (Fouquet 2016), capturing these benefits requires a shift away from 'short-termism' drivers and reactive measures. This paper thus explores a new policy concept to allow international climate finance providers to proactively help enable and realize the long-term benefits of FFSR.

Historically, a large share of international finance for supporting climate change mitigation in developing countries was channeled through the Clean Development Mechanism (CDM)—a market mechanism that allowed industrialized countries to offset a share of their emissions by purchasing emissions reductions credits from projects in developing countries. As the CDM operated with the aim of generating credible emissions reductions, it has resulted in a portfolio of internationally accepted MRV methodologies (Okubo et al 2011). However, renewable energy technologies² (RETs), which often face high risks and non-financial barriers, were underrepresented under the purely market-driven CDM (Schneider et al 2010).

With the Paris Agreement, the paradigm has shifted towards a bottom-up governance structure in which developing country governments formulate nationally-determined mitigation actions in line with their respective capabilities and development goals (UNFCCC 2015). Unlike under the CDM, a large number of the proposed actions have been policies that support the deployment of RETs (DTU and UNEP 2016, Schmidt and Huenteler 2016). Many of these renewable energy deployment policies (REDPs) are seeking climate finance support, in part due to the ability to quantify their climate impacts using established CDM MRV methodologies (Okubo et al 2011). However, often these REDPs are proposed in countries with subsidies for fossil fueled electricity, creating both a dissonance in policy objectives at a national level and an additional financial burden to climate finance providers expected to cover incremental policy costs (Schmidt et al 2012).

While some research has begun to investigate the effects of recycling savings from FFSR into RET investments (Merrill et al 2015), it has focused on FFSR as the cornerstone policy. Instead, we seek to fill a gap by investigating the synergies of a hybrid FFSR+REDP policy in four illustrative case studies, particularly from a climate finance perspective. Importantly, REDPs do not just provide incentives for RET investments (e.g. via a feed-in-tariff or power purchasing agreement). They also help establish the regulatory and institutional framework necessary for RET diffusion (e.g. grid codes, a framework for independent power producers, long-term targets) (Glemarec et al 2012) and, by incentivizing domestic low-carbon industrial activity, help build 'winning coalitions' for decarbonization (Meckling et al 2015). We thus argue that hybridizing FFSR, a policy with complicated implementation but high transformative potential in the long-term, with REDP, a well-established mitigation action that spurs change in the near-term, can help balance the methodological, political and financial dimensions that climate finance providers face when evaluating national mitigation actions.

Specifically, we develop a bottom-up techno-economic model that incorporates country- and technology-specific characteristics to quantify the policy costs and abatement potential for a REDP and FFSR policy (see section 2). In a first step, we model a deployment policy that provides 20-year support for a 10-year phase-in of wind and solar photovoltaic (PV) generation, in order to understand the impact of fossil fuel subsidies on the REDP costs (the results and their interpretation are presented in section 3.1). In a second step, we analyze the effect of fossil fuel subsidy phase out on average generation costs in 2025 and compare it with the case in which it is enacted alongside renewable energy deployment (section 3.2). In section 4 we assess the FFSR+REDP hybrid policy against typical climate finance criteria (see supplementary table S8 available at stacks.iop.org/ERL/12/014002/mmedia) before concluding in section 5.

The model operates on two layers which are described in sections 2.1 and 2.2. We apply our model to the four cases of Lebanon, Saudi Arabia, South Africa and Tunisia. This country selection represents a mix of net exporters and importers of the fuels that they subsidize. They were chosen to reflect variation in their baseline generation costs and emissions and their subsidization levels (see supplementary tables S1 and S2). These differentiating characteristics translate to wide variation in policy costs, and thus different implications for international support.

2.1. Modelling electricity generation costs and emissions

2.2. Policy costs and assumptions

This section presents the results of the model. We discuss policy costs of the REDP in section 2.1 and generation costs in a scenario in which fossil fuel subsidies have been phased out in section 2.2.

3.1. The impact of fossil fuel subsidies on REDP costs

The results in figure 1 show the economic barrier that fossil fuel subsidies pose to the diffusion of RETs. In each of the four case countries, incremental costs of renewable generation over subsidized baselines are positive, leading to marginal abatement costs ranging from 22 USD/tCO₂ in South Africa to 46 USD/tCO₂ in Tunisia. The marginal costs also reveal the large distortion that subsidies introduce to incremental cost calculations: although Lebanon's baseline is dominated by expensive diesel and heavy fuel oil, renewable generation appears one of the least competitive of the four countries, whereas in South Africa, whose coal-based generation mix is the cheapest of all the countries', renewables appear most competitive.

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Correcting the fossil fuel subsidy distortion can lower the REDP abatement cost by as much as 259% in Saudi Arabia to 44% in South Africa. From the policy financing perspective, in countries with high subsidies and expensive baseline fuel inputs (e.g. Saudi Arabia and Lebanon) these avoided subsidies, which can also be considered as the unilateral financial contribution to the policy, are theoretically sufficient to support RET generation without further international finance. International support would therefore play a more indirect role, for example by assisting in the policy design or by helping lower non-financial barriers to RET diffusion, discussed further in section 4. In countries with both lower fuel costs and subsidy levels, the REDP incremental costs would likely entail a sharing of unilateral and international finance. Proper accounting of subsidies helps in allocating financing responsibilities of the REDP in the near-term (Schmidt et al 2012); however if low-carbon technology deployment is to be sustainable in the long-term, the baseline must not only be accounted but also reformed through the removal of fossil fuel subsidies.

3.2. The impact of adding REDP to FFSR on average generation costs in 2025

Figure 2 presents the effect of fully removing subsidies on average 2025 generation costs in three fuel price scenarios (see supplementary figure S2) and two hypothetical generation mixes: the mix that assumes continued utilization of non-renewable generation to meet electricity demands (pure FFSR), and the previously modelled mix that assumes renewables comprise 20% of 2025 generation (REDP + FFSR). The average generation cost presents an end-user perspective of subsidy removal, given that the public impact and response to reform can pose a barrier to its implementation (Arze del Granado et al 2012, Williams and Kahrl 2008).

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In all cases, the addition of REDP to FFSR has relatively little impact on average generation cost compared to the pure FFSR case. In Saudi Arabia and Lebanon, where renewables are already cheaper than the unsubsidized baseline, the REDP even reduces the generation cost increase. In South Africa, where the addition of the REDP has the greatest impact on generation cost, this increase is only 13% greater than the pure FFSR case in the moderate fuel price scenario. However, in all cases, the 20% share of RETs in the REDP + FFSR mix reduces exposure to world fuel prices, thus cushioning the impact of a fuel price shock. This effect is most pronounced in countries in which fuel is the dominant factor in determining generation costs: in Lebanon and Saudi Arabia, it buffers cost increases in a high fuel price scenario by 22% and 19%, respectively. Reducing the uncertainty of the magnitude of a fuel price shock has two benefits. In case of high price shocks, it facilitates government planning for social safety nets to reduce impacts on vulnerable members of the population. In case of low price shocks, it constrains the incremental cost of the REDP that would need to be covered either by international commitments or domestic budgets (Huenteler 2014).

The results of the model have shown the need to level the playing field for low-carbon technologies: the removal of subsidies is arguably a necessary, but insufficient, condition for unlocking current and future mitigation activities. At the same time, combining REDP with FFSR has only a marginal impact on overall generation costs yet an added benefit of reducing fuel price exposure. While it has been suggested that subsidy savings could be recycled into supporting RETs (Merrill et al 2015), we instead argue that a hybrid policy approach in which REDP is packaged with subsidy reduction would be effective from a climate finance perspective given its mitigation potential, cost and self-sustainability.

Regarding mitigation potential, the REDP—unlike the pure FFSR policy—guarantees a minimum 'MRVable' mitigation volume, relatively independent of both elasticities and international fuel prices. Any additional long-term mitigation resulting from the FFSR would be 'net mitigation'. Financing a hybrid REDP + FFSR policy can therefore potentially leverage large mitigation volumes.

Regarding cost, international finance could support a portion of the incremental REDP cost through a payment mechanism contingent on a FFSR schedule. Unlike past conditional lending used to coerce subsidy removal as a means to free up immediate fiscal space, the process-oriented conditionality (Winkler and Dubash 2015) suggested here would entail a country gaining access to climate finance provided it develop and implement a FFSR strategy. Crucially, this process should be nationally-driven in order to outline a FFSR strategy adapted to national political and socio-economic contexts—rather than the one-size-fits-all approach historically dictated by international organizations. In the past, such open consultation processes that engaged public opinion played a key role in helping overcome political economy barriers to policy implementation (Rentschler and Bazilian 2016, IMF 2013). At the same time, this payment mechanism can help hold national policymakers accountable to both maintaining and credibly allocating the benefits of subsidy removal, and also provides leverage to international climate finance providers—actors who typically cannot directly influence fiscal policy—in supporting FFSR.

The effectiveness of such a scheme, however, requires a degree of political will for FFSR and REDP at the national level (Hansen and Nygaard 2013). Willingness to reform subsidies is likelier witnessed in importing countries where subsidies are more transparent and explicitly strain state budgets. Subsidy reform has moved up political agendas in many net-importing countries, even those in which subsidies are deeply embedded in the social contract (e.g. Tunisia and Egypt). However, the viability of using RET support to leverage FFSR in the two exporting countries reviewed in this paper remains questionable. In South Africa, where coal subsidies are rather hidden, the renewable energy power purchasing agreements are financed unilaterally, although international actors provided technical and financial assistance in the program set-up (Eberhard et al 2014). And, while Saudi Arabia does aim to cut subsidies to alleviate its growing budget deficit (Ball 2015), RET development will likely be seen as a unilateral responsibility⁷.

The second characteristic, or the ambition to introduce REDPs, largely stems from non-climate concerns. In net importing countries, energy security—as is the case of Tunisia (Laumanns et al 2012)—is a key driver, whereas in exporting countries hit economically by declining commodity prices, REDP may be viewed as a component of industrial policy. In South Africa, for instance, local content requirements form a cornerstone of its renewable energy program (Baker et al 2014) and in Saudi Arabia, investments are flowing to solar manufacturing facilities in hopes of creating jobs for its unemployed youth (Ball 2015). Consequently, capacity building and technical assistance to help achieve these co-benefits will also be important to leverage national political buy-in to the policy support package. In this way, we argue that successful FFSR also requires supporting the winners of a low-carbon transition, rather than simply utilizing subsidy savings to compensate the losers of reform.

Finally, and related to the above point, a hybrid approach can also create mutually reinforcing characteristics to help safeguard the self-sustainability of both policies. While the removal of fossil fuel subsidies, and carbon pricing reform in general, is theoretically the most efficient means of achieving emissions reductions (Edenhofer et al 2015), political barriers often prohibit such a direct policy approach (Jenkins 2014). In the short-term, REDPs are more politically feasible and, because of their quantifiable environmental impacts, can seek climate finance more justifiably than carbon pricing policies alone (Wooders et al 2016). For example in South Africa—a country characterized by powerful coal interests—RET has grown, with some bilateral support, from a niche perceived as unthreatening to fossil fuel incumbents; the introduction of a carbon tax, on the other hand, has been delayed several times due to political push-back (Baker et al 2014). Yet we argue that a hybrid package in which REDP is strategically sequenced before FFSR can make reform more sustainable in the long-term for two reasons. Firstly, diversification of the energy mix away from subsidized fuels erodes the necessity for subsidies and the impact of their removal. Past successful reforms often involved the provision of a suitable energy alternative, such as Indonesia's support for liquefied petroleum gas technologies during its kerosene subsidy removal (Vagliasindi 2013). Secondly, while not the direct focus of this paper, green industrial policies such as a feed-in-tariff or renewable portfolio standard can help build stronger green coalitions and therefore carve a political landscape conducive to more transformational, yet presently politically contentious, long-term change. This argument has recently been made with regards to carbon pricing (Meckling et al 2015), but a similar rationale can be applied to subsidy removal, which is synonymous with the removal of a negative carbon price.

In this paper, we proposed that 'hybrid' FFSR and REDPs can package mutually reinforcing near-term environmental outcomes with long-term 'transformational' objectives. As we focused on the climate finance perspective, an analysis of the country-specific distributional impacts and sociocultural considerations of REDP and FFSR policies was beyond the scope of this paper. Past research has and should continue to conduct country-specific analyses to advance our concept of policy hybridization in light of different political economy constraints, as other innovative approaches for coupling climate finance with FFSR have been proposed in literature (e.g. Jakob and Hilaire 2015) may also be appropriate in some circumstances.

Instead, our proposed hybrid policy aimed to find a balance between the politically controversial one-size-fits-all approach characterized by past international involvement in structural reform, with ad-hoc country analyses that may offer little generalizability to international climate finance providers wishing to support reforms more broadly. We have argued that supporting REDPs that quantifiably reduce emissions is not simply a means of correcting an environmental externality, but also a means of fostering a low-carbon transition: strengthening national allies, inducing cost reductions through local technological learning, and localizing a low-carbon industry. All of these effects, however, manifest on a timescale longer than the typical supported climate policy lifetime. Leveraging these transformational changes therefore requires that low-carbon technology deployment be self-sustaining in the long-term. Introducing structural reforms necessary for a greener growth trajectory, such as removing fossil fuel subsidies, should thus be viewed as more than simply correcting a market failure, but as enabling an environment in which low-carbon alternatives can compete fairly with incumbent technologies—both economically and politically. While here we focused on REDP and FFSR in the power sector, hybridization of concrete near-term measures with longer-term structural reforms may help overcome the 'carbon lock-in' (Unruh 2002, Erickson et al 2015) of other policy constellations and of other climate-relevant sectors.

We gratefully acknowledge the financial support by the Swiss National Science Foundation (Project number PYAPP1_166905). We also wish to thank ETH Zurich's EPG team members, Joern Huenteler, and two anonymous referees for their constructive feedback on the paper.