The real fossil fuel subsidy – its not what you think.

A “$5.2 trillion subsidy for fossil fuels” scream the headlines, followed rapidly by the conclusion that the subsidy-free “real” price to consumers should be much higher. The logic being that this artificially low price drives consumer demand of fossil fuels and thereby acts as a barrier to entry of renewables. The figures bandied about are eye-watering: US$5.2 trillion is 6.5% of global GDP… a very big number indeed. And this is a very emotive subject. So before getting onto the *real* fossil fuel subsidy, let’s take a moment to consider what is meant by “subsidy”.

Indirect Subsidies (Ignoring Externalities)

The figure of $5.2 Trillion comes from an IMF report that was of course latched-onto with glee by all “keep it in the ground” commentators. Behind the headline is the fact that the IMF tried to quantify all the “externalities”, including indirect costs of pollution, items such as healthcare costs and climate change adaptation are all included – so the notion of this as a subsidy is quite different to the usual understanding of subsidies as a direct cash-related stimulus.  So firstly, we should ensure we are comparing like with like when talking about subsidies, and secondly one should be more generic if this line of reasoning is to be assumed.

On the latter point, if we are to consider externalities, should the same logic be applied to all businesses? There is no corner of a capitalist consumer society that doesn’t have some externalities, yet these are never quantified. Food manufacturers who spend vast sums promoting unhealthy products with packaging designed to ensnare unwary consumers are not held accountable for plastic in the oceans nor for the cost of treating obesity/diabetes epidemics.  This is odd, as the quantifiable culpability around future healthcare costs is much easier to prove than the quantification of potential/likely future climate change costs; idem Supermarkets who place sweets by checkout tills at children’s eye level, marketing departments and advertisers who encourage the sale of unhealthy foods and drinks… journalists who write Shock and Awe click-bait headlines and breathless articles – are judged on their ability to attract sales… sales whether paper or digital have an energy cost and an environmental footprint…. When including externalities where do you start and where do you stop?

Subsidies at Production

Subsidies at production for oil and gas are typically inferred from purported “tax breaks”. There is great difficulty in refuting this as there are many different ways in which oil and gas production are taxed around the world.

In the US, there may be cases which are genuinely favourable to the oil companies. In the rest of the world, oil production is governed by either Tax-Royalty systems or Production Sharing arrangements (“Contracts” or “Agreements”, “PSC” or “PSA”). Tax regimes for upstream usually include a mix of taxes: some linked to profits (corporate income tax (“CIT”), profit oil sharing, excess profits tax) but others are on gross revenues (royalties) or triggered even before production commences (rental payments, signature bonuses). This makes the tax systems applying to the industry far more complex than those applying to a widget manufacturer and the marginal rate varies significantly between countries and even projects within a single country. But as a general rule it is fair to say that the overall tax take from the upstream industry is far higher than that applied to other industries. 

The reason for the very high marginal rates is the aim of the state (as resource owner) to recover ‘economic rent’, i.e. the profits over and above the minimum commercial return a company would require to justify its investment. That minimum commercial return depends on the risk profile of a project, e.g. a lower potential post-tax return would usually be acceptable for rehabilitating an existing mature field than for initiating frontier exploration in an area with no commercial discoveries.

Due to the high-risk and massive capex requirements, there is often a favourable cost-recovery mechanism and lack of CIT: this is usually what is being referred to when anti-oil talk up the “huge subsidies”.

The part that is missed when talking about the “favourable” treatment of oil companies is the fact that oil and gas companies are subject to specific and very high petroleum taxes. In Norway a widget factory will have to pay 19% corporate tax on its taxable income. The petroleum tax rate for oil companies is 78%, (and in Nigeria 85%).  Do you know of any other business that could survive with 85% tax?

The exact terms tend to reflect the risk of the licence – if it is a frontier exploration with no known oil, then the terms can be very favourable to encourage the extremely risky investments. Such favourable treatment is necessary as the risk is huge for the explorer: generous fiscal terms for produced oil are of no help if you drill a dry well and never have production or revenues.  

What generally happens after a discovery in a frontier region is the host government looks askance at the “dreadful” deal that was done (usually by a previous administration), and there is a clamour to renegotiate the deal as the press screams that the big bad oil company is pillaging. Hindsight is a wonderful thing.  Similarly, the vintage of a licence can make a difference, if like in 1998 oil is at $12/bbl then favourable tax rates are needed to attract anyone, whatever the geological risk. 

Conversely, in areas with proven hydrocarbons, the lower geological risk is usually associated with higher tax rates. As noted above, oil-rich Nigeria has an 85% tax rate on profits for oil production. 

Whilst oil and gas companies do have different treatment than “normal” companies, much of it is ephemeral reductions in overarching punitive tax systems that would kill any normal industry. I’m not asking anyone to shed a tear for oil companies, but trying to provide some context to the simplistic view that tax breaks automatically mean “subsidy”.

Subsidies at Consumption

Many countries do have fuel subsidies – this is very common in the developing nations whereby fuel (petrol, diesel) is sold below cost to ease access. For countries who are a net exporter of petroleum products this is a choice. However, for any country who imports, this is a case of robbing Peter to pay Paul. The government must import the petroleum products at cost and sell below cost – so the government is making a loss on every transaction. Since the government is funded by taxes, the population as a whole is still paying for the petrol, albeit indirectly by general taxation.

Developed countries tend to have the opposite – with the price of petrol being heavily taxed. It has been estimated that the total tax generated from sales of fuel is greater than the entire revenue of OPEC…. (a figure published by… er, OPEC 2015).  Fuel Tax is clearly the opposite of a subsidy.  In the UK, the government receives something in the order of £27 billion annually from fuel tax.  Indeed, given that the “cost at the pump” is 65% tax in the UK, it is clearly refutes the logic that says fossil fuels are subsidised (and thus encourage consumption). Remove fuel tax in the OECD countries and just watch driving habits change. 

Charging an EV is either free or uses super cheap electricity – with the cost spread over all consumers and no fuel tax.  The absence of fuel tax on electricity for EVs is a form of subsidy. Irony anyone?

As we transition from ICE vehicles to EVs, does anyone seriously expect our governments to just give up the fuel tax? Of course not, abstracting from all other reasons, just this should tell us that the golden age of EV ownership is now and the future will be more expensive.

The Real Fossil-Fuel Subsidy

The one area no one ever thinks of subsidies is in the “cost of everything”. Everything, whether goods or services, has an energy footprint. People are generally very focused on the carbon-footprint, and even this is poorly understood. The energy-footprint is not generally recognized as existing; but is a fundamental concept in understanding in how the economy works.

I have discussed this in a previous article looking specifically at the true value of oil. We all know the price of oil, but almost no one appreciates the value. The summary version is that, because of the high energy density and incredibly convenient storage medium that is oil (and similarly, but less so for gas), we get vast amounts of “excess energy” into the economy for free.  As has been pointed out by Vaclav Smil, talking about the economy and energy is tautology. They are the same thing, or rather there is no economy without energy. The current disdain for fossil fuels belies a monumental misunderstanding about how the world works. You can eliminate tobacco, and the economy wouldn’t change, likewise Facebook, or Apple or any consumer product. Take energy out, and all the rest collapses. Change the cost of energy and you will distort the economy for good or bad…

Replaceable, not immortal

It is becoming more frequently noted that renewable energy itself has a carbon-footprint. This is due to the embodied energy used in the long chain of making the machinery that harvests renewable energy sources. the machines are “replacable” not renewable. The hope (wishful thinking?) is that as we “transition”, so the next generation of energy will be carbon-free, consequently the subsequent generation of renewable energy harvesters will also be carbon-free.  

Abstracting from the carbon-footprint, let’s just focus on the energy footprint.  To make a wind-turbine you have to have geologists finding mineral deposits, mining-companies mining and processing, then there is transportation, more processing and likely storage and more transport. Fabrication, transportation, installation and maintenance all follow. Clearly, as with anything and everything we have, there is a long and deep call on energy at every step. The cumulative of these steps is the embodied energy.

Embodied energy is the sum of all the energy required to produce any goods or services, considered as if that energy was incorporated or ’embodied’ in the product itself.

Given that the world is powered by 85% fossil-fuels, it is inevitable that on average 85% of the embodied energy is of fossil-fuel origin.   Put another way, to build a wind or solar farm today you have to use energy, that energy is 85% fossil-fuel origin and that energy has a cost-base that is dominated by the cost of fossil-fuel energy. This cost reflects the energy/cost of all the steps outlined above, from mining to installation and maintenance. The output (total cost) is driven by the low unit cost of energy in our current economy.  

Given the increasing penetration of renewables into the energy mix:

  • If the underlying cost of energy rises, logically the next generation of renewables will be more expensive. 
  • If the cost of energy decreases the cost of the next generation will decrease.

These concepts require much more detailed analysis than possible in a post such as this, but even conceptually it is easy to think about how this would play out. In the case of rising energy costs, the replacement cost increases, making energy more expensive and the overall pie (economy) shrink. Put another way, everyone will get poorer, and the world will be less resilient.  

The alternative (that each generation gets cheaper) is in my opinion utopic in the extreme, bordering on the idea of a perpetual motion machine.  If you take this idea to a logical end-point, each iteration would supply cheaper and cheaper energy until it would end up being free.  Readers with long memories may recall that Nuclear power was expected to become “too cheap to meter”, and that didn’t work out quite as planned, so it is surprising to see the same kinds of predictions being made about renewables today. John Delaney [Dem candidate 2019] predicted that, one day, energy will “basically be free,” because “every surface” on the planet will be covered with solar absorption technology.

And here is an interesting thought to tie it all together: One way of “checking our work” is to see whether wind and solar PV can pay a reasonably high level of taxes, because any source of energy that is producing considerable net energy should be able to pay high taxes to support the government—supporting the government is, in fact, the primary use of net energy. Fossil fuel energy has always paid high taxes. My conclusion is that intermittent renewables are, in fact, net energy sinks. Gail Tverberg

Stretching To The Future

Ultimately, fossil-fuels “subsidising” the renewable industry is good thing and is an essential part of the energy transition. It does not sit comfortably with the narrative that we have to usurp one system with another “immediately”. It does not sit well with the view that fossil fuels are inherently only bad.  

But every wind turbine, hydro project, solar farm that is built cheaply, we reduce dependence on fossil fuels by a small fraction. This will stretch-out the remaining-resource base over a longer time period and keep the price of depleting resources lower. Again, to be very clear, we will not run out of oil, gas or coal anytime in the foreseeable future, even if there is no reduction in usage; but we will run out of cheap oil and gas (coal is a bit different, but by far the least desirable).  If we are trying to build “renewables – generation 2.0” using oil which is $200/bbl, there will be shock and horror that the cost of the renewable power has risen. Cost-parity with fossil-fuels is a bit of a two-way street.

Optimal use of the remaining cheap hydrocarbons is, in my opinion, an essential part of achieving an energy transition, but one that is politically unacceptable whilst the general population demands to “stop using fossil-fuels” by the fear and urgency of “we must act now”. Divesting will make hydrocarbons more expensive and it is entirely plausible that this policy will push up the cost of renewables sooner than resource scarcity would. Unintended. Consequences.

I would like to thank Bill Page of Cristal Advocates for helping tidy my notes on how oil company taxation works, albeit a horribly simplistic overview. Any errors are of course my own.