Understanding Energy Subsidies

Badr Al-Rumaih
November 20, 2016

Submitted as coursework for PH240, Stanford University, Fall 2016

Fig. 1: Supply subsidy causes an outward shift of the market supply curve leading to a lower equilibrium price point, from P* to Ps. (Source: Wikimedia Commons).

Energy subsidies remain a key driver of growth in renewable energy projects, rising from $66bn in 2010 to $250bn in 2035 for the new policy scenario, and much higher for the 450 scenario. [1] Such subsidies to renewables can bring long-term economic as well as environmental benefits. However, fossil fuel subsidies could turn distortive when the consumer is charged less than the real cost of production as they may encourage over-consumption, illustrated in Fig. 1, while discouraging investment in renewable projects.

Fossil fuel subsidies can impose a significant burden on national budgets, discourage energy efficiency, and encourage smuggling and illegal trade of subsidized petroleum products. Pressure is building up in the global energy arena for governments to phase-out "blanket" subsidies - which have been disproportionately benefiting wealthy consumers. It is important to ensure that subsidy reform programs are carefully designed, as low-income households - spending a higher percentage of their household income on energy - are not disproportionately affected by the elimination of consumption subsidies.

The most commonly applied approach for quantifying consumption subsidies is the price-gap method. It is designed to capture the net effect of all subsidies that would reduce energy prices below those of a competitive market. However, estimates generated by the price-gap approach do not capture all types of government intervention. For example, the method does not take into account revenue loss in countries where under-collection of energy bills, particularly for electricity, is prevalent, or where energy theft is common. Despite these limitations, the price-gap approach is a valuable tool for comparative analysis of subsidy levels across countries to make new policy decisions.

However, it is challenging to estimate the threshold for the onset of price distortion (harmful subsidy) to economic growth (healthy subsidy) to any particular energy source; some of the reasons for that are:

© Badr Al-Rumaih. The author grants permission to copy, distribute and display this work in unaltered form, with attribution to the author, for noncommercial purposes only. All other rights, including commercial rights, are reserved to the author.


[1] J. Cust and K. Neuhoff, "The Economics, Politics and Future of Energy Subsidies," Climate Policy Initiative, 21 Mar 10..