Aligning Carbon Taxes and Fuel Subsidies to Meet Climate Goals

Asia and the Pacific, the world’s most weather-related disaster-prone area, faces dire threats to food security, livelihoods, economic prosperity, and fiscal health due to climate change. Since 1970, 2 million people have lost their lives to disasters. In 2022 alone, 140 disasters caused an estimated $57 billion in economic damage.

Placing a price on carbon is crucial to achieving the greenhouse gas (GHG) emission reductions needed to stabilize the climate. According to International Monetary Fund (IMF) estimates, cutting GHG emissions sufficiently to limit global warming to 2°C or less by 2030 requires measures equivalent to a global carbon price of approximately $75 per ton. By charging emitters, carbon pricing instruments can drive investments in low-carbon technologies.

As economies in the region increasingly adopt explicit carbon pricing mechanisms such as taxes and emissions trading schemes, it is important to align these efforts with existing policy instruments. Two key tools influencing carbon pricing are environmental taxes and fossil fuel subsidies.

In essence, fossil fuel subsidies serve as a negative price on carbon, undermining the impact of carbon pricing and environmental taxes. Some ways governments subsidize fossil fuels include fixing prices or capping fuel and electricity price increases, offering exemptions from energy taxes and levies, easing gas and electricity payment terms or banning disconnections for nonpayment, and providing subsidies to help vulnerable households access liquefied petroleum gas and pay heating bills. In 2022, total fossil fuel subsidies globally (as measured by the IMF: explicit + implicit) amounted to $7 trillion, or 7.1% of GDP, and are projected to rise to $8.2 trillion by 2030. Of these, $5.7 trillion (82%) were implicit subsidies.

Implicit fossil fuel subsidies measure the undercharging for environmental costs and foregone consumption tax revenues associated with fossil fuel consumption. These implicit fossil fuel subsidies capture the societal costs of fossil fuel contributions to global warming; local air pollution; congestion, accidents, and road damage from road fuels; and environmental costs of other fuel products. Undercharging for fossil fuels by not including these societal costs results in fossil fuel prices that encourage overconsumption. Meanwhile, explicit fossil fuel subsidies are government expenditures that directly decrease a fossil fuel’s retail price below its supply cost. These can take the form of price caps on gasoline and diesel or subsidies for electricity consumption.

Environmental taxes, including excise, sales, and import taxes on fossil fuels and other carbon-intensive products, have been used extensively in Asia and the Pacific to mobilize domestic resources. In 2021, such taxes contributed the equivalent of 1.5% of GDP to total tax revenues in the region.

Despite this, many countries in Asia and the Pacific lower the cost of fossil fuel production and consumption through subsidies to reduce poverty and support energy-intensive industries. In 2022, 12 of the top 25 global providers of fossil fuel subsidies were in Asia. Fossil fuel subsidies in East Asia and the Pacific amounted to $3.2 trillion (9.5% of GDP), with an additional $431 billion (10.0% of GDP) in South Asia.

The role of environmental taxes and, specifically, carbon pricing in advancing climate goals is clear: they mobilize domestic resources and reduce GHG emissions by holding polluters accountable. However, fossil fuel subsidies undermine these efforts and work against climate ambitions in several ways:

• Diverting resources: Fossil fuel subsidies redirect funds from critical investments in climate change adaptation, mitigation, health, and education.
• Revenue neutrality: Policymakers must consider the net impact of revenues generated by carbon pricing versus expenditures on subsidies, particularly since carbon pricing often targets narrow sectors while fossil fuel subsidies apply more broadly (e.g., electricity subsidies).
• Counteracting incentives: Subsidies can weaken government initiatives to promote clean energy investments, electric vehicle adoption, and other GHG-reduction strategies, ultimately hindering progress toward climate goals.

Developing member countries (DMCs) must assess and rationalize the negative impacts of fossil fuel subsidies while simultaneously implementing carbon taxes, pollution taxes, and other measures to reduce fossil fuel consumption. The first step could involve mapping out how subsidies counteract climate initiatives and quantifying fossil fuel spending relative to revenue from carbon and environmental taxes. This analysis would provide a foundation for reforming fossil fuel subsidies.

The next step could involve devising a carbon pricing strategy that addresses economic, political, and social challenges. The Asian Development Bank has developed a Carbon Pricing and Fossil Fuel Subsidy Rationalization Tool Kit, a step-by-step guide to help DMC policymakers navigate this process. This tool kit has already informed green policy-based loans in the Kyrgyz Republic and Uzbekistan.

Moreover, DMCs must periodically produce and publish comprehensive tax expenditure reports. These reports would identify revenue losses from tax preferences granted to fossil fuels and energy derived from “dirty” fuels.

The Intergovernmental Panel on Climate Change (IPCC) estimates that removing fossil fuel subsidies could reduce global carbon dioxide (CO2) emissions by 1%–4% and GHG emissions by up to 10% by 2030. According to IMF, raising fuel prices to fully efficient levels would reduce CO2 emissions from fossil fuels by 43% below baseline 2030 levels. Full fossil fuel price reform in emerging and developing economies could generate sufficient revenue to finance their spending needs to achieve the Sustainable Development Goals—estimated at $3 trillion. In East Asia and the Pacific, such reforms could raise $1.8 trillion (4.4% of GDP), while South Asia could generate $381 billion (5.5% of GDP).

Several countries in Asia and the Pacific have made progress in reforming fossil fuel subsidies:

• Philippines: Phased out petroleum price subsidies in the 1990s and 2000s, redirecting savings to college scholarships, subsidized loans for converting public transport to liquefied petroleum gas, and other social development initiatives.
• India: Capitalized on low oil prices in the 2010s to phase out gasoline and diesel consumer subsidies and increase motor fuel taxes, reducing fossil fuel subsidies by 72% from 2014 to 2021.
• Indonesia: Reformed gasoline and diesel subsidies in 2005, 2008, and 2013, redirecting funds to poverty eradication programs, infrastructure development, and social welfare initiatives.

International cooperation and support mechanisms also play a key role. For example, the Multilateral Carbon Tax Treaty helps countries meet their nationally determined contributions (NDCs) mitigation objectives through carbon taxation to enable a smoother transition to effective carbon pricing and subsidy reforms.

B. Edelman and S. Bhattacharya. 2024. Carbon Taxes and Fossil Fuel Subsidies. ADB The Governance Brief Series. No. 58. Asian Development Bank.