Tag: incentives

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Black Friday vs the Rational Consumer

When building supply and demand models, the assumption is usually made that both producers and consumers act in a ‘rational’ way to achieve the best possible outcomes. As far as producers are concerned, this would mean attempting to maximise profit. As far as consumers are concerned, it would mean attempting to achieve the highest satisfaction (utility) from their limited budget. This involves a cost–benefit calculation, where people weigh up the costs and benefits of allocating their money between different goods and services.

For consumers to act rationally, the following assumptions are made:

  • Consumer choices are made independently. Their individual choices and preferences are not influenced by other people’s, nor do their choices and preferences impact on other people’s choices.
  • The consumer’s preferences are consistent and fixed.
  • Consumers have full information about the products available and alternatives to them.
  • Given the information they have and the preferences they hold, consumers will then make an optimal choice.

Black Friday can be seen as a perfect occasion for consumers to get their hands on a bargain. It is an opportunity to fulfil a rational need, for example if you were needing to replace a household appliance but were waiting until there was a good deal before committing to a purchase.

The assumption that people act rationally has been at the forefront of economic theory for decades. However, this has been questioned by the rise in behavioural economics. Rather than assuming that all individuals are ‘rational maximisers’ and conduct a cost–benefit analysis for every decision, behavioural economists mix psychology with economics by focusing on the human. As humans, we do not always behave rationally but, instead, we act under bounded rationality.

As economic agents, we make different decisions depending on our emotional state that differ from the ‘rational choice’ assumption. We are also influenced by our social networks and often make choices that provide us with immediate gratification. Given this, Black Friday can also be viewed as a great opportunity to fall prey to irrational and emotional shopping behaviours.

Black Friday originated in the USA and is the day after Thanksgiving. During this annual shopping holiday, retailers typically offer steep discounts to kick off the holiday season. The Black Friday shopping phenomenon is less than a decade old in the UK but it’s now an established part of the pre-Christmas retail calendar. Between 2010 and 2013, Black Friday gradually built up momentum in the UK. In 2014, Black Friday became the peak pre-Christmas online sales day and many online retailers haven’t looked back.

Arguably, from a behavioural economist’s perspective, the big problem with Black Friday is that all the reasons consumers possibly have to partake can be largely illusory. Consumers are bombarded with the promise of one-off deals, large discounts, scarce products, and an opportunity to get their holiday shopping done all at once. However, on Black Friday, our rational decision-making faculties are tested, just as stores are trying their hardest to maximise consumers’ mistakes.

There are many ‘behavioural traps’ that consumers often fall into. The following two are most likely to occur on Black Friday:

  • Scarcity and loss aversion. Shoppers may fear that they will miss out on the best sales deals available if they don’t buy it now. Retailers commonly spark consumers’ interest by highlighting limited stocks available for a limited time only, which raises the perceived value of these goods. This sense of scarcity can further trigger the need to buy now, increasing the ‘Fear of Missing Out’. Consumers therefore need to ask themselves if they are really missing out if they don’t buy it now? And is the discount worth spending the money today, or is there something else I should be spending it on or saving for?
  • Sunk cost fallacy. Once consumers have started to invest, they often struggle to close out investments that prove unprofitable. On Black Friday, customers have already made the initial investment of getting up early, driving to the shops, finding parking and waiting in a queue, before they have purchased anything. Therefore, they will be inclined to buy more than they initially went for. It is important therefore to think about each purchase in isolation.

This year, however, there is also the added complication of the rising cost of living. Whilst this may deter some consumers from unnecessary, impulse purchases, some consumers are using Black Friday as an opportunity to stock up on expected future purchases, hedging against likely price rises over the coming months.

It is thought that more consumers will be looking for a combination of high quality but low price to make sure their purchases are affordable and can last for a long time. According to PwC, many consumers have closely monitored their favourite brands in anticipation that big-ticket electronics, more pricey winter wear or Christmas stocking fillers will be discounted. Consumers are also in search of bargains more than ever given rising inflation. This would suggest a shift in attitude, meaning consumers will be more aware of what they cannot afford rather than giving in to emotional temptation brought on by Black Friday.

Retailers are fully aware of the cognitive biases that surround Black Friday and take full advantage of them. ‘Cyber Monday’ follows right after Black Friday, giving retailers an extra opportunity for them to keep those ‘urgent’ or ‘unmissable’ sales going and increase their revenues.

Black Friday is one of the biggest shopping days of the year. However, the way retailers approach it is growing increasingly mixed. Stores such as Amazon, Argos, Currys and John Lewis have started offering Black Friday deals much earlier in the month, leading some to refer to the event as ‘Black November’. Other stores, such as M&S and Next, didn’t take part at all this year.

Ultimately, Consumers can use insights from behavioural economics to empower them to make more rational decisions in such circumstances: ones that better align with their individual budgets. Nevertheless, the Black Friday sales mania can trigger our deepest emotional and cognitive responses that lead to unnecessary spending.

Articles

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Questions

  1. Discuss what is meant by the term ‘rational consumer’. Is it a useful generalisation about the way consumers behave?
  2. Discuss what is meant by the term ‘rational producer’. Is it a useful generalisation about the way firms behave?
  3. What is cost–benefit analysis? What is the procedure used in conducting a cost–benefit analysis?
  4. In addition to scarcity and loss aversion and the sunk cost fallacy, are there any other reasons why consumers may not always act rationally?
  5. Are people likely to be more ‘rational’ about online Black Friday purchases than in-store ones? Explain.
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From Reaganomics to Trussonomics

In her bid to become Conservative party leader, Liz Truss promised to make achieving faster economic growth her number-one policy objective. This would involve pursuing market-orientated supply-side policies.

These policies would include lower taxes on individuals to encourage people to work harder and more efficiently, and lower taxes on business to encourage investment. The policy would also involve deregulation, which would again encourage investment, both domestic and inward investment from overseas. These proposals echoed the policies pursued in the 1980s by President Ronald Reagan in the USA and Margaret Thatcher in the UK.

On September 23, the new Chancellor, Kwasi Kwarteng, presented a ‘mini-Budget’ – although the size of the changes made it far from ‘mini’. This, as anticipated, included policies intended to boost growth, including scrapping the 45% top rate of income tax, which is currently paid by people earning over £150 000 (a policy withdrawn on 3 October after massive objections), cutting the basic rate of income tax from 20% to 19%, scrapping the planned rise in corporation tax from 19% to 25%, scrapping the planned rise in national insurance by 1.25 percentage points, a cut in the stamp duty on house purchase and scrapping the limit placed on bankers’ bonuses. In addition, he announced the introduction of an unlimited number of ‘investment zones’ which would have lower business taxes, streamlined planning rules and lower regulation. The policies would be funded largely from extra government borrowing.

Theoretically, the argument is simple. If people do work harder and firms do invest more, then potential GDP will rise – a rise in aggregate supply. This can be shown on an aggregate demand and supply diagram. If the policy works, the aggregate supply curve will shift to the right. Real GDP will rise and there will be downward pressure on prices. In Figure 1, real GDP will rise from Y0 to Y1 and the price level will fall from P0 to P1. However, things are not as simple as this. Indeed, there are two major problems.

The first concerns whether tax cuts will incentivise people to work harder. The second concerns what happens to aggregate demand. I addition to this, the policies are likely to have a profound effect on income distribution.

Tax cuts and incentives

Cutting the top rate of income tax would have immediately given people at the top of the income scale a rise in post-tax income. This would have created a substitution effect and an income effect. Each extra pound that such people earn would be worth more in post-tax income – 60p rather than 55p. This would provide an incentive for people to substitute work for leisure as work is now more rewarding. This is the substitution effect. On the other hand, with the windfall of extra income, they now would have needed to work less in order to maintain their post-tax income at its previous level. They may well indeed, therefore, have decided to work less and enjoy more leisure. This is the income effect.

With the diminishing marginal utility of income, generally the richer people are, the bigger will be the income effect and the smaller the substitution effect. Thus, cutting the top rate of income tax may well have led to richer people working less. There is no evidence that the substitution effect would be bigger.

If top rates of income tax are already at a very high level, then cutting then may well encourage more work. After all, there is little incentive to work more if the current rate of tax is over 90%, say. Cutting them to 80% could have a big effect. This was the point made by Art Laffer, one of Ronald Reagan’s advisors. He presented his arguments in terms of the now famous ‘Laffer curve’, shown in Figure 2. This shows the total tax revenue raised at different tax rates.

If the average tax rate were zero, no revenue would be raised. As the tax rate is raised above zero, tax revenues will increase. The curve will be upward sloping. Eventually, however, the curve will peak (at tax rate t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work.

If the economy were currently to the right of t1, then cutting taxes would increase revenue as there would be a major substitution effect. However, most commentators argue that the UK economy is to the left of t1 and that cutting the top rate would reduce tax revenues. Analysis by the Office for Budget Responsibility in 2012 suggested that t1 for the top rate of income tax was at around 48% and that cutting the rate below that would reduce tax revenue. Clearly according to this analysis, 40% is considerably below t1.

As far as corporation tax is concerned, the 19% rate is the lowest in the G20 and yet the UK suffers from low rates of both domestic investment and inward direct investment. There is no evidence that raising it somewhat, as previously planned, will cut investment. And as far as individual entrepreneurs are concerned, cutting taxes is likely to have little effect on the desire to invest and expand businesses. The motivation of entrepreneurs is only partly to do with the money. A major motivation is the sense of achievement in building a successful business.

Creating investment zones with lower taxes, no business rates and lower regulations may encourage firms to set up there. But much of this could simply be diverted investment from elsewhere in the country, leaving overall investment little changed.

To assess these questions, the government needs to model the outcomes and draw on evidence from elsewhere. So far this does not seem to have happened. They government did not even present a forecast of the effects of its policies on the public finances, something that the OBR normally presents at Budget time. This was one of the reasons for the collapse in confidence of sterling and gilts (government bonds) in the days following the mini-Budget.

Effects on aggregate demand

Cutting taxes and financing them from borrowing will expand aggregate demand. In Figure 1, the AD curve will also shift to the right and this will push up prices. Inflation is already a serious problem in the economy and unfunded tax cuts will make it worse. Higher inflation will result in the Bank of England raising interest rates further to curb aggregate demand. But higher interest rates, by raising borrowing costs, are likely to reduce investment, which will have a negative supply-side effect.

The problem here is one of timing. Market-orientated supply-side policies, if they work to increase potential GDP, will take time – measured in years rather than months. The rise in aggregate demand will be much quicker and will thus precede the rise in supply. This could therefore effectively kill off the rise in supply as interest rates rise, the exchange rate falls and the economy is pushed towards recession. Indeed, the mini-Budget immediately sparked a run on the pound and the exchange rate fell.

The rising government debt may force the government to make cuts in public expenditure. Rather than cutting current expenditure on things such as nurses, teachers and benefits, it is easier to cut capital expenditure on things such as roads and other infrastructure. But this will have adverse supply-side effects.

Effects on income distribution

Those advocating market-orientated supply-side policies argue that, by making GDP bigger, everyone can gain. They prefer to focus on the size of the national ‘pie’ rather than its distribution. If the rich initially gain, the benefits will trickle down to the poorest in society. This trickle-down theory was popular in the 1980s with politicians such as Margaret Thatcher and Ronald Reagan and, more recently, with Republican presidents, such as Goerge W Bush and Donald Trump. There are two problems with this, however.

The first, which we have already seen, is whether such policies actually do increase the size of the ‘pie’.

The second is how much does trickle down. During the Thatcher years, income inequality in the UK grew, as it did in the USA under Ronald Reagan. According to an IMF study in 2015 (see the link to the IMF analysis below), policies that increase the income share of the poor and the middle class do increase growth, while those that raise the income share of the top 20 per cent result in lower growth.

After the mini-Budget was presented, the IMF criticised it for giving large untargeted tax cuts that would heighten inequality. The poor would gain little from the tax cuts. The changes to income tax and national insurance mean that someone earning £20 000 per year will gain just £167 per year, while someone earning £200 000 will gain £5220. What is more, the higher interest rates and higher prices resulting from the lower exchange rate are likely to wipe out the modest gains to the poor.

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Articles

Analysis

Questions

  1. Distinguish between market-orientated supply-side policies and interventionist ones. Consider the advantages and disadvantages of each.
  2. Explain why bond prices fell after the mini-Budget. What was the Bank of England’s response and why did this run counter to its plan for quantitative tightening?
  3. How might a tax-cutting Budget be designed to help the poor rather than the rich? Would this have beneficial supply-side effects?
  4. Find out about the 1972 tax-cutting Budget of Anthony Barber, the Chancellor in Ted Heath’s government, that led to the ‘Barber boom’ and then rampant inflation. Are there any similarities between the 1972 Budget and the recent mini-Budget?
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Soaring gas prices (updated 1/10/22)

International wholesale gas prices have soared in recent months. This followed a cold winter in 2021/22 across Europe, the bounceback in demand as economies opened up after COVID and, more recently, pressure on supplies since the Russian invasion of Ukraine and the resulting restricted gas supplies from Russia. The price of gas traded on the UK wholesale market is shown in Chart 1 (click here for a PowerPoint). Analysts are forecasting that the wholesale price of gas will continue to rise for some time. The higher price of gas has had a knock-on effect on wholesale electricity prices, as gas-fired power stations are a major source of electricity generation and electricity prices.

In the UK, domestic fuel prices were capped by the regulator, Ofgem. The cap reflected wholesale prices and was designed to allow electricity suppliers to make reasonable but not excessive profits. The cap was adjusted every six months, but this was been reduced to three months to reflect the rapidly changing situation. Prices are capped for both gas and electricity for both the standing charge and the rate per kilowatt hour (kWh). This is illustrated in Chart 2 (click here for a PowerPoint).

The effects of the cap were then projected in terms of a total annual bill for a typical household consuming 12 000 kWh of gas and 2900 kWh of electricity. Chart 3 shows the typical fuel bill for the last four price caps and, prior to the mini-Budget of 23 September, the projected price caps for the first and second quarters of 2023 based on forecasts at the time of wholesale prices (click here for a PowerPoint). As you can see, wholesale gas and electricity prices account for an increasing proportion of the total bill. The remaining elements in cost consist of profits (1.9% assumed), VAT (5%), operating costs, grid connection costs and green levies (around £153). The chart shows that, without government support for prices, the price cap would have risen by 80.6% in October 2022 and was projected to rise by a further 51% in January 2023 and by another 23% in March 2023. If this were to have been the case, then prices would have risen by 481% between the summer of 2021 and March 2023.

This was leading to dire warnings of extreme fuel poverty, with huge consequences for people’s health and welfare, which would put extra demands on an already stretched health service. Many small businesses would not be able to survive the extra fuel costs, which would lead to bankruptcies and increased unemployment.

Future wholesale gas prices

Energy market analysts expect wholesale gas prices to remain high throughout 2023, with little likelihood that gas supplies from Russia will increase. Some European countries, such as Germany, have been buying large amounts of gas to fill storage facilities before winter and before prices rise further. This has added to demand.

The UK, however, has only limited storage facilities. Although it is not an importer of gas from Russia and so, in one sense, storage facilities are less important at the current time, wholesale gas prices reflect international demand and supply and thus gas prices in the UK will be directly affected by an overall global shortage of supply.

What would have been the response to the projected rise in gas prices? Eventually demand would fall as substitute fuels are used for electricity generation. But demand is highly inelastic. People cannot readily switch to alternative sources of heating. Most central heating is gas fired. People may reduce consumption of energy by turning down their heating or turning it off altogether, but such reductions are likely to be a much smaller percentage than the rise in price. Thus, despite some use of other fuels and despite people cutting their energy usage, people would still end up spending much more on energy.

Over the longer term, new sources of supply of gas, including liquified natural gas (LNG), may increase supply. And switching to green energy sources for electricity generation, may bring the price of electricity back down and lead to some substitution been gas and electricity in the home and businesses. Also improved home insulation and the installation of heat pumps and solar panels in homes, especially in new builds, may reduce the demand for gas. But these changes take time. Chart 4 illustrates the situation (click here for a PowerPoint).

Both demand and supply are relatively inelastic. The initial demand and supply curves are D1 and S1. Equilibrium price is P1 (point a). There is now a fall in supply. Supply shifts to S2. With an inelastic demand, there is a large rise in price to P2 (point b).

Over two or three years, there is a modest fall in demand (as described above) to D2 and a modest rise in supply to S3. Price falls back somewhat to P3 (point c). Over a longer period of time, these shifts would be greater and the price would fall further.

Possible policy responses

What could the government do to alleviate the problem? Consensus was that the new Conservative Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, would have to take radical measures if many households were to avoid severe hardship and debt. One proposal was to reduce VAT on domestic energy from 5% to zero and to cut green levies. Although this would help, it would make only a relatively small dent in people’s rising bills.

Another proposal was to give people cash payments to help with their bills. The more generous and widespread these payments, the more costly they would be.

One solution here would be to impose larger windfall taxes on oil and gas producers (as opposed to retailers). Their profits have soared as oil and gas prices have soared. Such a move is generally resisted by those on the right of politics, arguing that it could discourage investment in energy production. Those on the centre and left of politics argue that the profits are the result of global factors and not because of wise business decisions by the energy producers. A windfall tax would only take away these excess profits.

The EU has agreed a tax on fossil fuel companies’ surplus profits made either this year or next. It is also introducing a levy on the excess revenues that other low-cost power producers make from higher electricity prices.

Another proposal was to freeze retail energy prices at the current or some other level. This would make it impossible for energy suppliers to cover their costs and so they would have to be subsidised. This again would be very expensive and would require substantially increased borrowing at a time when interest rates are rising, or increased taxation at a time when people’s finances are already squeezed by higher inflation. An alternative would be to cap the price North Sea producers receive. As around half of the UK’s gas consumption is from the North Sea, this would help considerably if it could be achieved, but it might be difficult to do so given that the gas is sold onto international markets.

One proposal that was gaining support from energy producers and suppliers is for the government to set up a ‘deficit fund’. Energy suppliers (retailers) would freeze energy prices for two years and take out state-backed loans from banks. These would then be paid back over time by prices being capped sufficiently high to cover costs (which, hopefully, by then would be lower) plus repayments.

Another policy response would be to decouple electricity prices from the wholesale price of gas. This is being urgently considered in the EU, and Ofgem is also consulting on such a measure. This could make wholesale electricity prices reflect the costs of the different means of generation, including wind, solar and nuclear, and would see a fall in wholesale electricity prices. At the moment, generators using these methods are making large profits.

The government’s response

On September 23, the government held a mini-Budget. One of its key elements was a capping of the unit price of energy for both households and firms. The government called this the Energy Price Guarantee. For example, those households on a variable dual-fuel, direct-debit tariff would pay no more than 34.0p/kWh for electricity and 10.3p/kWh for gas. Standing charges are capped at 46p per day for electricity and 28p per day for gas. These rates will apply for 2 years from 1/10/22 and should give an average annual household bill of £2500.

Although the government has widely referred to the ‘£2500 cap’, it is the unit price that is capped, not the annual bill. It is still the case that the more you consume, the more you will pay. As you can see from Chart 3, the average £2500 still represents an average increase per annum of just over £500 per household and is almost double the cap of £1277 a year ago. It will thus still put considerable strain on many household finances.

For businesses, prices will be capped for 6 months from 1 October at 21.1p per kWh for electricity and 7.5p per KWh for gas – considerably lower than for domestic consumers.

The government will pay subsidies to the retail energy companies to allow them to make sufficient, but not excess, profit. These subsidies are estimated to cost around £150 billion. This will be funded by borrowing, not by tax increases, with the government ruling out a windfall tax on North Sea oil and gas extracting companies. Indeed, the mini-Budget contained a number of tax reductions, including scrapping the 45% top rate of income tax, cutting the basic rate of income tax from 20% to 19% and scrapping the planned rise in corporation tax from 19% to 25%.

Articles

Data

Questions

  1. Why are the demand and supply of gas relatively inelastic with respect to price?
  2. Why are the long-run elasticities of demand and supply of gas likely to be greater than the short-run elasticities?
  3. Find out how wholesale electricity prices are determined. Is there a case for reforming the system and, if so, how?
  4. Identify ways in which people could be protected from rising energy bills.
  5. Assess these different methods in terms of (a) targeting help to those most in need; (b) economic efficiency.
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Tackling the menace of fly-tipping

If it costs to dispose of waste, there is the danger that people may resort to fly-tipping – the illegal dumping of waste in the countryside or on the streets. But several local authorities have indeed been charging for the disposal of building/DIY waste, with the inevitable consequences of huge quantities of dumped rubbish.

Apart from being an eyesore and damaging the environment, fly-tipped waste can be a health hazard, often containing toxic materials, such as asbestos and chemicals. According to the UK government, in 2020/21 there were over 60 000 incidents of fly-tipping of construction, demolition and excavation material, costing an estimated £392 million. In addition, people leave black bags of household waste and single items, such as mattresses, on the roadside.

The external costs are considerably greater than the benefits to those doing the dumping, but because the costs are largely external, people are encouraged to fly-tip, especially if they think that they are unlikely to be caught. Many householders are happy to pay low rates to have their DIY waste disposed of and ‘ask no questions’ about what will happen to it.

It is clearly socially efficient to stop fly-tipping. One solution is to enforce the law more rigorously and to introduce stiffer penalties. Increasingly, local authorities and private landowners are installing CCTV cameras to identify people doing the tipping. To be effective, the cameras must be out of reach. Also, the police must then follow up any cases and arrest and charge the culprits.

An alternative is to provide free disposal at council tips. The UK government has launched a consultation on a proposal to prevent local authorities from charging for the disposal of DIY waste. This still involves an externality in that the costs of disposal are not being borne by the person creating the waste, but clearly the size of the negative externality is considerably less than if the waste had been fly-tipped.

Selected local authorities can apply for new grants totalling £450 000 to help fund the provision of free DIY waste disposal and to install systems, such as CCTV and automatic number-plate recognition, to catch fly-tippers in action.

Devising policies to reduce externalities often involves understanding the incentive mechanisms which encourage people to engage in such activities in the first place and then making it in people’s interests not to engage in them in the future.

Videos

Articles

Government publications

Questions

  1. Draw a diagram to illustrate how the consumption of products with large negative externalities is considerably above the socially efficient level.
  2. Compare the relative advantages and disadvantages of the various policy alternatives to tackle fly-tipping that are discussed in the articles.
  3. Are there any ‘nudges’ that could be used to prevent fly-tipping?
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Good COP and bad COP: reflections on the Glasgow climate change conference


The Climate Change Pact agreed by leaders at the end of COP26 in Glasgow went further than many pessimists had forecast, but not far enough to meet the goal of keeping global warming to 1.5°C above pre-industrial levels. The Pact states that:

limiting global warming to 1.5°C requires rapid, deep and sustained reductions in global greenhouse gas emissions, including reducing global carbon dioxide emissions by 45 per cent by 2030 relative to the 2010 level and to net zero around mid-century, as well as deep reductions in other greenhouse gases.

So how far would the commitments made in Glasgow restrict global warming and what actions need to be put in place to meet these commitments?

Short-term commitments and long-term goals

According to Climate Action Tracker, the short-term commitments to action that countries set out would cause global warming of 2.4°C by the end of the century, the effects of which would be calamitous in terms of rising sea levels and extreme weather.

However, long-term commitments to goals, as opposed to specific actions, if turned into specific actions to meet the goals would restrict warming to around 1.8°C by the end of the century. These long-term goals include reaching net zero emissions by certain dates. For the majority of the 136 countries agreeing to reach net zero, the date they set was 2050, but for some developing countries, it was later. China, Brazil, Indonesia, Russia, Nigeria, Sri Lanka and Saudi Arabia, for example, set a date of 2060 and India of 2070. Some countries set an earlier target and others, such as Benin, Bhutan, Cambodia, Guyana, Liberia and Madagascar, claimed they had already reached zero net emissions.

Despite these target dates, Climate Action Tracker argues that only 6 per cent of countries pledging net zero have robust policies in place to meet the targets. The problem is that actions are required by firms and individuals. They must cut their direct emissions and reduce the consumption of products whose production involved emissions.

Governments can incentivise individuals and firms through emissions and product taxes, through carbon pricing, through cap-and-trade schemes, through subsidies on green investment, production and consumption, through legal limits on emissions, through trying to change behaviour by education campaigns, and so on. In each case, the extent to which individuals and firms will respond is hard to predict. People may want to reduce global warming and yet be reluctant to change their own behaviour, seeing themselves as too insignificant to make any difference and blaming big business, governments or rich individuals. It is important, therefore, for governments to get incentive mechanisms right to achieve the stated targets.

Let us turn to some specific targets specified in the Climate Change Pact.

Phasing out fossil fuel subsidies

Paragraph 20 of the Climate Change Pact

Calls upon Parties to accelerate … efforts towards the … phase-out of inefficient fossil fuel subsidies, while providing targeted support to the poorest and most vulnerable in line with national circumstances and recognizing the need for support towards a just transition.

Production subsidies include tax breaks or direct payments that reduce the cost of producing coal, oil or gas. Consumption subsidies cut fuel prices for the end user, such as by fixing the price at the petrol pump below the market rate. They are often justified as a way of making energy cheaper for poorer people. In fact, they provide a bigger benefit to wealthier people, who are larger users of energy. A more efficient way of helping the poor would be through benefits or general tax relief. Removing consumption subsidies in 32 countries alone would, according to International Institute for Sustainable Development, cut greenhouse gas emission by an average of 6 per cent by 2025.

The chart shows the 15 countries providing the largest amount of support to fossil fuel industries in 2020 (in 2021 prices). The bars are in billions of dollars and the percentage of GDP is also given for each country. Subsidies include both production and consumption subsidies. (Click here for a PowerPoint of the chart.) In addition to the direct subsidies shown in the chart, there are the indirect costs of subsidies, including pollution, environmental destruction and the impact on the climate. According to the IMF, these amounted to $5.4 trillion in 2020.

But getting countries to agree on a path to cutting subsidies, when conditions vary enormously from one country to another, proved very difficult.

The first draft of the conference agreement called for countries to ‘to accelerate the phasing-out of coal and subsidies for fossil fuels’. But, after objections from major coal producing countries, such as China, India and Australia, this was weakened to calling on countries to accelerate the shift to clean energy systems ‘by scaling up the deployment of clean power generation and energy efficiency measures, including accelerating efforts towards the phasedown of unabated coal power and phase-out of inefficient fossil fuel subsidies’. (‘Unabated’ coal power refers to power generation with no carbon capture.) Changing ‘phasing-out’ to ‘the phasedown’ caused consternation among many delegates who saw this as a substantial weakening of the drive to end the use of coal.

Another problem is in defining ‘inefficient’ subsidies. Countries are likely to define them in a way that suits them.

The key question was the extent to which countries would actually adopt such measures and what the details would be. Would they be strong enough? This remained to be seen.

As an article in the journal, Nature, points out:

There are three main barriers to removing production subsidies … First, fossil-fuel companies are powerful political groups. Second, there are legitimate concerns about job losses in communities that have few alternative employment options. And third, people often worry that rising energy prices might depress economic growth or trigger inflation.

The other question with the phasing out of subsidies is how and how much would there be ‘targeted support to the poorest and most vulnerable in line with national circumstances’.

Financial support for developing countries

Transitioning to a low-carbon economy and investing in measures to protect people from rising sea levels, floods, droughts, fires, etc. costs money. With many developing countries facing serious financial problems, especially in the light of measures to support their economies and healthcare systems to mitigate the effects of COVID-19, support is needed from the developed world.

In the COP21 Paris Agreement in 2015, developed countries pledged $100 billion by 2020 to support mitigation of and adaptation to the effects of climate change by developing countries. But the target was not reached. The COP26 Pact urged ‘developed country Parties to fully deliver on the $100 billion goal urgently and through to 2025’. It also emphasised the importance of transparency in the implementation of their pledges. The proposal was also discussed to set up a trillion dollar per year fund from 2025, but no agreement was reached.

It remains to be seen just how much support will be given.

Then there was the question of compensating developing countries for the loss and damage which has already resulted from climate change. Large historical polluters, such as the USA, the UK and various EU countries, were unwilling to agree to a compensation mechanism, fearing that any recognition of culpability could make them open to lawsuits and demands for financial compensation.

Other decisions

  • More than 100 countries at the meeting agreed to cut global methane emissions by at least 30 per cent from 2020 levels by 2030. Methane is a more powerful but shorter-living greenhouse gas than carbon. It is responsible for about a third of all human-generated global warming. China, India and Russia, however, did not sign up.
  • Again, more than 100 countries agreed to stop deforestation by 2030. These countries include Indonesia and Brazil, which has been heavily criticised for allowing large parts of the Amazon rainforest to be cleared for farming, such that the Amazon region in recent years has been a net emitter of carbon from the felling and burning of trees. The pledge has been met with considerable cynicism, however, as it unclear how it will be policed. Much of the deforestation around the world is already illegal but goes ahead anyway.
  • A mechanism for trading carbon credits was agreed. This allows countries which plant forests or build wind farms to earn credits. However, it may simply provide a mechanism for rich countries and businesses to keep emitting as usual by buying credits.
  • Forty-five countries pledged to invest in green agricultural practices to make farming more sustainable.
  • Twenty-two countries signed a declaration to create zero-emission maritime shipping routes.
  • The USA and China signed a joint declaration promising to boost co-operation over the next decade on various climate actions, including reducing methane emissions, tackling deforestation and regulating decarbonisation.

Blah, blah, blah or real action?

Many of the decisions merely represent targets. What is essential is for countries clearly to spell out the mechanisms they will use for achieving them. So far there is too little detail. It was agreed, therefore, to reconvene in a year’s time at COP27 in Egypt. Countries will be expected to spell out in detail what actions they are taking to meet their emissions targets and other targets such as ending deforestation and reducing coal-fired generation.

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Questions

  1. What were the main achievements of COP26?
  2. What were the main failings of COP26?
  3. How can people be incentivised to reduce their direct and indirect greenhouse gas emissions?
  4. How is game theory relevant to understanding the difficulties in achieving global net zero emissions?
  5. Should developing countries be required to give up coal power?
  6. If the world is to achieve net zero greenhouse gas emissions, should all countries achieve net zero or should some countries achieve net negative emissions to allow others to continue with net positive emissions (albeit at a lower level)?