Free market economics is based on the equilibrium of supply and demand, in which incentives naturally align to optimize the price of goods and services. Yet often our "free market" doesn't operate properly, resulting in market failures in which resources are not allocated efficiently. Because our economic system doesn't properly value scarce natural resources, environmental services and goods are often the most vulnerable to the system. This is especially true in the energy sector where the winners and losers have been manipulated by subsidies and continue to be, perpetuating one of the biggest market failures our market has yet to see: climate change.
In the case of climate change, carbon dioxide and greenhouse gases, which have been largely unregulated, were overproduced because the negative social and environmental impacts were not included in the price of producing them. Similarly, these impacts did not directly affect those producing the CO2 and GHG, resulting in a lack of incentives for reducing production.
The Fix Gone Wrong
The most common solution to market failures is some of type of government intervention, such as a tax, regulation or subsidy. These are intended to incentivize those causing the market failure to change their behavior by signaling an increase in the cost of their actions. Yet, as we look to climate change as of currently, we see that governments have not efficiently intervened in correcting the market failure that is climate change. Instead of low carbon technologies in the energy sector, governments continue to use subsidies to help fossil fuel companies who were the original culprits of the market failure, which actually inhibits the development of low-carbon economies as they can't compete with the prices of government subsidized fossil fuels. In a pure economic sense, this is actually exacerbating a market inefficiency. So why are such policies still in place?
Any government action that "lowers the cost of fossil fuel energy production, raises the price received by energy producers or lowers the price paid by energy consumers" can be considered a fossil fuel subsidy. Rich countries' average spending for fossil fuel subsidies runs at $112 per adult, and subsidies to fossil fuel companies in the U.S. alone (most frequently in the form of tax breaks) ranges from $10 billion to $52 billion annually. In the U.S., fossil fuel interest groups are tremendously influential in policy-making and government processes; since 2006, Republican senators have each raised an average of $386,077 from oil and gas interests. It's safe to say that these policymakers have avoided any type of vote against fossil fuel subsidies in the past eight years.
Making it Work
In order to successfully address climate change as a market failure, the oil and gas industry must internalize social and environmental costs involved with producing carbon dioxide -- not be given tax breaks and subsidies for continuing this economically inefficient and environmentally devastating behavior. In the United States, the most efficient way to do this is to directly change the tax code and close the loopholes that were written specifically for this industry, while extending production tax credits for renewable energy. Implementing significant change will consist of holding our representatives accountable for the decisions they make and the money they accept from lobbyists.
Subsidies given to promote clean energy technology and energy efficiency operations encourage and incentivize the type of behavior that we need from the energy sector in order to successfully correct the market failure. The subsidies given to the nascent renewable energy industry are nowhere near what the oil industry received when it was first blooming: with inflation adjustments, oil and gas benefited from government subsidies an average of $4.86 billion per year between 1918 and 2009, while renewables have received an average of only $0.37 billion per year between 1994 and 2009.
Another factor that plays a role in the subsidy debate must also be addressed: the differentiation between consumption vs. production subsidies. A common argument for fossil fuel subsidies is that they keep household energy costs low. These types of subsidies (which are more prevalent in the developing world but do exist in industrialized countries including the U.S.), need to be differentiated as consumption-subsidies to signal to the public that a difference exists. In both developed and developing countries, governments can use the money saved from not handing out tax breaks to oil companies to directly help low-income homes with energy bills that would increase from the absence of fossil fuel subsidies. For instance, Indonesia is replacing fossil fuel subsidies with a cash transfer program targeting low-income households to help with energy costs. But public campaigns demonstrating this differentiation are needed: most subsidy reforms will be met with opposition if there's potential for increased energy prices. A conscious public that understands this difference can be the first step in removing obstacles to subsidy reform: policymakers in developed countries won't have the excuse that they must keep subsidies around in order to protect their constituents from energy price hikes, while in the developing world it can ease opposition to such subsidy reforms. Of course this must also be met with action: governments must follow through on commitments to provide consumption subsidies to low-income groups in compensation for reductions in production subsidies.
The leaders of the Group of Twenty (G-20) countries agreed in September 2009 to "phase-out inefficient fossil-fuel subsidies over the medium term." Yet this is largely voluntary, and multilateral action with ambitions and timelines are needed to ensure that this phasing out does in fact occur. The IEA has estimated that "even a partial phase-out by 2020 would reduce greenhouse gas (GHG) emissions by 360 million tonnes, which equates to 12% of the reduction in GHGs needed to hold temperature rise to 2 degrees." If serious about these numbers, the international community could make headway in reducing GHG emissions by incorporating subsidy reform into global climate negotiations. Signaling the true costs of fossil fuel production (and use) to investors, producers and consumers alike is one step in fixing the market failure of climate change.