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Chapter 2. Energy Systems, Environmental Problems, and Current Fiscal Policy: A Quick Look

Author(s):
Ian Parry, Dirk Heine, Eliza Lis, and Shanjun Li
Published Date:
July 2014
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Fossil fuels are used pervasively to generate electricity, power transportation vehicles, and provide heat for buildings and manufacturing processes. Fuel combustion produces carbon dioxide (CO2) emissions and various local air pollutants, and use of transportation vehicles also causes road congestion, accidents, and (less important) pavement damage.

This chapter provides a quick look at energy systems, elaborates on their major environmental impacts, and discusses existing fiscal provisions affecting energy. Although the information here is not directly relevant for estimating corrective fuel taxes, it provides broader context and suggests why corrective taxes, and their impacts, are likely to differ considerably across countries.

Overview of Energy Systems

Although insofar as possible this volume presents results for 156 countries, a focus on 20 countries is used to illustrate how corrective taxes and their impacts vary with per capita income, fuel mixes, population density, road fatalities, and so on. This section provides some basic statistics for these countries for 2010 (or the latest year for which data are available).

Figure 2.1 shows primary energy consumption (i.e., the energy content of fossil and other fuels before transformation into electricity) in gigajoules per capita. Energy consumption is highest in the United States and roughly half as high in countries such as Germany, Japan, and the United Kingdom. At the other end of the spectrum, energy consumption per capita in India, Indonesia, and Nigeria is 8 percent or less of that in the United States.

Figure 2.1Primary Energy Consumption per Capita, Selected Countries, 2010

Source: US EIA (2013).

Note: Primary energy consumption is the energy content of fossil and other fuels before transformation into power generation.

These differences primarily reflect variations in reliance on electricity and motor vehicles. As indicated in Figure 2.2, relative differences in electricity consumption per capita broadly follow the patterns for total energy consumption per capita. In the United States, for example, people tend to live in relatively large homes requiring higher electricity use, whereas in Indonesia and India, about 35 percent of the population lacks access to electricity, as do about 50 percent in Nigeria (World Bank, 2013).

Figure 2.2Electricity Consumption per Capita, Selected Countries, 2010

Source: US EIA (2013).

Note: Electricity consumption includes residential and industrial uses.

Similarly, countries with lower per capita energy consumption also tend to have lower vehicle ownership rates (Figure 2.3). The United States and Australia, for example, have about 800 and 700 motor vehicles per thousand people, respectively, whereas China, Egypt, India, Indonesia, and Nigeria, have fewer (sometimes far fewer) than 100 vehicles per thousand people.

Figure 2.3Motor Vehicle Ownership Rates, Selected Countries, 2010

(or latest available)

Source: World Bank (2013).

Note: Motor vehicles include cars, trucks, and buses. However, two-wheeled motorized vehicles (which are used pervasively in many Asian countries) are not included in the data.

The scale of environmental problems also depends critically on a country’s fuel mix, and again there are large differences, as indicated in Figure 2.4. For example, coal constitutes more than half of total energy consumption in China, India, Kazakhstan, Poland, and South Africa, but 5 percent or less in Brazil, Egypt, Mexico, and Nigeria. Petroleum varies from 19 percent of energy consumption in China to 71 percent in Nigeria. And natural gas varies from 2 percent in South Africa to 50 percent in Egypt. Countries use some renewables (wind, solar, hydro, and others), but there are challenges to their growth, such as the intermittent supply from wind and solar power and the mismatch between their ideal location and urban centers.

Figure 2.4Share of Final Energy Use by Fuel Type, Selected Countries, 2010

(or latest available)

Source: US EIA (2013).

Note: The figure shows the share of primary energy (from direct fuel combustion) and secondary energy (primarily power generation) attributed to different fuels. Fuels are compared on an energy-equivalent basis.

Differences in energy consumption per capita, in particular, but also in fuel mixes, explain differences in energy-related CO2 emissions per capita, shown in Figure 2.5. For example, annual emissions per capita are almost 20 metric tons in Australia and the United States, countries that both use a lot of energy and have relatively emissions-intensive fuel mixes.

Figure 2.5Carbon Dioxide (CO2) Emissions per Capita, Selected Countries, 2010

Source: US EIA (2013).

The severity of environmental problems also depends on population density (greater density generally indicates that more people are exposed to local air emissions and that road systems are more crowded), which again varies considerably across countries. For example, the share of the population living in urban areas ranges from about 90 percent in Australia, Chile, Israel, and Japan to less than 40 percent in India and Thailand (Figure 2.6).

Figure 2.6Urban Population, Selected Countries, 2010

Source: World Bank (2013).

Note: Urban population refers to the share of people living in urban areas as defined by national statistical offices.

Environmental Side Effects

Fossil fuel use is associated with a variety of environmental side effects, or “externalities.” An adverse externality occurs when the actions (e.g., fuel combustion) of individuals or firms impose costs on others that the actors do not take into account. Externalities call for policy intervention, principally monetary charges that are directly targeted at the source of environmental harm and that are set at levels to reflect environmental damage (Chapter 3).

The main externalities of concern for this study are CO2 emissions, local air pollution, and the broader costs of vehicle use. Further environmental problems are discussed in Box 2.1.

Box 2.1Broader Environmental Effects beyond the Study Scope

A variety of other costs associated with fossil fuel production and use are not considered in this study for one or more of the following reasons (see, e.g., NRC, 2009, Chapter 2, for further discussion):

  • These costs might be taken into account by individuals and firms
  • They may be modest in quantitative terms
  • They might be too difficult to quantify
  • They may call for policies other than fuel taxes

Examples include the following:

Additional pollutants: Carbon monoxide (CO), a by-product of fuel combustion, reduces oxygen in the bloodstream, posing a danger to those with heart disease, but when released outdoors its concentration is usually not sufficient to cause significant health effects. Lead emissions cause neurological effects, especially for children, with potentially significant impacts on lifetime productivity (Grosse and others, 2002; Zax and Rees, 2002). However, lead has been, or is being, phased out from petroleum products in many countries. Various other toxins (e.g., benzene) are generally not released in sufficient quantities to cause health damage that is significant relative to the effects of pollutants considered in this book.

Upstream environmental impacts: Environmental impacts occurring during fuel extraction and production include

  • Despoiling of the natural environment (e.g., mountaintop removal for coal, accidents at oil wells)
  • Waste from fuel processing (e.g., slurry caused by the “washing” of raw coal)
  • Emissions leaks during fuel storage (e.g., from corrosion or evaporation at underground tanks at refineries and gasoline stations)
  • Further leakage during transportation (e.g., spills from oil tankers)

However, per unit of fuel use, the damage from these causes appear to be small relative to those estimated in this study (Jaramillo, Griffin, and Matthews, 2007; NRC, 2009, Chapter 2) and these problems call for interventions (e.g., double hull requirements for tankers, mandatory insurance for accident costs, requirements that mined areas be returned to their premining vegetative state) other than fuel taxes.

Occupational hazards: For fossil fuel extraction industries, occupational hazards include, for example, lung disease from long-term exposure to coal dust, coal mine collapses, and explosions at oil rigs. Individuals may account for these risks, however, when choosing among different occupations (a long-established literature in economics suggests that higher-risk jobs tend to compensate workers through higher wages; see, e.g., Rosen, 1986). To the extent policy intervention is warranted, perhaps because individuals understate risks, more targeted measures such as workplace health and safety regulations would be more efficient than fuel charges.

Indoor air pollution: Indoor air pollution causes an estimated 3.8 million deaths worldwide each year (Burnett and others, 2013). For example, in low-income countries, burning coal in poorly ventilated cooking stoves or open fires can create serious pollution-related health problems (Ezzati, 2005). Raising consumer coal prices may not be the best policy for dealing with indoor air pollution, however, particularly because doing so may promote the equally harmful use of biomass, at least until cleaner energy sources (e.g., charcoal, natural gas, electricity, or even processed coal that burns more cleanly), and better technologies such as better ventilated stoves, are made available.

Energy security: Although energy security concerns often motivate policies to reduce domestic consumption of oil and other fuels, quantifying a reasonable fuel tax level for this purpose is challenging. Some studies (e.g., Brown and Huntington, 2010) suggest the costs (not taken into account by the private sector) arising from the vulnerability of the macroeconomy to oil price volatility are not especially large, at least for the United States. More generally, dependence on oil supplies from politically volatile regions may realign a country’s foreign policy away from globally desirable objectives toward one focused on promoting access to oil markets (Council on Foreign Relations, 2006), though rapid development of unconventional oil, such as shale oil, may be alleviating these concerns.

CO2 Emissions

CO2 emissions from fossil fuel combustion are, by far, the largest source of global greenhouse gas (GHG) emissions. Emissions trends and the scientific basis for human-induced global warming are briefly summarized in this section. For an in-depth discussion, see successive reports of the Intergovernmental Panel on Climate Change (IPCC), most recently the assessment of the science in IPCC (2013).

Global, energy-related CO2 emissions have increased from about 2 billion metric tons in 1900 to about 30 billion tons in 2013 and, in the absence of mitigating measures, are projected to increase to almost 45 billion tons by 2035 (Figure 2.7). Emissions from non-OECD countries overtook those from OECD countries about 2005, and are projected to account for two-thirds of the global total by 2035.

Figure 2.7Projected Global Energy-Related CO2 Emissions

Source: US EIA (2011, Table A10).

Note: CO2 = carbon dioxide; OECD = Organization for Economic Cooperation and Development.

Roughly 50 percent of CO2 releases accumulate in the global atmosphere, where they remain, on average, for about 100 years; consequently, atmospheric CO2 concentrations have increased from pre-industrial levels of about 280 parts per million (ppm) to current levels of about 400 ppm. Accounting for other GHGs, such as methane and nitrous oxide (from agricultural and industrial sources), and expressing them in lifetime warming equivalents to CO2, atmospheric concentrations in CO2 equivalents are now about 440 ppm. In the absence of substantial emissions mitigation measures, GHG concentrations are expected to reach 550 ppm (in CO2 equivalent) by about the middle of this century, and to continue rising thereafter (Aldy and others, 2010; Bosetti and others, 2012).

IPCC (2013) estimates that global average temperatures have risen by 0.85°C since 1880 and is 95 percent certain that the main cause is fossil fuel combustion and other man-made GHGs (rather than other factors like changes in solar radiation and heat absorption in urban areas). However, because of lags in the climate system (i.e., gradual heat diffusion processes in the oceans), temperatures are expected to continue rising, even if concentrations were to be stabilized at current levels. As indicated in Figure 2.8, if GHG concentrations were stabilized at 450, 550, or 650 ppm, respectively, the eventual mean projected warming (over pre-industrial levels) is 2.1, 2.9, and 3.6°C, respectively.1 Alternatively, contemporaneous warming is expected to reach about 3–4°C by the end of the century, though actual warming could be substantially higher (or lower) than this (Bosetti and others, 2012; IPCC, 2013; Nordhaus, 2013, Figure 9).

Figure 2.8Projected Long-Term Warming above Pre-Industrial Temperatures from Stabilization at Different Greenhouse Gas Concentrations

Source: IPCC (2007, Table 10.8).

Note: CO2 = carbon dioxide; GHG = greenhouse gas; ppm = parts per million. Figure shows the projected increase in global temperature (once the climate system has fully adjusted, which takes at least several decades) over pre-industrial levels if atmospheric GHG concentrations are stabilized at different levels. The most recent assessment (IPCC, 2013) slightly lowered the bottom end of the confidence interval for a doubling of CO2 equivalent (not reflected in the figure).

The climatic consequences of warming include changed precipitation patterns, sea level rise caused by thermal expansion of the oceans and melting sea ice, more intense and perhaps frequent extreme weather events, and possibly more catastrophic outcomes like runaway warming, ice sheet collapses, or destruction of the marine food chain caused by warmer, more acidic oceans. Considerable uncertainty surrounds all of these effects, particularly from the potential for feedback effects (e.g., releases of methane from thawing permafrost tundra, less reflection of sunlight as glaciers melt) that might compound warming.

Policies to price the carbon content of fossil fuels (or otherwise mitigate CO2 emissions) are needed, because at present households and firms are generally not charged for the future climate change damage resulting from these emissions.2

Local Air Pollution

Unless it is priced to reflect environmental damage, local air pollution from fuel combustion is also excessive from society’s perspective. The sources of air pollution and their environmental impacts are discussed in this section.

Sources of air pollution

Fossil fuel use results in both primary pollutants, emitted during fuel combustion, and secondary pollutants, formed subsequently from chemical transformations of primary pollutants in the atmosphere. With regard to pollution-related health effects—the main manifestation of environmental damage—potentially the most important pollutant is fine particulates or PM2.5 (particulate matter with diameter up to 2.5 micrometers) because these particles permeate the lungs and bloodstream. Primary PM2.5 is directly emitted when fuels like coal are combusted, but is also formed indirectly from chemical reactions in the atmosphere involving certain primary pollutants.

The most important pollutants associated with coal are directly emitted PM2.5 and sulfur dioxide (SO2), which reacts in the atmosphere to form PM2.5. Fine particulates are also formed from nitrogen oxide (NOx) emissions, but generally in smaller quantities, because NOx emission rates are generally lower than for SO2 and are less reactive. Emission rates per unit of energy can vary considerably across different coal types, and a number of newer coal plants in many countries incorporate emissions control technologies. (Both factors should be considered in setting coal taxes.)

Natural gas is a much cleaner fuel than coal; it produces a minimal amount of SO2 and primary PM2.5 emissions, though it does generate significant amounts of NOx. Motor fuel combustion also produces NOx, and diesel fuel combustion causes some SO2 and primary PM2.5 emissions. Motor fuel combustion also releases volatile organic compounds that react with NOx in the presence of sunlight to form ozone, a major component of urban smog. Ozone has health effects, though the link to mortality is much weaker than for PM2.5 (damage from ozone is not considered here).3

Environmental damage

Local air pollution damage is potentially large, and has been estimated to be about 1 percent of GDP for the United States and almost 4 percent for China (NRC, 2009; Muller and Mendelsohn, 2012; World Bank and State Environmental Protection Agency of China, 2007). These harmful effects range from impaired visibility and nonfatal heart and respiratory illness to building corrosion and reduced agricultural yields when pollutants react with water to form acid rain. However, a number of studies suggest that, by far, the main damage component (and the component this study focuses on) is elevated risks of premature human mortality.4

The epidemiological literature has solidly established that long-term exposure to PM2.5 is associated with increased risk of lung cancer, chronic obstructive pulmonary disease, heart disease (from reduced blood supply), and stroke (Burnett and others, 2013; Health Effects Institute, 2013; Humbert and others, 2011; Krewski and others, 2009). Seniors, infants, and people with preexisting health conditions (e.g., those who have suffered strokes or who are suffering from cardiovascular disease) are most susceptible (Rowlatt and others, 1998).

Figure 2.9 shows ambient PM2.5 concentrations in 2010 for selected countries (averaged across regional pollution concentrations in each country after weighting regions by population shares). For many countries (e.g., Germany, Indonesia, Kazakhstan, Mexico, Poland, the United Kingdom, and the United States) average PM2.5 concentrations are between about 10 and 20 micrograms/cubic meter. Some countries have average PM2.5 concentrations of less than 10 micrograms/cubic meter (e.g., Australia, Brazil, and South Africa, where the coastal location of cities helps to disperse pollution). But in other countries, PM2.5 concentrations can be much greater; for example, between 30 and 40 micrograms/cubic meter in Egypt, India, and Korea and, strikingly, more than 70 micrograms/cubic meter in China.

Figure 2.9Air Pollution Concentrations, Selected Countries, 2010

Source: Brauer and others (2012).

Note: PM2.5 = fine particulate matter. Data are averages of regional pollution concentrations (weighted by population shares) within a country; regional observations are based on satellite data. Concentrations for specific urban centers can be much higher than national averages.

Figure 2.10 shows estimated deaths by region attributable to local outdoor air pollution in 2010. Worldwide, deaths were 3.2 million and were especially concentrated in East Asia (about 1.3 million) and South Asia (about 0.8 million).

Figure 2.10Air Pollution Deaths by Region, 2010

Source: Burnett and others (2013).

Note: Figure shows estimated deaths from outdoor ambient air pollution and excludes deaths from indoor air pollution (see Box 2.1). Data by country were not available at the time of writing.

Fuel taxes should not necessarily be highest in countries with the worst pollution, however, because the extra health risks posed by additional pollution do not necessarily depend on existing pollution concentrations (Chapter 3). Appropriate taxes depend, for example, on the size and composition of the exposed population and on how health risks are valued (which might vary with income levels). A given level of environmental tax, however, likely has relatively larger environmental impacts in high-pollution countries, where there is greater scope for reducing pollution.

Broader Externalities Related to Motor Fuel Use

Use of fuel in motor vehicles is associated with further side effects that should be factored into tax design, the most important of which are traffic congestion and traffic accidents. (Road damage plays a more minor role in corrective fuel taxes.)

Traffic congestion

Traffic on roads where speeds are below free-flow levels is generally excessive: unless they are charged for road use, motorists will not account for their own impact on adding to congestion and slowing speeds for other road users (Arnott, Rave, and Schöb, 2005; Lindsey, 2006; Litman, 2013; Santos, 2004). This applies irrespective of complementary policies such as investment in road or transit capacity or improved coordination of traffic signals, though these improvements can lower the appropriate charge for congestion (e.g., by alleviating bottlenecks).

Traffic congestion varies dramatically across urban and rural areas, and across time of day. It has been estimated, for example, that drivers in the London rush hour impose costs on others equivalent to US$10 per liter of fuel through their contribution to traffic congestion (Parry and Small, 2009). Congestion is best addressed through taxes on vehicle-kilometers driven on busy roads, with rates varying over the course of the day with prevailing traffic levels (Chapter 3). Until such charges are comprehensively implemented (e.g., using global positioning systems), however, congestion costs that motorists impose on others should be reflected appropriately in fuel taxes (Parry and Small, 2005).

The appropriate fuel charges are likely to vary considerably across countries, even if travel delays were valued similarly. Figure 2.11, which shows registered vehicles (cars, trucks, buses) per kilometer of nationwide road capacity, provides some sense, albeit very crude, of these variations. For example, Germany, Japan, Mexico, Poland, and the United Kingdom have far more vehicles per kilometer of road capacity than the United States, implying that a much greater portion of nationwide driving likely occurs under congested conditions in those countries.

Figure 2.11Vehicles and Road Capacity, Selected Countries, 2007

(or latest available)

Source: IRF (2009).

Note: Road capacity includes both paved and unpaved roads. Vehicles include cars, buses, and trucks but not motorized two wheelers.

Traffic accidents

Another side effect of vehicle use is traffic accidents. Although drivers should take into account some accident costs, such as injury risks to themselves, other costs (e.g., injury risks to pedestrians, property damage, medical costs borne by third parties) are not taken into account, implying excessive driving from a societal perspective. Again, this applies irrespective of other measures, such as drunk driver penalties, airbag and seatbelt mandates, and traffic medians, though these measures lower the appropriate charge for accidents (e.g., by reducing fatality rates).

Figure 2.12, which shows the number of road fatalities in 2010, gives some sense of the problem. In India, for example, there were about 134,000 road deaths; in China about 65,000; and even in South Africa (which has 4 percent of the population of China), there were about 14,000 fatalities.

Figure 2.12Road Deaths, Selected Countries, 2010

Source: IRF (2012).

Note: These data, which are for 2010 or the latest available year, may understate road fatalities in developing countries because of underreporting; see Chapter 5. WHO (2013) suggests, for example, that traffic deaths in India and China are much larger, and global total deaths are 1.2 million.

Fiscal Policies Currently Affecting Energy and Transportation

For data quality reasons, the discussion of tax policies in this subsection focuses on OECD countries.5 Among these countries, revenue from environment-related taxes (Figure 2.13) averaged about 6 percent of total tax revenue in 2010, varying between 15 percent of revenue in Turkey, to 3 percent in the United States, and about minus 1.5 percent in Mexico, where petroleum was subsidized significantly in 2010 (before price liberalization in 2013).

Figure 2.13Revenue from Environment-Related Taxes as Percent of Total Revenue in OECD Countries, 2010

(or latest available)

Source: OECD (2013).

These revenues mainly reflect three excise taxes: on fuel, on vehicle ownership, and on residential electricity consumption.

Although fuel taxes foster all possibilities for reducing fuel use (better fuel efficiency, less driving), the main issue in this analysis is whether tax levels reasonably reflect environmental damage. It seems unlikely that every country’s taxes reflect that damage, given the huge disparities in tax rates (Figure 2.14). In 2010, gasoline taxes varied from the equivalent of more than US$0.80/liter in Finland, France, Germany, Greece, Israel, Norway, Turkey, and the United Kingdom, to US$0.11/liter in the United States, and a subsidy of US$0.13/liter in Mexico. In most countries, diesel fuel is tax-favored relative to gasoline, though it is not obvious that trucks (the primary consumer of diesel) contribute less than cars to pollution, congestion, and so on.

Figure 2.14Excise Tax Rates on Motor Fuels, 2010

(or latest available)

Source: OECD (2013).

Other taxes underlying Figure 2.13 are not well targeted from an environmental perspective (see Chapter 3). Vehicle taxes do not encourage vehicle owners to drive less and, despite often varying with emissions classes, do not exploit all opportunities for raising fuel efficiency. Simple taxes on electricity consumption do not encourage cleaner power generation fuels, nor use of emissions control technologies. Although carbon pricing is gathering momentum (Ecofys, 2013), as of 2013 about 80 percent of global CO2 emissions were not covered by explicit carbon pricing programs, and CO2 prices (currently equivalent to about US$7 per ton of CO2 in the European Union Emissions Trading System) are typically a small fraction of estimated environmental damage (Chapter 5).

Moreover, many countries heavily subsidize—rather than tax—energy use. Estimated subsidies for fossil fuel use, measured by the gap between world fuel prices and domestic market prices, were $490 billion worldwide in 2011, with the Middle East and North African countries accounting for 48 percent of these subsidies (Figure 2.15). Notably, 44 percent of these subsidies were for petroleum products, 23 percent for natural gas, 31 percent for electricity consumption, but only 1 percent for coal (the most polluting fuel)—so just eliminating subsidies without introducing coal taxes will have limited effects on emissions.6

Figure 2.15Subsidies for Fossil Fuel Energy by Region and Fuel Type, 2011

Source: Clements and others (2013).

Note: CEE-CIS = Central and Eastern Europe and the Commonwealth of Independent States; ED Asia = Emerging and Developing Asia; LAC = Latin America and the Caribbean; MENA = the Middle East and North Africa; SSA = sub-Saharan Africa.

Nonetheless, the overall picture is one of ample opportunity to rationalize energy prices by eliminating fossil fuel subsidies and shifting some of the burden of broader taxes onto fossil fuel products. Even countries with high energy taxes have scope to restructure them (e.g., by shifting taxes off electricity and onto coal) to improve their effectiveness, and to better align tax rates to environmental damage. How to gauge appropriate tax levels for this purpose is the main contribution of this volume.

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1For perspective on the scale of these changes, current temperatures are about 5°C higher than at the peak of the last ice age about 20,000 years ago when the climate was radically different and much of the northern hemisphere was covered in ice.
2Other policies are also needed, but are largely beyond the scope of this book. These include policies to reduce emissions from international aviation and maritime activities (Keen, Parry, and Strand, 2013) and land use (Mendelsohn, Sedjo, and Sohngen, 2012); measures to enhance clean technology development (see Chapter 3); adaptation to climate change (e.g., coastal defenses, shifting to hardier crop varieties); development of last-resort technologies (e.g., to remove CO2 from the atmosphere or to “manage” solar radiation through sunlight-deflecting particles) for possible deployment in extreme scenarios; and mobilization of financial assistance for developing countries (de Mooij and Keen, 2012).
3This ground-level ozone is distinct from stratospheric ozone, which blocks cancer-causing, ultraviolet radiation. Stratospheric ozone depletion is caused by man-made chemicals, but such chemicals have now been largely phased out (Hammitt, 2010).
4For example, studies for China, Europe, and the United States find that mortality impacts typically account for 85 percent or more of the total damage from local air pollution (US EPA, 2011; European Commission, 1999; NRC, 2009; World Bank and State Environmental Protection Agency of China, 2007; Watkiss, Pye, and Holland, 2005).
5Estimates of taxes and subsidies by fuel product for all countries are provided in Annex 6.2.
6Renewables are also subsidized, at $66 billion in 2010, according to IEA (2011, Figure 14.13).

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