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Fossil fuel markets and the costs of distorted incentives

By Jun Rentschler, on 9 December 2013

Traffic and air pollution in Cairo, Egypt. Photo©Kim Eun Yeul World BankMarket distortions in the context of fossil fuels create inefficiencies with substantial environmental, social and economic costs. Tackling distorted prices, and creating functioning markets can align the incentives for sustainable development.

Around the world we observe countless examples in which the management and usage of natural resources (and fossil fuels in particular), fail to deliver socially, environmentally and economically optimal outcomes. Overconsumption of fossil fuels, local pollution, greenhouse gas emissions, unequal distributional impacts, excessive exposure to volatile market prices, technological lock-in, corruption, and misappropriation of resource revenues – the entire value chain of natural resources is prone to “market failures”, i.e. the inability of markets to achieve a socially, environmentally and economically efficient allocation.

It is widely acknowledged, especially in the context of climate change, that market distortions can entail environmental externalities. Yet it is important to understand how market distortions can also result in substantial economic inefficiencies, with further repercussions to environment and society.

Prices: One of the most critical market distortions in the context of fossil fuels relates to pricing –particularly when already inefficient market prices are further distorted through fiscal policies.

Indeed, it is commonly argued that the prices of fossil fuels traded on international commodity markets do not reflect their true costs to society and environment. Inadequately low prices thus incentivise over-consumption, with further indirect environmental and social externalities.

Such externalities due to market prices are further exacerbated as many governments maintain fiscal policies in support of fossil fuels: Direct subsidies for fossil fuel producing or dependant industries, subsidies to end-users, special tax reductions or exemptions, or a general failure of fiscal policy to account for environmental and social externalities – fossil fuel subsidies can take different forms, but essentially all distort incentives at substantial environmental, social and economic costs.

Especially as international oil prices become increasingly volatile, governments which maintain costly fossil fuel subsidies expose themselves to substantial budgetary risks. In developing countries this often means that resources are crowded out from investments which are essential for economic and human development – for instance, in education, health and other infrastructure. While often justified on the grounds of making energy more affordable for poorer households, fossil fuel subsidies mainly benefit the wealthy (i.e. the owners of multiple SUVs and large centrally heated houses).

The IMF, World Bank and others therefore advocate the removal of fossil fuel subsidies as a critical step towards sustainable development. Previous experience has shown that, if well implemented alongside other compensatory policies, such reforms can be successful despite major political economy obstacles. They may have enormous benefits not only in environmental terms by reducing emissions and pollution, but also in economic terms by freeing up funds for infrastructure investments and by incentivising energy efficiency and technological innovation in the private sector, alongside possible competitiveness gains.

Market structures: Other severe incentive distortions may result from market structures and their regulation (or lack thereof) – for instance in the presence of monopolies. Monopolies are often the sole providers and allocators of resources, such as oil, gas and electricity; in the past these were typically state-owned (e.g. in the former Soviet Union). This alone does not necessarily entail a market failure: the provision of certain goods and services is linked to such high fixed costs (e.g. establishing country-wide infrastructure for gas distribution) that operating a “natural” monopoly may be efficient. Yet, under insufficient oversight and regulation, low institutional capacity, intransparency and interference of political interests, monopolies can quickly become the root of market failures with environmental, social and economic externalities. Lacking competition removes incentives for investing in R&D, promoting technological innovation and pursuing efficiency gains. As a consequence, deteriorating competitiveness, technological standards, and service quality go hand in hand with increasing environmental, social and economic costs.

Of course distorted incentives due to market structures are by no means limited to monopolies. Whenever competition is restricted, or interests strongly politicised, then market mechanisms may be distorted and allocative efficiency obstructed. In addition, other structural patterns, such as network effects and incomplete markets, may play a further role in suboptimal market outcomes.

Further analyses, including country specific case studies, are needed to understand the exact nature, magnitude and consequences of different market distortions. Overall however, the potential benefits from mitigating such market distortions are tremendous for the environment, society, and economy, and could extend to governments, households, and the private sector.

Jun Rentschler, UCL ISR Doctoral Researcher

About Jun

Prior to starting his PhD, Jun was a Research Analyst at the World Bank’s Chief Economist’s Office for Sustainable Development, working on topics around risk, green growth, resources and climate policy. Before this, he worked as an Economic Adviser to the German Foreign Ministry, based at the German Embassy in Tokyo, where he focused on economic and energy policy. Besides various internships in the private sector, he has worked on projects with the Grameen Microfinance Bank in Bangladesh and the Partners for Financial Stability Program by USAID in Poland. Jun holds an MSc in Economics from University College London, with a specialisation in time series econometrics and resource economics.