Fossil Fuel Subsidy Swaps: A Path to Reform at the WTO

Critical Questions by Dhari AlSaleh andWilliam Alan Reinsch

Published August 27, 2024

Fifteen years after the initial attempt to reform international fossil fuel subsidies (FFSs) by the G7 and G20 in 2009, there remains no end in sight. While the conversation surrounding fossil fuel subsidy reform (FFSR) continues to dominate the World Trade Organization (WTO) via ongoing discussions about an FFSR initiative, significant opposition remains, especially within the developing world. Building an initiative with incentives to ensure engagement by and support from developing countries will be necessary for a successful resolution, and a system of FFS swaps could play a key role.

Q1: What are FFSs, and what are the debates around these subsidies?

A1: FFSs are subsidies directed at reducing the cost of consuming or producing fossil fuels, typically through tax breaks, direct transfers, and price controls. Global FFSs nearly doubled from 2021 to 2022, reaching around $1.5 trillion. This increase is largely attributed to sanctions on Russian energy exports after the invasion of Ukraine as well as repeated production cuts by the Organization of the Petroleum Exporting Countries (OPEC) in the last few years. This fiscal burden is why the International Monetary Fund (IMF) argues that reform is worthwhile, both for the efficient use of public resources and to meet ambitious climate goals.

A broad range of economists and international organizations have echoed this sentiment, while others argue that the entrenchment of FFSs creates a detrimental reliance on subsidies for energy access, particularly for developing countries that fear the risk of unrest upon reforming subsidies. These fears have materialized in several countries that have attempted reform, with notable examples including Bolivia and Lebanon, which may justify the reluctance to eliminate FFSs altogether.

Proponents of FFSs argue that they help ensure energy security by reducing price shocks. In this respect, FFSs are usually underpinned by noble intentions, as shown by the significant spike in subsidies in 2022 to compensate for rising energy costs. Without those subsidies, energy and fuel prices could have become prohibitive across the developing world, as seen in Ethiopia. That said, the IMF argues that the goal of energy security is better achieved through more targeted relief measures like cash and near-cash transfers directly to vulnerable groups that facilitate the green energy transition and wean reliance on fossil fuels, as was done in Morrocco and the Philippines to combat rising energy prices.

Q2: What are FFS swaps, and how would they function?

A2: FFS swaps, also commonly referred to as brown-to-green swaps, involve phasing out FFSs and reallocating those savings to subsidies for renewable energy research and deployment as well as green energy infrastructure. Countries would likely have to allocate some of these savings to support measures in the interim as the gradual phaseout takes place, such as cash or near-cash transfers to low-income households or public transport investment and support.

The WTO's Agreement on Subsidies and Countervailing Measures (ASCM) creates three categories of subsidies: actionable subsidies, non-actionable subsidies, and prohibited subsidies. Prohibited subsidies refer to export and local content subsidies, both of which are prohibited, while actionable subsidies must cause injury to local industry to be litigated or countervailed against. As it stands, the third category of non-actionable subsidies no longer exists after the expiration of Article 8.2 of the ASCM, though it was previously a category of subsidies that could not be litigated or countervailed against due to the Article 8.2 subsidies meeting a perceived public good.

A resurgent discussion around the need for permissible green subsidies to ensure a quick and effective energy transition has brought this category of subsidies and its potential uses back into the limelight. The revival of Article 8.2 non-actionable subsidies through the WTO's FFSR initiative could provide an avenue to create a form of FFS swaps. This would also entail recategorizing FFSs as prohibited subsidies due to the current "undercapture" of FFSs under the specificity requirement within the ASCM. As it stands, consumer subsidies, which make up 86 percent of all FFSs, do not fit within the WTO definition of subsidies due to the benefits permeating across a range of sectors and actors within supply chains.

The non-actionable category must be narrowly defined to avoid the potential for abuse, as WTO members may either complain about broad categories or seek to exploit them. Examples of subsidies to be included would be those related to renewable energy production or deployment, research and development in renewable technologies, and subsidizing the purchase of renewable products for individuals and households. Functionally, WTO members would need to notify the WTO of their FFSs and then inform the secretariat when they are swapping these subsidies to a category of non-actionable subsidy. A swaps process would likely have a specific deadline, to be agreed upon by the FFSR initiative, after which swapping subsidies from fossil fuels to renewables will no longer render those subsidies indefinitely non-actionable. This strict time limit for categorizing a country's subsidy swaps as non-actionable could incentivize WTO members to promptly implement swaps.

Q3: What are the benefits of taking the FFS swapping approach?

A3: FFS swaps could play a crucial role in boosting investment in renewable energy to achieve climate goals. Current estimates of the cost of the global green transition are in the $9.4-$12.2 trillion range, and they are likely to increase under a business-as-usual scenario that produces an estimated $2.3 quadrillion in losses. Early action to redirect FFS savings to green subsidies can help accelerate private investment and satisfy some of the funding deficit.

Incentivizing members to phase out their FFSs will be central to any hopes of reform. Historically, the FFSR initiative with the most buy-in was Sustainable Development Goal (SDG) 12, with 194 members. The WTO FFSR initiative and the Glasgow Climate Pact from the 26th UN Climate Change Conference of Parties have 48 and 39 members involved, respectively. While SDG Target 12.C forms a very loose intention to address inefficient FFSs, it also places a focus on minimizing adverse effects on countries' development and protecting poor and vulnerable communities, which seems to be a necessary element if any WTO reform initiatives are to succeed.

Swaps offer an opportunity to do this through the WTO secretariat-helping countries carefully craft a gradual phase-out policy, which must be calculated, transparent, and gradual, as past reform experiments in Chile and Ghana have proven. Other international organizations, including the Organization for Economic Co-operation and Development (OECD), the IMF, and the World Bank, would also play a key role in subsidy tracking and advising on where savings should be directed. The swaps mechanism also would permit countries to ensure energy security through subsidization of renewable energy without fearing retaliation from the WTO.

One of the other significant benefits would be on the climate front: a 2019 report by the International Institute for Sustainable Development (IISD) indicated that simply reforming FFSs would have an initial positive effect on greenhouse gas emissions but that this effect over time could decrease. This phenomenon is the result of other drivers, such as population growth, resource depletion, and GDP growth, having a greater impact on emissions in the long term. The study observed that the peak of emissions reductions from FFS reform would be around 10 percent; however, if 30 percent of the savings were invested in energy efficiency and renewable energy, then the average emissions reduction peak could be as high as 26 percent.

Q4: Where would the money be allocated?

A4: The reallocation of savings to country-specific needs is a central aspect of the FFS swap mechanism. General estimates by the IISD place swaps at 30 percent of total savings, with much of the remaining 70 percent needed for short-term energy support and investment in other public services. Crucially, certain technologies, such as solar stoves and heat pumps, are already available, and reallocating FFS savings to these technologies could provide a more sustainable and, in the long run, cheaper alternative in ensuring energy access while pushing the world toward its climate goals.

Another example of the reallocation of savings to country-specific needs is Indian kerosene subsidies, which have played a key role in providing access to lighting in rural areas of India. Subsidizing and providing solar lamps to the many households that rely on the kerosene subsidies would allow the same level of access and would have only cost the same as two years of kerosene subsidies per household.

A similar opportunity exists in Indonesia, which has heavily subsidized coal historically: comparing power purchase agreements shows that while coal is similarly priced, Indonesia's solar and wind are double the Indian price due to an inability to deploy renewables at scale, with only 1 percent of Indonesia's energy being generated from renewables in 2019. If Indonesia were to free up financial resources through coal and petroleum subsidy reform, these funds could then be reinvested into renewable subsidization and the establishment of a national grid to capitalize on Indonesia's significant renewable potential. Subsidy swaps in these renewable technologies could further boost their uptake as well as innovation and private investment in these areas, bringing the price down for consumers.

Q5: What are the obstacles to implementing swaps in FFSR?

A5: Ongoing trade tensions between China and the United States have blocked significant progress throughout the WTO's various negotiating fora, with solar photovoltaics and electric vehicles (EVs) being focal points within the trade war. Amid great power competition, the United States is unlikely to agree to a swaps mechanism that could permit China to transfer substantial amounts of existing FFS to renewable subsidies that further boost its comparative advantage in the EV and solar industries.

Another key issue is the form of the agreement at the WTO. As it currently stands, the FFSR initiative has 48 members, mainly high-income and upper-middle-income countries that are not the largest subsidizers of fossil fuels. To be truly effective, more inclusive participation is required, potentially through a multilateral, WTO-wide agreement rather than an ad hoc plurilateral one. A new, non-actionable category of subsidies for swaps cannot be created through a plurilateral agreement, as WTO members external to the plurilateral agreement could still litigate or retaliate against those swaps.

WTO negotiations have been unable to reach a consensus on the issue of fisheries, and the WTO FFSR initiative may face similar challenges. A possible alternative approach for decisionmaking at the WTO is provided under Article IX of the Marrakesh Agreement for a majority voting system to be used when consensus, which has been a mainstay since the General Agreement on Tariffs and Trade, cannot be reached. However, this could be extremely problematic for the organization due to the political sensitivities regarding consensus. A three-fourths majority of the WTO membership could also decide that an amendment is of such a nature that, should a member not accept it after it has passed by a two-thirds vote, then that member shall be free to leave the WTO or to remain with the consent of the Ministerial Conference. Such an approach could, however, shake the WTO to its foundation, eroding almost eight decades of convention in utilizing consensus for WTO decisionmaking. Even under the current dynamics surrounding India's utilization of the consensus mechanism as a veto, this voting mechanism has not been used. A slightly more realistic outcome may be a diplomatic agreement reached through negotiations, which will necessitate concessions and perhaps a package of incentives for holdouts that include technical assistance, financial aid, capacity building, and more to persuade the remaining WTO members to join the existing 48 cosponsors.

Legal and political issues relating to FFSs are not just restricted to the international level. There is no lack of obstacles at the domestic level due to widespread public reliance on subsidies and their widespread benefits provided to companies. This places significant roadblocks on any advancement. Nonetheless, progress on this issue can help phase out fossil fuels and move forward with the energy transition.

Dhari AlSaleh is an intern with the Scholl Chair in International Business at the Center for Strategic and International Studies (CSIS) in Washington, D.C. William Reinsch holds the Scholl Chair in International Business at CSIS.

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