Rio+20 • Volume 5 • Number 3 • November 2011

Governing clean energy subsidies: Why legal and policy clarity is needed

by Arunabha Ghosh

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International competition in the area of renewable energy is intensifying. On the flipside, investment is often lacking, due to uncertainties in the policy framework. Among the issues needing further clarification is the role of renewable energy subsidies, with potential new cases looming at the WTO.

For the last two years, the world’s leading economies (via the G20) have been debating how — and committing to — reduce subsidies for fossil fuel-based energy. These subsidies, amounting to more than US$550 billion annually, artificially keep prices low, distort energy choices and contribute to carbon emissions. Compared to this level of support, subsidies for renewable energy were estimated at US$43-46 billion in 2010. Counting energy subsidies is no easy task, and estimates vary. But there is no doubt that support for clean energy is a fraction of the public funds devoted to sustaining fossil fuel sources. Yet, the governance of clean energy subsidies is beginning to emerge in global and national policy discourse. Nearly two billion people have no access to modern sources of energy. Increasing energy access is going to be one of the key ingredients for human development. At the same time, energy-related CO2 emissions are also expected to increase over the next two decades, especially in developing countries. Clean energy subsidies are, therefore, needed to support two simultaneous transitions: from no energy to energy access; and from fossil fuel-based energy to a low-carbon energy pathway. But are clean energy subsidies entirely uncontroversial? If not, what are the sources of contention — and what can we do about them?

The raison d’être of clean energy subsidies: From energy access…

Why are clean energy subsidies needed? The answer, in short, is energy access and market failure. Increasing energy access to dispersed population settlements becomes harder the further they are from the electricity grid. This is particularly problematic for rural households. Even in densely populated regions, low electricity demand from rural households can make the installation of secondary and tertiary transmission lines and distribution systems uneconomical. Such households are unlikely to enjoy energy access unless part of the capital costs are subsidised.

Subsidies to increase energy access are not necessarily net costs for governments. The use of traditional biomass fuels for cooking and heating has severe health implications, especially for women. Access to modern energy sources means improved health outcomes, benefits that are often not included in economic cost-benefit analyses. Such omissions result in a market failure, whereby energy utilities have no incentive to extend transmission lines when the social benefits of better health outcomes are not internalised in their balance sheets. In these cases, subsidising off-grid energy systems might make even more sense.

…to addressing market failure

Market failures also emerge for clean energy technologies. Since solar, wind, small hydro, geothermal, and other renewable energy sources add up to only a small share of the electricity generation capacity in most countries, the average costs of additional capacity installation remain much higher than for the dominant fossil fuel sources, like coal or gas. Once again, not counting the positive environmental externalities of switching to cleaner sources of electricity means that pure economic calculation would preclude clean energy investments. And once again, there is a case for subsidising renewable energy both to increase scale (and thereby drive down costs) and to make energy choices based on a real reflection of the economic, social and environmental costs and benefits of alternative technologies. When the benefits of shifting away from traditional fuels are added along with the avoided fuel costs of using diesel or kerosene, subsidised off-grid renewable energy applications have yielded significant returns. Solar photovoltaic (PV) systems, for instance, have offered economic returns and consumer surplus of 27 to 94 percent for projects in Bolivia, China, Indonesia, Philippines, and Sri Lanka.[1]

Industrial policy and jobs

There are other rationales offered for clean energy support as well, but they need not make sound economic or policy sense. One is industrial policy. China, for instance, has elevated renewable energy and environmentally-friendly and energy-efficient technologies to the level of “strategic emerging industries”. By promoting the export of 95 percent of its domestic production, China’s solar panel manufacturing industry rapidly grew to become the world’s largest.[2] For its 12th Five Year Plan it is now planning US$300 billion of investment each year to be divided among seven strategic industries. The objective is to take advantage of market trends and close the relatively small gap between emerging and developed economies in these new sectors, according to Vice Premier Li Keqiang.[3]

The trouble is that picking winners is seldom easy. There is the danger of distorting markets and credit flows, encouraging rent seeking and other anti-competitive practices, locking in existing technologies at the cost of future innovation, or simply adding excess capacity relative to demand. China’s National Reform and Development Commission, its powerful planning body, observed that its wind energy sector was already suffering from over-capacity, thereby questioning the need for and ability to absorb such large-scale investments.[4]

Another rationale is job creation. Some have argued for promoting clean energy industries to create millions of “green jobs.” The German renewable energy industry, for instance, employs 380,000 people with 108,000 in the solar PV industry alone.[5] The argument for green jobs has particular resonance in recession-hit economies, justifying billions of dollars of stimulus spending in pursuit of reducing unemployment rates. While such efforts could increase employment in clean energy sectors, they need not create additional employment if job losses in fossil fuel industries are taken into account. Moreover, the overall contribution is itself small, at least in advanced economies where energy production might not account for a large share of the economy.[6]

Policy tensions around clean energy subsidies

These alternative rationales for using clean energy subsidies to pursue different policy and political ends mean that, despite the strong case for supporting a transition to a low-carbon economy, several tensions have either already emerged or are visible on the horizon.

At least four imperatives are driving a growing international debate on the governance of clean energy subsidies. The first clearly is the environment imperative. Climate change negotiations are, partly, hinged on promoting the transfer of clean technologies to developing countries and providing the financial resources to adopt these technologies. Investments in cleaner energy infrastructure have an incremental cost over and above what it would have already cost to install fossil fuel-based coal or gas-fired plants. Whether the incremental costs are covered from domestic or international funding sources, clean energy subsidies are needed until renewable energy reaches “grid parity” with fossil fuel energy. The question is how the incremental costs will be covered, and whether the financial support will be sustained over a period sufficient to scale up deployment of new and emerging clean energy technologies.

The other environmental imperative is the notion of a “green economy,” one of the two defining themes for the Rio+20 Sustainable Development Summit, scheduled for June 2012. As a concept, green economy aims for sustainable development along with poverty eradication, comprising a lens to focus efforts on advancing economic and environmental goals simultaneously. While laudable as an aim, many developing countries have stressed that pursuit of a green economy should preserve “ample flexibility and space for national authorities to make their own choices and define their paths towards sustainable development based on national circumstances and priorities.”[7] This is important, because how clean energy subsidies are governed would depend on how much flexibility individual countries retain in defining their low-carbon pathways. Each country would give priority to different clean energy sectors and to the form of support used. But not all support measures have similar consequences for other countries. The choices between subsidising R&D versus deployment, energy access versus manufacturing, clean energy production versus exports, all have differential impact on consumers, project developers, and equipment manufacturers at home and abroad.

The technology imperative is the second source of potential tension. Recent years have witnessed significant growth in manufacturing capacity and deployment of clean energy generation capacity (Germany and Spain in solar; China and the United States in wind and solar, for instance). But many technologies still remain at the R&D stage or have not been deployed at a scale that would make them commercially viable just yet. Technological innovation and leadership in these emerging sectors are partly a function of a country’s indigenous scientific prowess. But many bilateral ventures are also underway to jointly develop new technologies. In India, the most recent example is the US$100 million India-US Joint Clean Energy R&D Centre. At the multilateral level too, negotiations concerning a Technology Mechanism under the UN Framework Convention on Climate Change have assumed a critical role. The question is how partner countries support these joint ventures — through direct financial transfers or by contributions in kind — and how the fruits of such labour are shared.

Thirdly, the economic imperative underlies many of the decisions regarding investing in clean energy sectors. Sustainable energy investments rose steadily from the third quarter of 2004 (at US$4 billion) to the fourth quarter of 2007 (peaking at US$40 billion). The dip in investments began from early 2008, preceding the onset of the global economic crisis by a few months. Investors in clean energy might exit relatively less mature sectors sooner, or choose to defer their investment decisions until well after signs of general economic recovery become visible. Once again, the role of subsidies to smooth the fluctuations in clean energy sectors and increase investor confidence has become an international concern for sustaining investments in the face of the climate challenge.

A collective international concern, however, does not mean that all countries will converge on the role of national policy. Subsidies for clean energy sectors during a recession could assume a mercantilist purpose as well, especially if domestic industrial development, manufacturing capacity and employment generation come at the expense of other countries. Governments, and firms, are interested not only in the collective good of cleaner, low-carbon energy, but also in industrial and economic competitiveness.

And, therefore, the fourth source of tension: the trade imperative. Mercantilist policies discriminate between foreign and domestic firms within a country. They can also discriminate between imported clean energy products and local manufactures. Subsidies could be granted to promote clean energy exports, making domestic firms more competitive in the international market. Such concerns have prompted Japan and the European Union to launch a dispute at the World Trade Organization (WTO) against Ontario’s feed-in-tariff scheme, primarily because of the built in provisions on local content requirements. Most recently, the United States has notified the WTO that nearly 200 Chinese subsidies, many of them for clean energy purposes, have bankrolled Chinese companies at the expense of trade opportunities for American firms. Negotiations at the WTO on trade in environmental goods and services are also hampered by rival definitions of how to define such goods and services that have dual purpose, and then how to reduce tariff and non-tariff barriers, especially if the latter promote domestic clean tech industries.

Moving the debate ahead

Why should policy-makers and stakeholders in the trade community care about the imperatives for clean energy subsidies and the emerging tensions? The number of countries seeking to scale-up renewable energy investments, driven by some or all of the four imperatives discussed, is growing. Emerging economies, which still have to provide access to energy to many of their citizens and stand at the crossroads of choosing between alternate energy technologies, stand out in this regard in particular. Meanwhile, calls for transparent notification of subsidies are intensifying and some legal cases in the area of renewable energy have already entered the WTO arena. Such legal challenges could have a dual impact: constraining countries’ policy space and lowering investor sentiment, if the continuity of policies supporting clean energy is called into doubt.

What can be done? At least five aspects of the governance of clean energy subsidies need attention. First, common metrics to count subsidies can help to increase transparency. Secondly, the relationship between rationalising fossil fuel subsidy programmes as a precursor to promoting clean energy sources should be further emphasised. Thirdly, greater policy clarity is needed to establish the purpose of government support. While retaining policy flexibility is important, subsidies to increase energy access or energy generation capacity would have completely different impacts from those geared primarily for promoting manufacturing and exports. The pursuit of policy clarity would allow countries to review their policies and justify those that have limited mercantilist impacts. Therefore, fourthly, independent assessments of alleged adverse impacts of subsidy policies could reduce the threat of unilateral trade sanctions or other penalties.

Finally, international institutions with rules governing trade, energy flows and climate change need greater coordination.[8] For clean energy sectors, whether this takes the form of a separate agreement or clarifies existing rules can remain an open question for now. The months leading up to the Rio+20 summit are an opportunity to focus international attention on the issue. If the transition to a low-carbon green economy is going to be a long haul, then the aim must be to offer policy and legal clarity regarding supporting measures over the long term.

World Bank (2008) “Operational Guidance for World Bank Group Staff: Designing Sustainable Off- Grid Rural Electrification Projects: Principles and Practices,” November, p. 4; Accessed 31 October 2011.
Bradsher, Keith (2009) “China Builds High Wall to Guard Energy Industry,” New York Times, 14 July, p. B1.
Hart, Melanie (2011) “China Eyes Competitive Edge in Renewable Energy,” 24 August; accessed 31 October 2011.
China Daily (2010) “China mulls $1.5t boost for strategic industries,” 3 December; accessed 29 October 2011.
Vaughan, Adam, and Fiona Harvey (2011) “Solar subsidies to be cut by more than half,” Guardian, 28 October.
Levi, Michael (2011) “New Energy Jobs Won’t Solve the U.S. Unemployment Problem,” Foreign Affairs Snapshot, 18 October; Accessed 19 October 2011.
UN General Assembly, 2010, “Objective and themes of the United Nations Conference on Sustainable Development,” Preparatory Committee for the United Nations Conference on Sustainable Development Second Session, A/CONF.216/PC/7, 22 December, paragraphs 10, 14.
Ghosh, Arunabha (2011) “Seeking Coherence in Complexity? The Governance of Energy by Trade and Investment Institutions,” Global Policy 2 (Special Issue): 106-119.

Dr Arunabha Ghosh is CEO of the Council on Energy, Environment and Water, an independent policy think-tank in New Delhi. He is also Associate at the Global Economic Governance Programme and the Smith School of Enterprise and the Environment, Oxford.