Speech

Promoting Responsible Energy Pricing, By Christine Lagarde, Managing Director, International Monetary Fund

July 31, 2014

As prepared for delivery

Good morning!

I am delighted to be back at the Center for Global Development, and I would like especially to thank Nancy Birdsall and Lawrence MacDonald for the warm welcome.

We all know that CGD combines top-notch intellectual firepower with deep-rooted concern for the world’s poorest people. It is an indispensible agent of economic development. Thank you, Nancy, Lawrence—and all of your colleagues—for the great work that you do.

As some of you might recall, I was last here two years ago in the run-up to the Rio+20 conference on sustainable development. At that time, I talked about the path to a sustainable future that would require us to overcome a triple crisis—an economic crisis, a social crisis, and an environmental crisis.

Today, I want to follow up on the third area—the environmental crisis, which is shaping up to be one of the greatest crises facing our generation and our century. It is also the issue upon which future generations will judge us.

If we do nothing, we face a future that is grim indeed. Our fortunes will melt with the ice, evaporate like water under a relentless sun, and wither away like sand in a desert storm. And the planet’s poorest and most vulnerable people will be the first to feel the pain.

Clearly, that is simply not an option. We must push back against these grave threats to our environment—as a matter of utmost urgency. This certainly calls for the international community to come together. Yet there is also a lot that countries can and should do on their own—this is one of my themes today.

What is the IMF’s role in all of this? Two years ago, I made a commitment that the Fund would work hard to provide practical guidance—a kind of “toolkit”—to help our members ensure that they are pricing energy responsibly.

Today, we are following through on that commitment by releasing a new book: Getting Energy Prices Right: From Principle to Practice. In effect, it is the toolkit that we promised.

In that context, let me talk about three things this morning:

• First, why environmental issues—particularly those related to energy production and use—matter so much to the Fund.
  
  
• Second, what we mean by “responsible” energy pricing.
  
  
• And third, how this principle can be put into practice.

Environmental issues and the IMF

Let me begin with why the IMF is concerned about the environment. The reason is simple: a degraded environment leads to a degraded economy. Environmental damage has macroeconomic implications, and implications for the design and impact of fiscal policy.

So where environmental damage is “macro-critical” it must also be “mission-critical” for us.

Fossil fuels, we have learned, are a doubled-edged economic sword. The unprecedented improvement in global living standards over the past century certainly would not have been possible without the energy derived from these fuels.

Yet we seem to have lost some ancient wisdom on the importance of balance and moderation.

For while the world became richer as energy fueled economic expansion, only recently have we come to fully appreciate the damage done to our precious—and irreplaceable—natural resources.

Think of spiraling atmospheric concentrations of greenhouse gases, which—according to the latest assessment from the Intergovernmental Panel on Climate Change—will warm the planet by around 3-4 degrees Celsius by 2100, in the absence of firm policy responses.

Think also of dirty air, which is caused mainly by burning fossil fuels. According to the World Health Organization, outdoor air pollution alone causes 3.2 million premature deaths a year. Meanwhile, relentless growth in vehicle traffic results in ever more productive hours lost in the grind of daily congestion.

What can we do? We clearly cannot reset the clock to a time before the industrial revolution—that is as impossible as it is undesirable. The only viable solution is for policymakers to protect rather than plunder the environment, to steward rather than sabotage our precious resources.

As the American poet Wendell Berry put it, “To cherish what remains of the earth and to foster its renewal is our only legitimate hope of survival.”

But sometimes the poets need some help—in the form of clear, effective, practical advice on how to “cherish and foster”.

As we all know, there is no simple solution here. Protecting the environment involves a multitude of moving parts. It encompasses, for example, research and development, infrastructure upgrades for power and transportation systems, and appropriate tax and regulatory regimes for extractive industries.

Yet, in all of this, fiscal policy must take center stage. The message is simple: to get it right, price it right. Make sure that prices reflect not only the costs of supplying energy, but also the environmental side effects.

This brings me to the main entry point for the IMF.

We have already done quite a bit of work in this area. For example, we have been pushing hard for the elimination of energy subsidies, which—as discussed in IMF research published last year—are bad for the planet, bad for the economy, bad for the budget, and bad for social equity.

But we need to go well beyond the elimination of direct cash subsidies, and make sure that energy tax systems around the world properly reflect environmental side effects.

On this point, let me be crystal clear: we are generally talking about smarter taxes rather than higher taxes. This means re-calibrating tax systems to achieve fiscal objectives more efficiently, most obviously by using the proceeds to lower other burdensome taxes. The revenue from energy taxes could of course also be used to pay down public debt.

We would expect these sorts of tax shifts to have limited adverse economic effects—the whole point is to raise revenue in ways that make the economy work better by fixing market failures.

Of course, taxing energy is not the only route. We can certainly think of good alternatives like programs where governments sell rights to pollute. Cap and trade systems have been around for a number of years and, if set up properly, provide a very reasonable alternative to meet the same objective.

What does responsible energy pricing mean?

Moving on to my second point today—how can policymakers design responsible energy pricing?

Using fiscal instruments to reflect environmental damage in energy prices is not rocket science. It is really a matter of basic tax principles, or actually just common sense. The two main issues are the appropriate tax base and the appropriate tax rate.

Carefully targeting the source of the environmental harm is critical. This means, for example, making sure that charges on different fuels are proportional to emissions from those fuels. That way, we get the relative prices of dirty, intermediate, and clean fuels right—and environmental damage is properly factored into energy prices.

In turn, that encourages people to make green choices all across the spectrum—such as power generators switching to less polluting fuels or installing emissions-control technologies; and households driving less often, or upgrading to more energy-efficient vehicles and appliances.

Using a single fiscal instrument targeted at a particular source of environmental harm is both effective and administratively simple. It is better than relying on a patchwork of uncoordinated policies—such as telling some manufacturers to install certain control technologies, requiring others to use certain fuels, or rewarding households for buying certain vehicles.

The bottom line is that we can spur the same kinds of virtuous behavior by using a much simpler tool—a single fiscal instrument. And once we price bad things right, we will not need to worry so much about subsidizing good things—like renewable energy.

Once we know what to tax, the next logical question becomes how much to tax. Again, this is straightforward in principle. Aligning tax rates with environmental damage provides an automatic check and balance.

If taxes are too low, many socially desirable changes to energy production and use will not be made, and the environment suffers. If taxes are too high, energy will be produced with excessive costs, and the economy suffers.

So this is a delicate—but very important—balance to get right. To do this, policymakers need to have some sense of the magnitude of environmental damage and what this implies for appropriate energy tax systems.

Putting principle into practice

This brings me to my third area—putting principle into practice. This is really the whole point of the new IMF book—providing actionable guidance to policymakers on “pricing it right”.

The unique contribution of the book—or the toolkit—is that it lays out a practical methodology for quantifying environmental damage across developed and developing countries alike. It shows what this damage implies for appropriate energy taxes, and the benefits of policy reform.

Let me raise an obvious but important caveat. There are many controversies and uncertainties involved in measuring environmental damage—for example, in putting a price tag on future global warming or on the lives saved from cleaner air. It is possible to come up with many plausible values for such things, but the IMF is not in the business of telling governments what to assume here.

Rather, what the book provides is a framework for understanding the issues—the key factors that determine the environmental damage. It provides estimates of tax levels needed to incorporate environmental costs in the prices of coal, natural gas, gasoline, and diesel—for over 150 countries. It also offers an accompanying spreadsheet tool—available online—that traces out the implications of alternative assumptions for these factors.

So we see our contribution as helping to inform the debate, make transparent the policy implications of alternative assumptions, and provide a benchmark against which other—less efficient—policies can be evaluated so policymakers better understand the tradeoffs.

This is not the place to get into a technical discussion of how to measure concepts like deaths from air pollution or the costs of traffic congestion—for that you should read the book!

Instead, let me mention just one other important aspect—how pervasively energy seems to be mispriced at present, based on our assessment.

Take coal, for example. This is about the dirtiest of all fuels, yet almost no country imposes meaningful taxes on its use. Our work suggests that, to reflect the carbon damages alone, a reasonably-scaled charge would amount, on average, to around two-thirds of the current world price of coal. In countries where a lot of people are exposed to air pollution, the coal charge should be even higher—several times higher in some cases.

What about motor fuels? There are many costs to count here—the obvious carbon and air pollution damages, and also the costs coming from congestion and the risk of additional traffic accidents. If all of these costs were reflected in gasoline and diesel taxes, it would mean substantial charges across developed and developing countries.

Some countries are already in the vanguard here. Many countries in Europe, for example, already impose taxes on fuel at levels that seem broadly appropriate for the damage they cause. The more important question for them going forward will be the appropriate mix between traditional fuel taxes and more novel approaches—such as per-mile charges for peak-period driving on busy roads to deal with congestion.

We also need to make sure that the poorest and most vulnerable households are protected. But let’s be clear: keeping energy prices artificially low is no way to help the poor. Instead, policymakers should focus on the overall fairness of the tax system—and make sure that all have access to decent healthcare, education, and social benefits.

Pushing ahead with energy price reform might not be easy, but it will certainly be worth it—many times over. It produces a triple benefit—saving lives, saving the planet, and saving the budget. For example, we have estimated that these policies reduce fossil fuel deaths by 63 percent, reduce carbon emissions by 23 percent, and raise revenues by 2.6 of percent of GDP.

When we put it in these terms, the case for action becomes urgent. Yes, we need global cooperation to overcome global challenges like climate change. In this vein, we fully support ongoing international efforts to move climate mitigation policies forward. Yet this is proving hard because the costs of action are clear and they are borne by local communities while the benefits of action are more long-term and more dispersed across the globe.

But this is not an excuse for individual countries to stay in a holding pattern. As we have shown, there is a lot that countries can do to protect the environment on their own, by acting in their own national interests. If everyone cleans up their own neighborhood, our entire planet will be in much better shape.

Conclusion

Let me conclude on that note. We do not expect energy price reform to happen overnight. It will require education about why substantially higher fuel prices are needed—and indeed unavoidable—to deal with mounting environmental challenges.

Yet as Nelson Mandela once said, “it always seems impossible until it’s done”. So let’s get it done—at the national level and at the global level. We know where we need to go, and how to get there, so let us start the journey.

I promise you that the IMF will help countries move forward here—with our policy advice and, as countries seek it, our technical assistance. We are all in this together.

Thank you very much.