Is there a fairer way to finance energy subsidies?

Niall Farrell, of the Economic and Social Research Institute, argues that it’s important to ensure the burden of energy subsidies is distributed equitably.

In many countries, governments subsidise particular forms of energy to support environmental, security or social goals. Ultimately, energy consumers or taxpayers must finance these payments through one of many potential financing structures. Each structure affects each household type differently, with some having a more equitable impact than others. This article draws on recent research discussing the equity implications of various financing structures.

Ireland currently subsidises renewable energy, peat generation and a number of generators commissioned when demand was close to exceeding supply. The Public Service Obligation (PSO) levy is a charge included in all Irish electricity bills to raise this money. Like many other European countries such as Germany and Spain, this charge has been growing in recent years and is becoming a greater proportion of electricity costs. To illustrate, the 2013-2014 PSO levy was €42.87 per domestic consumer, 54 per cent greater than the 2012-2013 levy. This rose to €64.37 for the period October 2014 to September 2015. While this rate of growth may not transpire every year, more wind and persistently low fossil fuel prices suggest that subsidy costs will remain above zero, and potentially grow, in the foreseeable future. The means by which these subsidies are financed is of growing importance as a result.

Currently, the PSO levy appears on Irish electricity bills as a flat-rate surcharge. Although each household must pay the same levy, the burden, or cost relative to ability to pay, is greater for poorer households. When the amount charged is in proportion to electricity usage, heavy electricity users are charged more. As wealthier households tend to use more electricity, this results in wealthier income groups paying a greater average subsidy and poorer income groups paying a lower average subsidy. This shifts a greater proportion of the burden to wealthy households. The benefit for poorer households outweighs the cost to wealthy households as electricity tends to represent a higher proportion of a poor household’s income. A charge that is proportional to electricity use is more equitable as a result.

The argument in favour of a unit-based surcharge is strengthened when one considers the behaviour of the wind portion of the PSO levy alone. As wind is free, it reduces the wholesale cost of generation. In 2011, SEAI and EirGrid published research highlighting that the wind portion of the PSO levy is equal to wholesale cost reductions. On first glance, it would appear that these benefits and costs cancel each other out. However, as benefits are distributed through electricity price changes, those who consume more electricity will incur a greater proportion of the total benefit. If a flat rate charge is in place, the cost will exceed benefit for light electricity users, with benefits exceeding costs for heavy users. As heavy users are more likely to be wealthy, the cost of electricity will fall for high income groups and increase for low income groups.

A unit-based levy directly offsets a unit-based benefit, ensuring that there are no ‘winners’ and ‘losers’ and that the net zero impact found by SEAI and EirGrid prevails at the level of the individual consumer. This, of course, is predicated on suppliers passing wholesale cost reductions to consumers.
Overall, a unit-based levy is better able to take household ability-to-pay into account when raising money to finance energy policies. While this is true, a change to such a tariff creates winners and losers. Wealthy households are more likely to lose out as they consume more electricity.

However, as they have higher incomes, this increase in burden, or cost relative to their ability to pay, is negligible. While most low-income households benefit, some low income households who use a lot of electric

ity lose out.

The Irish tax and benefit system incorporates a number of social policies that may be augmented to offset negative impacts for low-income households. Ireland’s Households Benefits Package (HBP) is one such measure. The HBP contains a free electricity allowance to help certain vulnerable socioeconomic groups with household electricity or gas costs.

If the PSO cost was covered as part of the HBP, vulnerable social groups would be shielded from changes in the PSO levy. Indeed, this was how the Irish HBP was designed prior to Budget 2013. While low-income groups are the greatest beneficiaries of the HBP, it does not exclusively help those that are most negatively affected by a PSO levy. This is because many HBP beneficiaries are in middle-income groups. A social transfer mechanism that explicitly takes household income and size into account might be more efficient than the HBP at targeting those most negatively affected by the PSO levy.

To implement these policy mechanisms, a suitable legal framework is required to comply with EU laws regarding state aids. Currently, Ireland achieves this through a non-consumption based levy. An alternative justification is required for a consumption-based levy, similar to those put in place in other EU member states. Despite these legal requirements, ensuring that the burden of energy subsidies is distributed equitably is an important policy consideration. The current flat-rate levy has been shown to impose a greater burden on low-income households, with unit-based levies found to be a more equitable way to distribute the burden of this cost. Social transfers may be employed to protect vulnerable households negatively affected by such a switch.