Energy subsidies have become a hot-button issue for both renewable and conventional energy, with each side claiming the other receives more than it should. This issue is on the agenda for the meeting of the G-20 group of nations in Seoul, because they committed to the phase-out of subsidies for fossil energy at last year's Pittsburgh summit and will report on progress at this week's session. This coincides with the release of a new forecast from the International Energy Agency highlighting the urgency of phasing out these subsidies for the sake of reducing greenhouse gas emissions. It's worth noting that unlike US incentives for energy production that have attracted so much flak here, the bulk of the subsidies the G-20 and IEA want to eliminate are for the consumption of fossil fuels; most of them are provided in the developing world, often by governments that can ill afford them. Putting an end to these practices is a worthy goal, and not just because of climate change.

In addition to promoting stronger government support for renewable energy, the IEA report highlighted $312 billion in counterproductive subsidies for fossil energy last year--the figure was much higher in 2008--compared with $57 billion for all renewables, including biofuels. The subsidies in question are mainly in the form of price controls and market manipulation by governments in developing countries, including both large net energy producers and large net consumers. These governments effectively pay consumers to use more energy by keeping prices lower than free market levels. This is clearly counterproductive with regard to combating climate change, because it leads to higher emissions, but I'd like to focus on another drawback, in terms of how it affects global energy markets. Its effects haven't been as obvious recently, with demand down and spare production capacity ample for the moment, but it contributed significantly to the extreme oil prices we saw in 2007 and especially 2008.

Whether as simple as fuel price caps set by government fiat or as complex as the Philippines' former Oil Price Stabilization Fund that I used to monitor regularly in the 1990s--it acted as a sort of central bank for energy prices, until it ran out of money--these mechanisms insulate consumers from the global price of energy, usually oil. The benefits on which these measures are justified even make a certain amount of sense, in terms of protecting consumers from the effects of market volatility and promoting prosperity. If all they did was to smooth out market fluctuations while still reflecting average market values over time, those benefits might outweigh the damage these policies do to both national treasuries and to the capacity of oil prices to match supply and demand. In practice, these efforts often become politicized and end up entrenching below-market prices for their most vocal constituencies. Unfortunately, this not only boosts consumption but it also muffles or blocks price signals when global demand approaches the limits of supply, as we saw a couple of years ago.

The consequences of this are both local and global. Locally, either oil companies or oil price funds require ever greater cash infusions from governments, as global prices go up but consumers miss receiving the message to conserve. This decoupling, compounded over large segments of global demand, amplifies global price increases and focuses the necessary demand response on those countries without such mechanisms, like the US. This helps explain why oil prices skyrocketed to $145/bbl from the $70s just a year earlier, because that's what it took to force demand in non-subsidized countries down by enough to adjust for the global tightness of supply. In other words, oil consumption subsidies intended to stabilize local markets are paradoxically destabilizing for global oil markets.

It's important to draw a distinction between consumption subsidies like these and the fossil fuel subsidies that have come in for significant criticism in the US, which are focused not on consumption but on production. In fact, if their critics' claims about the unresponsiveness of global oil prices to incremental US production were right, then they would have zero impact in promoting consumption, which is the issue of concern to the G-20 and IEA. I don't believe either side of that thesis is correct. Supporting US domestic production inherently helps stabilize global oil prices by reducing US oil imports, but it likely does increase consumption modestly by nudging prices a bit lower than they'd be otherwise. That gives rise to an awkward trade-off, pitting increased energy security against slightly higher emissions, contrary to the rhetoric of some "energy hawks" who suggest that these two issues are always aligned.

In any case, as long as the G-20's efforts are focused on phasing out subsidies intended to hold down fossil fuel prices, they are on the right track, though consumers in developing countries will be in for a nasty shock when their governments follow through with this initiative. At the same time, the alternative to incentives for energy production is not their unilateral elimination, but the rationalization of tax and regulatory structures so that producers in one country aren't at a disadvantage compared to producers in another country, or to other industries in their own country. Sorting that out would require an entirely different and much more complex effort, and not just by the G-20's membership.