Efficiency, Distributional, and Fiscal Effects of Climate Policy: The Case of Fossil Fuel Subsidies and Externalities

The global public good nature of climate change mitigation and the resulting free-rider problem require a restructuring of the incentives for countries to price fossil energy consumption. Existing empirical evidence unequivocally documents the large magnitude of fossil fuel subsidies in terms of prices warranted by supply costs and local damages related to fossil energy use. This paper examines the efficiency, distributional, and fiscal effects at the regional and global level from removing explicit and implicit fossil fuel subsidies, the latter entailing Pigouvian pricing of major local externalities, and carbon pricing to achieve countries’ Paris climate targets. To perform counterfactual analysis, we develop a multi-sector multi-region general equilibrium model that incorporates granular data on fossil fuel subsidies, undercharging supply cost as well as marginal local external costs of fossil energy use by type of externality, fuel, economic sector, and country with national income and product accounts data, including information on bi-lateral international trade flows to capture international market responses and global supply chains related to fossil fuels. Removing explicit subsidies yields small welfare gains, while local Pigouvian energy pricing generates average gains of 4.3%, with country-level gains ranging from 5-25%. Pricing externalities from local air pollution captures 86% of these benefits. We also examine the impacts from subsidies removal on public budgets: fiscal revenues from removing both explicit and implicit subsidies amount to 5.1% of global consumption, or USD 2.4 trillion per year. Unilateral subsidy removal lowers the shadow cost of carbon by 86%, helping about 40% of countries, including the top CO2 emitters (US, China, India), surpass their Paris targets, while generating significant welfare gains. Unrealized welfare gains from underpricing fossil energy total 2.7% of global consumption, with 90% due to local air pollution.
Our analysis points to strong unilateral incentives for countries to eliminate explicit and implicit fossil fuel subsidies while contributing to the global public good of climate change mitigation. These incentives are reinforced when using the fiscal revenues from local energy pricing to lower pre-existing distortionary labor taxes. Finally, we find that local Pigouvian energy pricing can have unintended distributional effects across countries: while removing fossil fuel subsidies always is a dominant strategy from a unilateral perspective, a country’s action can trigger negative welfare effects for other countries through internationally linked product markets.
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Rausch, Sebastian und Tim Kalmey (2025), Efficiency, Distributional, and Fiscal Effects of Climate Policy: The Case of Fossil Fuel Subsidies and Externalities, Mannheim