Rationalize and Reform the Subsidy Mess: It’s Time

Mark Muro

Subsidy reform: It’s going to happen.  With the Senate’s rebuke of ethanol subsidies last week, the writing is on the wall.  A time of reckoning has arrived for the entire jury-rigged, inconsistent structure of the nation’s energy-sector subsidies.

Democrats are calling on Republicans to put oil and gas tax breaks on the table in deficit reduction talks.  Republicans want renewable-energy subsidies eliminated.  And this time, something is going to happen.  The only question would seem to be: Who’s ox is going to get gored?

And yet, here is another view: Notwithstanding the possibility of gridlock and rash slashing, the current moment holds out real hope for authentic reform, because something has to happen, everyone’s ox deserves goring, and a way forward can be discerned that is both fiscally sound and economically attractive.

Making true reform possible are several unavoidable realities.  First of all, rising concern about the national debt puts increased pressure on all federal expenditures and is forcing new scrutiny and new political outcomes (witness the ethanol vote).  That means that all energy subsidies—whether for fossil fuels or renewable energies—will henceforth come under tough new scrutiny. That that scrutiny will be universal expands the potential for productive political trades and deals.

Secondly, the new pressure is making the manifest incoherence of the current mish-mash of energy-sector subsidies harder to defend.

Defenders of oil and gas industry tax breaks are clearly finding it harder to maintain support for tax and other provisions for a mature, highly profitable industry whose incumbency essentially locks in U.S. economic vulnerability and energy dependency and inhibits the emergence of alternative energy sourcing.  The sheer cost of these provisions is one issue, given that the fossil fuel sector reeled in more than $72 billion in subsidies in a seven-year period in the 2000s, compared to the $29 billion received by the renewables sector, according to a 2009 analysis and cool graphic by the Environmental Law Institute. But even more vexing is the contradictory nature of these policies.  On its face, the simultaneous existence of preferences for the fossil fuel industry and clean energy production represents a classic case of cross-purposes.  Adding to the imbalance is the fact that while most of the largest subsidies to fossil fuel production are written into the U.S. Tax Code as permanent provisions, many subsidies for renewables are time-limited, implemented through energy bills, with expiration dates that continually create uncertainty for the industry and undercut deal-flow and deployment.  This is a problem we will discuss in a forthcoming report on the clean economy due next month and it’s a major added source of inconsistency.  Cases in point here are the federal Production Tax Credit (PTC) and the Investment Tax Credit (ITC) which have been allowed to lapse multiple times before being granted short-term extensions.

At the same time, though, legitimate questions are being raised about the nature and purpose of the major renewable energy subsidies and incentives.  These too are beginning to incur scrutiny, such as from Sen. Lamar Alexander (R-TN). Some complain about the extremely varied rates the government pays for a given amount of fossil fuel displacement (ethanol and biodiesel get roughly four times the support for a given unit of fossil fuel displaced than do wind, geothermal, or nuclear generation, according to a 2009 Joint Committee on Taxation report).  Others—including myself and colleagues at the American Enterprise Institute and the Breakthrough Institute—note that while the federal government showers subsidies across many energy options, from oil and coal to ethanol and wind power, none of these efforts are really designed to drive and reward innovation and ensure the prices of these technologies fall over time. In this regard, most renewable energy subsidies—like the fossil fuel opposite numbers—remain relatively static in their reward for production of more of the same product rather than of improved performance, and therefore greater American competitiveness.  For example, while the ITC and PTC and related cash grants reward capital investments and expanded production, they are not designed to drive and reward innovation or ensure that the prices of the technologies and the electricity they generate fall over time. Instead, they incentivize maximum capital expenditures and steady production.  In that sense, multiple clean economy subsidies help renewable technologies compete against conventional energy sources but they incorporate no systematic, predictable nudge toward innovation and cost-parity.  And that is a legitimate problem with the nation’s clean energy subsidies—a basic problem on the renewable energy side to go along with the basic problems on fossil fuel side.

And so the time is right for a grand trade—forced by budget necessity—aimed at winnowing, rationalizing, and rethinking the whole incoherent slew of expensive and poorly designed energy sector tax provisions.  In this respect, the moment’s rising deficit anxiety combined with the expiration of multiple elements of the nation’s mish-mash of clean energy supports represents an opportunity for plausible reform.

What might such reform look like?  Such a rethink could and should combine significant reductions of oil and gas tax expenditures with significant remodeling of the shaky array of renewable energy provisions.

On the oil and gas side, the need for revenue and the goal of supporting the competitiveness of clean energy each argue for trimming fossil fuel subsidies.  The nation simply cannot afford them, and they don’t make sense.

As to a new approach to provisions for renewables, reform might well pair selected extensions of key production, investment, and manufacturing tax credits as well as the Treasury grant cash-back program with staged, technology-specific phase-outs.  Along these lines, targeted and competitive deployment incentives could be created for various classes of energy technologies that would ensure that each has a chance to mature even as each is challenged to innovate and locate price declines. Incentive levels should fall at regular intervals, terminating if the technology class either fails to improve in price or reaches cost parity in the absence of further incentives.  Structured in this manner, reformed national energy deployment incentives will not select winners and losers, nor will it create permanently subsidized industries.  Instead, smart public investments will instead provide opportunity for all emerging low-carbon energy technologies to demonstrate progress toward competitive costs while increasing the rate at which early-stage clean and affordable energy technologies are commercialized.  The resulting reformed policy environment would at once provide new industries support, predictability, and a nudge toward innovation and cost-reduction. Alternatively, such a reform drive—which could be paired with a new look at reducing or eliminating subsidies to fossil fuel industries as well—might utilize competitive tendering processes like reverse auctions to contain subsidy expenditures and maximize the returns from given outlays, something Nate Gorence Sasha Mackler of the Bipartisan Policy Center have written about.

In any event, though, the time is right for a convergence of agendas that links fossil fuel subsidy reform and smarter renewables supports.  Sheer fiscal necessity, the array of subsidy problems in need of response, and the need to decide what to do with so many expiring renewables provisions are going to force a debate in the next two years.   Given that, reform along the lines noted here might appeal at once to deficit hawks, proponents of renewables, and others focused on unleashing investment and job-creation. Such a grand trade in Washington would be an auspicious development for the energy economy, both traditional and new.