Why fiscal policy matters for a green economy transition

  • Dr Suneel Pandey
  • 19 December 2014
  • Green Growth Knowledge Platform, Insights blog


There has been growing recognition that fiscal policy plays a crucial role in transforming economies to become greener and more inclusive. By reflecting the cost of externalities from natural resource use in the prices of goods and services, fiscal policy sends the right signal to the market. Such signals then stimulate a shift in production, consumption and investment to lower-carbon and socially inclusive options. Moreover, fiscal reforms aimed at removing perverse subsidies to polluting activities and unsustainable use of limited resources can not only create fiscal space for investing in development priorities, but can also can generate revenues for nurturing the environment.

Despite the strong potential of fiscal policy in driving the green economy, governments have not exploited this potential as much as they could. In many countries, the use of fiscal instruments to meet environmental objectives has been rather limited until now. In many cases, the approach towards pollution monitoring and control has mostly been in the form of legislation-based command and control measures while natural resource management has been largely programme driven. Yet where governments introduce fiscal instruments, the benefits can be substantial. Feed-in tariffs and similar support mechanisms, for instance, have been the primary driver in boosting the market growth of renewable energy and are now used in 98 states, provinces and countries worldwide. Moreover, the successful carbon tax in British Columbia, Canada, shows that it is possible to tax carbon while safeguarding economic performance, income levels and the environment.


Various fiscal measures could help green specific priority sectors. One example is the energy sector, which accounts for 35 per cent of anthropogenic greenhouse gas (GHG) emissions, the biggest contribution from all economic sectors, according to the IPCC's 2014 report. It also accounted for 47 per cent of the increase in GHG emissions between 2000 and 2010. This unsustainable trend calls for a shift to low-carbon, energy-efficient supply and better energy demand management.

Fiscal measures in the form of taxes, charges, subsidies, incentives and budget allocations can help generate revenue for environmental and social purposes, shift behaviour towards low-carbon activities and stimulate green investment by pricing environmental externalities. For example, governments around the world have implemented feed-in tariffs as a support measure to incentivize investment in renewable energy from clean sources such as solar, geothermal and wind by guaranteeing a tariff for a set period of time - up to 20 years in some cases. These support measures need to be reviewed periodically, though, and phased out in time as the share of renewable energy increases and renewable energy becomes competitive with conventional fuels. Governments also use targeted financial programs to support the purchase of energy efficient appliances. In Tunisia, for instance, US$24 million was provided from public funds to promote the use of solar water heaters and in Ethiopia, clean cook stoves have been increasingly adopted through revenues saved from the removal of fossil fuel subsidies. A pioneer in the use of environmental taxes, Mauritius introduced a suite of environmental fiscal measures, including an excise duty on petroleum products and a charge on energy inefficient products. The total contribution of these measures is equivalent to 2.6% of Mauritius' GDP in 2013.

To address the environmental impacts due to the operation and development of coal mines in India, in 2010 the Government of India introduced a nationwide cess on coal in 2010 of INR 50 (US$ 1 approx.) per metric tonne of coal both produced and imported into India. The cess has now been revised to INR 100. The proceeds of the cess go to the National Clean Energy Fund for funding research and innovative projects in clean energy technology.

While these measures can generate revenues, induce clean technology innovation and increase demand for clean energy, they can also hike up the prices of fuels, electricity and energy appliances thereby compromising the competitiveness of businesses and the purchasing power of households. Mitigation measures are therefore needed to protect vulnerable groups. In addition, there is still a lot to be done to remove subsidies for fossil fuel production and consumption, which are estimated to account for 3% of GDP on average in developing countries. These subsidies encourage excessive consumption of energy, tend to benefit high-income households and create a significant fiscal burden in many countries.

Realizing the drawbacks of these subsidies, countries as diverse as Indonesia, Ghana, and Ethiopia have implemented fossil fuel subsidy reform with the savings redirected to address human development priorities such as health and education. In Kenya, for example, the government was able to improve the country's electricity network due to the increased resources from subsidy removals. However, the examples of failed fossil fuel subsidy reform show that more effort is needed to build support for reform from key constituencies, to get energy prices right and to manage the impacts on different social strata and in particular on vulnerable groups.

Water is another sector where fiscal measures could be instrumental in ensuring sustainable water resources. Water is essential for health and human wellbeing, ecosystem services and economic development and is thus important for the green economy. The world confronts a number of growing challenges in the availability, conservation and supply of water resources. According to the 2030 Water Resources Group, demand for water is projected to exceed supply by 40 per cent by 2030 if no improvements in water efficiency are made. Moreover, the OECD projects that 40% of the world's population will live in water-stressed regions by 2050 under current trends. The rate of groundwater depletion doubled between 1960 and 2000 and many river basins - from the Yellow River in China to the Zayandeh Roud in Iran - are at risk of running dry. Universal access to drinking water remains elusive in many countries, and globally, 3.5 billion people lack access to clean drinking water. Climate change is exacerbating these challenges and an estimated 100 to 200 million people every year are victims of water-related disasters such as floods and droughts.

Fiscal measures can help create incentives for water efficiency, stimulate investment in water supply infrastructure, ensure affordability of water services and avert the unchecked pollution and abstraction of precious water resources. The role of public funding for the water sector is essential and in many countries, constitutes the primary source of funding. The Africa Infrastructure Country Diagnostic Study by the World Bank (2009) found that public expenditure was the primary source of funding for water supply and sanitation in Sub-Saharan Africa, accounting for 54% of all capital investment, operations and maintenance costs in the sector. Tax revenue is one of the ultimate sources of financing for the water sector (together with tariffs and transfers, collectively known as the 3Ts) and is used by central and sub-national governments to fund capital investment and water supply operations. Appropriate water pricing can ensure cost recovery in the water sector from a combination of the 3Ts, which can be used as the basis to attract repayable sources of finance such as loans and private equity.

Other fiscal measures aim to reflect the externalities associated with water use in the price that beneficiaries pay. Effluent charges can be used to dissuade individuals and companies from polluting water sources and to raise revenues for restoration efforts. In Manila, for example, a wastewater effluent fee was introduced in 1997 in response to the massive degradation of the Laguna de Bay watershed near Manila by industrial users. Following the implementation of the fee in 1997, industries changed their production processes and reduced the volume of effluent discharged into the watershed. In addition, water abstraction charges can ensure that groundwater or surface water sources are not overly exploited.

Governments can also provide fiscal incentives for water conservation projects. South Africa's Working for Water Programme, for instance, employs people from disadvantaged communities to clear water infested by invasive plant species. The Programme has generated 20,000 jobs a year and cleared a total of 1 million hectares of infested area, therefore expanding water availability. Also, tax reductions can expedite the uptake of water conservation technologies such as rainwater harvesting and reuse systems and public funds can be used to leverage private investment in capital projects, for instance through public-private partnerships.

The transport sector relies heavily on petrol and diesel to fuel vehicles, resulting in serious externalities such as air pollution from exhaust fumes, traffic congestion and accidents. According to the Intergovernmental Panel on Climate Change, the transport sector accounted for 14% of total anthropogenic greenhouse gas emissions in 2010, compared to 25% from electricity and heat production and 24% from agriculture, forestry and other land uses. Addressing GHG emissions in the transport sector is therefore indispensable for mitigating climate change. There are also important health implications from the current fossil fuel-intensive transport system. For instance, the World Health Organization recently reported that outdoor air pollution in both cities and rural areas was estimated to have caused 3.7 million premature deaths worldwide in 2012.

Fiscal reforms in the form of phasing out support to diesel and petroleum products can help reduce air pollution from the transport sector while reducing health burdens from respiratory diseases and preventing premature mortality. Moreover, fiscal incentives can induce investment in low-carbon transport infrastructure such as light rail and encourage the uptake of electric vehicles. Taxes on motor vehicles fuels, public investment in public transport and non-motorised transport, and tax breaks for efficient vehicles can also have a positive effect. According to UNEP's Green Economy Report (2011), investing US$ 419 billion per year (constant 2010 US dollars) between 2010 and 2050 in promoting modal share to bus and rail transport and increasing the efficiency of motor vehicles would reduce the travel volume of road vehicles by 35% compared to Business as Usual and would decrease the share of passengers travelling by car from 62% to 33%. In Copenhagen, a world leader in cycling mobility, 20% of all trips are undertaken through cycling, thanks in part to investments in cycling infrastructure.

The following are suggested in terms of sectoral responses:

Continuation and redoubling of efforts to move towards recovering the full costs of electricity, irrigation and municipal water, sanitation, and solid waste services, while at the same time improving the quality of services.

Gradual introduction of more sophisticated instruments such as time-of-use electricity tariffs, and encouraging inter-sectoral water charges where possible.

Redesigning the water cess in India in a phased manner. The cess should be based on pollution load rather than on the amount of water consumed. Second, it should apply to all industries and local bodies discharging effluents. Third, the cess rates should be revised gradually in real terms.

Moving towards industrial air pollution charges based on emissions, increasing the charges gradually.

Selection of industries/ regions for the implementation of pilot projects on tradable permits for air pollution.


Through fiscal policy reforms, the heavy fiscal burden of supporting the brown economy could be reduced and the resources diverted instead for development priorities such as healthcare and education and for investment in the environment. To illustrate, a 2012 study by the Energy and Resources Institute (TERI) in India estimated that the total size of under-recovery on petrol, diesel, kerosene and LPG in 2010-2011 was about 1.07 percent of India's GDP. In contrast, total expenditure by both central and state governments on health and education were 1.27 percent and 2.98 percent of GDP, respectively.

Successful fiscal policy reforms, however, require adequate complementary measures due to their potential distributional and macro-economic impacts particularly on certain segments of society, such as businesses in carbon-intensive industries and low-income households. Removing government subsidies on fossil fuels, for example, could lead to higher energy prices and weaker purchasing power for households. For this reason, fiscal policy reforms such as fuel taxes to stimulate a switch in transport modes sometimes face stiff resistance from certain groups. Regulation and land use planning policies can complement pricing instruments to achieve maximum impact.

Some lessons on how to overcome obstacles to reforms can be drawn from countries that have undertaken successful environmental fiscal reform. The first is that the political acceptability of fossil fuel subsidy reforms might be higher if they are introduced as part of broader fiscal reforms or overall energy sector reforms. Moreover, communication has to be clear about the concrete benefits of reforms and governments should engage with key stakeholders through various media. In addition, measures should be taken to mitigate the effects of reform on affected groups. The government of Indonesia, for example, introduced subsidized health care, a subsidized rice program, village infrastructure projects and scholarships as compensation measures to cushion the poor against inflation shocks as a result of fossil fuel subsidy reform.

A strong case for using fiscal policy to achieve economic, social and environmental goals has been made, and the examples from countries around the world show that fiscal reform is not only desirable but feasible to transform a greener and more inclusive economy. At a global scale, the adoption of new Sustainable Development Goals to 2030 and the forthcoming negotiations for a new climate change deal in 2015 offer opportunities to use fiscal policy as a tool for achieving objectives such as ensuring sustainable energy for all. While fiscal policy remains the remit of national governments, the nature of the global challenges we face - from the depletion of natural capital to the effects of climate change to lingering poverty – mean that the potential of fiscal policy needs to be deployed on a broader scale to ensure benefits for all of humanity and for the planet we all share.


. A Citizen's Guide to Energy Subsidies in India, The Energy and Resources Institute (TERI) and the International Institute for Sustainable Development (IISD), 2012

. Green Budget Reform in India: Opportunities and Challenges, The Energy and Resources Institute (TERI), 2002

. Towards a Green Economy: Pathways for Sustainable Development and Poverty Eradication, United Nations Environment Programme (UNEP), 2011

. Tracking National Financial Flows into Sanitation, Hygiene and Drinking-Water, A Report by Sophie Trémolet and Martina Rama, UN Water-Global Analysis and Assessment of Sanitation and Drinking Water, World Health Organization (WHO), 2012

. A Framework for Financing Water Resources Management, OECD Studies on Water, Organisation for Economic Co-operation and Development (OECD), 2012

. Water Supply: Hitting the Target, Chapter 16: Africa Infrastructure Country Diagnostic Study, The African Development Bank (AFDB), 2010

. Action Plan for Green Budgeting in Punjab: Concepts, Rationale and Ways Forward, The Energy Resources Institute (TERI), 2014