Opinion – Why? Economês in good Portuguese: The problem of externalities and the subsidy

In the texts of this series of Why? we describe what are externalities in the context of environmental economics and explain how the tax can be a mechanism to solve them. Today we are going to talk about an alternative tool: the subsidy.

Mathematically speaking, the subsidy works very similarly to the tax to correct externalities. But the idea is: instead of the government increasing the price of products and services that, for example, cause damage to the environment, it reduces the price of goods based on clean technologies or associated with climate mitigation.

In our previous text, we imagined a university student who used to buy water in disposable bottles. To become more sustainable, this student’s faculty can distribute mugs for students to use in trays and canteens or to fill up at drinking fountains. This will create an incentive for fewer bottles to be purchased, as the college has eliminated the cost students would have to invest in a reusable mug.

The result can be the same as a tax on the plastic used in the production of the little bottle: the student decides to buy fewer bottles. However, perhaps the subsidy introduced by the college is much more popular, as people in general would rather get things for free than pay more for products.

We have several examples in the world that could be understood as subsidies introduced to circumvent environmental externalities: government incentives for clean technologies, tax allowances based on the sustainability of companies or even government contributions to universities and research centers that study solutions to mitigate climate effects.

However, governments also make use of subsidies that, on the contrary, would be generating more pollution. One example is the various incentives that countries give to their fossil fuel industries. Brazil itself has several fiscal measures to encourage oil companies. In general, these are policies formulated in the past decades with the aim of ensuring that new Brazilian companies were able to compete with fuels produced by international companies at lower prices. It was a strategy of economic growth, since oil is an industry with high returns, and also to promote jobs.

Nowadays this type of subsidy can be questioned. Firstly, because it goes against the polluter pays principle that exists in environmental economics. The idea is that the costs of pollution or environmental degradation need to fall on the activities/companies responsible for these damages. Bearing this in mind, it is not desirable for polluters to receive aid through subsidies.

And more: if in the past, encouraging the oil industry was essential for Brazil to enter this market, is this still true today, with the industries already established? According to researcher Alessandra Cardoso, from INEP, in an interview given to BBC Brasil, several projects would remain profitable even with the end of subsidies.

As seen in several discussions that took place at COP-26 last year, there is global recognition that subsidy policies for polluting industries and services need to be rethought in light of the current state of climate emergency, and more subsidies are needed with a focus on correct environmental externalities and encourage sustainability. More than 20 countries have announced measures related to this topic, including commitments to change agricultural policies, making agribusiness more sustainable and less polluting, and investments in the science needed to implement sustainable agendas.