Fossil fuel subsidy removal, economic welfare, and environmental quality under alternative policy schemes

Abstract

The literature related to the environmental impacts of fossil fuel subsidy removal is inconclusive and fragmented, with non-negligible methodological shortfalls. Also, can the adverse economic effects of such subsidy removal be mitigated through government transfer payments to the firms and households? Taking the 2020 subsidy reform in Nigeria as a case, this study introduces the African Energy and Environment Integrated Computable General Equilibrium (AEEICGE) model, version 2.0., to examine the economic and environmental impacts of fossil fuel subsidy removal. The AEEICGE V.2.0. model accounts for the substitutability of intermediate input demand for energy products. The results show that although subsidy removal on fossil fuels improves environmental quality, such reform negatively affects the economic well-being of the economic agents and raises overall prices. These adverse impacts are reversed when the subsidy is reallocated differently to businesses and households through the government's transfer payments nonetheless. Particularly, the subsidy removal makes a 0.25 bps contribution to aggregate inflation and leads to welfare losses of about ₦0.049 billion and ₦0.108 billion, on average, for the poor and rich Nigerian households respectively. Notwithstanding, their welfare improves and gains, on average, about ₦15.89 billion and ₦78.96 billion respectively with the proposed resource reallocation schemes. The AEEICGE V.2.0 modelling approach and results do not only resolve existing puzzles in the literature, but also offers both theoretical and practical implications that are pivotal for the scientific community, policymakers, and industry stakeholders alike.