World Development Report 2024: The Middle-Income Trap

In middle-income countries, emissions drive the impact of development on global climate change. Policy debates in middle- and high-income countries should be concerned primarily with decoupling GDP growth from emissions growth in all ways feasible. One important consideration is arrangements that lock middle-income countries into particular types of production, such as long-term investments in coal and other fossil fuels. To the extent that so-called lock-in effects are preventing progress toward actually meeting global environmental goals, all efforts should be directed toward reducing the path dependence from the specific energy source, while better protecting natural resources, including forests (box 8.5).

Policies and technologies to mitigate carbon emissions will vary among middle- and high-income countries, depending on their economic structures, resource endowments, and institutional and technical capabilities. A good starting point is fiscal policies. These can be surgically sharp if designed with care. The discussion that follows first examines economywide fiscal policies, then turns to sectoral policies, and finally explores the options for scaling up renewable technologies.

Economywide fiscal policies

Regarding energy, the ultimate impact of growth on global greenhouse gas emissions will depend on the carbon intensity of GDP, reflecting both GDP’s energy mix and energy intensity. Fiscal policies can influence both dimensions.

Carbon pricing is an essential policy for mitigating emissions, while helping to raise public revenue in an efficient and less distortive way than the alternatives. It signals to markets the social cost of emitting GHGs, creating financial incentives to abate emissions, reduce fossil fuel consumption, and innovate low-carbon products and processes. Some economists believe that carbon taxation is the most efficient instrument for reducing emissions in a growth-friendly way. On January 16, 2019, 43 of the world’s most prominent economists, including 27 Nobel Laureates, issued a statement published in the Wall Street Journal (2019) arguing that a carbon tax in the United States “offers the most cost-effective lever to reduce carbon emissions at the scale and speed that [are] necessary.” Others have proposed a strategic combination of temporary research subsidies and carbon taxes that could steer technological advancements toward more environmentally sustainable solutions.

Box 8.5 Productivity growth can slow deforestation in Brazil

Brazil’s Amazon region provides the world with immense ecosystem services. Estimates peg the services to be worth, at a minimum, US$317 billion a year, US$210 billion of which is accounted for by carbon dioxide (storage) alone.a Deforestation is among Brazil’s leading sources of greenhouse gas emissions and a major threat to biodiversity.b In fact, ecosystem collapse in the Amazon stemming from deforestation and climate change ranks among the most catastrophic tipping points for the planet.c In response, Brazil has made much progress in protecting the Amazon, improving forest and land governance by means of, for example, the Action Plan for the Prevention and Control of Deforestation in the Legal Amazon, first launched in 2004 and most recently reinvigorated in 2023.

And yet Brazil’s growth model also matters for the Amazon. The fact that it remains anchored in factor accumulation and land accumulation is synonymous with agricultural frontier expansion and deforestation. To overcome the middle-income trap Brazil will have to raise productivity—and growing through productivity rather than factor expansion would also slow deforestation.d Indeed, there is a strong relationship between Brazilian productivity and the change in forest cover in the country’s Amazon (figure B8.5.1).

Direct carbon pricing instruments include carbon pricing signals sent through carbon taxes and emissions trading systems (ETSs). According to the World Bank’s State and Trends of Carbon Pricing 2023 report, these schemes currently cover a relatively limited portion of global carbon emissions, but the greater a program’s scope, the more effective it can be. The report points out that the number of countries that have adopted direct carbon pricing schemes through ETSs or carbon taxes is limited. Perhaps more important, so is the coverage of such programs. With the introduction of the ETS in China in 2021, the share of global carbon dioxide (CO2) emissions from fossil fuels covered by direct carbon pricing schemes rose to about 31 percent (amounting to about one-quarter of global GHG emissions). Along with their coverage, average carbon prices have been rising over the last few years. The carbon price in the European Union (EU) through the EU ETS rose sharply from 2019 to 2021. Nevertheless, the carbon prices prevailing in most jurisdictions and their estimated global average remain quite modest.

Because the overall carbon price signal is not confined to direct carbon pricing, the concept of the total carbon price (TCP) has been introduced—a metric intended to assess the price signal resulting from a combination of direct and indirect carbon pricing instruments, including energy excise taxes and fuel subsidies. Illustrative TCP calculations carried out using the best available global data sets relying on annual data for 142 countries covering the last 30 years find that indirect carbon pricing instruments play a much more prominent role in sending price signals on carbon emissions. Among indirect carbon pricing instruments, an analysis of illustrative TCP calculations finds that energy taxes, in particular, send the strongest price signal. These taxes cover a significant share of global emissions and send much higher carbon price signals than their direct counterparts. By contrast, energy subsidies send strong signals in the opposite direction, undermining the positive signals sent from direct and indirect instruments, as illustrated in figure 8.6.

Removing inefficient fossil fuel subsidies is an integral part of the policy mix to reduce carbon emissions. This market distortion discourages the adoption of clean energy because regulated prices or taxes favor fossil fuels. After a noticeable dip in 2020 stemming from the COVID-19 pandemic, global fossil fuel subsidies for 2022 doubled from the previous year to an all-time high of US$1 trillion, as indicated by preliminary estimates. According to a global tracking effort, at least 60 countries increased (or even reintroduced) general fuel price subsidies (as opposed to targeted compensation), and at least 98 countries announced energy-related measures, including subsidies for fuel, electricity, transport, and electric vehicles, as well as price controls for fuel.

Well-designed taxes can be a starting point to incentivize citizens and businesses to make cleaner choices, thereby reducing climate damage and air pollution. Taxes also raise much-needed revenue, which can be used to fund vital government services and support vulnerable groups in adjusting to higher energy prices, including by introducing or strengthening social safety nets.

Policy makers, however, face strong resistance from industrial and residential consumers to removing subsidies and raising the social cost of carbon. Often, resistance comes from interest groups representing specific sectors concerned about bearing the brunt of the economic and job losses associated with the loss of those rents. Indeed, the literature simulating the impact of removing subsidies finds that reductions in GDP and welfare will occur in countries in the short term. In China, models indicate the GDP could decline by up to 3.8 percent. In the Islamic Republic of Iran, GDP could decrease by 2.2 percent and welfare by 5.2 percent, and the non-energy price index could increase by 26 percent. However, those short-term effects are reversed in the long term, leading to a substantial increase in GDP and welfare, particularly when subsidy reforms are accompanied by complementary policies such as cash transfers and other productive activities (including electrification, public transport, and investment in education and health).

Complementary sectoral policies

Countries such as Germany and Spain have used feed-in tariffs (FiTs) to support the deployment of new clean energy technologies, but as technologies mature, competitive bidding through auctions in middle-income countries (including Brazil, India, and South Africa) have been more cost-efficient in procuring renewable capacity (for example, by achieving lower prices per unit of electricity, as assigned in the power purchase agreements). FiTs guarantee a fixed price for the electricity produced by renewable energy sources. However, they may result in overpayment to producers if the cost of renewable energy technologies falls over time. Auctions create a competitive market for renewable energy and allow policy makers to manage the quantity and the quality of renewable energy projects by setting the volume, technology, and the criteria for the bids. Auctions can also foster innovation and diversification of renewable energy sources by creating different categories or segments for the bids. Auctions have led to low utility-scale prices for solar photovoltaics (PV) in middle-income countries (figure 8.7).

Technology adoption and deployment are aided by scale. In Europe, the companies most diversified in renewables are the largest firms—they have a lower risk because of their size advantage. Those companies able to obtain the cheapest capital to replace energy from the Russian Federation by means of additional renewable generation are those already most invested in renewables.

Raw materials are a significant element of the cost structure of many technologies, and any disruption in supply can increase the cost of capital. For lithium-ion batteries, technology advancement and economies of scale have reduced overall costs by 90 percent over the last decade. However, if both lithium and nickel prices were to double at the same time, it would offset all the anticipated cost reductions associated with a doubling of battery production capacity. For electricity networks, copper and aluminum currently represent about 20 percent of total grid investment costs. Higher prices arising from a tight supply could constrain the level of grid investment.

The most efficient way to scale up the deployment of low-carbon energy is to respect merit order: the sequence followed by grid operators selling power to the market. The starting point is set by the cheapest offer (made by the power station with the lowest running costs), which determines the wholesale market prices. Any provider that can offer renewable energy at zero marginal cost—that is, with insignificant operating costs—should have priority in meeting demand. When the merit order functions as designed, it shifts prices along the supply curve, which energy economists accordingly call the “merit order curve.”

The design and enforcement of effective regulations are vital in ensuring that the merit order is respected. Clear, transparent rules on interconnection will be needed to ensure entry by low-carbon energy providers and respect of the merit order. Allegations of abuse of dominance are common in wholesale electricity markets, which are more susceptible to the exercise of market power. This abuse includes both physical withholding (not offering available capacity to the market that could be profitably produced at the market price) and economic withholding (offering available capacity at a price that does not reflect its marginal cost—including the opportunity cost). Both cases of withholding make the merit order curve steeper and shifts its intersection with the demand curve, resulting in a higher price. Customers are then worse off while producers benefit.

Worldwide, promising regulatory initiatives are under way. In the European Union, regulators began investigating 109 cases of abuse of wholesale energy market integrity and transparency in 2021. Box 8.6 describes successful cases in detecting abuse of dominance in the Bulgarian and German wholesale markets. In Mexico, the Federal Economic Competition Commission (COFECE) issued a public report in 2021 about improving the regulation of Clean Energy Certificates, an instrument that provides incentives for generating electricity using clean technologies under the framework of the Electricity Industry Law and the Energy Transition Law.

In Colombia, the Superintendence of Industry and Commerce (SIC) developed an advocacy initiative in the energy sector in 2019 encouraging competitive bidding through renewable energy auctions. For example, SIC recommended arranging subsequent rounds of auctions (tenders), instead of a single tender, to enable the participation of companies that were still preparing to enter the market and would only be able to provide renewable energy sources after the initial date indicated in the first auction model.

Box 8.6 Correcting abuses of dominance in electricity markets

Liberalizing and opening up a sector that historically has been governed by the state and state-controlled actors are challenges that go far beyond updating the regulatory framework, as witnessed in Germany and Bulgaria.

Bulgaria. In 2019, the Bulgarian Commission for Protection of Competition (BCPC) fined the National Electricity Company EAD (NEK) for abuse of dominance. NEK is part of Bulgarian Energy Holding, which owns 80 percent of all hydropower plants in Bulgaria. It is historically the last-resort supplier and the coordinator of special balancing energy groups.a BCPC found that NEK abused its dominant position in the balancing market of electricity producers from renewable energy sources at preferential prices in two ways.b First, it unilaterally altered the forecasted hourly electricity production schedules submitted by renewable energy producers. NEK submitted a different schedule, usually unilaterally providing for less production (that is, without informing the respective producer). These changes made it practically impossible for the renewable producers to meet the amounts set by NEK. Second, the BCPC found that unilaterally the renewable energy supply producers were financially burdened by the artificially increased imbalances.c

Germany. In May 2021, the German Federal Network Agency (Bundesnetzagentur) imposed fines of €200,000 on Energi Danmark A/S and €175,000 on Optimax Energy GmbH for manipulation of the wholesale electricity market. The penalties were the outcomes of investigations opened in September 2020 after significant imbalances were observed in the system in June 2019. The Bundesnetzagentur’s analysis of trading activities indicated market manipulation involved sales of electricity that was not available. The companies placed offers to sell electricity on the intraday market shortly before the electricity was due to be supplied without intending to supply it. Their incentive to do so stemmed from the difference between the unusually high intraday price and the lower expected imbalance price in the balancing market.d The practice distorted market signals at a time when transmission system operators had to make full use of balancing energy and take other measures to ensure the stability of the German system. The practice not only allowed the companies to realize unjustified profits but also threatened system stability.e

a. A balancing group is a group of participants on the free market, both consumers and producers which optimize their electricity costs by netting their counter hourly deviations (imbalances) and reducing the overall deviation between the projected and reported electricity consumption. A special balancing group includes only participants of the regulated market.

d. Balancing services are reactive short-term means of leveling out frequency deviations in the power grid. These services (sometimes also called control reserve) are one of many ancillary services that system operators must provide for a secure power supply.

In many middle-income countries, policies need to be revisited and upgraded to reward merit activities. But this will require a change in mindset. Policy makers should think in terms of adding value (merit): economic, social, and environmental. That requires changes in policies to enhance value added across the economy through the efficient resource utilization of talent, capital, and energy. All these efforts will help middle-income countries escape the middle-income trap.