Avoiding the Subsidy Trap: How Countries Can Prepare for the Next Energy Crisis

Fossil-fuel price shocks have become a recurring challenge for governments. The past decade has seen wild swings in oil, fuel and fertilizer prices, from oil's historic lows during the COVID-19 pandemic in 2020 to extreme highs following Russia's 2022 invasion of Ukraine and the 2026 disruption of the Strait of Hormuz resulting from the war in Iran.

Transitioning away from fossil fuels is key to reducing this vulnerability. Europe's recent experience illustrates the benefits of shifting to renewable energy and heat pumps. Between 2021 and 2025, the European Union's natural gas consumption fell 17%, thereby lowering the impact of the surge in gas prices this year compared to 2022.

But the global economy’s transition from a system based on fossil fuels to one powered by alternative sources of energy will take decades. Countries are likely to remain exposed to fossil-fuel price and supply shocks for years to come, even as cleaner alternatives expand.

Recent analyses by the International Energy Agency and the World Bank show that about 30% of 102 countries tracked have responded to the latest shock with measures to support renewables and to reduce fossil fuel demand. But about 80% of the 102 countries have also introduced oil and gas subsidies or tax cuts, including 25% that have combined measures to encourage electrification and energy efficiency with subsidies or tax cuts.

The short-term political logic for such subsidies is clear: They are a highly visible response to the sudden economic pain felt by voters and businesses and may temporarily ease inflationary pressure. But by suppressing price volatility, they weaken incentives to shift away from fossil fuels, leaving societies vulnerable to the next price shock.

Subsidies are also costly, diverting money away from investments in long-term energy security, social welfare and public services. And because citizens are particularly economically sensitive to changes in fuel prices, fossil-fuel subsidies are difficult to reverse. A recent study of 21 countries showed that 90% of reforms that reduced or eliminated fossil fuel subsidies were overturned within three years, due to public protests, currency depreciation, inflation or rising fuel prices.

Here, we look at how three very diverse economies suffering from dependence on oil are using subsidies and tax cuts, and how countries can break free of this cycle.

3 Countries with a Shared Vulnerability

A comparative analysis of Ethiopia, India and Mexico illustrates how three very different economies are vulnerable to oil and fertilizer price shocks. It also reveals that in these three different contexts fossil-fuel subsidies and tax cuts are draining public budgets.

Mexico, despite being a crude oil exporter, is vulnerable because fossil fuels dominate its energy mix. Households and firms have been facing higher bills caused by the rise in global prices, even as the government and state-owned oil company Petróleos Mexicanos benefit from higher profits. As of October, Mexico was still increasing its subsidy on gasoline while collecting no taxes on diesel, putting further pressure on government finances at a time of slow economic growth.

India’s economy is less oil- and gas-intensive, but it is highly exposed because it imports most of its crude oil and nearly all of its liquefied petroleum gas (LPG), much of it via the Strait of Hormuz. Between March and May of this year alone, the government is estimated to have forgone nearly 140 billion Indian rupees ($1.5 billion) in fuel tax revenue after cutting central excise duties on petrol and diesel. This represents around 4% of the union government’s annual petroleum excise revenue and comes on top of a fertilizer subsidy bill that’s forecast to significantly exceed its budget.

Ethiopia is less reliant on fossil fuels than either Mexico or India, reflecting its nascent industrial base and low rate of vehicle ownership. But the country imports all its petroleum fuels and relies primarily on a single corridor via Djibouti, leaving it highly exposed to supply chain disruptions. And the fuel it does use is critical to its economy, as road freight transport relies heavily on diesel. The government has thus been subsidizing fuel, even though Ethiopia has been classified as in debt distress by the World Bank. Government revenue amounts to only 7%-8% of GDP, among the lowest in the world. Ethiopia's fuel subsidy, if maintained at current levels for a year, could cost the equivalent of 17% of those revenues.

Breaking the Cycle of Vulnerability

How can governments shield households against the immediate pain of spiking oil prices while accelerating a longer-term shift away from fossil fuels and reducing vulnerability to future shocks? Here are three options:

1. Gradually Replace Blanket Fossil-Fuel Subsidies With Social Protection

The benefits of fossil-fuel subsidies vary across income groups and other demographic factors, depending on how much fuel households consume and whether alternatives are available. WRI's analyses of Ethiopia, India and Mexico find that high-income households benefit more from gasoline subsidies than poorer households because gasoline makes up a higher share of their total consumption. In these three countries, subsidies for gasoline increase inequality more than subsidies for electricity, public transport or food.

To help the poorest households or those most vulnerable to price shocks, governments should invest in expanding the coverage of their social protection systems — including cash transfers, social insurance and labor protections — and ensure these programs address different vulnerabilities across the population. Mexico and India already have government assistance programs that reach half to two-thirds of the population, giving them an established way to provide cash directly to households during a crisis. Ethiopia also has such programs, but they reach only a fifth of the population, limiting the government's ability to provide widespread relief. To increase households’ ability to withstand economic shocks, the government should expand program coverage and increase benefits.

Countries are increasingly recognizing the value of targeted support measures over broad subsidies. A recent study of 124 countries found that phasing out fossil-fuel subsidies and redirecting some of the savings to targeted cash-transfer programs could reduce the number of people living in poverty by about 131 million. While building government assistance programs should be a long-term development priority, doing so can also make short-term crisis responses faster and more effective.

Evidence from past reforms suggests they are more likely to succeed when governments combine subsidy cuts with carefully sequenced measures — including transparent communication of the reform's rationale and benefits, targeted social protection for vulnerable households, compensation for powerful groups that stand to lose from the reform and phased implementation.

Nigeria is one of the few countries that have not reversed their subsidy reforms, but three years after implementing them in 2023 and 2024, the government is still facing political pressure to reinstate subsidies. The subsidy was removed after a contested election and during a period of high inflation. Cash transfers to rural, low-income and women-headed households that were proportionally most affected were inconsistent. The long-term success of the reform will likely hinge on whether the government can build trust with skeptical voters and interest groups and invest the revenues from subsidy removal in ways that benefit more Nigerians directly — like targeted social protection, public services and infrastructure.

As this example demonstrates, the timing of reforms is important: The best time to reinstate fuel taxes or remove subsidies is when global oil prices start to drop, as incomes rise, or both.

2. Shift Investment Incentives Away From Fossil Fuels

Changing the price of fuel today affects consumers and firms that already own gas-powered vehicles or diesel generators — and they will resist. Changing the incentives for new investment can be politically easier than raising the cost of existing fossil-fuel use, because it does not immediately penalize people who rely on gas and diesel. Ethiopia's 2024 ban on imports of nonelectric passenger vehicles — a response to the country's deep reliance on oil imports from one transport corridor and the need to protect its foreign exchange reserves — could serve as a model. It does not raise the cost of owning an existing vehicle but encourages Ethiopia to expand its vehicle fleet with electric vehicles rather than vehicles with internal combustion engines. This changes the long-term relationship between economic growth and oil demand without creating immediate losers.

Similar logic applies to investment incentives for industry, agricultural modernization and electricity generation. Accelerating renewable energy deployment can shift demand without triggering the backlash that comes from raising fuel prices.

3. Make Carbon Taxes More Predictable and Politically Sustainable

Once affordable clean energy alternatives become more widely available and enough low-carbon infrastructure is in place, fewer people will suffer from high fossil-fuel prices. The speed and efficiency of the transition can then be improved by combining instruments that support clean energy investments with tax reforms that increase the price of carbon (either through a carbon tax or higher fuel excise duties) while protecting those who remain vulnerable.

For these reforms to work, governments need to give households and businesses confidence that such taxes will remain in place and that the carbon price will continue to increase gradually. While many countries already indirectly price carbon through fuel excise duties, this price signal is not high or stable enough to guide long-term economic decisions. For example, when global crude oil prices collapsed between 2014 and 2016, India raised central taxes on petrol by 11 rupees ($0.12) per liter and on diesel by 13 rupees ($0.14) per liter instead of passing the savings on to consumers. But India's subsequent cuts to petrol and diesel taxes as global oil prices rose illustrate how difficult it can be to sustain such policies through price shocks.

A sustained carbon tax or restructured energy taxes that levy higher rates on fossil fuels could generate revenue for governments to return to households, cut other taxes or invest in public services. Ensuring that revenues are invested in visible, demand-driven ways, building broad political coalitions and sustaining clear communication can help build lasting support for the policy. For example, Sweden balanced carbon taxation with a broader tax reform that cut labor taxes and, over time, it gradually increased the carbon tax. Swedes have even  expressed support for raising the carbon tax if revenues are redistributed to those most affected, such as rural and low-income households.

In many countries, more research is needed to advise governments on the tax reforms that can encourage a shift away from fossil fuels while also winning broad support. For example, more transparent data are needed on the price of carbon that people and businesses effectively face  once all taxes and subsidies are taken into account. And more analyses on the distributional impacts of fiscal reforms that affect carbon prices should help identify which groups are likely to support or oppose reforms and how governments can use tax revenues to build public trust.

A Way Forward

As the war in Iran continues to impact oil prices and countries seek solutions to ease price spikes, it’s time for governments to break the subsidy cycle by strengthening their social protection systems, enabling cleaner energy supplies and electrification, and maintaining taxes that encourage a shift away from fossil fuels. The key is to protect people from today’s energy crisis without reinforcing the very dependence that leaves them exposed to the next one.