E NVI RONMENT Sb DEPARTMENT PAPERS PAPER NO. 028 ENVIRONMENTAL ECONOMICS SERIES Financing Pollution Abatement: Theory and Practice Magda Lovei October 1995 Environmentally Sustainable Development The World Bank ESD Pollution and Environmental Economics Division Financing Pollution Abatement: Theory and Practice Magda Lovei October 1995 Papers in this series are not formal publications of the World Bank. They are circulated to encourage thought and discussion. The use and citation of this paper should take this into account The views expressed are those of the authors and should not be attributed to the World Bank The author is especially grateful to Gordon Hughes and Richard Ackermann for helpful guidance and comments. Contents Glossary Executive Summary i 1. Pollution Abatement Financing - Theoretical Background 1 Market and Regulatory Failures - The Need for Intervention I Environmental Policy and Implementation Instruments 2 Fiscal Policy Framework 4 The Role of Financial and Capital Markets 6 Micro-perspective of Environmental Financing 7 2. OECD Countries 9. Environmental Policy Framework 9 Public Pollution Abatement Financing 10 Private Pollution Abatement Financing 11 Earmarked Environmental Financing Mechanisms 15 Summary ofPollution Abatement Financing in OECD Countries 19 3. Transition Economies 23 Macroeconomic Policy Framework 23 Environmental Policy Framework - The Legacy of Central Planning 24 The Role and Characteristics of Comprehensive National Environmental Funds 27 Revenues 27 Public Pollution Abatement Financing 29 Enterprise Pollution Abatement Financing 32 Disbursement Mechanism 33 Institutional Issues 35 Long-term Perspective 36 Summary of Pollution Abatement Financing in Transitional Economies 37 4. Developing Countries 39 Macroeconomic and Environmental Policy Framework 39 Public Pollution Abatement Financing 40 Private Pollution Abatement Financing 42 Environmental Funds 44 Summary of Pollution Abatement Financing in Developing Countries 45 Environmental Economics Series Financing Pollution Abatement Theory and Practice 5. The Role of External Finance 47 Economic Policies, Environmental Priorities and External Finance 47 Financial Intermediary Loans and the Experience of the World Bank 48 The Experience of Donors with Environmental Funds 50 Debt-for-Nature Swaps - A Special Form of External Finance 53 Global and International Pollution Issues and Donor Coordination 54 Summary of External Financing Issues 55 References 57 Tables and Boxes Boxes Box 1 Costs and Benefits of Pollution Abatement for Investors 3 Box 2 Water Quality Management and Financing in the U.S. 10 Box 3 Effluent Taxes in the Netherlands and Germany 11 Box 4 Public Water Sector Financing in the U.S. 12 Box 5 Market-based Financing of Municipal Environmental Investments 13 Box 6 Directed Credit and Technical Assistance for Industrial Pollution Abatement in Japan 16 Box 7 Federal Environmental Credit Programs in Germany 17 Box 8 Liability Issues Financed from Environmental Fund in Japan 18 Box 9 Environmental Clean-up Financed from Environmental Funds in the U.S. 19 Box 10 Earmarked Financing in the French River Basin Management Agencies 20 Box 11 The Consolidation of Earmarked Charges in the Netherlands 22 Box 12 Setting Emission Charges in Russia 24 Box 13 Industrial Pollution Abatement Financing in China 25 Box 14 Emission Charges in Poland 29 Box 15 Financing Categories of the Central Environmental Protection Fund (CEPF) of Hungary 33 Box 16 Cost-recovery in the Water Supply and Sewerage Services in the Ivory Coast 41 Box 17 Financing Municipal Services in Colombia 42 Box 18 Pollution Abatement Subsidies in India 43 Box 19 Directed Credit for Pollution Abatement in Mexico 44 Box 20 Comprehensive Environmental Funds in Turkey 45 Box 21 The World Bank's Experience with Industrial Pollution Control Financing from the 1980s in Brazil 49 Box 22 Types of Externally Financed Fund Mechanism 50 Box 23 Financing Pollution Abatement Projects from Parallel Envirnomental Funds in China 57 Box 24 The Polish DNS 53 Tables Table 1 Types of Earmarked Pollution Abatement Financing Mechanisms 5 Table 2 Pollution Abatement Expenditures in the U.S. (1986-1991) 14 Table 3 Main Types of Environmental Subsidies for Private Investments in OECD Countries 15 Table 4 Main Characteristics of Environmental Funds in Selected Transition Economies in 1993 27 Table 5 Sources of Environmental Expenditures in some Transition Economies in 1993 28 Table 6 Changes in the Real Level of Emission Charges in Russia (1991 - 7993) 30 Table 7 Projects Supported from NEF Expenditures in the Czech Republic During 1992-93 31 Table 8 Expenditures of the Hungarian NEF by Domestic and EC PHARE Sources in 1994 52 Environment Department Papers Glossary BADESP Sao Paolo State Development Bank BMFT German Federal Ministry for Research and Technology BMWI Bundesministerium fuer Wirtschaft BNH National Housing Bank of Brazil BOD Biological Oxygen Demand CAC Command and Control CEE Central and Eastern Europe CEPF Central Environmental Protection Fund CCF Capital Construction Fund COD Chemical Oxygen Demand DAB Deutsche Ausgleichsbank DE Water Directorate DEM German Mark DFI Development Finance Institution DNS Debt-for-Nature Swap EAI Enterprise of Americas Initiative EAPCEE Environmental Action Programme for Central and Eastern Europe EF Environmental Fund EIB European Investment Bank EPA Environmental Protection Agency EPM Environmental Program for the Mediterranean ERP European Recovery Program EU European Union FFDU Urban Development Fund of Colombia FIL Financial Intermediary Loan FNA National Sanitation Fund of the Ivory Coast FNE National Water Fund of the Ivory Coast Environmental Economics Series Financing Pollution Abatement Theory and Practice FNH National Water Works Fund of the Ivory Coast FONEI Industrial Equipment Fund of Mexico FSU Former Soviet Union GEF Global Environmental Facility ICICI Industrial Credit and Investment Corporation of India IDA International Development Agency IDBI Industrial Development Bank of India INSFOPAL National Institute of Urban Development of Colombia KfW Kreditanstalf fuer Wiederaufbau LDC Less Developed Country LUST Leaking Underground Storage Tank MBI Market Based Instrument MDF Municipal Development Fund MEPNR Ministry of Environmental Protection and Natural Resources MOE Ministry of Environment MPC Maximum Permitted Concentration NAPA National Academy of Public Administration NEF National Environmental Fund NEPA National Environmental Protection Agency NGO Non-Government Organization OECD Organization for Economic Cooperation and Development PAC Pollution Abatement and Control PHDCPA Pollution-Related Health Damage Compensation and Prevention Fund PPP Polluter Pays Principle RSFSR Russian Soviet Federal Socialist Republic SODECI Ivorian Water Distribution Company SRP Sector Reform Program TMPCF Tianjin Municipal Pollution Control Fund TRF Technology Renovation Fund UNCED United Nations Conference on Environment and Development UNDP United Nations Development Programme Environment Department Papers Executive Summary Theory has been financed almost exclusively from private sources, while the role of public Market and regulatory failures result in environmental services has been significant in extensive levels of pollution, causing damage water treatment and waste management. In to human health, and natural and productive the provision of public environmental ser- assets. The prevention and mitigation of these vices, there has been a trend towards full cost- effects at local, regional and global levels call recovery through the collection of user for the proper set of environmental policies charges. Improved cost-recovery has in- and policy implementation instruments. creased the efficiency of collective services Pollution abatement financing, the mechanism and facilitated the use of commercial financ- of raising and allocating financial resources ing mechanisms. for the prevention and control of negative effects due to pollution of the environment, is The paper reviews various subsidy schemes one instrument of a complex policy approach that OECD countries used to speed up private aiming to correct market and administrative pollution abatement and to reduce the finan- failures. The first part of the paper reviews cial burden of compliance with new regula- theoretical issues influencing the pollution tions and standards in the past decades. Most abatement financing framework including (i) subsidy programs operated on a temporary the need for government intervention to basis. Some countries provided grants to correct externalities; (ii) the effects of environ- promote the development and application of mental policy and implementation ap- cleaner technologies. In other countries, proaches; (iii) the connection with fiscal directed soft loans were used to support policies; and (iv) the development of capital private pollution abatement investments. and financial markets. Temporary tax incentives were even more widely used fiscal instruments of providing Experience of OECD Countries subsidies. These measures included tax credits, accelerated depreciatiorn, the creation Reviewing the experience of OECD countries, of tax deductible funds, and the use of tax-free the second part of the paper concludes that heavy reliance on command-and-control- distorted the relative prices, and certain tax based environmental regulations did not lead incentives created a bias towards the installa- to cost effective solutions in the past. In tion of control equipment (end-of-pipe con- response, OECD countries increased the role trol) as opposed to the application of cleaner of market-based mechanisms in the imple- technologies and processes. mentation of environmental policies. A strong regulatory framework and improved enforce- ment have led to a substantial increase in the created in some countries, typically tackled share of privately financed pollution abate- local, regional, or media-specific environmen- ment and control measures in most OECD tal problems. In some cases, environmental countries. Recently, air pollution abatement funds were established to finance national Environmental Economis i Series i Financing Pollution Abatement Theory and Practice priority programs on a temporary basis. . Subsidies provided through NEFs may Environmental charges were frequently levied replace investments from private resources; with the purpose of raising revenues needed to finance environmental investments. Gener- - Public and commercial financing functions ally, the more remote the connection between are mixed in the operation of NEFs, and taxation and spending objectives is, the less commercial banking functions may over- clear the advantage of earmarking becomes. shadow the main objective of environmen- The benefits of earmarking are more pro- tal financing; nounced when direct environmental charges Banking operations create a self-perpetuat- are earmarked in decentralized programs. The main advantages of that scheme in OECD im th fo eF s o aoivi countries have been the incentive effect of toamerove o charges, and the increased transparency and political acceptability of the system due to the Revenue allocation is rarely supported by close relationship between revenue sources dear environmental priorities; and and the spending of the revenues. Earmarked mechanisms, however, have not played a Transparency, accountability and financial dominant role in the environmental financing supervision are inadequate. system of OECD countries. Therefore, the role of NEFs should be defined Transition Economies and their relationship vis-a-vis the enterprise sector clarified. NEFs can play a catalytic role The third part of the paper discusses environ- by (i) strengthening the environmental policy mental policy and financing issues in transi- framework; (ii) financing priority investments tion economies. The paper concludes that where no alternative to public financing exists; overly ambitious environmental quality and (iii) accelerating environmental improve- objectives combined with weak enforcement ments in the enterprise sector on a temporary capabilities characterized the central planning basis. NEFs should have only a limited era. The reliance on comprehensive national mandate in enterprise financing duning the environmental funds (NEFs) for pollution transition. They should concentrate on financing is another legacy of central planning. priority areas, help to mobilize private and The transition to market economy, however, is enterprise resources, improve the effective- expected to generate positive environmental ness of environmental regulations, promote changes, and a dramatic increase in the role of cost-effective solutions, improve project private environmental financing in the long preparation and assessment techniques, and run. During transition, several factors, enhance a constructive relationship between including weak environmental management, the environmental policy authority and the severely curtailed availability of private enterprise sector. NEFs should avoid, how- financing, slow pace of privatization, inad- ever, extending their operation to areas where equacies of banking, underdeveloped capital they have no expertise or comparative advan- markets, uncertain political and fiscal systems, tage and should minimize exposure to com- inadequate information, and weak public mercial risk. Their project preparation, participation constrain the development of an assessment and post-project evaluation effective environmental financing system, and capabilities, decision making procedures, and NEFs preserved their role in environmental accountability should be significantly in- financing. There are numerous problems, proved. however, with the current structure of envi- ronmental funding that relies heavily on NEFs Improvements in environmental management, in transition economies: a stronger private sector, and tightened budget constraints for the public sector can Earmarking creates an obstacle to increas- gradually eliminate the need for NEFs. The ing charges and fines to more efficient combined impact of a gradual increase in the levels in the long run; incentive effects of environmental taxes and ti r Environment Department Papers Pollution Abatement Financing - Theoretical Background strengthened enforcement will significantly comply with bureaucratic conditions more increase the role of private investments, while easily than small borrowers. tightened budget constraint will contribute to improved cost-recovery in public services. As Additionally, private pollution abatement is a result, the spending structure of NEFs will supported by various other types of subsidies shift to the funding of areas where no alterna- that try to compensate for the lack of strong tive to public finance exists, such as research enforcement of environmental regulations. and development of new technologies, educa- Subsidies are sometimes channelled through tion, and information dissemination. With environmental funds, that have been estab- improved political decision making, informa- lished to provide a relatively steady flow of tion availability and citizen and NGO partici- resources for pollution abatement. Due to the pation, the routine budgeting process should limited amount of revenues raised by environ- ultimately take over the role of earmarked mental charges, EFs frequently rely on budget funds. allocations and external funding. Allocation of environmental revenues is typically not Developing Countries guided by dear environmental priorities and cost-effectiveness criteria. In the forth part, the paper reviews pollution abatement financing in developing countries. External Financing Besides direct regulations that typically dominate the selection of environmental Finally, the paper reviews the role of external policy instruments, MBIs are increasingly financing in pollution abatement. The paper applied in several countries, and informal notes that donor assistance has shifted from bargaining frequently plays a significant addressing specific problems to aiming at supplementary role. Due to traditions and complex policies that support environmen- political considerations in water and waste tally sustainable development. Donor financ- management, cost-recovery in public environ- ing supplements domestic resources, but mental service provision is generally low, and cannot compensate for the lack of domestic service charges levied on industrial discharges environmental financing systems. Donor are typically ineffective to encourage signifi- assistance, therefore, should focus on the cant industrial pretreatment and waste establishment of a proper environmental minimization measures. As a result, the bulk policy framework before large scale invest- of capital expenditures and operating costs of ments are undertaken. Investment assistance public environmental services are financed should evaluate all pollution abatement through general municipal revenues and alternatives (including changes in manage- national budget transfers. In some countries, ment practices, the application or cleaner Municipal Development Funds (MDFs) have technologies and processes, and the installa- been established to finance infrastructural tion of pollution control equipments) accord- services. MDFs, however, typically cannot ing to their cost-effectiveness. achieve self-sustainability. The paper reviews the experience of various Underdeveloped and dysfunctional financial mechanisms applied to channel donor assis- and capital markets constrain the private tance. The experience of the World Bank with sector's access to financial resources and the industrial pollution abatement financing has menu of financing options. Therefore, di- demonstrated that strengthened environmen- rected credit programs have been widely used tal management and directed financing result to enhance lending to priority areas in several in improvements in private pollution abate- countries. Typically, directed lending for ment, and subsidies could be phased out as a pollution abatement has been carried out by result of better environmental enforcement. financial institutions responsible for directed There has been a shift in World Bank assis- industrial lending. The provision of directed tance from the support of end-of-pipe pollu- credit at subsidized rates, however, has been tion control towards a more complex ap- demonstrated to favor large companies that proach of pollution prevention and the application of cleaner technologies. Environmental Economics Series m Financing Pollution Abatement Theory and Practice The paper also points out that existing NEF provide consistency in lending terms and in mechanisms in transition economies have not resource use to finance environmental priori- been extensively used to channel donor funds, ties. probably due to incompatibilities in project evaluation, selection and decision making The paper underlines that differences exist in procedures, the lack of transparency in the valuation of global environmental quality existing fund mechanisms, and the lack of between various countries, and points out that dear division between the public financing mismatches occur at the national level be- and the commercial banking functions of tween the benefits and costs of investments NEFs. During the transition period, donors mitigating global pollution effects. Therefore, may be willing to channel funds through donor intervention is necessary to identify and earmarked environmental funds if the opera- support the least cost solutions. Despite tions, project selection and decision making theoretical advantages in donor coordination processes, transparency and accountability of and in the establishment of "clearing houses" NEFs are significantly improved. An um- for donor funds, such mechanisms have brella fund may be useful to channel both limited appeal to donors, and the higher the donor contributions, and domestic resources. number of donors is, the more narrow the Such a mechanism would coordinate various area of mutually acceptable environmental revenue sources, integrate them into the objectives becomes. domestic environmental financing system, and iv Environment Department Pauers 1 Pollution Abatement Financing - Theoretical Background Pollution abatement financing is the mecha- When pollution abatement decisions are nism of raising and allocating revenues for the integrated with decisions about production prevention and control of negative effects due technology, however, such division is nearly to the pollution of the environment. Some- impossible. Available statistics concentrate on times, improvements can be achieved by expenditures that are directly aimed at the changing management practices such as abatement of pollution. While relying on maintenance and industrial housekeeping. these statistics, this paper will nevertheless try The financial requirements of such measures to address the issue from the broader, more are usually minimal. Frequently, however, complex perspective. capital investments are needed to reach the required level of pollution abatement. Rajah Pollution prevention is frequently less costly and Smith (1993) distinguished three types of than control. Additionally, the integration of pollution abatement measures: (i) -"add-on" environmental considerations into productive control measures (end-of-pipe technologies) investment decisions by the application of installed in the production processes, repre- cleaner technologies and processes may lead senting the classical cases of pollution abate- to simultaneous financial and environmental ment; (ii) "add-on" investments with private benefits ("W-m-win7 scenarios). Environmen- benefits generating some revenue besides tal policy makers, therefore, should adopt a pollution reduction, for example by recover- comprehensive approach to pollution abate- ing useful materials from waste; and (iii) ment issues. integrated technology choices that are mainly productive investments with significant Market and Regulatory Failures - The pollution reduction potential, for example by Need for Intervention replacing old technology for newer, more productive and less polluting alternatives, or Most pollution problems are the results of installing energy saving technologies. Other market failures. Economic agents make categorizations also exist. In Agenda 21 decisions about the level of their production adopted by UNCED, for example, two main and consumption based on market prices, environmental protection strategies were considering the costs and benefits of their distinguished: (1) end-of-pipe technologies; actions. Environment doesn't have a market and (2) the use of cleaner technologies. price, however, and private costs don't include the external social cost of damage Revenue-generating and productive invest- caused to other members of society by using ments are usually undertaken as part of and polluting the environment. Although normal business operations. Environmental optimally polluters should internalize all the regulations, however, influence investment costs' of damage caused by pollution, without decisions. Ideally, investments could be government intervention they have no incen- divided by the motivation of investors into tive to do so, causing excessive pollution of all productive and pollution control components. environmental media. Environmental Economics Series Financing Pollution Abatement Theory and Practice Macro policies that support economic growth level of pollution, policy makers approximate and development may also contribute to and substitute it by politically acceptable and environmental problems. Environmentally desirable environmental quality objectives harmful subsidies reduce the private costs of (ambient standards). producers and/or consumers resulting in over-utilization of natural resources. Energy Compliance with environmental quality subsidies, for example, lead to energy-inten- objectives requires substantial financial sive economic structures and technologies, resources that may be beyond the financing and wasteful management practices. The capacity of the society. Therefore, intermedi- environmental consequences are more atmo- ate targets and phase-in periods may be build spheric pollution, causing damage to human into the policy framework to harmonize health, properties and natural resources, and achievable, realistic objectives with available contributing to global warming. It has been financing resources. Further, unless the estimated (Shah and Larsen, 1992), that the achievement of objectives is guided by well elimination of energy subsidies world-wide defined priorities, resource allocation becomes would reduce global carbon emissions by 9.5 suboptimal. Therefore, government interven- percent (by reducing carbon emissions in the tion in pollution control should be based on subsidizing countries by 21 percent). the careful analyses of (i) the main environ- mental concerns (human health damage, The extensive role of the public sector in the damage to ecosystems, and the productivity economy also introduces inefficiencies that of assets); (ii) the main causes of damage; (iii) adversely effect the environment. Govern- alternatives for mitigating the damage; and ments as owners of public enterprises estab- (iv) the cost-effectiveness of alternatives. The lish production targets, but usually don't hold selection of priorities based on such analyses enterprise managers responsible and account- should provide guidelines for the allocation of able for efficient operation. The result is scarce resources. output maximizing, rather than cost-benefit optimalizing behavior. The inefficient man- Policy instruments determine the style and agement and operation of productive assets cost-effectiveness of policy implementation lead to wasteful use of resources and inad- and create a framework for financing mecha- equate housekeeping, contributing to pollu- nisms. Environmental objectives can be tion. achieved by governments directly regulating pollution-generating activities (command-and- Environmental Policy and control (CAC) approach), or indirectly, by Implementation Instruments influencing the decision making process on the micro level (market based instruments Environmental policy addresses the correction (MBIs)).' Both CAC and MBIs can induce of market and administrative failures and polluters to finance pollution abatementfrom determines long-term objectives for environ- their own sources. The CAC approach mental quality. The correction of administra- constrains polluting activities for each source tive failures through the elimination of uniformly by setting standards for technolo- environmentally harmful price distortions, for gies, processes or emissions. By setting and example, should be an important part of enforcing standards, the regulator can be environmental policy objectives2. Ideally, assured that emissions and ambient quality environmental policy should lead to optimal will stay at a predetermined level. The cost of levels of pollution by imposing the social costs pollution abatement, however, varies across of external damage on those who cause the polluters, and the same environmental quality damage. In practice, the determination of the could be achieved by making polluters with external social costs of pollution and environ- lower abatement cost to abate more, while mental degradation is hindered by (i) the lack others with higher costs abating less. Such a of precise information concerning the causal- cost-effective solution can be achieved by ity of damage3; and (ii) the exact monetary MBIs that provide price-based choices. value attached to the damage4. As a result, Polluters may decide whether to abate their instead of pursuing the economically optimal emissions, or to pay pollution charges (alter- 2 Environnent Department Papers Pollution Abatement Financing - Theoretical Background Box 1. Costs and Benefits of Pollution Abatement for Investors Polluters will undertake pollution abatement investments if their benefits exceed their costs: PV(P) + PV(p[T]) + PV(p[L]) > (C&I) + PV(O&M) - S Where: PV(P): present value of profit stream from the investment PV(p[TJ): present value of avoided pollution taxes and other environmental charges during the lifetime of the investment with p probability; PV(p[L]): present value of the difference between avoided legal costs (due to environmental liability with p probability) with and without the investment; C&I: capital equipment and installation cost; PV(O&M): present value of operating and maintenance cost during the lifetime of the investment S: subsidy. Environmental authorities can induce abatement by influencing three factors: (i) the probability of taxes and charges levied by strengthened enforcement (ii) the level of taxes; and (iii) the size of subsidies. Interventions on the left side of the equasion are more efficient ways to influence polluter behavior and should get priority over subsidies. natively, to buy emission permits on thegrams may vary. From administrative point market). As a result, MBIs are generally more of view, grants are more transparent and cost-effective than CAC regulations simple to handle than soft loans, while the (Tietenberg, 1992). Several empirical studies system of tax incentives, for example, requires have demonstrated that gains from efficient administrative procedures and iter-agency allocation of abatement are substantial when coordination between fiscal and environmen- compared to direct regulation (Atkinson and tal authorities. Lewins, 1974, Seskin et.al, 1983). In addition to efficiently allocating abatement across Subsidy programs always face the conceptual polluters, MBIs may also create incentives for and practical problems of defining (i) the finding least-cost technologies and measures eligibility of investments; and (b) the size of for prevention and control rather than concen- subsidies. While end-of-pipe control invest- trating on end-of-pipe solutions. ments are easy to identify, pollution abate- Theoretically, subsidies may be used to ment investments frequently combine produc- achieve incentive effects similar to those of tivity and environmental performance charac- efficient pollution taxes by equivalent subsi- adrfit-orte copoenisoneal dies paid for each unit of pollution abated. impo e e eligibilt iteary Practically, subsidies are used to compensate narowl (fexml end-fip cntrol for the cost of pollution abatement invest- oly re ale bias torh ments (rather than for actual pollution abate- invetes andudefining t oadl les ment achieved), when (i) environmental tnecesay supprtno profital ies policies otherwise don't induce the required ts Furher, it is diffit inva level of pollution abatement; and (ii) other subsid prgr tt rs di ectl to t market failures, such as dysfunctional finan- actiy to be rae doest cowd cial and capital markets, or access to informa- autimarkt bas ed an des re tion about available technology prevent tialy a ed inacinationswih plc pollution abatement investments. Equal levels itrumentsienr on taxe a rl- of subsidization can be achieved by providing insthats con eto the correono (i) low interest rate (soft) loans; (ii) grants the sa t faiue the necar lv blended with commercial credit; and (iii) of sie trefore Tol depend o e other forms of subsidies, such as tax incen- ombie eeo all evo en olicy tives. However, the costs attached to, as well in en ee ox al) Frtr abteen as te efectvenss ovaioussubidyro-ingrmnt may e vary .. Ftadministatempont costs vary across polluters depending on the Environmental Economics Series 3 Financing Pollution Abatement Theory and Practice age of assets, type of processes and location of instrument of environmental policy and the plants. Uniform subsidy programs, therefore, degree of decentralization of the taxation cannot achieve efficient allocation of re- system effect environmental policy decisions. sources. Pigou (1920) recommended the use of correc- tive taxes to eliminate the distortive effects of Although theoretically the use of subsidies negative externalities. Such taxes would be leads to the same level of pollution abatement designed to adjust the marginal private costs as the use of other MBIs, subsidies could lead of economic activity to include its social costs. to a suboptimal situation in the long run; as Taxes levied on measured quantities of subsidies reduce the equilibrium market price polluting emissions are Pigouvian taxes that, for industry output, they tend to expand sales when they are set right, change the behavior attracting more polluters and altogether more of polluters by internalizing external social pollution to the market (Baumol and Oates, costs. 1988, Conrad and Wan& 1993). Subsidies provided for industrial pollution abatement Similarly to Pigouvian taxes, indirect taxes also tend to bias decision making in favor of (such as value added or excise taxes) on goods capital intensive end-of-pipe control invest- and services that are associated with environ- ments, as opposed to pollution prevention and mental damage may influence the decision low-cost alternative control measures. The making of polluters. For example, carbon larger the subsidy element is in pollution taxes levied on fossil fuels raise the price of abatement financing, the more serious the energy and, as a result, reduce energy de- long term negative effects of subsidies can be mand, change the structure of energy demand on the total pollution load. In addition, shifting away from fossil fuels, and reduce the subsidies also weaken fiscal performance (as emission of carbon dioxide emitted per unit of opposed to environmental taxes that energy used. Due to the looser connection strengthen it). Due to these negative effects, with the source of pollution, these taxes are subsidies should be avoided as environmental generally less effective than taxes levied on policy instruments. direct emissions, however, they require lower administrative costs, since the existing tax Various environmental policy instruments collection and enforcement system can be applied in combination is most likely to cost- utilized. There is, therefore, a trade-off effectively achieve the desired environmental between lower administrative costs connected quality. Finding the combination of the with indirect taxes and greater incentive various instruments requires the solution of effects associated with direct environmental complex political, economic, trans-sectoral taxes. and trans-media issues. Setting sensible environmental objectives, and selecting the The integration of taxation into environmental optimal combination of implementation policy involves (i) redesigning existing (indi- instruments and financing mechanisms, rect) taxes to reflect environmental concerns; however, can only be effective if supported by and/or (ii) introducing direct environmental dear regulations and strong enforcement taxes (Pigouvian taxes) aimed at correcting measures that, in turn, require certain legal negative externalities. The reform of tax and institutional capabilities. Additionally, systems could be carried out in a revenue- public access to information can significantly neutral way by replacing existing taxes (for enhance, or in some cases supplement policy example income taxes) with environmental implementation by facilitating public partici- (direct or indirect) taxes. Several analysts pation, informal and formal bargaining, and (Pearce, 1991; Terkla, 1984) argue that such social pressure. revenue-neutral tax reforms may offer a "double dividend" by simultaneously improv- Fiscal Policy Framework ing environmental quality and reducing distortions and costs of the tax system. Environmental financing is also closely Although there has been no scientific proof of influenced by the fiscal policy framework. the existence of double dividend (Goulder, The extent to which taxation can be used as an 1994), the notion of "greening the tax system" 4 Environment Department Papers Pollution Abatement Financing - Theoretical Background Table 1 Types of Earmarked Pollution Abatement Financing Mechanisms Revenues Expenditures Characteristics Examples Media-specific emission Regional/local, media-specific Main purpose is revenue French River Basin charges levied at pollution abatement programs; raising; dose connection Management Agencies local/regional levels; public and private abatement; between revenue sources and expenditures; transparency; accountability; Media-specific emission Media-specific pollution Main purpose is revenue US. Superfund- earmarked charges levied at national abatement programs at the raising for priority or media- sulfur-dioxide emission levels; national level; frequently specific programs; charges in France; earmarked temporary; mainly public: aircraft noise charges in pollution abatement programs; Belgium, France, Germany; Various types of emission Wide range of environmental and Dominant sources of national Environmental funds in charges and other pollution abatement expenditures pollution abatement financing transition economies environmental taxes levied at local/regional and national systems; blurred lines of (for example, Bulgaria at the national level; levels; public and private public and enterprise/private Hungary, Poland); abatement, responsibilities; General tax (budget Specific pollution control Fixed amount allocated from U.S. State Revolving Funds allocation); investments; public abatement budget, temporary character; programs; General tax; external Wide range of pollution Environmental taxes alone Environmental funds in some funds; and environmental abatement investments at the don't cover expenditure need; developing countries (for taxes; national and local levels; public dependent on other funds; example, Sri Lanka, Algeria, and private abatement; and Thailand). by introducing efficient environmental taxes local taxation may be needed to supplement in a revenue neutral manner is a widely user charges. Central intervention may also recommended policy approach. be necessary if fiscal capacities and the costs of environmental improvements vary across Fiscal policies also determine the autonomy lower levels of jurisdictions, and uniform and revenue raising capabilities of the various federal or national regulations impose an levels of governments, and the allocation of uneven burden on regional or local govern- public environmental expenditures. Gener- ments. Predictability and transparency of ally, the level of government that is respon- central government support are essential sible for carrying out environmental programs requirements to avoid inefficiencies. Since is in the best position to determine funding central budgetary allocations may create needs, and to choose the most efficient fund- disincentives for the generation of local ing source and mechanism. Theoretically, revenues, the application of matching funds is local or regional governments should provide advisable. those public services for which local residents are willing to pay for. Directly charging for Various forms of earmarking (see Table 1.) services increases the efficiency of resource may attempt to secure a steady flow of allocation and supports social equity by revenues for pollution abatement investments. imposing the costs on those who benefit. The Such mechanisms operate at national or local failure to recover costs is frequently the result levels, and their revenues come from the of considerations that try to protect the poor. budget or from designated general or environ- Free or highly subsidized environmental ment-related taxes. Politically, earmarking services are, however, very ineffective means environmental taxes for pollution prevention of addressing equity issues. Less than full and control investments is attractive because cost-recovery may be justified, however, by it can lead to environmental improvements the existence of collective benefits that cannot and raise revenues simultaneously. Although be allocated to specific individuals. Therefore, a distinction sometimes is made between Environmental Economics Series 5 Financing Pollution Abatement Theory and Practice environmental charges raised to achieve economic agents. Research and development incentive effects and those levied with rev- in advanced pollution abatement technologies, enue raising purposes, there is no rationale a- or dean-up of past pollution damage, for priori to make such a distinction. Even a example, may be justified on this ground. minimal charge may have incentive effects Mainly due to the public good nature of when there are polluters that can decrease knowledge generated by research, public their emissions at a lower cost (for example, finance of basic and applied research is the cost of better housekeeping may be small). considered better policy than tax incentives that would be needed in order to compensate Earmarking (assigning revenues from specific the private sector for the high financial risk taxes' or groups of taxes to specific govern- and the risk due to changing environmental ment activities or areas) may have serious regulations. In cases of clean-up, the liability disadvantages, including (i) the loss of fiscal for past damage is frequently impossible to control and accountability; (ii) inefficient use determine and, as a result, no alternative of revenues; (iii) inefficient management and exists to public financing. Governments can disbursement due to the lack of public scru- also play a catalytic role in mobilizing private tiny; (iv) mismatch between revenues raised resources and accelerating environmental and the financing need; and (v) the burden of improvements due to changing macro- a separate administrative mechanism (EPM economic conditions or environmental regula- 1992). Even if taxes are matched with the tions. The government's role in these areas is financing need initially, a mismatch is likely to temporary by its nature, harnessing the effects occur over time. As a result, pollution abate- of market conditions and environmental ment spending will be determined by the size regulations that induce changes in the behav- of revenues rather than by economically ior of private economic actors. justified expenditure allocation. While general revenues of the budget fluctuate, The Role of Financial and Capital earmarked funds may attract dispropoition- Markets ately large share of revenues compared to other, socially equally or more worthwhile Well functioning financial and capital markets causes. In certain cases, however, limitations are necessary for an effective pollution abate- on the reallocation of revenues can be accept- ment financing system. Pollution abatement able. Smith (1992), for example, points out financing needs to provide for both current that under imperfect political and administra- and capital investment costs. The operation tive systems, public support for taxes is and maintenance of control technology and weakened by concern that they will be di- housekeeping measures are recurrent costs verted to undesired purposes, and earmarking that are normally funded from operating may generate support. McCleary (1991) revenues. The financing of capital invest- similarly underlines that earmarking ensures a ments can come from internally generated the minimum level of financing for causes cash or from external financing sources such which are considered socially worthwhile, but as new common or preferred stock issues, would otherwise become neglected. Environ- debt financing in the form of bond issues, and mental considerations typically become commercial borrowing. Under well function- neglected during the budgeting process due to ing financial markets, investors have unre- (i) the lack of public awareness of the extent stricted access to various financial sources, and cost of damage due to pollution; and (ii) and their choice of financing is mainly deter- weak or non-existent political representation mined by their preferred capital structure. of the environmental protection cause. Dysfunctional, underdeveloped financial Public investment in pollution abatement can markets, however, may significantly reduce be justified only if private investment is the volume and the allocative efficiency of unavailable, less economical or the benefits of funds invested. Additionally, restrictions investments cannot be directly linked to implied by governmental regulations of the 6 Environment Department Papers Pollution Abatement Financing - Theoretical Background financial sector may increase the cost of institutions. In addition, staff training in lending by banks and other formal financial project evaluation and risk assessment tech- institutions. Informal money markets may niques is also needed to enhance policy supplement formal markets in the provision of changes. Although the start-up phase of these credit. The informal markets, however, are new lending programs may be quite costly, usually fragmented, non-competitive, and not cost-effectiveness improves over time with well integrated with the formal market. As a increased experience and economies of scale. result, in dysfunctional financial markets, self- financing frequently constitutes the main Micro-perspective of Environmental source of funds, and institutional credit becomes rationed by governments pursuing their own credit policies through designated As long as environmental policies induce the financial institutions and channels. internalization of external costs caused by pollution, "environmental investments" are Small and medium size enterprises frequently not different from any other investment face special difficulties in obtaining financing: Investors will undertake such investments if (i) their internally generated cash funds are the expected financial benefits of these invest- generally limited; (ii) they are precluded from ments exceed their costs (see Box 1.). Invest- capital markets due to their size; (iii) their ments with a pollution abatement component, relative transaction cost of project preparation however, introduce a great deal of uncertainty and assessment is high; (iv) the risk and cost into traditional enterprise decision making. of lending to small enterprises by financial This uncertainty originates from (i) the institutions is perceived to be high due to the complex impact of pollution on human health lack of conventional credit securities and and the environment; and (ii) changing small size of credits; and (v) small enterprises environmental regulations. A number of lack adequate information about application factors such as expectations reflecting current requirements and available financing sources. experience with environmental costs, subjec- In order to support small and medium sized tive judgement, and perceptions also influence enterprises overcoming these difficulties, project evaluation. Additionally, procedures national or local governments sometimes and practices of (i) traditional enterprise intervene in various forms, such as (i) creating decision making; (ii) capital budgeting; (iii) special financial institutions that channel cost accounting; and (iv) financial accounting funds through small credit programs man- influence the way environmental costs and aged by commercial banks; (ii) setting interest benefits are being considered and evaluated. rate ceilings; (iii) creating subsidy programs; The organizational structure of enterprises, for and (iv) providing technical assistance and example, may inhibit the participation of advisory services. While technical assistance environmental management in strategic programs tackle the root of the problem decision making and limit information flow (information disparities), subsidy programs among environmental and financial manage- and special financing institutions can easily ment. Limited time horizon of project evalua- lead to misdirected credit, perpetual depen- tion in capital budgeting may ignore long- dence on government subsidies, and ineffi- term benefits of pollution abatement invest- cient allocation of public resources without ments. Financial accounting practices may addressing the causes of high transaction costs prevent the monetary valuation of potential and poor access of credit. liability costs. Cost-accounting practices may also blur the sources of specific environmental Lending for environmental investments is a protection costs and benefits (White, 1993). relatively new field for financing institutions. Enterprise organizational structure decision A change of lending policy and better under- making culture, and capital budgetig and standing of environmental projects are neces- accounting practices, therefore, are important sary at the level of the (i) management; (ii) factors that determine the way enterprises owners; and (iii) staff members of the financial respond to environmental regulations. Environmental Economics Series 7 Financing Pollution Abatement Theory and Practice These costs include (i) the cost of health damage due to the population's exposure to harmful substances emitted into the environment; (ii) the cost of productivity loss elsewhere; (iii) cost of damage caused to nature and biodiversity; and (iv) lost amenity value due to lost environmental quality. 2 In addition to their environmental benefits, the correction of administrative failures generally contributes to improved fiscal balance and balance of payment (Gupta et.al., 1993). The human dose-response functions of harmful substances in the environment, for example, are not known precisely (however, estimates of such relationships have been established). * The costs of health damage, for example, can be estimated by using the cost of illness or willingness to pay methods. The former uses the economic costs of hospital treatment, emergency care, loss productivity days etc., associated with exposure to pollution, while the latter estimates the costs of damage based on individuals' willingness to pay for improvements in environmental quality, primarily based on the contingent valuation method. For a detailed analysis of environmental policy instruments, see Eskeland, and Jimenez, 1991. 6 Although the mechanism of financing through earmarked emission charges and other environmental fees may be viewed as a "self-financing" mechanism that is outside of the taxation system, there is no conceptual justification not to consider these charges environmental taxes that are returned to polluters in the form of subsidies. 8 Environment Department Papers 2 OECD Countries Environmental Policy Framework of environmental improvements and the efficiency of resource allocation, and started to The increased concern about environmental recognize the benefits of MBIs and the integra- quality during the last decades has made tion of environmental considerations into their policy makers of OECD countries search for fiscal policy. As a result, direct regulations instruments that can guarantee the achieve- are being gradually supplemented by MBIs ment of their environmental goals. CAC (Opschoor et.al., 1993) and taxes are increas- regulatory approaches appeared to suit their ingly used with the dual purpose of generat- objectives for a number of political, adminis- ing revenues and providing incentives for trative and practical reasons, and the applica- environmental improvements. Although tion of MBIs was rejected (see Opschoor and there are examples (see Box 3.) of direct taxes Vos, 1989). The U.S. Congress, for example, (emission taxes), the introduction or increase voted against the Proxmire Amendment to the of indirect taxes on energy, fuels, and prod- Clean Water Act that proposed the introduc- ucts (for example, fertilizers and pesticides) tion of effluent fees in 1971. The factors with environmental protection purposes are influencing the decision included (i) an the more widely applied instruments. Taxes aversion to new taxes; (ii) a perception that are frequently levied only on a narrow range fees would provide the "right to pollute"; (iii) of commodities such as batteries, plastic bags conviction that regulations were the only or non-recyclable containers. Tax differentia- appropriate legislative means of answering a tion is extensively used, for example, to speed social need; (iv) uncertainties regarding the up the introduction of cleaner cars on the effects of effluent fees; and (v) strong indus- domestic market. Tax differentiation have trial lobbying against the fees claiming that the been provided according to air pollution money taken away would otherwise be used characteristics (Netherlands, Germany), car on pollution control (Casey, 1988). Potential size, weight, or age (Sweden, Germany). effects on international competitiveness due to Different rates apply to imported crude oil new environmental taxes also frequently according to sulfur content in Japan. Sales tax invoke opposition from certain industrial differentiation proved to be successful in the groups. As a result, cost effectiveness consid- Netherlands, for example, where the number erations remained unimportant in most of cars complying with future Euro-standards countries for a long time. The political increased dramatically (Bressers and acceptability of MBIs, however, was not Schuddeboom, 1993). Fuel tax differentiation equally low across countries. Effluent according to sulfur content was similarly charges, for example, were acceptable in some successful in Sweden, where diesel fuels were countries (for example, in the Netherlands, divided into three environmental classes in France, Germany). 1991, and the various classes of fuels were taxed differently. As a result, large oil compa- Recently, OECD countries have become nies have shifted their production toward increasingly concerned about the rising costs cleaner fuels, and a dramatic increase oc- Environmental Economics Series 9 Financing Pollution Abatement Theory and Practice Box 2 Water Quality Management and Financing in the U.S. The Federal Water Pollution Act of 1972 established technology-based standards for all sources of pollution, and aimed to ban all discharges of wastes into public waters regardless of the costs and benefits of such an approach. By setting overly ambitious quality objectives and imposing uniform standards, water quality policy required large costs that frequently exceeded the benefits of improved water quality (Freeman, 1990). The implementation and enforcement of regulations relied heavily on the threat of punishment (fines, imprisonment) rather than on inducing polluters to reduce their discharges to public water bodies. Neither the choice of environmental objectives, nor the means chosen to achieve them were driven by economic efficiency criteria, and the result was the wasteful use of resources. As a result, large public resistance has developed to unfunded mandates and overly ambitious goals with little consideration to the costs and benefits of the implementation of such goals. curred in the cleaner fuel classes. The existing such as good housekeeping practices or the tax system has been frequently adjusted to application of deaner production techolo- accommodate environmental considerations gies. Therefore, traditional public approaches in a revenue-neutral way. In Austria, for have been revisited and cost-recovery mecha- example, a tax on car registration was intro- nisms introduced. In Britain, for example, duced in 1992 based on sales price and about 60 percent of the cost of sewerage and average fuel consumption. Simultaneously, sewage treatment was financed by subsidies value added tax rates on new vehides were through the "rate support grant" until 1974 reduced. (Dangerfield, 1979). Since 1974, a gradual move towards greater degree of self-financing Public Pollution Abatement has taken place, and now borrowing is fre- Finacingquently used to finance the investment costs Financing of wastewater treatment facilities. The majority of public pollution abatement Public services incuding collective pollution and control (PAC)' expenditures (including abatement are typically delivered by local direct public investments, operating and maintenance costs of environmental services goernmen i st PC countres and subsidies to the providers of public thefore, pbi sec re c n re environmental services) in OECD countries was spent on collective water pollution typically concentrated at local levels of abatement (over 70 percent in the U.S. and government. Local governments were respon- Finland, and around 60 percent in a number of sible for around 90 percent of total public PAC other OECD countries in the mid 1980s) and expenditures in the mid 1980s, for example in on waste management programs (around 20 Denmark, Sweden and Finland (OECD, percent in the U.S., and even higher in other 1990b). User charges and local taxes consti- conre,rhn 0percentinNraad tuted the main sources of local public environ- countries, reaching 40 percent in Norway and mental service expenditures, however, they Sweden in the mid 1980s).were frequently supplemented by transfers The role of the subsidized public sector in the from higher levels of governments, typically provision of water and wastewater treatment in the form of grants (see Box 4.). Historically, was justified by the public good nature of the private sector has played an important these services. Public treatment, however, role in the development of environmental was often less cost-effective than private services in most OECD countries. Currently, measures for pollution prevention and con- both private and public sectors provide these trol. Also, subsidized public wastewater services, for example, in France, the United treatment usually resulted in a lack of incen- Kingdom and the U.S. tives for cost effective preventive measures 10 Environment Department Papers OE'CD Countries Box 3 Effluent Taxes in the Netherlands and Germany In order to finance the construction of water treatment facilities in compliance with the water quality requirements of the Surface Water Pollution Act of 1970, water effluent charges were introduced in addition to CAC regulations in the Netherlands. The effluent charge system operates through two subsystems: (i) the State Water Authority levying charges on the pollution of state waters; and (ii) Water Boards levying charges on industries and households discharging into other than state waters. In addition to fulfilling their declared primary financing function, the charges have proven to be effective policy instruments by influencing the amount of industrial effluent discharges. A dramatic decrease in pollution took place in the early 1970s, despite the growth in economic activities. As indicated by the results of a statistical analysis (Bressers and Schuddeboom, 1993), the reduction of industrial wastewater discharges was due to the increased incentive role of effluent charges rather than to CAC regulations. Due to increased voluntary abatement as an unexpected regulatory side-effect, there were signs of potential overcapacity in water treatment facilities. Effluent charges were also introduced in Germany in 1976. Although the level of charges was too low to achieve the desired water quality objectives through incentive effects alone, even these low charges were shown to have noticeable incentive effects when private abatement costs were lower than the effluent charge. Brown and Johnson (1984) demonstrated, for example, that BASF (a large chemical firm) achieved low unit abatement costs by a large-scale integrated treatment process that treated not only the company's own waste water, but the waste of neighboring municipalities as well. Individual branches were subject to implicit effluent charges based on an accounting price per unit of effluent for the branch. The internal charge system resulted in a substantial voluntary decrease in discharge through process change, recycing, and other management responses. during the last decades, both in absolute terms Municipal Development Funds (MDFs), and as a percentage of GDP. For example, created to provide financing for local private expenditures for PAC increased by 86 infrastructural investments (water supplies, percent in real terms between 1972 and 1986 sanitation, drainage, waste disposal and in the U.S. (from 0.67 percent of GDP to 0.86 collection), have existed in many countries percent), and by 67 percent between 1975 and since the 19th century (for example in Bel- 1985 in Germany (from 0.57 percent of GDP gium, Denmark, Netherlands, Japan). Typi- to 0.74 percent). Air pollution control, that cally, the majority of funds have been used for was almost exclusively financed from private water related expenditures. Although MDFs sources, represented the largest share of are initially capitalized by the central or local private sector expenditures (around 60 governments (for example subscription of percent of private pollution abatement expen- share capital), lending is typically funded by ditures during the 1980s in the U.S., and 40 the financial markets. Pension funds, insur- percent in the Netherlands, Germany and ance companies and commercial banks have Austria). The share of expenditures spent on been the major financing sources through water pollution abatement and waste manage- bond issues or directly negotiated deposits ment programs varied across countries. (Davey, 1988). Due to the ability of borrowers Depending on the sectoral composition of to recover their costs through fees and industries, a small number of industrial charges, loans are reliably serviced, and MDFs branches (typically the chemical, metal are self supporting. products, machinery, paper and pulp indus- tries) represented the bulk of private pollu- Private Pollution Abatement tion control expenditures. Financing Direct regulations are generally enforced by a As a result of strict environmental regulations, formal enforcement apparatus supplemented private expenditures on PAC exhibited a to greater or lesser extent by administrative steady increase in several OECD countries bargaining between the regulator and regu- Environmental Economics Series 11 Financing Pollution Abatement Theory and Practice Box 4 Public Water Sector Financing in the U.S. The provision of straight federal grants between 1972 and 1989 contributed to the inefficiencies of water quality management under the Federal Water Pollution Act of 1972. The provision of federal grants to cover up to 75 percent of the construction costs of wastewater treatment facilities, together with local and state budgets available for further subsidies, resulted in large inefficiencies and no incentives to recover costs. There were indications that municipalities simply substituted federal grants for their own funds (Freeman, 1990) and drastic over-capacities were created (Vaughan, 1983). By subsidizing municipal waste treatment, subsidies were practically transferred to private polluters creating an uneconomic mix of industrial and municipal wastes (Renshaw, 1974). Even when user charges levied by municipalities on industries covered operation and maintenance costs, charges were lower than economic costs, and the system imposed an excessive burden on the budget. Therefore, large-scale straight federal grant financ- ing was eliminated in 1989. State Revolving Funds replaced federal grants.2 They reflected the growing financing responsibilities of states and encouraged the increase of efficiency and cost-recovery in program implementation. State Revolving Funds are credit mechanisms capitalized from federal grants and matching state funds (80 percent and 20 percent, respectively). They provide low-interest rate loans and other non-grant assis- tance to local and municipal governments to build or improve sewage treatment systems. While in the framework of the construction grant program states typically provided grants up to 10-15 percent of costs to municipalities, under the revolving fund program, states typically discontinued this practice (US. EPA, 1991). As a result of the change from grant to loan mechanism, the increase in household user fees was typically around 20 percent (U.S. EPA, 1991), and annual adjustments in charges have become common. Additionally, the incentive to construct lower cost facilities to minimize the impact of capital costs on user fees has increased (U.S. EPA, 1991). As a result of shrinking federal funding, states and municipalities had to find alternative channels of financing, and were forced to require greater efficiency and greater cost-recovery in service provision. With increased cost-recovery, market-based financing schemes (see Box 5.) gained larger acceptance. Earmarked funds have been established in some municipalities. In Los Angeles, for example, all wastewater system costs are financed from sewer- related revenues accruing to the Sewer Construction and Maintenance Fund. Such revenues include sewer service charges, industrial waste quality surcharges, inspection and other fees. lated sector. Bargaining can significantly schemes were frequently of transitory charac- change the cost of pollution abatement for ter, introduced to tackle specific environmen- polluters by influencing (i) the stringency of tal problems with a pre-set time limit for regulations; and (ii) the effectiveness of operation. During the 1970s, most assistance enforcement. The role played by bargaining to industries was directed to air and water doesn't always depend on the style of admin- pollution abatement investments, while in the istrative system and the traditional role of 1980s, several schemes aimed at specific law. In Germany, for example, regulatory individual pollutants, and the assistance agencies widely apply bargaining in air and provided to research and development of new water pollution control despite the authoritar- technologies was also increased (OECD, ian Prussian tradition of control (Hucke, 1990a). In the United Kingdom, for example, 1978). the government provided up to 50 percent of the cost of industrial research projects aimed Various subsidy programs have supported at improving environmental standards. private pollution abatement investments in Subsidies were also used to tackle problem most OECD countries. These programs were areas where long-term pollution effects generally aimed at speeding up the implemen- created policy concerns. Such an area was, for tation of environmental programs and as- example, the protection of groundwater sisted those industries that faced sudden cash resources from irreversible damages (and the flow problems due to abnormally high costs reduction of related health threats) due to required by new regulations. Assistance agricultural activities in Denmark. The 12 Environment Department Papers OECD Countries Box 5 Market-based Financing of Municipal Environmental Investments Equity financing. In publicly owned utilities, equity is simply the net worth of the utility (assets less liabilities), while in investor-owned utilities, equity can be divided into common capital stock, paid-in capital and retained earnings. Equity financing may be preferred to debt financing when the cost of debt is high or the capital structure is overly leveraged. Long-term debt financing. Municipal governments can raise funds to cover capital costs by issuing general obligation or revenue bonds. General obligation bonds are backed by the issuer's financial power, while debt service under revenue bonds is provided from user fees generated by the project itself after completion. Higher level governments can offer bond issues with lower interest rates due to their better credit rating. In the U.S., for example, states support smaller communities or municipalities with lower or no credit rating by selling their own bonds, and use the proceeds to purchase local community bonds. Alternatively, small communities can create bond banks by pooling their smaller long-term loans together into a large issue. In either case, small communities have to finance interest and principal payments through the application of user charges. Leasing. Leasing may be attractive to utilities as a means of acquiring the use of needed equipment and facilities if debt limitations restrict direct purchase. Based on the lease agreement, the lessor purchases the equipment or constructs the facility, while the lessee (utility) pays rental and, typically, O&M costs. Main sources of lease financing include large banks, equipment manufacturers, real estate developers and leasing companies. Privatization. Privatization may extend to the financing, construction, ownership and operation of a facility that provides public environmental services. Frequently, privatization is supported by govern- ment incentives provided through the tax system. Agricultural Investment Support Act of 1987 banks at interest rates ranging from zero to introduced subsidies to farmers who were just marginally below commercial interest obliged to undertake investments to reduce rates. In Japan, for example, interest-free nitrate, phosphorus and organic matter loans up to 50 percent of capital expenditures contamination of surface and ground waters supported technology updates during 1973-75, in order to comply with more stringent and loans at lower-than-market interest rates environmental requirements. have been provided for other pollution abatement investments (see Box 6.). In Direct grants were typically provided for the Finland, subsidized loans were provided at installation of dean production technologies. 3.25 percentage points below market rates Such a program was introduced, for example, between 1974 and 1976 for water pollution in the Netherlands under the Air Pollution abatement projects. The interest rate subsidy Act of 1970. Surveys found that the compen- was reduced later, and the scope of eligible sation program indeed induced businesses to environmental projects was extended to air invest more extensively in environmental pollution control and waste recycling in 1979 measures than they would have done other- and 1983, respectively. In the U.S., the Small wise (Bressers and Schuddeboom, 1993). Business Administration provided long-term Several of these programs were gradually low interest loan programs for financing phased out or terminated. In Denmark, for pollution control facilities for marginally example, up to 50 percent of eligible invest- viable firms (however, excluded profitable ments by existing firms were compensated by firms that were able to obtain financing grants from 1975. The ceiling was later through commercial sources). Government reduced to 25 percent, and the program was guarantees for environmental investment finally abolished in 1986 (OECD, 1990a). loans were also provided, for example, in Finland under the State Guarantees for Directed soft loans were extended to indus- Industrial Pollution Control Act of 1973 tries in several countries. Such loans were (revised in 1984) for both normal commercial typically channelled through state owned loans and for already subsidized environmen- Environmental Economics Series 13 Financing Pollution Abatement Theory and Practice Table 2 Pollution Abatement Expenditures in the U.S., 1986-1991 Year Total industrial Industrial Share of pollution Industrial Total industrial Change from capital expenditures pollution abatement abatement in total pollution abatement pollution previous year (US. SM) capital expenditures industrial capital recurrent costs' abatement cost (%) (US. SM) expenditures (%) (US. SM) (US. SM) 1986 76,354 2,847 3.7 12,258 15,105 NA 1987 78,648 NA NA NA NA NA 1988 80,572 3,423 4.2 14,008 17,431 NA 1989 97,187 4,309 4.4 15,626 19,935 14 1990 101,953 6,031 5.9 17,071 23,102 16 1991 98,916 7,390 7.5 17,387 24,777 7 Source: US. DOC, 1993. 1 Including payments to the government tal loans. Finally, directed environmental credits are usually claimed against positive credit lines were also established on a revolv- tax liability. In order to mitigate potential ing basis. The European Recovery Program inequities among enterprises with and with- (ERP) in Germany, for example, was capital- out taxable profits, credit carry-over and ized from the Marshall Plan to provide loans transfer schemes have been introduced (for for small and medium sized enterprises to example in Canada). accelerate economic development, as well as to support special priority areas. In 1993, 14 Other tax incentives have allowed the depre- percent of ERP loans were directed to invest- ciation of certain assets at higher than normal ments in environmental protection (BMW, rates or over shorter periods (or both), post- 1993). The original capital has remained poning tax liabilities in the early years of the intact, while interest revenues and repaid loan life of the asset, and reducing the net present amounts are used for subsidized credit (see value of future tax liabilities. Germany, for Box 7.). example, allowed the accelerated depreciation of water, air and soil pollution abatement Temporary investment tax incentives have technology, as well as noise control equipment been the favored fiscal instrument for pollu- between 1975 and 1980 (60 percent was the tion control in many OECD countries. Rajah allowed depreciation rate in the first year, and and Smith (1993) pointed out that temporary 10 percent per annum in the following four incentives may have larger effects on invest- years compared to the 6.67 percent standard ments than permanent ones by changing the straight-line depreciation extended over 15 timing and level of investments. Besides years). Investments in capital equipment environmental considerations, tax incentives qualified for the accelerated depreciation until often corresponded to concerns about indus- 1991, if the pollution-abatement aspect of the trial competitiveness and promoted employ- investment accounted for at least 70 percent of ment, productivity improvements and techno- the cost of investment. In the U.S., the Tax logical progress. Investment tax credits that Reform Act of 1969 provided rapid amortiza- provide an outright tax reduction by subsidiz- tion of eligible pollution control facilities over ing the purchase price of an asset have been a five year period for the first 15 years of widely used, for example, in Canada, the depreciable life of the pollution control Netherlands and Norway. Investment tax equipment at old industrial facilities for a 14 Environment Department Papers OECD Countries Table 3 Main Types of Environmental Subsidies for Private Investments in OECD Countries Grants Soft loans Accelerated Tax reduction Tax deductible Earmarked taxes depreciation funds Austria X Canada X X Denmark X Finland X X X X France X X X Germany X X X Japan X X X X Netherlands X X X Norway X X X X Sweden X X U.S. X X X X X limited time. In Luxembourg, assets acquired during 1984 and 1992 that contribute to In most countries, tax incentive schemes have energy saving may qualify for accelerated been available principally for equipment depreciation. In Canada, water and air purchases, that may have led to a bias against pollution control investments at sites that the adoption of cleaner production processes. started operation before 1974, and energy- Additionally, some analysts (Jenkins and saving equipments can qualify for accelerated Lamech, 1992) pointed out that tax incentives depreciation or "capital cost allowance". distorted the relative price signals and, in Japan tax authorities similarly allow investors some cases, the removal of subsidies could of pollution abatement, recycling, solar and have reduced pollution levels allowing a more energy-saving equipment to use accelerated effective use of economic instruments. Differ- depreciation of such assets. entiation in eligibility and conditionality that try to account for differences among polluters Tax deductible funds (used, for example, in in abatement costs has been demonstrated to Japan) have similar effects than accelerated help improve the environmental cost-effec- depreciation: when company income is set tiveness of incentives (Jenkins and Lamech, aside for environmental investment, such 1992). Such differentiation has been intro- funds become tax exempt. Once the funds are duced, for example, in Canada, where acceler- withdrawn for environmental investments, ated capital cost-recovery incentives are they are subject to taxation. The main advan- provided only to older plants (counissioned tage of the system is derived from the deferral before 1974), that are likely to achieve higher of taxes. In other cases (for example in the cost-effectiveness in marginal pollution U.S.), large industrial corporations could often abatement than newer ones. save 1.5-2.0 percentage points on the cost of borrowing to cover pollution abatement Earmarked Environmental Financing investments by issuing tax-free industrial Mechanisms development bonds (Renshaw, 1973)3. Yet in other examples, (in Louisiana), business In some countries, special earmarked financ- property tax rates have been linked to the ing mechanisms are used to secure a steady environmental records of enterprises flow of revenues for certain environmental (Schneider, 1991). protection objectives. Typically, they have Environmental Economics Series 15 Financing Pollution Abatement Theory and Practice Box 6 Directed Credit and Technical Assistance for Industrial Pollution Abatement in Japan The Environmental Pollution Control Service Corporation, later renamed Japan Environment Corpora- tion (JEC) was established and capitalized by the government of Japan in 1965. JEC has become a significant financial instrument of the government to promote pollution abatement JEC has three main areas of operation: (i) it provides basic infrastructure for industrial development providing open space, municipal services and measures to reduce the impact of industrial pollution (for example, development of green belts and parks); (ii) it provides long-term loans for industries at lower-than-market interest rates for pollution abatement investments; and (iii) it provides technical assistance and guidance to industrial enterprises. JEC played a significant role in financing private pollution abatement investment during the 1960-70s, when commercial banks were reluctant to lend for nonproductive investments. Since then, its role vis-a- vis enterprise investments has shifted to the provision of technical assistance. In 1991, JEC loans contrib- uted to 6 percent of private pollution control investments. In addition to JEC, other governmental lending institutions finance about 18 percent of the total private investment costs. These include: (i) loans by the Funding System for Modernization of Facilities of Medium and Small Businesses that are extended for pollution prevention facilities specified by the government; (ii) loans by the Small Business Finance Corporation for People's Finance Corporation assisting small and medium-sized businesses to relocate; (iii) loans by the Japan Development Bank for pollution control representing a small share of total lending, mainly for general industrial development; and (iv) other institutions such as the Metal Mining Agency of Japan and the Hokkaido and Tohoku Development Corporation. Source: MEIP, 1994. been used to finance investments in public maintained through normal budget alloca- environmental services to achieve compliance tions. Similarly, earmarking budgetary with regulations. The more direct the connec- revenues provided a stable source of financing tion between the revenue source and its use is for public wastewater treatment facilities in the more politically acceptable the earmarking the U.S. in the framework of Construction system becomes. Earmarked mechanisms that Grants program during 1979-89, and the State use revenues from non-environment related Revolving Fund program from 1989 (see Box taxes, or the budget, have neither direct 4.). Besides revenues coming from the exist- connection nor the incentive effect that ing tax system, additional revenues may be earmarked environmental charges may have. raised specifically with the purpose of ear- The only purpose of earmarking non-environ- marking for environmental protection. Fre- mental revenues is the provision of funds that quently, sin-taxes levied on tobacco and would not be available through the general alcohol appear to be the least difficult way budgeting process. politically to raise funds for environmental protection programs. Washington State in the Earmarked environmental funds capitalized U.S., for example, levies a cigarette tax to be from the budget were established on a transi- earmarked for financing water quality pro- tory basis in Sweden in the early 1970s, for grams. example, where environmental funds ex- tended grants to industries, municipalities Environmental funds (EFs) have been created and water companies up to 75 percent of by earmarking environmental levies at the investment costs. Besides accelerating envi- national level in some countries to provide ronmental improvements by providing public guaranteed financing for priority public support through the funds, policy makers also programs. Not economic efficiency, but the intended to have an incentive effect on em- political priority assigned to certain environ- ployment. Although these earmarked funds mental issues has been the primary criteria of were abolished after a few years of operation, establishing these funds. Very frequently, grant financing from the general budget for these priority programs are connected with pollution control investments have been environmental liability issues. Since the 16 Environment Department Papers OECD Countries Box 7 Federal Environmental Credit Programs in Germany Most federal environmental credit programs are carried out by two public financial institutions in Germany: the Kreditanstalt fuer Wiederaufbau (KfW) and the Deutsche Ausgleichsbank (DAB). While the main objective of KfW and DAB is the promotion of economic development, both banks have gradually developed an environmen- tal protection lending program: The European Recovery Program (ERP). ERP is a revolving fund mechanism that was capitalized by the Marshall Plan after the Second World War. The ERP program was carried out by KfW until 1992, when it was taken over by DAB. ERP credits have supported small and medium size private enterprises (with less than 500 million DEM annual revenues) by providing funding up to 50 percent of the investment costs at fixed interest rates. Pollution abatement credits are provided for (i) sewage treatment; (ii) waste management; (iii) air pollution abatement; and (iv) energy conservation investments, carrying favorable interest rates, loan maturity, grace period, and no penalties for early repayment After the unification of Germany, differentiated credit terms were awarded to the Eastern States (0.25 percentage points lower interest rates, 5 years longer maturities, and 2 years longer grace periods). The credit program is executed through commercial banks that bear the credit risk, provide advisory services, and carry out financial assessment for a one percentage point margin. Municipal Credit Program. The program is available for municipalities and communities in the former East German territories. Investments supported by the program cover environmental and infrastructural improve- ments. One of the maine objectives of the program is the support of water supply and water treatment projects through credits extended directly by KfW or DAB. KfW's primary field is lending for water treatment, water supply, noise reduction, air pollution abatement, and traffic infrastructure investments, while DAB specializes in lending for waste management. energy saving, waste recovery and hospitals. Besides communities, investors providing public environmental services can borrow from this credit line up to two-thirds of the investment cost. KfW and DAB raise the capital needed in the capital markets, while the Federal Government reduces the interest rate on the loans to municipalities by 2 percentage points from the budget. KfW and DAB lend to municipalities at their own risk Environmental Guarantee Programs. Since the introduction of new products is frequently constrained by the lack of sufficient securities, the Guarantee Porgrams support the introduction of innovative environmentally friendly porducts through guarantees porvided for up to 80 percent of the amount of environmental assessment of projects carried out by the MOE. KfW/MOE Environmental Demonstration Program. The program was developed in 1992 to be carried out by the MOE and Federal Banks. The objective of the program is to accelerate the adoption of cleaner technology in environmental protection through supporting demonstration projects. Noise, air, and water pollution abatement, energy saving, waste management, waste recovery and integrated and cross-media pollution abatement projects are supported. Large enterprises in metallurgy, electronics and chemical industries have been the largest beneficiaries of the program. Currently, interest rates are fixed for maximum 10 years at 6.5 percent. The interest rate subsidy provided by MOE is 5 percentage points during the 5 years of the program's lifetime. In addition to environmental credit programs carried out by KfW and DAB, several other federal programs exist with significant environmental objectives: Federal Environmental Endowment Program. The federal environmental endowment was capitalized by the sale of the previously state owned Salzgitter Ltd. DEM 200 million is available annually to support the introduction and transfer of environmental technology, and the protection of cultural heritage from environmental damage. Small and medium size enterprises have priority in obtaining support from the program. Regional Economic Improvement Program. Water treatment, energy saving, and waste management investments are supported through 12 to 18 percent contributions to project costs (23 percent in the new territories). The programs are financed jointly from state and federal funds. A special contribution is provided from the federal budget for the new states. Energy Saving Program of the Federal Ministry for Research and Technology (BMFT). The BMFT provides support for the wider use of solar and wind energy utilization programs. Investment contributions of 50 percent (60 percent in the new states) of project costs are extended, while additional subsidies can be provided for the production costs of wind energy generation. BMFT provides additional support for the development of new environmental technologies under the Environmental Research and Technology program Source: KfW & DAB documents. Environmental Economics Series 27 Financing Pollution Abatement Theory and Practice Box 8 Liability Issues Financed from Environmental Fund in Japan In 1973, a law was adopted on the compensation of pollution-related health injuries. The law categorized eligible victims into two groups; (i) those suffering from illnesses that cannot be related to specific pollution sources, although nonspecific, pollution-related statistically significant correlation between pollution and disease has been established; and (ii) those suffering from specific pollution-related illnesses traceable to individual sources. In the latter case, victims could be compensated directly by the companies responsible. In order to finance compensation for the first group of pollution victims, pollution levies were directed to a fund administered by the Pollution-Related Health Damage Compen- sation and Prevention Association (PHDCPA). PHDCPA proved to by highly effective in collecting levies, based on detailed statistics on fuel use by industries. The levies were based on sources of sulfur- dioxide emissions. liability for pollution is often hard or impos- used at the local level. Usually, effluent sible to determine when (i) the pollution charges provide the revenue base for these occurred in the distant past; or (ii) causal funds. In most cases, however, the charges relationship between pollution and damage are set too low to significantly influence the cannot be proven with certainty, government polluters' behavior, and the financing function intervention may be necessary to provide of these systems is more important than their compensation for the victims, and/or finance incentive function. The level of charges the cleanup. In Japan, for example, an EF was reflects a compromise between the affected created to provide compensation to those main stakeholders (industries, municipalities, victims of pollution related health injuries, agriculture) and local environmental protec- who could not be compensated by individual tion agencies. With growing acceptance of the companies (see Box 8.). funds, however, there has been a gradual increase in the charge levels (Opschoor and Due to the marginal role of these funds in the Vos, 1989). Since the link between expendi- environmental management system, the funds ture and revenue in these arrangements is a seldom have significant impact on the effi- close one, the danger of a mismatch between ciency of the national environmental financing the amount of revenues raised and the financ- system. In many cases, the priority programs ing need (a serious drawback of earmarking) are of temporary nature. In the U.S., for is greatly reduced. Earmarking at the local example, the Superfund and the Leaking level is more likely to gain political support Underground Storage Tank Funds were and compliance (beneficiaries are easier to created to mitigate contamination from identify). The local nature and transparency hazardous waste sites (see Box 9.). After of these models contribute mainly to their cleaning up the most health threatening sites, acceptability. Best known systems are the the role of the funds was envisaged to dimin- French River Basin Management Agencies that ish. levy effluent charges in order to cover the costs of water supply, as well as water quality In case of earmarking direct environmental management in the river basin (see Box 10.). taxes, incentive effects are important by- Similar mechanisms also operate in Germany products (see Box 3.). As a result, some and the Netherlands. earmarked financing systems achieve simulta- neous revenue raising and pollution abate- In most cases, environmental taxes (charges) ment functions. The benefits of earmarking are levied with only revenue raising purposes. have been most pronounced when direct Earmarked mechanisms established from environmental charges were earmarked in environmental charges for air quality control decentralized programs. Most pollution exist, for example, in Canada, Portugal, problems are local in nature, and revenues France and the U.S. (Opschoor et al., 1990). In from charges on local pollutants are very often the U.S., states levy air emission charges 18 Environment Department Papers OECD Countries Box 9 Environmental Clean-up Financed from Environmental Funds in the U.S. In the late 1970s it became apparent that uncontrolled environmental contamination from hazardous waste sites was a nationwide problem. The Comprehensive Environmental Response Compensation and Liability Act of 1980 created an earmarked federal fund, known as Superfund, to finance the cleanup of those toxic waste sites that (i) present threats to public health or the environment; and (ii) create liability that cannot be assigned to individual polluters. The Superfund was originally conceived as a short-term program. In 1986, by the Superfund Amendments and Reauthorization Act (U.S., 1992), Congress asked EPA to develop permanent remedies for Superfund sites. The Superfund is financed from petroleum and feedstock chemical excise taxes, environmental taxes, and by appropriation from general revenues. Responding to an increasing threat of groundwater contamination through leaking storage tanks of petroleum and other hazardous substances, the US. Congress created another earmarked financing mechanism in 1988, the Leaking Underground Storage Tank (LUST) trust fund. LUST was assigned to finance corrective and remedial actions at abandoned sites or in cases where liability could not be determined or enforced. The revenues of the fund are generated from gasoline taxes. earmarked to support air quality programs effective solutions of environmental prob- (Shields, 1989). Air emission charges have lems, and the environmental financing been typically levied on certain types of systems frequently reinforced policy polluters or on a limited number of pollutants. inefficiencies. More recently, however, In France, for example, only industrial enter- environmental considerations increasingly prises that generate power beyond certain influenced the taxation system, and MBIs capacity, or emit sulfur oxides or nitrogen have become more widely applied to oxides beyond certain volume are charged. supplement other policy implementation Aircraft noise charges are also typically instruments. Although the main purpose of earmarked to cover noise abatement costs MBIs has been revenue raising their effects (Belgium, France, Germany, Switzerland), and of influencing polluter behavior increased waste disposal taxes are directed to treatment the cost-effectiveness of environmental and recycling expenditures in a number of protetion measures. countries (Opschoor et al., 1993). Frequently, the connection between the source and Due to improving environmental manage- allocation of tax revenues is distant, and direct ment, the share of the private sector in total incentive effects are not detectable. Generally, PAC expenditures has been increasing. the more remote the connection between Industrial pollution abatement is typically taxation and the objective of the fund is, the financed from private resources in OECD less dear the advantage of earmarking be- countries. Air pollution represented the comes. Product charges, for example, are less largest share of private sedor PAC expen- directly connected to the sources of pollution ditures. than emission charges. Additionally, the proliferation of earmarking reduces the Various forms of subsidy schemes have efficiency of the environmental financing been used in most OECD countries to system (see Box 11.). speed up the process and reduce the financial burden of compliance with new Summary of Pollution Abatement regulations and standards. Investment tax Financing in OECD Countries incentives have been the favored type of fiscal subsidies. The use of certain incen- tives created bias towards end-of-pipe Environmental financing mechanisms in control investments as opposed to the OECD countries have been significantly application of cleaner technologies and influenced by the dominance of CAC processes. Typically, these schemes have instrtiments that did not lead to cost operated on a temporary basis that changed Environmental Economics Series 19 Financing Pollution Abatement: Theory and Practice Box 10 Earmarked Financing in the French River Basin Management Agencies Six river basin agencies" represent the main hydrographic basins of France. The river basin agencies are managed by Basin Committees, the Boards of which are representing the main stakeholders (national, regional and local governments, industrial and agricultural interests and citizens). The Basin Commit- tees, supported by technical and financial basin agencies, prepare five-year environmental action programs based on (i) the analysis of problems in the basin, (ii) selection of projects and their costs and benefits; and (iii) amount of fees necessary to ensure the projects' financing need. The fees collected are earmarked for these purposes. Effluent charges that represent the largest part of the agencies' annual revenue sources (close to 70 percent) have been levied for various water pollutants (suspended solids, oxidizable matter, soluble slats, BOD, organic/ammonia nitrogen and total phosphorus) since 1969 (Bernstein, 1993). These charges are paid by industries, municipalities and households (Hahn, 1989). The level of effluent charges is generally low, and rarely based on actual performance. Instead, the charges are based on expected levels of discharges by various industries. The number of pollutants on which charges are levied has grown since the initiation of the program. In addition to the effluent charges, resource fees (representing roughly 14 percent of the agencies' annual revenues) are collected for water withdrawal, based on the volume of water abstracted (measured or estimated) and on coefficients of various types of water usage. Resource fees vary depending on the geographic area, seasonality of usage, etc. Grants provided by the basin agencies range from 15 to 50 percent of the capital costs, while low interest rate loans range from 20 to 50 percent (Bower, et al, 1981). The size of subsidies depends on the type of project, the beneficiary and the zone in which the project is to be implemented. In addition to subsidies from the basin agencies, the national government may also provide subsidies or grants to public entities. Investments in water quality improvement represent the majority (about three fourths) of financial outlays. Typical projects financed from the funds are municipal and industrial waste treatment, toxic pollution control, and interceptor sewers. Municipalities receive the bulk of the subsidies. the timing of investments and accelerated Financing schemes through earmarked polluter response to environmental regula- environmental taxes have been created tions. with the purpose of tackling media-specific or local/regional environmental problems. The main contribution of the public sector These earmarked mechanisms have not to PAC expenditures has come from public played a major role in the environmental enterprises, whose revenues are financed financing systems of OECD countries. In from user charges, occasionally supple- some cases when direct environmental mented by central government subsidies taxes have been earmarked, incentive directed to municipalities. There has been effects also appeared supplementing the a trend towards greater cost-recovery. This primary revenue raising functions. The has increased the efficiency of collective advantages of earmarking have been treatment services, and led to the use of greater in local/regional financing schemes, market-based financing mechanisms. when a dose relationship exists between the source and spending of revenues. 20 Environment Department Papers OECD Countries Box 11 The Consolidation of Earmarked Charges in the Netherlands Charges for air pollution, chemical waste, traffic and industrial noise were formerly earmarked in the Netherlands to finance environmental programs in the area where the revenues were raised. The practice of different environmental programs, each charge financing only part of the environmental investments, led to a nontransparent, fragmented, inflexible environmental finance system. In response to the need for a more integrated financing system, the various types of product charges were consolidated in 1988 into a single charge levied on fuels (in 1990, the sulfur-dioxide tax was also incorporated into the fuel charge) that was considered to provide a general link with pollution. Clearly, the purpose of the fuel charge was revenue raising rather than creating pollution abatement incentives. Since the previous taxes on air pollution and traffic noise were already based on the same fuels, the transition was carried out with little change in the country's energy policy or in the effect the taxes had on polluters. The more general the charge became, however, the less sustainable the earmarked system was. Additionally, the character of the charge changed from a specific financial instrument to a taxation instrument Therefore, earmarking was eliminated in 1992. The revenues of the previously earmarked fuel charge now accrue to the general budget, and the allocation of funds for environmental expenses takes place in the normal budgeting process. PAC expenditures data refer to investments and current expenditures directly aimed at environmental protection. Due to difficulties estimating the share of expenditures that is due to PAC requirements, differences in interpretation, definition and data collection, reported figures may not be comparable across countries. 2 The program came into effect in 1989, with a five-year mandate. a The Revenue and Expenditure Control Act of 1968 effectively eliminated industrial revenue bond financing except for small issues and pollution abatement financing. Environmental Economics Series 21  3 Transition Economies Macroeconomic Policy Framework tion in public enterprise autonomy, break Central planning severely restricted and cpettio tat m poves anageme distorted the function of markets. The gov- pra it a reso e se; ernment as the owner of production means concentrated in large public enterprises, Monetary reforms introduce tight control established production targets but didn't hold over money supply and eliminate interest enterprise managers responsible and account- rate subsidies, resulting in a reduction in able for technically and commercially efficient capital-intensive investments, more realistic operation. Cost-plus price controls generally valuation of resources, and changes in the assured profits for public enterprises without economic structure in the long term (par- the risk of being displaced by less costly or ticularly the decline in the share of the more innovative competitors. Inefficient management and operation of productive assets led to stoppages, breakdowns, and Fiscal policy reforms reduce subsidies and inadequate housekeeping practices, contribut- price controls, and create a more efficient ing to excessive levels of pollution. The tax system, resulting in more efficient emphasis on heavy industries combined with resource use and less pollution intensive highly subsidized energy and raw material practices; and prices led to very low energy-efficiency, wasteful use of resources and high pollution Trade policy reforms change protectionist intensity. In order to support domestic foreign trade policy, by eliminating the industrial development, high import protec- over-valuation of exchange rates and tion was introduced and external price signals reducing trade restrictions, resulting in didn't reach domestic economies. Underde- efficiency increases due to increased import veloped financial systems relied on a domi- competition and increased import of nant central bank that, as an agent of the deaner technologies. government, allocated credit according to central plans. Not all the effects of economic restructuring and macro-policy changes are environmen- The transition from central planning to tally positive. The environmental effects of market-oriented economies that started in macro-policy measures greatly depend on the most countries of Central and Eastern Europe coherence of structural adjustment. Negative (CEE), the former Soviet Union (FSU) and environmental affects occur when reforms are China in the late 1980s, introduces complex not fully coordinated', and market failures are macroeconomic reforms that are expected to not addressed comprehensively (Munasinghe generate positive environmental changes: and Cruz, 1994) - for example, darification of property rights concerning natural re- * Public sector reforms decrease the dominance sources such as forests and fisheries. of public enterprises, reduce state intervean- Environmental Economics Series 23 Financing Pollution Abatement Theory and Practice Box 12 Setting Emission Charges in Russia Ambient standards (maximum permitted concentrations (MPCs)) were established during the former Soviet regime, based on the requirement of zero damage from pollution sources to human health, demonstrating the idealistic objectives of Soviet-type legislation. In practice, the permanent emission limits determined to achieve MPCs had to be supplemented by temporary emission limits corresponding to the technological and economic capabilities of the society. Environmental damage calculations undertaken from the early 1970s created the basis for the emission charge system, that was gradually introduced starting from 1988 (NAPA, 1994). During the experimen- tal phase, large differences existed between regions in the methodologies of calculating charges, and also in actual charge levels. Emission charges for carbon-monoxide, for example, showed variation in the order of several hundred between the cities of Perm and Dnepropetrovsk (Ukraine). The national charge system introduced in 1991 included some 200 base rates for both air and water pollutants (Lvovsky et al, 1994). The rates were determined by using MPCs, and reflected the desire to centrally evaluate and mitigate environmental health and other pollution risks. Regional characteristics such as background pollution and the assimilative capacity of the ecosystem were expressed by coeffi- cients determined by national regulations (MEPNR, 1993). Despite the intention to create corrective taxes that induce optimal pollution levels, charge rates were calculated merely to yield enough revenues for mitigating damage. The present system of charges in Russia is a combination of noncompliance penalties and emission charges. The base emission charge system applies when discharges are within maximum permitted levels, set according to MPCs. Charges increase considerably (up to 5 times) for discharges between the maximum permitted and temporary permitted levels, and yet even higher are the penalty charges for emissions beyond the temporary permitted levels (up to 25 times the base rates). The level of charges, however, is still very low (even in the highest category), and doesn't meet the objective of inducing optimal pollution levels. Since 1992, agreements between polluters and the environmental protection authorities create the legal basis for the collection of pollution charges. Such agreements specify (i) the permitted level of dis- charges; (ii) base rates and penalty rates for each pollutant discharged; and (iii) the schedule of charge payments. Source: NAPA, 1994; Averchenkov, 1994 Environmental Policy Framework - principles rather than guidelines to set prior- The Legacy of Central Planning ties and resolve conflicts. Their implementa- tion and enforcement were less important Transition economies inherited a unique than the declaration of commitment to these environmental policy framework that empha- ideals. The good intentions frequently re- sized overly ambitious and strict environmen- mained unfulfilled and laws unenforced. tal quality objectives (ambient standards), supported with relatively weak capabilities of The need to address the problem of environ- policy implementation and enforcement. The mental degradation in a more effective way combined effects of market and administra- and provide a financing mechanism for tive failures during central planning increased environmental protection became acute in the the social costs of pollution and excessive use 1970s-1980s. in response, several countries of natural resources, and led to serious increased the responsibility of enterprises for environmental deterioration. Environmental pollution abatement. Some countries (Bul- deterioration contradicted the environmental garia, Hungary) introduced non-compliance quality objectives manifested in strict ambient fines, and others created a framework of standards and basic environmental laws corrective taxes. In Poland, for example, enacted in some countries as early as in the environmental fees were introduced in the 190s.1970s with the declared intention of motivat- and laws represented a set of idealisticriori- systemr of environmental fees in the Soviet 24 Environment Department Papers Transition Economies Box 13. Industrial Pollution Abatement Financing in China Financial resources for industrial pollution abatement come from various earmarked sources in China: * Capital Construction Funds (CCFs) accumulated from 7 percent of new investment costs designated for pollution control; * Technology Renovation Funds (TRFs) or depreciation funds that carry out the rehabilitation of existing technologies, 7 percent of which should be spent on pollution control; * Comprehensive Utilization Profits gained from utilization of waste are allowed to remain in the industry instead of being transferred to local finance bureaus; * Environmental Funds (EFs) accumulated from pollution charges and fines at local environmental protection bureaus. Eighty percent of total environmental levies is earmarked for industrial pollution control investments. The largest share of industrial pollution abatement investments (45 percent in 1990) is financed from CCFs and TRFs. Other environmental investments are financed from industrial bank loans, and also from grants or loans from EFs. Since 1986, the role of soft loans as opposed to grants has increased among the expenditures of EFs. However, upon completion of pollution abatement projects, many polluters have been given exemption from repaying the loan. The system of pollution control financing in China exhibits the characteristics of revenue allocation under central planning. Enterprise resources are designated to centrally determined purposes. The practice of legally mandating the use of 7 percent of investment and amortization funds for pollution abatement, for example, (i) leads to inefficient resource allocation among polluters; (ii) favors capital investments over other pollution abatement measures; and (iii) doesn't promote the effective operation and maintenance of abatement technology. Source: NEPA, 1992 Union was based on a complex economic integral part of a public financing system that valuation methodology trying to estimate the provided all the capital needs of enterprises value of environmental damages, and setting by centralizing and redistributing enterprise charges accordingly. Under central planning, revenues (see Box 13.). Typically operating as however, enterprise managers had very off-budget mechanisms, NEFs blurred the limited authority. Inputs and outputs in the distinction between the budgetary tasks of the production process were externally deter- government and the financing tasks of enter- mined, and profits centralized and reallo- prises. They became supplements to the cated. Decisions about investments were budgetary revenues of the central environ- made centrally, and enterprises became mere mental protection authority, with a complex executors of the central plans. In addition, mandate to finance (i) institution building and political pressure discouraged environmental strengthening of the environmental protection protection authorities from introducing truly authority; (ii) R & D activities in pollution incentive charges. As a result, pollution control technology and development; (iii) charges couldn't effectively change the environmental education, information collec- behavior of polluters, and served merely as tion and dissemination; (iv) nature and revenue raising mechanisms, earmarked biodiversity conservation; (v) public environ- through comprehensive national environmen- mental services (such as wastewater treat- tal funds (NEFs). ment); and (vi) pollution abatement invest- ments in commercial activities. NEFs, as one of the numerous earmarked mechanisms operating in the fiscal systems of The development of the private sector, public centrally planned economies, became an enterprise restructuring, and tightening Environmental Economics Series 25 Financing Pollution Abatement Theory and Practice budget constraints are changes that shift poor understanding of cost-effective financing decisions from the center to the solutions make decision making subopti- enterprises. Environmental improvements are mal; and increasingly financed from private resources in response to the combined effect of incentive policy instruments, environmental regulations don't influence effectively the political and enforcement. Commercial banks are decision making process. transforming themselves from passive allocators of credit who simply follow govern- fianin throg riate sorea ment instructions into real financial institu- tions. As a result, the role of enterprises in budgetary allocations remains insufficient to financing environmental investments is achieve socially desired environmental quality expected to increase dramatically in the long goals, and comprehensive NEFs have pre- term. In the early stage of transition from served their role in the environmental policy centrally planned to market economies, systems as important factors in environmental however, there are several factors that con- financing of most transition economies. Even strain the evolution of an effective environ- new NEFs have been established in some mental financing system: countries. Earmarking environmental levies have made them politically more acceptable * Changes in enterprise behavior typically lag due to the connection between tax payments behind the introduction of macro-economic and environmental expenditures. changes and incentives; SWeaknesses of the environmental policyin pollution abatement * Wekneses f th enironentl poicyfinancing varies widely. More mature NEFs framework: taxes, regulations and enforce- (for example in Poland) with large revenue ment are not effective enough to induce sources finance the bulk of environmental private and enterprise investments to reach investments, while others appear to be less the desired level of pollution abatement; dominant, but still significant. The impor- * The failure to recover full costs of public tance of NEF in environmental expenditures environmental services creates large appears to be growing in most countries. In financing need; Russia, for example, the share of NEFs in capital investments for pollution abatement * Severe financial constraints at industrial increased from 6.6 percent in 1990 to 29.6 enterprises delay the replacement of percent in 1991. In Poland, the share of NEFs outdated, polluting technology; from total environmental expenditures increased from 2 percent in 1990 to 22.3 * The slow pace of privatization hinders percent in 1993 while the contribution of positive changes in management practices; regional funds to total expenditures showed a * Insufficiencies of the banking system create similarly strong increase. The significant credit shortage and rationing, severely eediunicates thenlomcot-o limiting access to financial resources; epniue niae h o otrcvr limiingacces t finncil reoures;of public environmental services, and share of * Underdeveloped capital markets constrain enterprise and private pollution abatement the use of advanced financing instruments; financing is generally low. * Environmental issues are frequently Due to similarities of history, institutional neglected in the political decision making framework, and economic and environmental and budgeting process; problems in transition economies, the opera- " Chngig fsca sytemsreslt n uceraintion of NEFs exhibits similarities. Differences * Changing fiscal systems result in uncertain are determined, among other factors, by (i) the revenue raising capabilities at various state of domestic economy; (ii) the develop- government levels;ment of private sector; (i) the political * Inadequate information on the extent and commitment to address environmental social costs of environmsental damage, and problems; (iv) the development of domestic financial and capital markets; (v) the sources 26 Environment Department Papers Transition Economies Table 4 Main Characteristics of Environmental Funds in Selected Transition Economies in 1993 Sources of revenues Size of Contribution Main expenditures Disbursement (% of total revenues) revenues to total (% of total mechanism (U.S. SM) environmental expenditures) (% of total expenditures (%) disbursement) Bulgaria pollution fines (58); 2-3 7 monitoring (40); grants (68); import tax on used cars (33) loans to enterprises (32); interest-free other (9); public services (19); loans (32); Czech water charges (41); 107 10 water projects (58); grants (71); Republic air emission charges (30); air pollution control (33); soft loans (29); waste charges (13); other (9); land charges (12); Estonia water pollution charges (35); 1.7 10 public environmental grants (50); waste disposal charges (35); services (50); soft loans (25); air pollution charges (18); loan guarantees for loan other (12); enterprises (25); guarantees (25); other (education enforcement) (25); Hungary fuel tax (44); 27.7 11 air pollution control (70); grants; traffic transit fee (20); waste management (15); interest-free loans; PHARE grant (19); water pollution other soft loans; pollution fines (17); control (11); other (4);' Poland air pollution charges; 515 58 air pollution control (47); grants (17); water pollution charges; water pollution control (35); soft loans (77); water use charges; other (soil protection, loan interest waste charges; monitoring, eductation, etc.) (18); subsidies (6); Russia pollution charges (83); 84 NA capital expenditures for grants; claims for damages (7); pollution control (24); fines (2); current expenditures (11); other (8); R&D (7); institution building (28); bank deposits (22); other (8); Slovak state budget (37); 34.7 20 water pollution abatement (48); grants (99); Republic water pollution charges (30); air pollution abatement (27); loan interest air pollution charges (25); waste management (8); subsidies (1). other (8); other (17); Sources: Averchenkov, 1994; REC, 1994; Personal interview with Eva Krav, Chairperson of the National Board of the Estonian NEF. Doesn't include the Water Management Fund. and size of NEF revenues; and (iv) the matu- Hungary), and emission charges (in Clina, rity of NEFs. Czech Republic, Estonia, Poland, Slovak Republic and the Russian Federation). Addi- The Role and Characteristics of tional revenues are raised from product Comprehensive National charges (for example, fuel tax in Hungary), ompreesi'veother environment-related taxes and levies Environmental Funds (for example, transit traffic tax in Hungary, Revenuesimport tax on used cars in Bulgaria), and Revenuesother sources (for example, external sources The sources of NEF revenues are non-compli- from the PHARE program in Hungary, state ance fines (for example in Bulgaria and budget in the Slovak Republic). Although Environmental Economics Series 27 Financing Pollution Abatement Theory and Practice Table 5 Sources of Environmental Expenditures in some Transition Economies in 1993 (percent) Bulgaria Czech Republic Estonia Hungary Poland State budget 46 29 20' 48 5 Municipalities 2 612 30 10 Enterprises 343 8 23 NEFs 7 10 10 1 58 Other 115 706 3 4 100 100 100 100 100 Source: REC, 1994 Includes municipal and enterprise expenditures. Includes enterprise expenditures. Mainly state-owned enterprises. Excludes expenditures from the Water Management Fund. EC PHARE program. Foreign assistance. fines and charges are set in proportion to the Even if emission charges were increased to damage caused, their level is rarely high higher, more efficient levels, the cost-effective- enough to achieve more than raising revenues. ness of the system would be questionable. In Estonia, for example, the charge for sul- Increased real level of charges levied on a phur-dioxide emissions below permitted smaller number of pollutants would be more limits is set at $0.05 per ton, for carbon- desirable. Direct regulations would be more monoxide at $0.008 per ton (Kallaste, 1994). effective for other pollutants that are hard to The Polish example shows, however, that detect and monitor (for example, heavy charges can be increased considerably if there metals). is a political will. At $72 per ton, emission charges for sulphur-dioxide (Zylicz, 1994), for The principle of measuring and charging for example, are likely to have substantial incen- actual damage is further compromised by (i) tive effects in Poland (the marginal abatement the centralized determination of charges with cost in the U.S. set by the market is about $150 limited differentiation among regions; (ii) (Selling..., 1994), and enterprises in Poland severely constrained capabilities to reliably may be at a flatter part of the pollution monitor even a limited number of pollutant abatement curve due to the large potential for discharges; (iii) ineffective tax collection; (iv) management, operation and maintenance widespread exemptions; and (v) the dilution improvements). effect of inflation. Centrally determined charges are incapable of reliably approximat- Emission charges are typically levied for a ing environmental damage and, there is large number of pollutants, making the mismatch between revenues and the financing administration of the system overly compli- need at local and regional levels even with cated. In Russia, for example, charges are set decentralized revenue allocation schemes. for 217 air pollutants, and 198 water pollut- Given the serious constraints of monitoring ants. Although such a complex set of charges capabilities, most typically, charges are based may try to effectively approximate the dam- on discharge estimates rather than actual age caused, the large administrative costs measurements, that greatly reduces their compared to the current low levels of charges effectiveness. Due to economic hardship and and revenues make the system inefficient. lax enforcement, the efficiency of revenue 28 Environment Department Papers Transition Economies Box 14 Emission Charges in Poland Environmental charges were introduced in Poland in the 1970s, with the intention of influencing the behavior of polluters. Although fee levels were increased several times during the central planning era, their effects were counterbalanced by the lack of financial motivation of economic actors, mainly state owned enterprises facing budget constraints. Environmental authorities utilized a political opportunity during the collapse of the old regime to strengthen the role of environmental charges by increasing their real levels, pegging them to the official inflation index (later changed to predicted inflation rate pegging), and changing collection frequency. As a result, some charges have the potential to provide significant incentives to abate. In most cases, however, charges are below the estimated damage functions, and site-specific damages are not reflected in a satisfactory way (Zylicz, 1994). Charges are levied on a high number of water and atmospheric pollutants, the reliable monitoring of which exceeds available capacities. As a result, levies are frequently challenged by polluters. However, it also provides motivations to monitoring agencies to upgrade their capabilities. collection is low. In Poland, for example, only economies are being introduced. The budget- 65 percent of imposed charges were collected ing process is slowly changing, however, and in 1993 (REC, 1994). Another characteristic of still shows the characteristics of central NEFs is the ability of polluters to negotiate the planning in many countries. The lack of payment of pollution charges. Polluters in functional and economic classification of many countries may be totally or partially expenditures, for example, often skews exempt of taxes if they undertake pollution transparency and economic analysis. Addi- abatement investments. Considering the tionally, extensive political and fiscal decen- outdated technology of many industrial tralization is taking place. enterprises in these countries, investments in technology update lead to considerable The autonomy over local matters is increas- reduction of pollution and qualify for pollu- ingly being decentralized. However, despite tion tax exemption. Consequently, collected the expenditure autonomy assigned to tax revenues are substantially reduced (in subnational levels of governments, their Russia, for example, about one-fourth of the autonomy on the revenue side is frequently taxed amount is not collected due to exemp- curtailed. Additionally, the adjustment of tions). Finally, since many transition econo- user charges in the public environmental mies experience high rates of inflation and the sector depends on national reforms of social pollution fee systems are generally not in- protection systems due to the traditional dexed (Poland is the only exception), the distributional functions of these charges. dilution of revenues creates another problem Setting charges right is further constrained by for NEFs (Table 6). political resistance and weak accounting systems. The adjustment of prices for public Public Pollution Abatement Financing sector services has been very sluggish even in The transition from central planning to market countries where national price reforms Tetnsitio fromlitated ce nttliongl tom liberalized private sector prices and public economies, facilitated by institutional reform sector pricing appears likely to be one of the process, changes the role of government, last areas to be reformed in most countries Traditional revenue sources, expenditure (Bird and Wallich, 1993). It has been esti- structures and the organizational framework mated that in some transition economies, of financial flows are changing dramatically. rasn the icsof publitiliesoost Tax dmiistatin, ccoutin, aditng,taxraising the prices of public utilities to cost Tax administration, accounting, auditing, tax recovery levels could cost households more collection and enforcement procedures, than 50 percent of their average household compatible with requirements of market income (Schiavo-Campo, 1994). Therefore, Environmental Economics Series 29 Financing Pollution Abatement Theory and Practice Table 6 Changes in the Real Level of Emission Charges in Russia (1991-93) 1992 1993 Adjustment of Emission Charges (1991=1) 5 25 Ruble/U.S. $ Exchange Rate (1991=1) 12.50 48 Ratio 0.4 0.52 Source: Averchenkov et al., 1994 while responsibilities for providing services system, monitor and enforce compliance have been transferred to local levels, fre- with regulations, and collect taxes. Up- quently, the central governments set uniform grading monitoring systems in priority prices due to equity considerations. areas, where high ambient concentrations of certain pollutants expose the population As extra-budgetary funds, NEFs are not to high health risks, and the monitoring of affected by the fluctuations of normal budget the disposal of hazardous, toxic and revenues. By design, NEFs can tackle a wide nudear wastes should receive high priority. range of environmental problems in a compre- Improverents in the maintenance and hensive way at various levels of governments. operation of existing equipment should be Realistic environmental objectives and clear carried out before new investments are financing priorities should, therefore, guide financed. Improvements in information NEFs to allocate resources to those areas that analysis and reporting should involve most effectively speed up positive environ- coordination with various levels of govern- mental processes. The following areas, ment agencies. Applied research should be therefore, are expected to receive high priority funded in high priority areas to find cost- in NEF spending structures: effective solutions to environmental prob- Improvement of the environmental policy lems (for example, groundwater protection framework.from nitrate contanation, prevention of frameork.ecological damage caused by large-scale Strengthening of enforcement capabilities. development projects). NEFs should ensure that environmental improvements are sustainable. In order to Financing of high priority public pollution improve enterprise compliance with abatement programs and services. environmental regulations, and increase the role of environmental financing from Abatement ofpollution from non-point sources. private sources, NEFs should contribute to NEFs may play a significant role in areas the development of an effectively operat- where private benefits of pollution abate- ing, independent environmental ment are not enough to compensate for the inspectorate system. The organization of full cost of investments, or pollution inspectorates should ensure their freedom abatement is hard to measure and control. from political influence and isolation of Such area is, for example, the protection of industrial pressures. groundwater reserves from contamination. Solutions to this type of problems generate Upgrading of information systems. Reliable both public and private benefits, and environmental information is necessary for household resources available to pay for an effective environmental policy frame- the pnvate benefits can be effectively work: information is needed to set priori- mobilized by NEFs supporting these ties, design a well functioning emission tax environmentally beneficial investments. 30 Environment Department Papers Transition Economies Table 7 Projects Supported from NEF Expenditures in the Czech Republic During 1992-93 Number of projects Value of projects (U.S. $M) Wastewater treatment plants 154 (30%) 113 (51%) Municipal fuel conversion program 116 (22%) 22 (10%) Fuel conversion in district heating 88 (17%) 30 (13%) Air pollution abatement 34 (7%) 13 (6%) Solid waste management 19 (4%) 5 (2%) Waste incinerators 5 (1%) 6 (3%) Other 96 (19%) 34 (15%) Total 512 (100%) 223 (100%) Source: REC, 1994 Reinforcement of the impact of macroeconomic wastewater treatment and solid waste policies. In response to the incentive effects management facilities. However, large of macroeconomic policy reforms, behav- public investments are seldom cost-effec- ioral changes are expected to result in tive solutions to environmental problems in positive environmental impacts. Fuel price CEE (see EAPCEE, 1993) and, therefore, changes and technical development, for should be supported by NEFs on an excep- example, have led to the replacement of tional basis only. Such support can be coal for gas in households, district heating justified if (i) investment in public facilities systems and small-scale industries in many is a cost-effective alternative to solve an large cities in the world, contributing to environmental problem; (ii) NEF funding is significant improvements in urban air the best available alternative2; (iii) matching quality. However, behavioral changes in contribution is provided from the munici- response to market incentives (for example, pality or locality; and (iv) cost-recovery the reduction of fuel price subsidies leads criteria can be satisfied. to energy saving investments) may be sluggish. Therefore, NEFs can play a In practice, NEFs don't appear to support the catalytic role in accelerating the adjustment most stressing environmental problems in of polluter behavior by mobilizing private transition economies. Although air pollution resources. in big cities is the a main health threat in most Central and Eastern European countries Priority public pollution abatement services. (EAPCEE, 1993), a large proportion of fund Most public environmental services are resources are used to finance capital invest- provided locally and are expected to be ments in water pollution control (for example, increasingly financed from user charges. 58 percent in the Czech, 48 percent in the However, due to slow changes in cost- Slovak Republic, see: Table 7, and REC, 1994). recovery and the uncertain revenue raising Few NEFs seriously support the improvement and allocating capabilities of local adminis- of environmental policy framework. National trations, increased pressure is put on NEFs environmental strategies (if they exist) fre- to support investments in public environ- quently fail to provide practical guidance for mental services such as the construction of NEFs to set their spending priorities. As a Environmental Economics Series 31 Financing Pollution Abatement Theory and Practice result, long "wish lists" are created and any through sector ministry budgets, pollution project with some positive environmental abatement investments are being neglected impact may receive support. Some funds due to the weakness of environmental man- allocate their resources on a "first-come-first- agement framework. For these enterprises, served" basis. Cost-effectiveness criteria support from NEFs, therefore, may be justi- don't appear to have much influence on the fled on a temporary basis.3 However, NEF selection of projects. should only have a limited mandate in enter- prise financing during the transition period Enterprise Pollution Abatement Financing with the following conditions: In the central planning system, enterprise Clear environmental priorities should investments were financed from designated guide revenue allocation focussing on sources, and blurred responsibilities charac- highly polluting industries or "hot spots" terized government-enterprise relationships. only; In this system, NEFs served as one of the designated financing channels fulfilling a dual - NEFs should contribute to the strengthen- role of budget and enterprise financing. As ing of enforcement capabilities parallel with long as state ownership of enterprises doi- enterprise support to change enterprise nated, and resources were centrally controlled behavior; and allocated, the contradiction between these - With their financing role, NEFs should roles did not become apparent. The reform facilitate a long-term partnership between process, however, increases the role of the industries and the environmental policy private sector, changes government-enterprise authority using a carrot-and-stick ap- relationships, and increasingly delegates investment decisions to the micro level. Due to tightening budget constraints, enterprises NEFs should mobilize enterprise resources are expected to rely more on their own by requiring matching investment funds (i) retained earnings and on the financial markets to ensure the commitment of enterprises; for investment resources. As a result, the and (Ji) to avoid the moral hazard of controversial functions of NEFs vis-a-vis the enterprises deferrng investments in enterprise sector have to be clarified and anticipation of support; streamlined during the transition. stremlind dringthe ranitio. -Eligible enterprises should be financially Transition economies have a large portfolio of viable with positive net present values of inefficiently operating public enterprises. future operations; Although privatization of the public sector is NEFs should facilitate changes in the under way, it is dear that (i) the process of privatization takes much longer than previ- managemenandoerationoenterpris ously anticipated; and (ii) several large, highly by ic-ning envion t aui polluting industrial complexes will stay ini thaseni ot solutions state ownership for long periods of time in thejassessmetiof alternaivemsuin without sufficient financial resources to in project evalution; undertake investments. Most economies in transition attempt to restructure and provide NEFs should require the use of environ- budgetary support to these enterprises. In mental assessment methods in project many cases, liquidation is rejected due to preparation, enhancing enterprise capital social reasons (mainly to avoid large unem- ployment). State-owned holding companies have been established in some countries to Specific environmental improvements manage the portfolio of public enterprises and should be conditions of financing and their to restructure individual companies to in- attainment and maintenance should be crease their efficiency. While most of the monitored; budgetary support for the restructuring of state owned enterprises are channelledee 32 Environment Department Papers Transition Economies Box 15 Financing Categories of the Central Environmental Protection Fund (CEPF) of Hungary The CEPF categorizes environmental investments into four groups: * Profitable investments are environmental investments that generate profit These are eligible for a credit guarantee up to 70 percent of commercial credit amount from CEPF; * Cost-saving investments that save costs (for example, by reducing emission charges or fines) to cover part of the investment and operating costs. These can be financed by interest free or low-interest credit from CEPF (CEPF interest rates vary from 60 to 120 percent of the central bank base rate); * Revenue-generating investments that cannot cover the costs of investments and operations. Environ- mental impacts rather than financial return are the main criteria of project evaluation in these cases. All types of support can be extended. * Not revenue-generating investments are generally eligible for grants or interest-free loans or their combinations up to 60 percent of the investment costs. Source: CEPF, 1994 In addition to their public financing role, Commercial banking operations may several NEFs have shifted their operation to overshadow or overtake NEF's main quasi-commercial banking by financing function of environmental financing; profitable investments with positive environ- mental impacts. During a period when the Banking operations create a self-perpetuat- economy is restructuring and obsolete tech- ing function for NEFs without improving nologies are replaced by new, modem and the effectiveness of environmental policy environmentally cleaner ones, a large share of and financing. profit-maximizing investments have signifi- cant environmental benefits ("win-win" Therefore, the finance of profitable invest- investments). Such investments, however, are ments and commercial banking operations mainly driven by market forces, rather than should not be undertaken by NEFs and better by environmental requirements. By financing be left to the banking system. "win-win" investments, NEFs are simulta- neously (i) correcting financial system failures; Disbursement Mechanism and (ii) subsidizing certain environmentally In the early stage of NEF operations, enter- friendly investments. Although public outlays prise subsidies were distributed mainly as in order to compensate for market imperfec- grants. The reforms immediately before and tions (for example the failures of the financial during transition intended to increase the system) can be justified during the transition financial independence of enterprises, and to support private initiatives, NEFs are not the their awareness of the costs of capital. Subsi- best choice since: bestchoie sice:dies that didn't cover the full amount of * NEFs have no special expertise or advan- investment costs, had to be supplemented by tage in carrying out banking activities; own resources or commercial bank loans. However, the immaturity of the commercial * NEFs handle public money that should not banking sector in central planning and during be exposed to commercial risk; transition have constrained access to borrow- * NEFs are not subject to banking supervi- g, sion and regulation, therefore, there are example soft oaninreaedhisar fr limited checks and balances built into their 5apeent o 68prcenthi 1991 (NPm operatio; 5 pefuntin of8 enionm pent financi1N PA 1992), and in the Czech Republic, from 6 Environmental Economics Series 33 Financing Pollution Abatement Theory and Practice percent in 1992 to 28 percent in 1994 (REC, example, in environmentally friendly tech- 1994). The share of soft loans is highest in nologies or in the acceleration of conversion to Poland (77 percent in 1993, see: REC, 1994). cleaner fuels in households. The experience of OECD countries shows that directed credit However, there is no a-priori advantage in programs have been frequently used in using soft loans as opposed to grants to developed countries to temporarily support, allocate public resources. The same amount for example, the introduction of new technolo- of subsidies can be provided either way. The gies in the private sector. Such programs, provision of soft loans rather than grants have however, should be connected to strong reduced the transparency of NEFs and re- enforcement of environmental regulations in quired banking expertise that NEFs lacked order to change enterprise behavior and badly. In response, some (for example, the mobilize enterprise resources. Further, Hungarian) NEFs delegated their banking environmental improvements don't necessar- operations to the commercial banking system. ily require large capital investments. Old Others (for example, in Bulgaria), have central planning practices that tended to decided to undertake the task themselves. emphasize the role of investments and ig- This has imposed large administrative bur- nored the importance of efficient operation dens on the NEFs, and created numerous and management, have to be re-evaluated and inefficiencies. Setting up a lending program low-cost alternative measures identified. Eco- rather than providing grants has also unneces- banks are not strongly motivated to support sarily tied up financial resources, as the this process and facilitate a change in invest- subsidy had to be spread over the lifetime of ment-biased enterprise behavior. Addition- the loans (in the form of the difference be- ally, backed with the steady revenue flow of tween market and subsidized interest rates). environmental funds, eco-banks don't face the same scrutiny as normal banks do. Besides Generally, banking operations should not be one-time capitalization, equity contribution of undertaken by NEFs, and better be left to the NEFs to Eco-banks should be restricted. banking system. If NEFs decide to provide Finally, without dearly defined mandate and soft loans rather than grants, they should financing objectives, sub-optimal resource minimize their exposure to commercial risk. allocation and distortions in the financial For example, reimbursing the difference system may occur. Eco-banks, therefore, are between commercial and subsidized interest not a preferred form of pollution abatement rates to the commercial banks that extend financing, should have a limited mandate, and loans for environmental projects, is preferable transform into normal commercial banking to direct loans. Seconding lending operations institutions. to commercial banks (i) helps to spin off banking functions where NEFs have no The proliferation of earmarking is characteris- expertise; (ii) introduces environmental tic of the operation of most NEFs. Revenues evaluation techniques into bank project derived from certain groups of polluters are assessment; and (iii) imposes more rigorous earmarked to be returned to the same group, regulations and supervision on the financial or sub-funds are established for further operations. earmarking. In Poland, for example, re- sources transferred to the NEF from provinces Some NEFs have made steps to separate some are kept on separate sub-accounts, while of their commercial banking functions by functional earmarking exists for charges to be founding ecological banks. In Poland, for recycled for pollution abatement concerning example, the NEF was co-founder of the saline coal mining waters, and atmospheric Environmental Protection Bank, in the Russian sulphur dioxide and nitrogen oxide emissions. Federation, 80 percent equity contribution was In Hungary, revenues from the fuel tax can provided from NEF resources to the capitali- only be spent on investments in traffic-related zation of the National Bank for Environmental pollution abatement, and several windows are Protection (Econatsbank). Eco-banks may established for different spending categories. facilitate investments in priority areas, for In the Czech Republic, revenues are pre- 34 Environment Department Papers Transition Economies earmarked according to their origin both by Institutional Issues media and geographic regions: charges for air Most typically, the management of NEFs is pollution are used to support air pollution abatement programs, and 60 percent of the ain o th centr ermenthe prote- funds are returned to the area or region where tro od Enrussial f o ale,tMni the revenues originated from (REC, 1994). In Resources has control over the funds through China, enterprises are entitled to receive its committees at various government levels; subsidies from the fund up to 80 percent of i H the NEF is one of the depart- the emission charges paid. Such dose ear- ments of the MOE; in Bulgaria, the work of marking prevents the funds to reallocate the NEF is carried out by various departments revenues according to immediate priorities, of the MOE with one department functioning while potential advantages (political support as coordinator. The role of the environmental of charges, matched revenues and expendi- minister is generally significant in appointing tures, transparent allocation) of close relation- the directors of NEFs, approving the guide- ship between revenue sources and uses (a ines for NEF operation, and making fnal characteristic of the French River Basin decision about resource allocation. Even in Management Agencies) are largely lost due to Poland, where the NEF was established by the (i) the complicated bureaucratic process of arliament as a structurall independent revenue collection and reallocation; and (ii) i o mu the lack of transparency inare appointed (and can be recalled) by the and revenue allocation. environment minister. Frequently, NEFs don't spend all the revenues Close connection to the MOE underlines the available to them. Averchenkov (1994) reported, for example, that large parts of the publi fianing tion of nEFs. Alhog earmarked resources of NEFs at the regional itfailta the obteation nioal en levels in the Russian Federation remained roetol objEct an rities o unspent in 1993. The unused amount was 67 teoperatin o NEF,t a blurtinso percent of the total resources, for example, in r e e f bg oration s Tyumen, 62 percent in Tver, and 54 percent in Soe dewee of s an the Murmansk regions. Similar situation was nsrybten te manament of the reported from Poland (REC, 1994): despite Enviret pr n dyndhateofeth increasing revenues of the NEF during 1992- Nein ordet d disinui n 93, its expenditures decreased. While 92 theirdroes, and decson makig percent of NEF resources were spent in 1992, preure and orc otenti only 70 percent was disbursed in 1993. Such phenomenon may be the result of the lack of Parallel with the gradual decentralization of (i) dear priorities and spending strategies; (ii) political and fiscal systems, NEFs established viable investments under current conditions; nationally may decentralize their revenues to or (iii) information about investment options. regonal or local levels. The collection and Unspent NEF resources create a serious cash di management problem, especially under high disbremnt of revenues , the r r inflation conditions. The practice of the Polish re gnao any heve,the rl of NEF of equity investment in "environmentally renuelgenerin n ations of ope friendly" ventures may indicate an attempt to Russian Federation and Belarus, for example, invest excess cash rather than being the environmental funds receive 90 percent of outcome of an established strategy for rev- total environmental revenues (10 percent is enue allocation. The practice of not fully accrued to the budget) that is divided among spending NEF resources also points out one of national (10 percent), regional (30 percent) and the main weaknesses of earmarked financing local (60 percent) levels. In Bulgaria, 70 mechanisms: NEFs manage idle funds or invest suboptimally while other, socially pere there fo on-complianc worthhile rogras mayremaiunfude. Insitutionasuerrdts aioa,ad3 percent to municipal levels. The greater Environmental Economics Series 35 Financing Pollution Abatement Theory and Practice freedom is provided to regional and local Hungarian NEF requires the repayment of authorities in operating the funds, the closer financial support and interest charges by NEF the relationship between the source and use of beneficiaries if expected environmental revenues is. With decentralized revenue improvements are not achieved. allocation, the spending structure of NEFs at the national level are likely to shift towards The movement toward market economy is international and global environmental frequently associated with a trend toward problems, while funds at local and regional more political freedom and democracy. In the levels may become more involved in financing public finance and budgeting process, two environmental programs of local and regional features are expected to be strengthened: (i) character, transparency ensuring that main stakeholders are involved in decision making; and (ii) When national NEF systems decentralize the accountability ensuring that services are allocation of revenues, local and regional delivered in an efficient and effective manner authorities have no control over the determi- by creating a system of checks and balances. nation of charges (although there are incen- The operation of NEFs should reflect this tives to increase collection efficiency). In this process. The representation of major interest sense, they remain executing bodies of a groups in the decision making process of centrally regulated financing system. In NEFs can also (i) increase the acceptance of Russia, for example, Ministerial Order No. 151 pollution charges; (ii) facilitate the develop- on "Standard Regulations of Environmental ment of a consensus between polluters and the Funds" approved in 1992, recommended that regulating authorities; and (iii) help to set local and regional governments adopt com- priorities. mon procedures for operating the funds. Consequently, mismatches between local/ Several NEFs established administrative regional financing need and revenue sources framework for inter-ministerial consultations are inevitable. The extent of real decentraliza- and more transparent decision making. In tion depends, besides political considerations, Bulgaria, for example, the board of directors on the degree of decentralization in the fiscal consists of representatives of the Ministries of system. Strictly centralized fiscal systems Finance, Construction, Industry, Agriculture, resist the allocation of revenue raising capa- Environment, Energy and Health, the Com- bilities to local and regional authorities. mittee of Geology and Mineral Resources, Decentralization also requires that NEFs at Committee of Tourism, Institute of Ecology, various levels possess capabilities to set dear and a private insurance company (the invita- priorities and operate efficiently. Such tion for an NGO was, however, revoked). In capabilities are frequently missing. Hungary, an Interministerial Committee (representing the Ministries of Environment, Funds frequently measure their effectiveness Transport, Telecommunications and Water, in the amounts of pollutants controlled or Industry, Agriculture, Finance, Welfare and number of projects completed rather than by Internal Affairs) participates in the decision improvements achieved in environmental making process. Although considerable quality or costs saved in achieving environ- progress has been made in the coordinating mental improvements. However, investments function of NEFs, still no public participation supported by NEFs don't necessarily lead to is built into NEF operations. NGO and citizen environmental improvements. In China, for participation has been minimal or non- example, the operation and maintenance of existent. pollution control technologies are not moni- tored, and the equipment is frequently not Long-term Perspective operated to save operating costs that typically exceed emission charges. Post-project evalua- The majority of spending for pollution abate- tion and monitoring capabilities of NEFs are ment should come from private sources in the usually non-existent or weak. Only the long run, while public spending should be 36 Environment Department Papers Transition Economies part of the budgetary process, competing with parallel with increasing the real level and other public expenditures. The proliferation incentive effect of emission taxes, and improv- of earmarking, as it was demonstrated by the ing the environmental management frame- Dutch example, leads to inefficiencies in the work. A timetable for this should be negoti- fiscal system and distortions in environmental ated with fiscal authorities. As the role of financing. NEFs, therefore, should be viewed private environmental financing increases, as temporary instruments to correct imperfec- and greater cost-recovery is achieved in the tions during transition. provision of public environmental services, NEFs are expected to shift their investment In order to increase the role of private pollu- priorities to areas where no alterative to tion abatement, the environmental policy public finance exists. Under improved framework should be strengthened consider- political systems, information availability, and ably. CEE countries have a unique opportu- increased role of NGOs, these traditional nity to build on the existing system of emis- public finance functions, however, should be sion taxes, and establish a policy framework overtaken by normal budgeting in the long that gives a significant role to market incen- run_ tives. Environmental taxes can induce volun- tary private pollution abatement and, supple- Summary of Pollution Abatement mented by a carefully selected set of direct regulations where incentives are insufficient to achieve environmental quality objectives, Macroeconomic reforms introduced dunng could result in environmental improvements the transition from central planning to in a cost effective way. With the transition to market economies are expected to generate market economies, constraints created by positive environmental changes. The underdeveloped, dysfunctional financial development of the private sector, public markets are expected to disappear, and many enterprise restructuring and tightening financing channels become available for budget constraints gradually shift financing private (and public) direct investments. decisions from the center to the micro level. Strengthening the environmental policy As a result, the role of enterprises in rege requres a serious effort of consensuspollution abatement financing is expected building with the decision makers responsible for financial and fiscal policy, and is likely to take a long time. NEFs can effectively contrib- compreenipEtat urreny ute to this process. A gradual approach is contitutean ipotatouce fe most realistic, during which NEFs support the m ental fiacnn I te ae development of strong environmental policy le iof cetral l e tras framework, and mobilize private financial tiori y should bns iere as resources. NEFs can be politically attractive, par financing insuen t c since voters (and polluters) are more willing plsiifcat role inspe ing to support taxes if a direct connection is po met proceses andinancing provided between tax payments and environ- environ rioentes by restribtin mental improvements. Earmarking, however, and alloc at re ue tnvestmentn not only creates inefficiencies in fiscal policy, priori aastrece environe but also hinders the introduction of a more da in a coseffeve way. Te effective environmental policy instruments, since the combined effect of environmental taxes, regulations and financial support taiable environmental financing system. through NEFs would lead to excessive levels NEFs are expected, therefore, to (i) improve of pollution abatement. Therefore, the ear- the environmental policy framework; (ii) marked share of environmental tax revenues finance high priority public environmental should be gradually reduced over time, programs and services; and (iii) provide Environmental Economics Series 37 Financing Pollution Abatement Theory and Practice temporary support to the enterprise sector priorities and cost-effectiveness criteria by mobilizing enterprise resources in should guide their project selection, sup- priority areas. ported by increased transparency and SNEFs should have only a limited mandatein the decision making NEFsshold hve nly liitedmanateprocesses. Post project evaluation func- in enterprise financing. NEFs should play a tions should ensure the sustainability of catalytic role by (i) focussing on priority environmental improvements. Institutional areas only; (ii) facilitating a long-term capabilities of NEFs at regional and local partnership between industries and the levels should be strengthened and the environmental policy authority; (iii) mobi- separation of roles, management and lizing private financial resources; (iv) budgets of NEFs from those of the environ- influencing enterprise behavior by focus- mental protection body should be ensured. sing on cost-effective solutions; and (v) ensuring the sustainability of environmen- With a stronger private sector, the restruc- tal improvements. The role of NEFs in turing of the public sector, tightened enterprise financing should be temporary. budget constraint, and improved environ- mental regulations and enforcement, the * NEFs should improve their revenue raising, burden of environmental financing is resource allocation and decision making expected to shift to the enterprises and procedures. The current practice of levying improved cost-recovery can be achieved in very low emission charges on a large public environmental services. Therefore, number of pollutants should be evaluated the role of NEFs in pollution abatement and revised; revenue collection should be should diminish, the share of earmarked significantly improved, exceptions reduced environmental charges reduced, their and charge levels automatically adjusted to spending structure shift to traditional the rate of inflation. Clear environmiontal public finance roles, and eventually taken over by normal budgeting. If price subsidies are lifted, for example, on hydrocarbons but not on coal, adverse pollution affects occur. Besides NEFs, other earmarked funds are also frequently used to finance public environmental investments. In Hungary, for example, wastewater treatment facilities can be financed from (i) the NEF; (ii) the Water Management Fund established from earmarked water charges and fees; (iii) Regional Development Funds mainly designated for infrastructural investments; and (iv) directed municipal support programs. There is inadequate coordination among the various sources and, as a result, there are overlaps and inconsistent eligibility criteria and financing conditions. Priorities may include as (i) the installation of dust collection systems in metal smelters; (ii) investments in equipment to reduce toxic pollutant discharges where large populations are exposed; and (iii) pre-treatment of wastewater in small- and medium-sized industrial plants where water contamination by heavy metals and toxic chemicals is a serious environmental threat (EAPCEE, 1993). 38 Environment Department Papers 4 Developing Countries Macroeconomic and Environmental regulations is generally inadequate, largely Policy Framework curtailing their choice of policy instruments for pollution control. Environmental manage- In order to protect their "infant" industries ment, therefore, frequently relies on sectoral during the process of industrialization, most self-control and self-regulation. developing countries increased the role of public sector in their economies, introduced CAC instruments such as emission standards central planning, price and interest rate and licensing dominate the choice of environ- controls, and strict import protection. Finan- mental policy implementation instruments. In cial markets have been often characterized by Mexico, for example, federal laws created a distortions due to controlled interest rates, framework for the establishment of minimum credit ceilings, and selective credit policies. industrial emission discharge standards by Subsidized interest rates encouraged capital- major industries for the main pollutants. In and pollution intensive investments and Brazil, state licensing of polluting activities capital structure. By the 1970-80s, complex creates a framework for establishing indi- structural inefficiencies led to low rates of vidual emission limitations. The issuance of productivity, slow economic growth, budget compliance certificates and authorization to deficits, and serious balance of payment construct and operate industrial plants are the problems in many developing countries main regulatory instruments in the Philip- around the world, and adjustment programs pines. In Thailand, source-specific emission became necessary to restore macroeconomic standards are applied. However, the enforce- stability. The environmental effects of central ment of environmental regulations in most planning and macroeconomic reforms, as well developing countries is generally weak, as the constraints of developing an effective frequently relying on self-regulation and environmental financing system are very warnings. The level and collection probability similar to those described in chapter III. of non-compliance fines are typically low, and plant closures, even if legally allowed, are The system of environmental regulation and extremely rare due to the lack of political will the institutional framework are still evolving to seriously tackle industrial pollution. In in most developing countries. Environmental cases (for example in Turkey and Mexico) policy formulation and regulatory functions where fines have been set according to the are not well defined. Environmental protec- severity of the pollution damage, they were tion functions are typically dispersed among effective in reducing pollution at the source several line ministries even if a separate (Bernstein, 1993). environmental protection body is established, or one of the line ministries is assigned to In many countries, MBIs are increasingly used carry out the main environmental protection to supplement direct regulations, and taxation functions. Further, the regulatory agencies' is increasingly used with the purpose of ability to monitor pollution and enforce achieving environmental improvements. Tax Envirohnental Economics Series 39 Financing Pollution Abatement Theory and Practice differentiation policy on gasoline in Mexico, tion and created a need for sustainable for example, successfully contributed to the strategies for water resource, water quality reduction of traffic-related pollution. Addi- and waste management. Traditional water tionally, direct environmental taxes and other ownership rights and political and social MBIs have been introduced in several coun- considerations, however, frequently prevent tries. For example, an air pollution permit the water sector from establishing an efficient trading system supplemented CAC measures management and financing system. Wastewa- in Santiago, Chile to curb point source emis- ter treatment, waste collection and manage- sions. In Korea, emission charges and non- ment are frequently considered basic social compliance fees are applied for discharges services that governments should provide over effluent limits, and product charges and free. Charges, therefore, are typically too low a deposit-refund system supplement waste to cover costs. Sewerage tariffs are generally management regulations. In Malaysia, set as a certain percentage of the applicable effluent-related license fees are charged on the water tariffs (in Colombia, for example, BOD load discharged to waters. Some states sewerage tariffs are set at 60 percent of the in Brazil (Sao Paolo and Parana) introduced water tariff in Cali, 50 percent in Cartagena, effluent charges based on pollutant content in 30 percent in Bogota (Bahl and Linn, 1992)). order to cover the costs of public water treatment. The tariff imposed on polluters has Sewerage charges levied on industrial dis- resulted in an impact on polluLon abatement charges into the sewerage system are typically behavior, reducing pollution coefficients low on the (incorrect) assumption that there (World Bank, 1993b). will be significant pre-treatment of industrial wastewaters. Higher levels of sewerage Informal regulation through bargaining charges, however could significantly influence between polluters and the environmental the treatment level and the volume of emis- protection authority frequently supplements sions. Bernstein (1993) cited, for example, the laws and regulations. In Brazil, for example, case of Suzano in Sao Paolo state where high agreements between the State Environmental tariff levels set by the state sanitation com- Protection Agencies and polluters are formal- pany induced the local paper mill to construct ized to determine implementation schedules its own treatment facility. The treatment costs for pollution abatement plans. In countries of the facility were lower than the sewerage where formal regulation is missing or weak charge, demonstrating that industrial treat- (for example, in Bangladesh and Indonesia), ment is frequently cheaper than collective information dissemination about the pollution treatment. records of large polluters facilitates informal bargaining between polluters and affected Management and operating practices in the communities. Community pressure is gener- public environmental services sector are poor ally able to tackle highly visible and easily and, as a result, service levels are low. Water identifiable pollution sources. Information supply and sanitation systems only rarely asymmetry between negotiators, transaction achieve high levels of cost-recovery. There are costs and social considerations such as em- a few exceptions where cost-recovery allowed ployment, however, create constraints to the the involvement of private sector in water sole use of informal regulation. service provision (see Box 16.). Typically, however, most expenses are financed through Public Pollution Abatement municipal general revenues and national Financing budget transfers, supplemented in some cases by external financial resources. Significant The process of urbanization and industrializa- decentralization of public expenditures and tion resulted in the degradation of the water responsibilities have taken place in most quality of rivers and reservoirs, uncontrolled developing countries in the past decade. discharging of solid wastes, untreated munici- Frequently, decentralization of government pal and industrial sewage and runoff that functions has been the reflection of democrati- have adversely effected the health of popula- zation processes marked by the adoption of new constitutions (for example, in Brazil, 40 Environment Department Papers Developing Countries Box 16 Cost-recovery in the Water Supply and Sewerage Services in the Ivory Coast According to the National Water Supply Program of 1973, pricing policies in the water supply and sewerage sector were aimed to provide full cost-recovery of operating costs and debt service. Two funds, the National Water Works Fund (FNH) and the National Sanitation Fund (FNA) were set up to manage water sector finances. The Ivorian Water Distribution Company (SODECI), operating all urban piped water systems, maintaining rural water facilities and also the sewerage and drainage systems in Abidjan, collected the fees for water services. A fixed amount of the fees were periodically retained to cover O&M costs, while the balance of revenues were transferred to the sector funds. While SODECI's compensation from the collected revenues remained fairly constant, the portion transferred to FNH and FNA contributions varied substantially. Additional difficulties emerged in the late 1980s, when arrears of unpaid public water bills have started to threaten the survival of SODECI, and the financial sources of FNH. Due to the limited amount of cash FNH could generate, it had to borrow money from the Central Bank, contributing to the increasing indebtedness of the sector. While FNH was running a deficit, however, FNA showed surplus. The sector funds were used to finance water supply and sanitation projects. Although FNH and FNA had the responsibility to manage sector finances, they were never in full control, since investment decisions were left to the Water Directorate (DE). Recognizing the negative effects of fragmented responsibilities for investment programming and finance, the Government decided to rationalize the financial management of the sector. In 1987, FNH and FNA were replaced by the National Water Fund (FNE). The function of ENE is to (i) keep an account for the surcharges on water sales levied by SODECI, the sanitation tax collected by the Treasury and the user charges paid by operators of private wells; (ii) pay for the operation and maintenance of sewerage networks in Abidjan to SODECI; and (iii) service the debt used to finance investments. Over time, unlike most water supply and sewerage management systems in developing countries, the Ivorian system has achieved a high level of sustainability and self-financing. Source: World Bank, 1990b. Colombia and the Philippines), redefining the Municipal Development Funds (MDFs) have roles of various government levels and been created in several countries to provide providing more authority to local government the financing need for municipal infrastruc- levels. In some cases, local governments ture management. MDFs are managed by the received authority to create new tax bases and central government (Kenya, Tunisia, Uganda), charges (for example, in Venezuela) or to or by autonomous institutions with separate adjust existing tax bases. In other cases, legal and financial identity. Autonomous revenue raising responsibilities remained with institutions may be municipal development the national or federal government, but larger banks, whose primary objective is municipal proportions were shared with lower govern- investment financing (for example, Honduras ment levels (for example, in Argentina, Brazil, and Jordan), or they may be part of lending Venezuela). In many countries, central institutions with broader scope of operations governments require a large part of their (for example in Mexico and Colombia). In revenue transfers be dedicated to local capital some cases, they are part of lending institu- investment in infrastructure facilities. In some tions established to manage state controlled countries (see Box 17.), central government pensions, insurance and saving funds (in transfers were coupled with increased lending Brazil and Morocco). Many of the specialized to municipalities to stimulate local spending MDFs also provide technical assistance. on infrastructure. The reliance on national Generally, the management of these institu- budget transfers for environmental service tions is appointed by the central government, provision has been especially significant in however, municipal governments are fre- countries where the authority of the munici- quently represented. Due to low cost-recov- palities to set tariffs remained curtailed (for ery, MDFs are dependent on budgetary example, in Mexico). contributions, while service provision quality Environmental Economics Series 41 Financing Pollution Abatement Theory and Practice Box 17 Financing Municipal Services in Colombia A revolving fund managed by the National Institute for Urban Development (INSFOPAL) served as the principal financial mechanism in Columbia for many years. INSFOPAL's responsibilities included the distribution of Government grants and other financial resources. Cost-recovery, financial viability, and administrative and operational efficiency played secondary role in its operation. Loans were the general form of financing provided by INSFOPAL for the execution of sanitation works, however, grants were awarded under special circumstances decreasing financial discipline and opening the possibility for more lenient financing terms. Due to unsatisfactory debt service, the revolving fund never developed into a viable source for sector investments, and INSFOPAL had to rely on contributions from the national budget As part of the Sector Reform Program (SRP) adopted in 1989, responsibilities for decision making and administration were transferred from the central Government to municipalities. INSFOPAL was abolished, and Findeter, an independent financing institution took over the financing role for sector investments, with responsibilities for mobilizing domestic and external resources, and identifying, preparing, evaluating, approving and supervising sector projects. One of the most important objectives of SPR was to promote the establishment of autonomous, operationally efficient and financially viable municipal or regional water supply and sewerage utilities. Institutions eligible for SRP loan funds should comply with the cost-recovery principle. Findeter is operating through the banking sector financing up to 70 percent of public works, requiring 30 percent counterpart contribution. Onlending rates are pegged to the market interest rates, covering the costs of funds. In lack of competition in retail banking, a cap on interest rate spread of 2.5 percent has been set to prevent excessive rates charged by intermediary commercial banks to municipalities and utilities. Positive cash flows of utilities used as collateral make the lending program viable. Findeter has demonstrated a significant impact on the preparation and management of investments, and contributed to the development of municipal credit market and banking relations. Source: World Bank, 1988. is low. Selective credit policies frequently proper maintenance and management of support the poorest areas through grants or pollution control equipment, contributing to low interest rate loans. further inefficiencies in the use of financing resources. Private Pollution Abatement Financing The menu of financing options available for industries is typically severely limited in Compliance with emission standards and developed countries due to underdeveloped permits requires extensive monitoring that is and dysfunctional financial and capital beyond the capabilities of most developing markets. The absence of open markets for countries. Therefore, environmental protec- securities (such as bonds, stocks, mortgages, tion authorities frequently pursue a selective commercial bills), combined with approach concentrating on the largest pollut- macroeconomic istability inflicts more risk ers. In the Philippines, for example, due to y , g limited resources available for the enforce- government regulation was generally intro- ment of environmental regulations, the twelve duced to ensure the safety of the banking most polluting industrial units in each region system. Although several countries experi- weretarete by he Diry Doen"prorammented with financial liberalization by rapidly were targeted by the "Dirty Dozen" program (World Bank, 1993c). Such approach imposes (for example, Chile and Argentina) or gradu- the burden of financing on a selected group of ally (for example, Korea and Indonesia) polluters without regard to the cost-effective- abolishing interest rate ceilings, central credit ness of pollution abatement. Additionally, the allocation and market entry barriers in the late initial enforcement of compliance is rarely 1970s and early 1980s, the full liberalization of followed by the continued monitoring of the financial markets has been constrained by various macroeconomic imbalances. Con- 42 Environment Department Papers Developing Countries Box 18 Pollution Abatement Subsidies in India Fiscal incentives for pollution abatement financing have been widely used in India: * Soft loans are provided for technology upgrade by the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI); * Depreciation allowances are higher (50 rather than 30 percent) for certain pollution control equipment; * Excise taxes are reduced (from 15 to 5 percent) for certain pollution control equipment; * The maximum customs duty is reduced from 85 to 40 percent for all pollution control equip- ment; and * The income tax exemption is extended to private contributions to environmental organizations. Incentives, however, should be combined with strong environmental management and enforce- ment in order to be effective. In India, subsidies have only a limited effect stimulating pollution control measures. Entrepreneurs try to maximize government subsidies, and minimize their individual contribution to environmental investments, even if that requires the delaying of planned investments. Source: World Bank, 1991b. trolled interest rates for directed government countries. The most common channels of lending and free rates for other lending directing credit to priority areas have been (i) frequently coexist. The cost of collecting commercial bank loans rediscounted by the information to screen and monitor debtors is Central Bank, (ii) lending by state-owned very high. As a result, a large portfolio of financial intermediaries; (iii) regulations non-performing loans and the high adminis- mandating banks to lend certain share of their trative costs of the banking system have raised portfolios to specific purposes; and (iv) easing interest rates substantially in many countries, the banking regulations applicable to lending restricting borrowing for investments with to priority sectors (for example, by requiring moderate returns (for example, average real lower reserves). lending rates in the 1980s were over 20 percent in Argentina, Chile and Uruguay Typically, directed lending for pollution (Morris et al, 1990)). abatement has been carried out by financial institutions responsible for directed industrial Institutional financing appears to be especially lending. In Mexico in the 1980s, for example, constrained for small-scale enterprises. Banks the earmarked environmental lending mecha- frequently play a more significant role in nism of the Industrial Equipment Fund financing larger firms, while the use of credit (FONEI) was capitalized by the government by smaller firms is limited, indicating dis- (see Box 19.). In India, development banks criminatory credit rationing practices. As a with majority state ownership such as ICICI result, small-scale enterprises are frequently and the IDBI provide directed credit to forced to turn to more costly, informal credit industries for various priority projects, sources. Due to the high cost, such sources including pollution control. The provision of can only be used, however, for financing directed credit at subsidized rates has been investments and operations with relatively demonstrated to favor large companies that high returns. comply with bureaucratic conditions more easily than small borrowers (Morris et al, Under these conditions, financing pollution 1990). Such loans suppress competition and abatement investments through normal discourage the development of commercial commercial banking channels is considerably banking and credit markets. limited. Therefore, directed credit programs have been established in order to support Other types of subsidies also frequently pollution abatement financing in several supplement environmental regulations and Environmental Economics Series 43 Financing Pollution Abatement Theory and Practice Box 19 Directed Credit for Pollution Abatement in Mexico The Mexican Government set up several trust funds in the 1970s to provide long-term financing to priority sectors. Trust funds were typical in a highly fragmented fiscal system. FONEI, established in 1971 and administered by the Central Bank, provided financing for industrial projects through the entire network of Mexican investment and multipurpose banks. In the 1980s, FONEI started to promote lending for pollution control financing. FONEIs highest decision making body, the Technical Committee, consisted of high level government officials (finance, commerce and industrial ministries, banks and the private sector). The Committee defined the types of projects, terms and limits of loans, interest rates, criteria for project selection and procedures for authorization of financing. FONEPs pollution control loans were eligible for 2-5 percent- age points below market interest rates. The majority of FONEIs pollution control loans supported air pollution abatement investments. After FONEI was abolished, the National Finance Institution took over lending for pollution abatement investments. charges that are typically not effective enough inadequate without earmarking. Since to induce the level of private pollution abate- emission charges and other environmental ment investments necessary to achieve the taxes do not play an important role in most required environmental quality. In India, for developing countries, the revenue sources of example, tax and interest rate incentives are the EFs are usually derived from or supple- used (see Box 18.). In Malaysia, subsidies are mented by (i) designated, not directly environ- provided for companies that establish facili- ment-related levies (the National Environmen- ties to store, treat and dispose of their wastes, tal Fund in Algeria, for example, has been set and import duty and sales tax exemptions are up to raise its revenues from international extended for technology used for the storage, airline tickets); or (ii) external sources (the treatment and disposal of hazardous wastes. Pollution Abatement Fund in Sri Lanka was In Thailand, import duties are reduced to created with the help of donor contribution). below 10 percent on pollution control and In some developing countries (see Box 21), the treatment equipment. A law enacted in 1977 creation of EFs reflects the failure of the fiscal in the Philippines allowed the waiver of mechanism, leading to the proliferation of import tariff on pollution control equipment earmarked funds as means of public revenue for a period of ten years, and rebates for allocation. domestically produced equipments were also introduced. Subsidized credit has been The characteristics of EFs, disbursement provided in some countries to support the mechanisms and use of resources vary among relocation of highly polluting industries. In developing countries. In cases when EFs are Turkey, for example, loans at negative real established to correct failures in the fiscal interest rates were extended to leather tanner- system (for example, in Turkey), funds finance ies that relocated from Iznir. Subsidies have a wide range of environment-related projects also been frequently justified by political including investment in pollution abatement considerations such as the promotion of equipment, environmental cleanup, natural industrial development and trade. resource protection, as well as education and training programs. The majority of these Environmental Funds investments are classic public expenditures in the form of grants. In other cases, especially Environmental funds have been established in when environmental charges are earmarked, some developed countries, mainly where the scope of eligible use is narrower. In economic growth was accompanied by serious Thailand, for example, the EF is designated environmental degradation that led to govern- for investments in wastewater treatment and ment intervention, and outlays from general solid waste disposal facilities; in Nigeria, the budget for the environment sector were majority of EF resources are used for disaster 44 Environment Department Papers Developing Countries Box 20 Comprehensive Environmental Funds in Turkey The Turkish fiscal system is highly fragmented with numerous earmarked financing mechanisms. Several environmental funds exist with a broad range of mandate. * The Pollution Prevention Fund was set up in 1985 from the collection of environment-related taxes and levies including taxes on motor vehicles and transportation (for example, motor vehicle inspec- tion fees and vehicle purchase tax), as well as pollution permit fees and fines. * The Environmental Protection Fund was created in 1989 from earmarked shares of property, income and corporate income taxes. * The Special Protection Fund derives its resources from various charges in connection with recre- ational activities in environmentally sensitive areas. Spending priorities are broadly defined and include (i) research activities in pollution prevention; (ii) environmental cleanup; (iii) education and training; (iv) purchase of technology; (v) nature conservation; and (vi) provision of credit for pollution abatement investments. However, EF resources have been used mainly for capital transfers to municipalities and to the Ministry of Finance. EF mechanisms in Turkey are fiscal, rather than environmental policy instruments. relief, environmental cleanup and flood levels of private pollution abatement control projects; in Sri Lanka, loans, as well as investments. Dominantly CAC policy technical assistance are financed from the EF. approaches are supplemented with MBIs, Frequently, especially in cases when revenue but monitoring capabilities and the enforce- sources are not directly related to environ- ment of regulations are typically weak. mental damage, eligibility criteria and rev- enue allocation mechanisms are not clearly * Due to traditions, social and political defined (for example in Egypt or Algeria). considerations, cost-recovery in public environmental service provision is typically In addition to institutional weaknesses, the low. User charges are not high enough to managerial capability, technical, economic and encourage industrial pre-treatment or administrative expertise available in develop- waste-minimization measures, further ing countries are also inadequate to properly increasing the demand for public services. assess, quantify and prioritize environmental Municipal and national budgets are the costs and benefits. Comprehensive environ- main sources of funding. Due to the mental policy and clearly defined environ- limited availability of these funds, how- mental priorities and strategies are typically ever, the quality and coverage of these missing. Consequently, the use of EFs is often services are low. Public environmental based on ad hoc decisions, emergencies, or services may be financed through special political priorities. Although EFs may func- lending institutions, such as municipal tion as catalysts to mobilize private and development funds. Their sustainability enterprise resources, without significantly and success depends on the financial increasing the level of environmental charges viability of environmental service sector. the role of these financing mechanisms remains marginal. Due to underdeveloped and dysfunctional financial and capital markets, the private Summary of Pollution Abatement sector has limited access to financing Financing in Developing Countries resources. Therefore, directed credit has been extended in several countries to The evolving environmental policy and finance priority investments. Directed regulatory framework is inadequate in lending for pollution abatement invest- developing countries to induce substantial ments is typically channelled through Environmental Economics Series 45 Financing Pollution Abatement Theory and Practice financial institutions responsible for di- been established to provide a relatively rected industrial lending. Private pollution steady flow of resources for pollution abatement financing is supported by abatement. The reliance of EFs on budget various types of subsidies such as grants, allocations and external funding is largely tax incentives and soft loans to compensate due to the limited amount of revenues for the lack of strong enforcement of raised by environmental charges. Without regulations. clear spending priorities and adequate Subsidies are sometimes channelled institutional capabilities to evaluate expen- diture alternatives, EF resource allocation through environmental funds that have decisions are frequently suboptimal. 46 Environment Department Papers 5 The Role of External Finance Economic Policies, Environmental Before substantial environmental investments Priorities and External Finance are undertaen, a proper framework for comprehensive environmental policy needs to Donor assistance has gradually shifted from be established and financing priorities deter- addressing problems to aiming at complex mined. Without this approach, investments policies that support sustainable development. may be directed suboptimally (see Box 21.). Environmental considerations and policy Integrated environmental management and implications have become integral part of coordinating mechanisms should be devel- macroeconomic stabilization, structural oped by strengthening institutional capabil- adjutmet, nd sctoal.deveopmnt ro-ties. In. order to set dear and cost-effective adjustment, and sectoral development pro-eniom ta orisadfnncn ed- grams. Most stabilization and adjustment g programs have generated substantial environ- nisms, technical assistance is often needed to mental benefits, however, additional external (i) contribute to the improvement of environ- assistance was sometimesmental management systems, regulatory potential environmentally needet ie framework, and institutional capabilities to unaddressed market failures (Munasinghe (including monitoring and enforcement and Cruz, 1994). Most donor agencine capabilities and cost-recovery mechanisms); established mechanisms in their project (ii) support environmental education, training preparation processes specifically aimed at andresearch; and (ifi) facilitate information reducing potentially negative environmental dissemination that promote pollution preven- impacts using environmental guidelines and tion and the application of cleaner technolo- impact assessments. Additionally, sector gies. Donors may assist in the preparation of development programs have frequently been national environmental strategies, reviews supplemented by environmental components. and action plans that also serve as guides for investment assistance. External funds in the form of grants, soft Ivsmn sitnei olto btmn loans, commercial loans or equity investments Icoempren si stae in all ui bment may supplement domestic resources available shoudpomossana blmhsinedevofppent.o for pollution abatement financing. These areetr exogenous factors, however, that cannot has, therefore, been supplemented by greater compensate for the lack of a comprehensive reliance on the application of technologies, environmental financing system based prima- processes and management practices that rily on domestic resources. Grants and loans improve the efficiency of environmental from bilateral and multilateral organizations resource use and reduce the damage caused may serve as catalysts to establish domestic by pollution. Less developed countries environmental financing mechanisms and to (LDCs) generally lack financial, technical, attract additional funding from commercial institutional and human capabilities to initiate sources. significant technological change. Donor Enviroeinental Economics Series 47 Financing Pollution Abatement Theory and Practice assistance, therefore, may facilitate the trans- investments at market terms; (ii) should not fer of cleaner technologies' to LDCs. The create a bias towards certain types of pollu- feasibility of the transfer of technology de- tion control investments; (iii) should be pends on (i) the adoptive capabilities of the supplemented with measures to correct recipient country; and (ii) the extent of market market failures, and strengthen environmental failures in the recipient country. management; and (iv) should be gradually phased out. Recipient countries may not be able to adopt new technologies efficiently if, for example, Financial Intermediary Loans and the human capital constraints the effective opera- Experience of the World Bank tion, management and service of the technol- ogy, or there is a lack of capability to integrate In order to avoid large inefficiencies of direct new technology to other areas of the economy. lending due to the large number of final The application of cleaner technology is borrowers and small amounts of individual effective if it contributes to the improvement loans, World Bank funds have been frequently of environmental quality at the least cost. channelled through financial intermediaries Cost-effectiveness requires the combination of (Fs). Fls not only operate as mere executive end-of-pipe control and the application of agencies of the Bank but, strengthened by cleaner technology approaches. Market technical assistance, they also serve as devel- failures may also constrain investments in opment financing institutions (DFIs) that can pollution abatement and the diffusion of play a catalytic role in domestic development cleaner technologies in LDCs: and domestic resource mobilization. Their * When environmental regulations and objectives frequently indude a mix of com- enforcement capabilities are non-existent or mercial and development goals. When DFIs weak, the social costs of pollution are not are expected to correct not only financial built in the cost of production, and inves- sector failures but also market, administrative, tors face no incentives to pay a premium or regulatory failures, directed credit and for dean technologies; interest rate subsidies are frequently used. The goal of financial intermediary loans (FILs) * When protectionist trade policies support is to supplement domestic investment re- domestic industries, the import of cleaner sources without crowding out domestic technologies is discouraged; financing credit mechanisms or undermining * When the public sector is dominant in the the efficiency of domestic financial markets. economy, enterprises are not motivated to Typically, pollution abatement FILs simulta- improve performance; neously attempt to correct the failures of the * When financial markets are underdevel- financial sector and the failure and inad- oped or dysfunctional, access to credit is equacy of the environmental management severely limited, frequently rationed and system. However, when serious also very costly; macroeconomic, real sector or financial sector distortions exist, FILs are not likely to succeed * When the dissemination of information unless these distortions are removed. When, carries high transaction costs, investors are for example, high inflation rates prevail, long- not able to make optimal decisions. term borrowing is crowded out, and when governments directly allocate credit, FILs are Donors frequently support the correction of likely to fail in creating a market-based credit these market failures through assistance with mechanism. Therefore, FILs should not be macro-economic restructuring and sector extended under severe macroeconomic and development programs. Additionally, policy sectoral instability and should be preceded by makers in LDCs may decide to use temporary and coordinated with complex subsidies in order to accelerate environmental macroeconomic, real sector and financial investments. Such subsidies, however, (i) sector reforms. Market failures and the should not crowd out commercially viable inadequacy of environmental management are 48 Environment Department Papers The Role of External Finance Box 21 The World Bank's Experience with Industrial Pollution Control Financing from the 1980s in Brazil Several Bank projects have been designed to channel resources through FIs for industrial pollution abatement investments in Brazil. The objectives of Bank projects have been to (i) provide financial sources for pollution control investments; and (ii) strengthen the environmental management system. Basic environmental regulations, standards, environmental institutions and permit systems had been put in place before lending started. However, monitoring and enforcement mechanisms operated ineffi- ciently. As a result, private sources and the banking system played a marginal role in environmental financing, and industrial pollution control investments relied heavily on grants from the budget The early industrial pollution control projects did not attempt to address environmental problems in a comprehensive way and, as a result, the lack of comprehensive environmental strategy and priorities led to suboptimal revenue allocation. The Sao Paolo Industrial Pollution Control Project, for example, successfully reduced industrial dust emissions, however, the city's ambient dust levels didn't improve due to the dominant role of mobile pollution sources (World Bank, 1987). Recognizing the need to set priorities and base lending on well defined environmental policy, the Brazil National Industrial Pollution Control Project (World Bank, 1992a) made the existence of Bank-approved environmental strategies as a condition of credit eligibility. The success of industrial pollution abatement credit programs also strongly depended on the environ- mental management capabilities and the enforcement of environmental regulations. Inadequate enforce- ment was one of the main reasons why the credit lines for pollution control investments remained under-utilized during the first Sao Paolo project (World Bank, 1989). Improved monitoring and enforce- ment also reduced the need for subsidies extended through lower-than-market interest rates. While subsidized interest rates were offered during the first two industrial pollution control projects in Brazil (World Bank, 1980 and 1987), the third project (World Bank, 1992a) has eliminated the subsidies by matching subloan interest rates with longterm market rates. Bank projects considerably strengthened the environmental assessment capabilities of the financial intermediary (BADESP), creating a special expertise in environmental lending, and BADESP gradually took over most project evaluation functions from the environmental protection bodies. usually addressed by directed credit for sources can achieve the desired financing pollution abatement investments, frequently conditions. As the World Bank's experience at concessional credit terms. The subsidies with industrial pollution control credit lines provided this way supplement private re- showed, subsidies could be gradually elimi- sources committed for pollution abatement nated and normal commercial lending could that are insufficient to achieve socially desired take over subsidized environmental lending environmental quality objectives. Subsidies, as environmental management and the however, are suboptimal environmental enforcement of environmental regulations policy instruments, therefore, with the im- were strengthened (see Box 21). provement of the environmental management system that increases private abatement The first World Bank credit lines (World Bank measures, subsidy programs should be 1975, 1980, 1987) limited assistance to direct gradually phased out. pollution control investments. In the first free-standing pollution control project (World Multilateral and bilateral donor agencies are Bank, 1975), for example, project selection rarely ready to soften their lending terms to criteria strictly excluded alternatives to end- provide subsidies for their borrowers, and of-pipe pollution control investments. In the government contributions to the capitalization first Brazilian pollution control project (World of DFIs have been frequently encouraged to Bank, 1980), the identification of alternative soften lending conditions for final borrowers pollution abatement solutions was not dis- without jeopardizing the financial viability of couraged, however, project preparation and DFIs. Donor lending blended with other selection criteria were biased against alterna- Environmental Economics Series 49 Financing Pollution Abatement Theory and Practice Box 22 Types of Externally Financed Environmental Fund Mechanism Trust Funds are created by legally allocating financial resources to be used for specific purposes and designated beneficiaries. The assets of trust funds are invested to earn interest and appreciate market value, while the income earned is distributed for the beneficiaries of the fund. Foundations are similar to trust funds. While trust funds typically operate in countries with common law systems, foundations are mechanisms allowed by civil law. Foundations are legally independent entity under government supervision. Endowments are grants or gifts provided by multi- or bilateral donors. They can be designated for financing specific projects or areas and can be managed by trust funds or foundations. Sinking Funds are designed to disburse their principal amount over a specified period of time. Trust funds or foundations may also operate as sinking funds. Revolving Funds have a steady source of revenues either by continuous replenishment of the assets or by preserving the value of core assets and disbursing only the income earned. Trust funds and foundations are frequently established as revolving funds. Source: Mikitin, 1995. tive approaches. The financing of subprojects Bank 1993a), subsidies were awarded accord- was limited to the costs that would have been ing to estimated social costs saved by pollu- required to achieve required performance by tion abatement but not internalized by pollut- the least-cost direct control option. Although ers due to failures of environmental manage- this criterion was aimed at safeguarding ment. against financing (subsidizing) investments not directly associated with pollution control, Due to their cost-recovery capabilities, "win- it led to a time-consuming, bureaucratic win" investments with simultaneous financial project selection process that increased loan and environmental benefits are more suitable processing costs and discriminated against for investment lending than end-of-pipe alternative pollution abatement solutions. control investments that do not generate revenues. However, if this preference is Recently, the Bank's approach has shifted translated to an eligibility criterion that from the support of direct pollution control to excludes end-of-pipe control investments (for pollution prevention and alternative solutions example, World Bank, 1994b), the objective of of abatement. Most recent projects did not supporting least-cost solutions to environmen- express preference to one type of pollution tal problems may not be met. Such approach abatement investment as opposed to others could be justified only to correct existing bias (World Bank, 1992a), or specifically empha- in the financing system towards end-of-pipe sized investments in cleaner technologies, investments (for example, when other chan- waste recovery, energy conservation, recy- nels exist that are more suited to finance end- cling and other "win-win" measures (World of-pipe control investments). Bank 1993a, 1994a, 1994b, 1994c). In these projects, credit is allocated to final borrowers The Experience of Donors with at market (or near-market) rates, however, Environmental Funds limited subsidies in the form of grants have been maintained in some cases. In India, for Donor contributions capitalized several EFs in example, grants were allocated for invest- developing countries. Although the majority ments in innovative technologies and pro- of externally funded EFs tackle nature and cesses that didn't qualify for commercial biodiversity conservation issues, several EFs financing, but showed potential for wide- were also established with pollution abate- spread use of the proposed pollution abate- ment objectives. In Sri Lanka, for example, a ment or cleaner technology (World Bank revolving pollution abatement fund was 1991b). In other cases (for example, World established by a contribution from the Gov- 50 Environment Department Papers The Role of External Finance Box 23 Financing Pollution Abatement Projects from Parallel Environmental Funds in China Revenues generated from pollution charges have represented the major source of pollution control financing in Tianjin municipality. The earmarked charges are typically provided as grants or, since 1986, as soft loans for the installation of pollution control technology. However, the demand for soft loans has been low and repayments sluggish. In practice, loans are frequently converted to grants. Beneficiaries have little incentives to choose the most efficient pollution abatement alternatives and to maintain the positive environmental effects of investments. In the framework of the Tianjin Urban Development and Environment Project, the Tianjin Municipal Pollution Control Fund (TMPCF) was established in 1992 as an autonomous legal entity capitalized from pollution levies and from IDA credit (40 to 60 percent, respectively). Its board of directors includes representatives of various government agencies, and the day-to-day operations are carried out by permanent staff. The main objective of TMPCF was the creation of a sustainable pollution abatement financing mechanism. Forty percent of the pollution charge expenditures accruing to the municipal environmental fund are transferred to TMPCF, creating a steady flow of revenues. TMPCF finances investment projects that are financially viable and reduce pollution at existing industrial plants. Loans are extended at market interest rates (similar to rates charged by local banks for similar maturity), however, a small part of resources is designated to be provided as grants (up to 30 percent of project cost) in order to encourage projects that don't generate enough returns, but significantly reduce pollution. While the domestic EF is essentially a financing instrument of the municipal government, TMPCF is a financial development institute. TMPCF simultaneously attempts to correct the failures of financial sector to provide adequate credit for financially viable investments and to achieve environmental improvements. Source: World Bank, 1992b. ernment of the Netherlands in order to besides existing domestic earmarked financ- support enterprise pollution abatement ing mechanisms in China (World Bank, 1992b, investments with loans and technical assis- 1993a, 1994a), and the Russian Federation tance. Similarly, OECD funding and budget (World Bank, 1994b). By creating separate allocation capitalized the EF in Thailand. legal entities, own professional staff, and Externally founded EFs encourage the partici- project selection procedures, these funds may pation of a wide range of interested parties duplicate already existing ones. The establish- and the public review of EF operations. ment of parallel earmarked financing mecha- Externally capitalized EFs are typically nisms may lead to the proliferation of EFs established through multi-or bilateral grant resulting in inefficient resource use and the contributions or debt-for-nature swaps. EFs disintegration of environmental objectives. can also be created as trust funds (see Box Further, differences in the financing condi- 22.), however, this arrangements are most tions (for example, interest rates and loan typical for nature conservation funds. Al- application mechanism) between the existing though many of the externally capitalized EFs and those created by Bank projects may pollution abatement EFs have their own contribute to the segmentation of domestic designated domestic revenue sources, these environmental financing and create inconsis- sources are generally inadequate, and tencies in lending terms. In China, for ex- sustainability of EFs typically depends on ample, Bank-supported funds offer environ- further donor contributions. mental loans at interest rates considerably higher than those offered by the domestic So far, limited experience and success have counterpart. Coordination between domestic been achieved in channelling donor funds and Bank-assisted EFs is minimal, however, through existing EFs in transition economies. Bank resources have been supplemented by Several Bank projects have established EFs pollution charge revenues from domestic s Environmental Economics Series 51 Financing Pollution Abatement Theory and Practice Table 8 Expenditures of the Hungarian NEF by Domestic and EC PHARE Sources in 1994 (%) Domestic PHARE Air pollution control: industrial emission control 12.6 traffic-related emission control 22.6 household-related emission control 11.8 reduction of ozone-depleting substances 0.4 31.0 energy saving investments 8.0 transport-related environmentally friendly solutions 21.2 abatement of air emissions from incineration and hospital waste 0.6 Waste management waste neutralization 0-9 15.0 waste utilization 15.0 transport-related waste management 7.1 Water quality protection: protection of vulnerable water resources 1.5 31.0 Infrastructure and environmental protection: 17.6 Nature conservation: 1.2 Noise and vibration control: 0.4 Public awareness programs: 21 Total: 100.0 100.0 Source: Adopted from REC, 1994 in some cases (for example, World Bank requirements and prudent financing practices 1992b, 1993a), to cover the cost of subsidies that external donors require in order to (see Box 23.). channel their resources through a financial intermediary. The main reasons why NEFs have appeared to be incompatible with donor lending objectives Channelling donor resources in the form of and procedures originate from the nature of grants has shown similar difficulties with NEFs inherited from the central planning era. harmonizing the financing objectives, resource Their public financing role dominates over allocation criteria and procedural require- their commercial banking functions. Eligibil- ments of existing EFs and donor organiza- ity criteria for the various types of financing tions. In Bulgaria, for example, a separate forms (grants or soft loans) are frequently structural unit was established within the skewed. In China, for example, the forgive- MOE to manage resources provided by the EC ness of loan repayment is standard practice. PHARE program. So far, external (PHARE) As a result, NEFs, as quasi-lending operations resources have been channelled successfully don't have dear project selection criteria, through an existing NEF only in Hungary. rigorous operational procedures, appraisal Channelling donor resources through the 52 Environment Department Papers The Role of External Finance Box 24 The Polish DNS Creditor countries of Poland (the Paris Club) agreed in 1991 to reduce the country's debt by 50 percent with optional bilateral DNS agreements to cover further 10 percent of the original debt Such deals were completed with the Governments of Finland (1990), the U.S. (1991), Switzerland (1993), and France (1993), capitalizing the Ecofund from the proceeds (a total of 481 million U.S. dollars). The Environmental financing criteria of Ecofund represent a mix of pollution abatement and nature conservation objectives: * Greenhouse gas emission abatement; * Transboundary air emission abatement; * Pollution abatement in the Baltic Sea; and * Biodiversity conservation. Pollution abatement projects financed from the Ecofund included the conversion of coal to gas in the heating system in Zakopane Valley, a pilot project for the use of geothermal energy in an urban heating system, desulphurization of flue gases in power plants and investments in various waste water treat- ment facilities along the coast of the Baltic Sea. Hungarian NEF has resulted in significant mechanisms for project-level coordination of improvements in project appraisal, selection, assistance, an umbrella EF may be an attrac- and post-project evaluation procedures in tive mechanism for pooling donor resources. decision making processes, and in the trans- In Bolivia, for example, the National Fund for parency of operations. It has also demon- the Environment provides a framework for a strated that donor objectives and financing number of sub-funds that have been set up by priorities can be harmonized with existing donors with various financing and fund NEF operations (see Table 8.), and that NEFs management objectives.2 Through the sub- can restructure their operations and proce- funds, each donor's specific requirements can dures to accommodate donor requirements. be taken into account, while the umbrella fund Clearly, the flexibility and willingness to provides coordination and ensures the inte- adjust NEFs to donor requirements depend on gration of funds into the national environment the size of donor contribution. Even in the program. Hungarian case, however, there are inconsis- tencies in the lending terms between the Debt-for-Nature Swaps - A Special domestic and PHARE resource allocation Form of External Finance procedures. For example, municipalities can receive straight grant support from the Debt-for-Nature Swaps (DNSs) represent a domestic funds of NEF, while PHARE pro- special form of debt conversion programs, as vides interest-free loans to the same beneficia- well as a special form of external financing ries. through EFs. DNS programs have dual EFs may offer an administrative framework,the debtor country's eFptse a d fferancdinistorativeoramwork,s foreign debt obligations; and (ii) attract capital expertise and financing for donors who wish frevrnetlivsmnsta tews to finance small-scale pollution abatement c on ended i n y a DNheal,sa investments without direct involvement in the internat environental N (salla revenue allocation process. In order to (i) anaon endon buthe ebt ofsa provide a consistent and coherent policy de i cun o the dary ma framework; (ii) facilitate improved informa- deepdiscount, tn exchangesatheadet tion flow and use; and (iii) utilize existinges e Environmental Economics Series 53 Financing Pollution Abatement Theory and Practice with the debtor country for a commitment of DNS transactions are, however, not without the country to spend the equivalent amount problems. In order for such transaction to on nature protection. The funds raised by take Place, both debtor and creditor countries NGOs are typically capitalized from dona- have to acknowledge that the debtor's out- tions of private parties or of commercial standing foreign exchange obligations cannot banks. DNS deals have been carried out in be serviced. Consequently, DNS deals are numerous Latin American countries (Bolivia, appropriate only for those countries, that Costa Rica, Ecuador etc.), in Africa (Nigeria, otherwise would be seeking debt rescheduling Niger, Zambia) and in Eastern Europe (Po- or other debt reduction schemes. Further- land). more, swapping foreign exchange obligations to local currency outlays doesn't -relieve The majority of DNS arrangements involved governments of the fiscal burden of debt commercial debts for which well functioning service, and such deals may increase the secondary markets exist. Recently, however, country's inflation rate Finally, creditors are official creditors have also started to initiate not willing to release very large amounts of such programs. In 1990, the Paris Club of their debt holdings at deep discount rates, and official creditors introduced a range of new the amounts involved in typical DNS deals repayment conditions for lower middle have been rather small: the average face value income countries, including the possibility of has been around $6 million (World Bank, DNS transactions on a bilateral basis. Such 1993-94). transactions have been announced, for ex- ample, between the Swedish and the Tunisian Global and International Pollution Governments in 1992 and 1993. Canada also Issues and Donor Coordination initiated a program in 1992 to convert debt owed by Latin American countries into local Although most pollution problems are local in funds to finance environmental and other nature, some have serious transboundary and sustainable development programs. In the global effects. The mitigation of U.S., the Enterprise of Americas Initiative transboundary and global environmental (EAI) opened the way for DNS transactions. problems receives increased donor attention. Under this initiative, concessional debt owed Priorities assigned to the solution of interna- by Latin American and Caribbean countries is tional and global environmental problems exchanged for new and restructured debt with may differ among countries due to (i) differ- reduced face value. The principal on the new ent values assigned to the same international debt is to be paid in hard currency, however, and global environmental quality; and (ii) a the interest is payable in local currency, and ismismatch between benefits and costs at the deposited in an Environmental Fund. The national level. Global and international first debt write-down and DNS arrangements environmental problems, however, have to be under the EAI programs were carried out in solved nationally, at the level where the least- Chile, Bolivia and Jamaica. cost solution can be found. Domestic pollu- tion abatement measures that simultaneously DNS transactions, similarly to other externally contribute to the mitigation of international funded programs, usually target specific and global problems produce generally the programs or areas. Donor organizations often most environmental benefits. Global interven- wish to choose "high profile" programs to tion may be justified to finance the incremen- demonstrate their commitment to environ- tal costs of investments that are needed to mental protection. Although the majority of mitigate global environmental problems. DNS deals completed so far, has targeted nature or biodiversity conservation, pollution Since the same level of global environmental abatement financing has not been excluded improvement can be achieved by implement- (see Box 24.). Global and transboundary ing projects with different marginal abatement pollution abatement is likely to gain larger costs, cost-effectiveness considerations call for role in the objectives of DNS transactions. the joint implementation of international 54 Environment Department Papers The Role of External Finance obligations and the solution of international This has been demonstrated during the and global environmental problems (for establishment of the Global Environmental example, using carbon offsets). Transition Facility (GEE); after several years of negotia- economies and developing countries may tions, participants could agree only on four benefit from such opportunities. Joint imple- global environmental objectives (Sjoberg, mentation has already been agreed between 1994). Regional "clearing houses" of donor Norway and both Poland and Mexico (within contributions are likely to agree on a more the GEF framework). Norway will finance a complex set of priorities and strategies than conversion programs from coal to natural gas. global ones. Altogether, institutionalized According to the U.S. Government's Forest for donor coordination has limited appeal for the Future Initiative, carbon offset agreements donors. will be negotiated between the US and other countries including Russia, Mexico, Guate- Summary of External Financing mala and Indonesia. In another example, the Issues state electricity generating board in the Netherlands has established a non-profit enterprise to invest in forest rehabilitation in Czechoslovakia and several other countries resources. Environmental considerations with the purpose of absorbing carbon dioxide gly g p (Pearce, 1994). macroeconomic, structural and sectoral aid programs with the aim of achieving envi- Donor coordination of various aid programs ronmentally sustainable development. was initiated decades ago in the form of consultations and roundtable discussions. It has been suggested recently that donors set uphas been frequently channelled through "clearing houses" by placing their funds in a financial intermediaries. Borrower govern- jointly managed pools. Although the idea of a ments have supplemented funds when the "clearing house" is a logical response to the softening of the credit terms for final coordination problem, it is not without borrowers was considered desirable. difficulties. Donors often have strong political Intermediary lending for pollution abate- motivations when providing support to ment demonstrated that strengthened specific projects or countries. They focus on environmental management, parallel with different sectors, countries or regions. It has pollution control lending could result in been demonstrated (Arnold, 1982), that improved compliance with environmental historical factors such as previous colonial regulations, and subsidies could be elimi- relationships, and foreign policy and foreign nated over time. trade considerations significantly influence donor orientation. Informal agreements are frequently negotiated between donors and funds in some countries in order to support beneficiaries, together with associated political pollution abatement financing. The existing commitments. A "clearing house" of donor environmental funds, however, have been funds, therefore, may lead to the loss of frequently unable to meet donor require- individual donor control over the use of ments. In order to avoid the proliferation funds, and, consequently, may weaken the of earmarked lending mechanisms, incon- political support in donor countries leading to sistencies in lending terms, fragmentation the overall reduction of contributions. Also, of financing mechanisms and iefficiencies due to varying donor interests, the scope of of resource use, it is proposed to establish assistance provided by a "clearing house" national umbrella fund mechanisms. These would need to be reduced to areas agreeable umbrella funds would integrate donor to all donors. The greater the range of donors preferences with domestic financing is, the narrower the scope of mutually accept- mechanism and environmental policy able priorities and objectives is going to be. objectives. Environmental Economics Series 55 Financing Pollution Abatement Theory and Practice * Debt-for-nature swaps represent a special problems due to differences among nations form of external environmental financing in the values assigned to international and that has been mainly used to solve nature global environmental quality and a mis- conservation problems. Although the role match between the cost and benefits of of global pollution abatement programs is global pollution abatement investments at expected to increase in DNS in the future, the national level. Although several the volume and applicability of DNS advantages may come from coordinated arrangements will remain limited. donor assistance through "clearing houses", the possibility and scope for such * Donor intervention is necessary to solve institutional coordination is limited. international and global environmental g56 Environment Department Papers References Arnold, Steven H. 1982. 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