-- >¢ LOTION MANAGE1q&. _F Focus DISCUSSION NOTE NUMBER 1 JANUARY 1 999 20018 E nvironnental Environmental funds (EFs) are increasingly popular environmental financing mechanisms in developing and transition economies. The failure of govern- Funds ments to tackle environmental problems by putting in place incentive policies, environmental regulations and enforcement mechanisms, as well as failures of the financial and capital markets to provide access to financ- ing at reasonable terms are typically the underlying reasons why special environmental financing mechanisms are established. EFs, however, often only postpone rather than solve these problems, and they may contribute to existing distortions. This note provides guidance on approaches to Magda Lovei dealing with EFs. EFs are earmarked financing mecha- awareness building, research and insti- signed to finance small commercial or nisms that may support a variety of tution building, and public and private municipal pollution abatement projects environmental expenditures.1 Three pollution abatement. Both public and by avoiding the cost of direct financ- main categories of EFs can be distin- commercial financing functions are ing.2 DCFs typically operate on a guished: earmarked tax funds (ETFs), mixed in ETFs, which typically provide revolving basis, often for a predeter- directed credit Funds (DCFs), and grants and soft loans. ETFs are usually mined period corresponding, for green funds (GFs). Some examples of set up as extrabudgetary funds func- example, to the disbursement period EFs are shown in the Table. tioning as part of the Environment of donor lending. They are commercial Ministry or strongly influenced by it. institutions with strong development Earmarked Tax Funds EFs are often susceptible to political in- goals aimed at correcting certain mar- ETFs are created by governinents fromn fluence, lack transparency, and the ket, administrative, and regulatory participation of main stakeholders in failures. Donor lending is sometimes decisionmaking. supplemented by the recipient govern- other, mainly environment-related ment or other sources in order to soften earmarked levies. ETFs are used ex- Directed Credit Funds on lending terms through grant ele- tensively in transition economies, DCFs may be established as financial mieiats, technical assistance, or where they have broad environmental intermediaries by either donor organi- better-than-market interest rates. Ex- objectives including nature and biodi- zations-such as the World Bank-or perience has shown that DCFs have versity conservation, education and national governments. They are de- been rarely effective in achieving sig- Pollu/tioNMa7nagemenltDsicusnionl Noes(PIIDNs) are part of the knowledge management effort of the Environment Family at the World Bank Group. They are aimed at fostering professional discussion, the dissemination of lessons learned from Bank operations, and the transfer of best practices in pollution management. The views herein are those of the authors and should not be considered as official policy or attributed to the World Bank Group. The PMDNs are an open forum. Suggestions for future publications or comments should be directed to Magda Lovei (mlovei @worldbank.org; Room MC 5-139). Printed on recycledpaper THE WORLD BANK nificant environmental improvements, mental investments are typically on the use of public funds to finance environ- and they often struggled writh the lack demand side due to: mental expenditures is justified when of demand for credit and difficulties in a The failure of governme-nts to benefits cannot be allocated to private separating their financial and environ- tackle environmental problems by economic agents, or where public fi- mental objectives. putting into place proper incentive nancing is more efficient than private. pohcies. environmental regulations Most green environmental expendi- green Funds and enforcement; 1:;reen furIcis and enforcement; tures fall into this category due to theiI a Low political priority attached to GFs are typically capitalized at the ini- environment in government bud- global and trans-generational benefits. tiative of donors through one-time geting; By contrast, pollution, however, is a contributions or debt-for-nature *1 lTncertainties about environmental negative externality that can be tack- swaps.3 GFs finance nature and biodi- regulations and the low perceived led most effectively by making polluters likelihood of serious penalties for pav the social costs of pollution. The versitv protection, most often by violating regulations; use of public funds to support pollu- providing grants to cover the operating * Limited knowledge and expertise tion abatement should, therefore, be costs of national parks and small com- available to municipalities, local munity-based programs. Manv GFs groups, and enterprises for identi- where thev can speed up the pace of have successfully pooled revenues from fying solutions to environmental various donor sources. The willingness problems, use alternative funding environmental improvements and help variof s donorstourcntributes o T s ilingde- sources, and prepare projects for with the adjustment to the changing financing; environmental regulations. veloping countries is driven by the a Sluggish response of polluters to Because of the fundamental dif- environmental benefits of investments incentives as a result of the domi- ferences between the various categories in nature conservation that accrue nance of public sector; and of EFs, they do not mix easily. For ex- across national boundaries. In some * Slow change in traditional enter- ample, donors do not consider most cases, domestic sources, such as roy- prise decision making, capital ETFs suitable channels for their finan- budgeting, and accounting prac- alties and ecotourism revenues, also ' cial resources. The WNorld Bank has tices that traditionally exclude accrue to the fund. A popular form of environmental considerations. capitalized new DCFs in several coun- GFs is trust funds that utilize only tries (e.g., China and Russia) despite earned revenues from the fund, leav- I-.ey Le55on5 from existing ETFs. The many reasons for ing the principal intact. GFs usually Experience such incompatibility; including: con- require transparency in spending and Raising awareness of environmental ceptual problems in using earmarked decisionmaking and the participation problems has been one of the main ben- tax revenues for primarily commercial of the main stakeholders such as NGOs efits of EFs. Donors have used their lending; lack of financial and banking expertise in ETFs; a too broadlv defined and communitv groups, financial leverage successfullv during mandates of most ETFs; lack of trans- the establishment of several GFs, for ConceptuaL 155ue5 e b parency and accountability in the example, bv requiring matching r'unds operation of ETFs, and limited Nvilling- EFs are established to solve the prob- and government commitment to policy ness of ETFs to accommodate donor lem of insufficient fundingfor environ- reform. ETFs have facilitated the in- requirements. mental projects. Although dysfunc- troduction of environmental taxes, Financing through EFs will1 be ef- tional and under-developed financial establishing the framework for iincen- fective only if the underlying reasons and capital markets, unsolved collat- tive environmental policies and raising for the environmental problems are si- eral issues, high transaction costs, and enterprise awareness of environmen- multaneously tackled at the policy insufficient information often limit ac- tal costs. level. Most environmental problems are cess to financing in developing and EFs are generally better suited to the results of regulatory and market transition economies, such constraints addressing "green" issues (nature and failures such as price subsidies for en- are not unique to environmentalinvest- biodiversity protection) than to ergy and fertilizers, underpriced ments. The key constraints of environ- "brown" (pollution abatement). The natural resources, undefined property rights, and the failure of environmen- mismanagement of public funds. environmental quality should be tal regulations and enforcement to Mechanisms for the participation of the carried out after the initial phase penalize environmental damage and main stakeholders in the decisionmak- of operation. change polluter behavior. Without ing of EFs not only contribute to the Onlending Criteria pohcy reform to accompany the use of transparency of the fund operations but nDedine criteria * Define clear criteria for project se- EFs, environmental problems recreate also build local capacity to identifv and ' ~~~~~~~~~~~~~~~~~~lection based on environmental themselves, and EFs just postpone the implement environmental projects. Ca- priorities. work of finding real solutions. pacity building has been especially * Instead of softening the financing Without strengthened environ- strongly emphasized and successfully conditions of onlending, give pref- mental regulations and enforcement, carried out by GFs. erence to assistance in eliminating EFs send the wrong messages and con- the main constraints on financing. tribute to existing distortions. Subsidies Possible areas for support include for remedying environmental problems for \orLd bank financing environmental audits to Project5 identify low-cost solutions to and providing public environmental services may reward and attract envi- When a government suggests using environmental problems and al- ternatives for improving environmental ronmentally damaging practices; cause Bank resources to support or set up an performance; providing technical environmental improvements to be EF the following checklist can be used post- pone inexpctatonfsppot; tgudeouriscssins:assistance in appraising and prepar- post- poned in expectation of support; to guide your discussions: ing loan applications for environ- and crowd out commercial financing. Only a carrot-and-stick approach that Policy Issues mental projects; and disseminating Only Examirrot-anti-sttck envirooach tinformation about available tech- rewards improved practices and * nologies and best practices. strengthens environmental policies, tal priorities of the country. * If softening the final credit terms regulation and enforcement can ensure Identify steps and measurable in- of sub-projects becomes necessary the positive role of EFs. dicators of strengthened environ- to target existing pollution sources, EFs can be made more effective if mental policies. credit-plus-grant schemes are usu- it strengthens the self-financing capac- Design Issues ally preferable to subsidized interest ity of beneficiaries and tackles the * Evaluate the pros and cons of di- rates because of transparency. cassof financial constraints. EFs l0c essitrmdaylnig Financial performance indicators causes sf financial constraints.EFs rect veTsus intermediary lending. should be at least as strict as indi- should therefore focus on eliminating * If intermediary lending is justified cators used in commercial lending. such constraints as lack of information because of the high transaction cost * Eligibility for grants has to be about alternative ways to achieve envi- of reaching a large number of small linked to non-internalized environ- ronmental improvements, limited borrowers, assess the available mental benefits expected from access to commercial financing, and choices of intermediaries: the bank- sub-projects. lack of cost recovery ing sector, an existing EF, or a new * Clear and measurable environmen- Without a clear spending strat- EE The default should be to onlend tal performance indicators have to egy and eligibility and project selection through the banking sector rather be agreed, and grants should be criteria based on cost-effective solu- than establishing new institutions converted to credit at market terms tions to environmental priorities, the or EFs. if a borrower does not comply ivith allocation of financial resources be- * For EFs designed to address pollu- these indicators. comes sub-optimal and wasteful. EFs. tion abatement, estabhish a schedule * Grant allocation should be trans- parent, and the people and insti- therefore, should have links to the en- for phasing out the EF tied to tution in charge of the grant facilitv vironmental policymaking bodv to monitorable improvements in slhould be held accountable for the obtain guidance for spendingpriorities, environmental regulations and b proper handling of funds. The par- and settheir spendingcriteria accordingly. enforcement. ticipation of NGOs or community Transparency and accountability * Onlending is best introduced on a groups in the design of the program in the operation of EFs are essentialfor pilot basis, and a thorough eco- and in the rmonitoring of implemen- avoiding ad-hoc political influence and nomic analysis of impacts on tation is highly desirable. Table - Examples of Environmental Funds Revenues Main Expenditures Beneficiaries Disbursement Earmarked Tax Funds Hungary Fuel tax, product charges, Air pollution abatement, waste Public transportation companies, Grants, low- CEPF traffic transit fee, pollution management, water pollution municipalities, industrial interest loans fines, EU PHARE grant control, public awareness building enterprises, research institutes Poland Air and water pollution Air and water pollution abatement, Industrial enterprises, municipal Soft loans, loan NFEPWM charges, water use and soil protection, environmental companies, universities guarantees, waste charges monitoring and education grants Russia Pollution charges, fines Pollution control, environmrental Municipal companies, industrial Grants FEF R&D, institution building enterprise, research institutes Directed Credit Funds China IDA credit, pollution charges Waste reduction and recovery, industrial enterprises Market-rate Tianjin pollution prevention (cleaner loans plus grant IPCF technology) (10-30%) Russia IBRD loan Waste recovery. Public and private industrial IBRD rate plus PAF enterprises 400 BPs Slovenia Budget allocation, IBRD loan Urban pollution abatement Households, cooperatives, LIBOR plus 200 Eco-Fund commercial and industrial BPs enterprises, municipalities Green Funds Bolivia DNSs by international Support to protected areas in Local communities, NGOs Grants FONAMA NGOs, foreign government nature conservation contributions Colombia DNSs, NGOs, foreign Nature protection, environmental NGOs, local groups Grants ECOFONDO governments education, integrated watershed management Note: BP: basis points; CEPF: Central Environmental Protection Fund; FEF: Federal Environrnental Func; IPCF: Industrial Pollution Coritrol Fund; LIBOR: London interbank rate; NFEPWM: National Fund for Environmental Protection and Water Management; PAF: Pollution Abatement Facility. To be Avoided 2. In a broader sense, social funds also 1_eference5 * Setting up an onlending program belong to this category insofar as they Lovei, M. 1995. "Financing Pollution Setting ~~~~~~~~~~~finance basic environmental services with soft credit terms for pollution such aaste dsol and saniain Abatement: Theory and Practice." abatement when significant Although social funds often have en- World Bank Environment Depart- improvement in environmental vironment related expenditures, their ment Paper 28. Washington D.C. regulations and enforcement can- primary objectives are to alleviate pov- Mikitin, K. 1994. 'Issues and Options not be expected; or enterprise ertv and provide a social safety net in the Design of GEF Supported managementisnonresponsive.targeting t}re poor. Trust Funds for Biodiversitv Conser- management is nonresponsive.taginthpor 3. Debt for nature swaps are debt- vation." World Bank Environment * Financing pollution abatement conversion programs in which either Department. Paper 11. Washington projects at soft terms without clear an intemational NGO purchases c.om- D.C. objectives for environmental qual- mercial debt of a developing country OECD. 1995. Environmental Funds in ity improvements and stronglinks on the secondary market at a discount, Economies in Transition. Paris: of subproject financing to these or official debt is forgiven v leder Organization for Economic Co- Governments in exchange for the improvements. dehtor country's commitment to Operation and Development. LJ ote spend an equal or agreed amount on Panayotou, T 1995. "Effective Financ- E-ndnaote5 nature protection. Commercial debt- ing of Environmentally Sustainable 1. The term "environmental fund" is also for-nature swaps typically establish Development in Eastern Europe used to denote investmentfunds that GFs, while EFs created by official and Central Asia." Environmental specialize in environmentally friendly DNSs (for example, in. Poland and Discussion Paper 10. Cambridge industries and services. This note Bulgaria) have broader environmen- MA: Harvard Institute for Interna- does not deal with this type of funds. tal objectives. tional Development. _ B@ X __'E:'M.,asnunun ''D 1rn :.111.StSDa