SOFIA INITIATIVE ON ECONOMIC INSTRUMENTS
Improving Environment and Economy
The Potential of Economic Incentives for Environmental Improvements and Sustainable Development in Countries with Economies in Transition
This report was published with the support of
The Danish Environmental Protection Agency
The Swiss Agency for the Environment, Forests and Landscape
Chair of the Sofia Initiative on Economic Instruments:
Ministry of Environment of the Czech Republic
Secretariat of the Sofia Initiative on Economic Instruments:
The Regional Environmental Center for Central and Eastern Europe
Published by the Regional Environmental Center for Central and Eastern Europe.
- Introductory Note
- Executive Summary
NOTE: The online version of this publication contains only the initial three sections. You can read them by clicking on the links above. To read the full document:
FOREWORDIn recent years new environmental policy instruments have been successfully implemented which address environmental concerns while simultaneously promoting economic development. It is now recognized that these "economic instruments" are central to integrating economic and environmental decision-making, an essential requirement for governments aiming at sustainable development. OECD countries' experience shows that economic instruments, if designed and implemented properly, often in combination with other environmental policy instruments, can contribute to achieving economic benefits by helping to:
- provide flexibility to polluters in choosing the most cost-efficient and environmentally effective measures, thereby reducing compliance costs;
- change the relative prices of environmentally sensitive goods, leading to an allocation of resources towards more environmentally sustainable production and consumption;
- create "win-win" incentives for environmental investments which generate profits and environmental benefits at the same time;
- promote technological innovation needed for more environmentally sustainable production and consumption; and
- raise revenues which governments can use for catalyzing environmental investments of national priority, or for decreasing income taxes, profit taxes or social security contributions.
This report, "Improving Environment and Economy," provides a thorough discussion of how the above-mentioned benefits can be attained and provides practical examples of experience with economic instruments in OECD countries and economies in transition. The report focuses on the specific circumstances of economies in transition and demonstrates the importance of integrating modern environmental management policies into emerging economic policies now rather than in the future. This report is a timely contribution: Economies in transition have a unique opportunity to learn from the experience of OECD countries and to avoid high costs of environmental policies, implementation deficits and environmental distortions to economic policies. The report should also be a useful contribution for discussion in those countries of Central and Eastern Europe which are in the process of acceding to the European Union and which will have to adopt and implement European Union environmental legislation. The report highlights many possibilities for achieving European Union environmental standards in a cost- effective way and discusses how the environmental accession process may lead to additional economic benefits.
I am pleased that the framework for analysing economic instruments, originally developed in OECD, is finding use beyond the traditional OECD membership. I would commend the REC, an organisation rooted in Central and Eastern Europe, for producing this valuable report in cooperation with experts from the region. I hope that the lessons synthesised in this volume will stimulate further progress in the implementation of cost-effective environmental policies in Central and Eastern European countries and beyond.
Director, Environment Directorate,
Organization for Economic Cooperation and Development, OECD
INTRODUCTORY NOTEThe goal of this report is to inform the reader of the potential benefits of economic instruments for environmental policy and to provide the latest information regarding the role of economic instruments in addressing urgent environmental problems while simultaneously contributing to sustainable economic development and growth in countries of Central and Eastern Europe (CEE) and the Newly Independent States (NIS). Experience with economic instruments in Western Europe and North America is reviewed and compared to the experience in CEE and NIS, and recommendations for the continued and expanded use of economic instruments in CEE and NIS are elaborated. The report is written primarily for high level economic and political decision-makers but should also be valuable for environmental policy-makers as well as a wider audience. This report is published in English language (original) and Russian, Croatian, Estonian and Romanian languages and is widely distributed among the economic and political decision-makers in the CEE and NIS regions, especially in those countries for which a national language version was produced.
This report has been produced under the mandate of the "Sofia Initiative on Economic Instruments" (SIEI) stemming from the 1995 Environment for Europe Ministerial Conference in Sofia, Bulgaria. European environment ministers welcomed the work completed under the SIEI and renewed the mandate at the 1998 Environment for Europe Ministerial Conference in Aarhus, Denmark. The SIEI is implemented as part of the work program of the Environmental Action Program Task Force with Secretariat at the Organisation for Economic Cooperation and Development (OECD) and the Regional Environmental Center for Central and Eastern Europe (REC). For more information on the SIEI see: http://www.rec.org/REC/Programs/SofiaInitiatives.
The report was written by Jürg Klarer (principal author), Project Manager at the REC and environmental economics and financing consultant; Patrick Francis, environmental economics and financing consultant and former Program Manager of the Environmental Financing Program of the EAP Task Force at OECD; and Jim McNicholas, economic instruments expert at the REC.
The national coordination for producing the translated versions was carried out by: Alexander Golub, Professor at the Higher School of Economics Moscow (Russian version); Mirjana Papafava, Senior Advisor at the State Directorate for the Protection of Nature and the Environment of Croatia (Croatian version); Ljubov Gornaja, environmental economics consultant (Estonian version) and Mihaela Popovici, Director, Center for Environmentally Sustainable Economic Policy (CESEP), Bucharest, and expert for the Harvard Institute for International Development (Romanian version). These experts also contributed to the report with specific inputs as indicated in the text, by commenting on a draft version and by proofreading translations. The translations were completed by Alina Averchenkova (Russian version), Irena Brnada (Croatian version), Siiri Kerge, Mari Lahtmets and Ene Laur (Estonian version) and Carmen Constantin (Romanian version).
The design, layout and final publication of all reports was coordinated by Sylvia Magyar, REC publications officer, with the help of Reuben Stern. The English language version was edited by Daniel McAdams and copy edited by Tom Popper.
The generous support of the Danish Environmental Protection Agency and the Swiss Agency for Environment, Forests and Landscape that made the implementation of this report possible is gratefully acknowledged.
We would like to thank all experts mentioned above for their important contribution.
Secretariat of the Sofia Initiative on Economic Instruments
The Regional Environmental Center for Central and Eastern Europe
Szentendre, Hungary June 1999
The Need for ActionThe countries of Central and Eastern Europe (CEE) and the Newly Independent States (NIS) of the former Soviet Union continue to face substantial environmental challenges. Priority problems typically identified include: centres of severe industrial pollution; pollution intensive and inefficient heat generation and distribution systems; increasing pollution from road transport; poor surface and groundwater quality; underdeveloped municipal environmental infrastructure; and the inefficient use of natural resources. Immediate action is required to allow for environmentally sustainable economic growth and to prevent long-term negative effects on human health and damage perhaps irreversible to natural habitats. Opting for short term, unsustainable economic development, rather than working toward solutions for environmental problems now, may prove to be much more costly in the years ahead.
During the economic transition period, a degree of pollution reduction has been achieved in many countries in the CEE and NIS regions. Most noteworthy is the autonomous reduction in some key pollutants which accompanied the massive reduction in industrial output in the early years of transition. Such pollution reduction may be temporary unless regained growth is separated from a corresponding growth in pollution. Economic restructuring in advanced economies in transition (EITs) in CEE and NIS has resulted in cleaner and more efficient production, and the gradual introduction of market-based reforms such as reducing subsidies and price controls, imposition of hard budget constraints, privatisation and trade liberalisation has brought further environmental benefits. Pollution patterns in the region and in western countries, however, clearly indicate that economic reform alone is not enough to resolve environmental problems.
More effective environmental policies, accompanied by improved implementation and enforcement practices, are also needed and are gradually being introduced in the CEE and NIS regions. In the more advanced EITs, some attention is also being given to developing policy initiatives that simultaneously address environmental concerns and provide long term signals for economic development patterns. In CEE countries, European Union accession has acted to catalyse many of these initiatives. The costs of meeting the environmental requirements of EU accession, an estimated EUR 120 billion only in the air, water and waste sectors, provide a benchmark for policymakers in these countries and give an indication of the environmental challenge faced by these countries. Annual environmental investments of up to 2-4 percent of GDP over 10-20 years will be necessary. A similar benchmark does not exist in the NIS, but costs may be even higher, as environmental progress in the early transition period has been slower in these countries than in CEE countries.
Western environmental policy has rather effectively addressed key concerns in most areas that constitute present priority environmental problems in CEE and the NIS. Higher levels of investment, the development and introduction of modern technologies and increased efficiency of industrial and heating processes have contributed to the lower pollution intensity of most western economies. Command and control environmental policy instruments traditionally applied in the West, however, have lead to implementation deficits and high costs for achieving environmental improvements. These same policies have proven largely unsuccessful in preventing or controlling new environmental problems (e.g., non-point source pollution from road transport). Based on these negative experiences, a gradual reorientation has taken place which is reflected in recent trends in Western environmental policy. Increasingly, current environmental policies attempt to recognise market forces; internalise social costs from pollution and resource use; shift toward full cost pricing in municipal services, such as water supply/treatment, waste management, energy supply etc.; and search for cost-efficient and flexible instruments, which simultaneously support economic development. Economic instruments have proven very useful to achieve such policy goals.
A common conclusion that can be reached based on regional and Western experience is that environmental and economic variables are mutually-dependant (not mutually-exclusive), in the sense that the environment is a key input to many economic activities, and economic decisions are also important for the quality of the physical environment. It is therefore not generally a question of "either the environment or the economy," but of "both the environment and the economy." While past environmental policy and management in Western countries, as well as CEE and NIS countries, has tended to be divorced from economic policy, today there is growing experience and evidence that a rather new set of policy instruments -- economic instruments -- can combine environmental and economic objectives.
The Need for Economic InstrumentsEconomic Instruments (EIs) have gained particular attention in recent years as effective instruments which serve to integrate environmental concerns into economic development strategies. EIs offer numerous benefits:
- EIs are key to environmentally sustainable development: By integrating environmental concerns directly into the economic incentive structure that producers and consumers face each day, EIs implicitly promote a shift in the allocation of resources towards those activities which are both environmentally sound and economically attractive.
- EIs help internalise environmental costs: Economic instruments can reflect the real costs of pollution and attempt to incorporate them into the prices of goods and services. In the absence of the corrective role played by EIs, the under-pricing of pollution and natural resources allow distortions and inefficiencies to remain in the economy.
- EIs often are more cost efficient than traditional policy instruments: Due to the flexibility granted to polluters in achieving pollution targets, EIs encourage pollution reduction where abatement activities can be implemented in the most cost efficient way.
- EIs support the Polluter and User Pays Principles: Economic instruments solicit direct payments from those who introduce pollution into the environment and those who use natural resources taken from the environment. In other cases, i.e. packaging, EIs require a deposit from potential polluters.
- EIs raise revenues for environmental investments or general government expenditure: In most EITs, revenues from pollution charges are used to co-finance priority environmental investments, often via environmental funds. The current trend in Western countries is toward "eco-tax reform," where revenues from eco-taxes flow to the central government budget. The ultimate goal of eco-tax reform is to shift taxes from "goods" such as employment or income to "bads" such as pollution or resource consumption.
- EIs are compatible with current priorities and trends in regulatory and fiscal reform: EIs can contribute to achieving overall policy objectives such as: making government intervention more effective; reducing cost; promoting technological innovation; encouraging private investment; and reducing distortions in fiscal systems.
- EIs may have positive effects on innovation and competitiveness: By raising the price of pollution and natural resources, EIs encourage the development and trade of more efficient technologies. Enterprises that operate more cleanly and efficiently reap the reward of lower costs and increased competitiveness.
- EIs help businesses and consumers in taking longer term choices: By revealing the high, cumulative costs of pollution and resource consumption to producers and consumers, EIs help enterprises and individuals develop strategic plans to reduce environmentally damaging behaviour and save money in the long run.
- EIs are useful to mitigate "diffuse pollution": Pollution coming from various, small sources such as vehicle emissions, chemical run-off from farms and packaging wastes etc. can be better and more cost-efficiently controlled by EIs than traditional policy instruments.
Experience in Economies in TransitionMost of the countries in CEE have introduced pollution charges on air emissions, water effluents and waste disposal. These charges have generally been introduced in conjunction with a permit system: a base charge rate is applied for permitted emissions and a penalty rate encourages compliance with the permitted standard. Product charges, which have been introduced extensively in Hungary and Latvia, are increasingly being introduced in other countries in the region. It is difficult to assess the incentive effect of these charge systems, but available evidence does suggest that they do provide positive environmental and economic effects. Experience in Poland shows that environmental charges -- even if set at high rates -- have contributed to accelerated economic restructuring, which has also lead to improved economic performance.
Although most charges were introduced with an incentive effect for pollution reduction in mind, a review of these pollution and product charge systems suggests that the primary function has been to raise revenues for supporting environmental investments. With the exception of Albania, Croatia, Romania and Slovenia, the revenue from environmental charges is earmarked for environmental funds in CEE countries. For reasons associated with inherited debt burdens and the under-development of financial markets, environmental funds have been effective in catalysing priority environmental investments that may otherwise not have been completed. The administration of public revenues by environmental funds remains a debated issue in some countries, but if efficiently and transparently managed, funds will most likely play an important role in financing environmental investments in the future. In CEE countries preparing for European Union Accession, environmental funds are already being considered to play special roles in financing necessary environmental improvements.
The introduction of full-cost user pricing in sectors such as energy, water and waste management has also been initiated in most CEE countries and, though to a lesser degree, in the NIS. Current user charges still remain well below full cost pricing, and further increases in charge rates in line with increases in purchase power of citizens are inevitable for both environmental and economic reasons. Although the reduction of price controls is generally a politically and socially sensitive issue where incomes are low, long term benefits of improved services, environmental quality and more efficient resource use should outweigh initial price increases.
Economic subsidies in the industry, transport, energy and agriculture sectors -- including support such as tax allowances and exemptions, non-payments or delayed payments, debt forgiveness, direct support (grants, preferential loans, loan guarantees) and tariff barriers and exemptions -- may continue. There has been little analysis on the possible negative environmental effects of such subsidies in the region, though experience in the west indicates that such subsidies contributed to unsustainable economic growth patterns. It appears that some direct subsidies were reduced in the transition period due to budget deficits, but it is also possible that previous subsidy schemes were turned into more hidden forms of subsidisation. The potential negative environmental side effects of large new subsidy schemes that will probably emerge in the context of EU Accession, for example in the transport area (expanding the road network) or the agriculture area (harmonisation with EU Common Agricultural Policy) should be assessed. Experience in Western Europe and North America
The use of economic instruments has been increasing rapidly in Western countries since the late 1980s, and it is expected that environmental taxes, tradable permits and deposit refund systems will play a larger role in future environmental policies. This trend of applying more economic instruments is strongly supported both by the OECD and the European Commission.
An important reason for the increased use of economic instruments in all Western countries is related to the positive experiences gained with economic instruments that have been in place for some time already. Both environmental effectiveness and economic efficiency of some older instruments has been proven in empirical evaluation studies (examples discussed in the text include the Swedish sulphur tax, the Norwegian CO2 tax, the Danish waste charge and the Dutch wastewater charges). Key for achieving positive results was careful and proper design of the instruments, formulation of clear objectives and gradual implementation.
Recent analysis found that certain economic subsidies in the industry, energy, transport and agriculture sectors can have undesired negative environmental effects (often referred to as "perverse incentives") and have contributed to the development of environmentally unsustainable economic structures. Environmentally harmful subsidies can affect or offset improvements arduously achieved by environmental policy. In some cases, support schemes no longer serve their well-intended original purpose, and it would be wise to reform or remove the support schemes both for environmental and economic reasons. However, experience shows that once a support scheme is in place it is extremely difficult to remove or reform it, due to the vested interest of those benefiting directly from the scheme. The non-internalisation of external environmental costs can be also considered an "implicit subsidy." CEE and NIS countries should prevent the development of similarly distorting economic schemes while gradually developing a market economy.
Ecological tax reform currently receives priority attention in Western Europe, and, currently, ten European Union member states have implemented or are about to implement an ecological tax reform. The political attractiveness of eco-tax reform has consisted of the possibility to achieve a "double-double dividend" by delivering simultaneous improvements in: a) the environment; b) innovation and competitiveness; c) employment; and d) the tax system. Eco-tax reform usually involves three complementary approaches: a removal or modification of existing distorting subsidies and tax provisions; a restructuring of existing taxes; and the introduction of new eco-taxes. The introduction or alteration of environmental taxes is often carried out under constraints of revenue neutrality (i.e. constant overall tax revenue), for example by shifts from income or labour taxes towards environmental and resource use taxes. Already in 1995, environmental taxes accounted for 7 percent of total tax revenues in the European Union average (corresponding to 3 percent of GDP). The potential for eco-tax reform in the CEE region has not yet been thoroughly assessed and related analysis should be initiated. A regional fore-runner may be Slovenia, which has recently introduced un-earmarked taxes on CO2 and wastewater effluent.
Very positive experience has been gained with tradable emission permits primarily in the United States and Canada. The potential for more cost-efficient and market-based environmental policies using tradable permits has also been recognised in the CEE and NIS regions to some extent and a few experimental pilot emission trading schemes have been implemented (Poland and Kazakhstan). Additional research and time is needed before possibly introducing this promising instrument in CEE and NIS countries.
The flexible mechanisms introduced under the Kyoto Protocol aimed at decreasing global greenhouse gas emissions are a special case and represent the first international economic instrument. The Kyoto flexible mechanisms include two project-based trading mechanisms (Joint Implementation and Clean Development Mechanism) and international emissions allowance trading. At present there are still many open questions about the technicalities under which these mechanisms would actually work. However, it is estimated that the global market created by these mechanisms could be as large as USD 10-20 billion in the period 2008-2012, with a major part of funds flowing to EITs. Apart from financial transfers, EITs could profit also from technology transfer and secondary environmental benefits. However, in order to realise these promising gains, EITs will have to take a number of institutional and policy steps to be ready for greenhouse gas trading in the year 2008. The implementation of domestic greenhouse gas mitigation measures will allow EITs to benefit most from international trading.
Conclusions and Recommendations
- Make greater use of economic instruments to more fully capture the benefits they offer. The dynamic events occurring in the transition period create a tremendous scope (and need) for new and more effective and efficient policy instruments. Notwithstanding the numerous, and sometimes daunting, challenges posed by the reform process now underway, opportunities for improving existing economic instruments -- and introducing new ones -- abound.
- Ensure that the objective(s) of economic instruments are clearly and explicitly specified. As tools of environmental policy, the environmental objectives of each instrument, and how those objectives will be achieved, should be clearly spelled out by its enabling legislation.
- Economic instruments currently in effect should be systematically evaluated. Existing economic instruments should generally be evaluated according to the criteria suggested by OECD: environmental effectiveness; economic efficiency; administration and compliance costs; dynamic effects (innovation); and soft effects (capacity building, awareness raising). Similarly the earmarking of revenue generated by economic instruments and its use should be continuously reviewed. Regular evaluation would provide useful feedback for modifying and adapting the instruments to their changing context and would help decrease barriers to introducing new instruments by showing their positive environmental and economic effects.
- Involve key stakeholders early in the design and implementation of economic instruments. The constructive involvement of key interest groups will ultimately lead to more effectively designed and implemented economic instruments. These other stakeholders will include (at a minimum) members of other ministries, parliament, industrial groups and environmental citizens' organisations, the latter of which may be very helpful in building public support for economic instruments.
- Environmentally harmful subsidies should be reduced or eliminated. In Western countries, certain subsidy schemes led to environmentally unsustainable economic development patterns and have affected or offset arduously achieved improvements by environmental policy. Existing and proposed new support schemes in EITs should be assessed for their environmental impacts and reforms should be initiated if necessary.
- Establish "green budget commissions" to spearhead more environmentally sustainable economic and fiscal reform. Experience in a number of OECD countries has shown such commissions to be effective in integrating environmental concerns into economic development and making fiscal policies both more environment-friendly and economically sound. The potential for ecological tax reform should be analysed in advanced EITs. Experience gained in this area in Western European countries should be taken into account.
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