The views and interpretation reflected in this paper are those of the author and do not necessarily reflect an expression of opinion on the part of the United Nations Environment Programme.
Acknowledgement is made to the Staff of the Environment and Economics Unit (EEU), UNEP for their contribution to this paper. Particular mention is made to Ms. Deborah Vorhies, Programme Officer, EEU in this respect.
Economic instruments aim to bridge the gap between the private and social costs by internalizing all external costs to their sources, namely the producers and consumers of resource depleting and polluting commodities. According to a definition from OECD, economic instruments are "instruments that affect costs and benefits of alternative actions open to economic agents, with the effect of influencing behavior in a way that is favorable to the environment".
This paper is designed to elaborate some ideas for the use of economic instruments for environmental management. A brief overview of the different instruments is given and recommendations on how to implement such tools on a regional or national level are described.
There is a wide range of economic instruments or incentives which can be used to internalize externalities of economic activities. Every incentive that aims to induce a change of behavior of economic agents by internalizing environmental or depletion cost qualifies as an economic instrument. A very general classification of economic instruments is, to divide them into two groups. The first group are the so called market based instruments. This covers all instruments and incentives that work by a change of either product or factor prices, e.g. taxes or pollution charges. Such instruments generate in one or the other way income for the governments. The second group are the non-market based instruments, such as command and control activities or land reclamation bonds. A perhaps better and more accurate typology of economic instruments was proposed by Panayotou (1994). He classified economic instruments into the following seven categories:
As already stated, inadequately defined and insecure property rights can be one of the reasons for environmental depletion and pollution. Therefore the establishment of secure (and tradeable) property rights will lead to more appropriate pricing of the use of natural resources. Establishing secure and transferable property rights will ensure that cost of depletion is internal to the user and that will ensure the sustainable use of his property. In case of somebody polluting or using natural resources from somebody else in a specific area, secured and tradeable property rights will ensure that they will negotiate with each other and find a solution to internalize the externalities.
However, the assignment of property rights can not solve all environmental problems. It is only useful under certain circumstances and conditions. For example, the assignment of property rights is not feasible if there are a lot of users of a specific environmental commodity, such as air, atmosphere or water, since exclusion of other users is technically not possible. In such a case alternative instruments must be used to ensure the environmentally sound use of the commodity.
The assignment of secure and tradable property rights would have the following advantages:
Limitations:
This type of instrument internalizes environmental damages on the production side because the government creates a market to use the environment as a waste sink or issues pollution permits. These rights can be bought and sold like any other commodities. An example for market creation are tradable pollution permits which allows a company to buy or sell the rights to pollute the environment with an allowable level of pollution. This ensures that a specific level of pollution or emission will be attained at the lowest cost to society.
Individuals or companies using the environment would have to pay pollution charges either directly to the government or they would have to purchase pollution permits. Pricing the use of the environment as a waste sink would internalize the cost of waste into the product prices and therefore in the long run reduce the waste per unit of output. This is also an instrument which can ensure that the environment is only affected as far as it can tolerate such impacts. To achieve sustainable use of the environment by charging for polluting it, it is essential to ensure that the environment is used below its self-healing-capacity. Otherwise economic activities would still be continued at an unsustainable level, although less than it would be without the pollution changes.
Advantages:
Disadvantages:
Fiscal instruments such as taxes or subsidies for environmentally sound production can be used for full cost pricing of production and consumption. For example current prices of petrol or pesticides do not incorporate the social costs of these products. Their effects on human health or the environment are not considered at all. Fiscal instruments therefore try to bridge the gap between the private and social cost of production and consumption. Ideally, the taxes or subsidies should be equal to the marginal environmental damage caused by a certain activity. If this is the case it would adjust the price of a good exactly by the amount of reduction in social welfare caused by the externalities associated with such a product. Taxation of environmentally hazardous products is a rather old instrument which was already proposed by Pigou in the early twenties of this century. Environmental taxes can be imposed on the production side (e.g. taxation of raw materials) as well as on the consumption side (e.g. taxation of petrol or pesticides).
Advantages:
Disadvantages:
Financial instruments could give incentives to support environmentally friendly activities or projects with positive externalities, such as reforestation or advanced techniques to control soil erosion. Financial instruments such as revolving funds, green funds, subsidized interest rates or soft loans may be justified as instruments for mobilizing additional financial resources for conservation, environmental protection and sustainable development. Financial instruments might be effective under certain circumstances and conditions, but they are mostly considered to be too blunt for an efficient internalization of social costs, since they only encourage a certain form of behavior but do not internalize costs.
Both systems are aimed at shifting responsibility for controlling, monitoring and enforcement to individual producers and consumers who are charged in advance for the potential damage. In any case the state has to pay the bill for environmental damages caused by the activities of single users of the environment. This could be avoided by introducing a deposit refund system, environmental bonds or similar incentives. This would make sure that companies act in compliance with environmental rules and use the environment in a sustainable matter. After proving this, individuals or companies can get their bonds refunded. If they have damaged the environment the bonds can be used by the government for cleaning up the environmental damages. Again, even if the controlling is done through the companies, the administrative costs are quite high.
In many cases governments are effectively subsidizing environmental bads. For example, the application of a carbon tax where governments are paying subsidies for the production of electricity are likely to be relatively ineffective. Before starting to assess the use of economic instruments, it is necessary to detect such unsustainable market distortions and reduce them. Perhaps this might already be sufficient to induce environmentally friendly production and no further action might be necessary.
The above mentioned instruments might give the impression that persons or companies always need to be forced by certain rules or regulation to take care of the environment. But a more efficient and cost effective way to achieve cost internalization is to induce self-regulation on the polluters side. In most of the cases the polluter knows best how to control their hazardous output or environmental damages.
In this chapter a brief overview was given on the different economic instruments which can be used. There are many more instruments available than outlined above. Sometimes it is not possible to fit an instrument into any of the above groups. It is clear that there is a bundle of different instruments available for the internalization of external costs. Each one has its advantages and disadvantages and they might only be effective under certain circumstances.
At the outset, the use of economic instruments as mentioned in chapter two,
seem to be straight forward. Since each instrument has its advantages and
disadvantages it would seem that it would be easy to select the appropriate
instrument for a given environmental problem. But before imposing a certain
instrument or mix of instruments it is necessary to consider all economic,
political, social and cultural constraints to make sure that the desired
outcome is achieved. Therefore it is difficult to give guidelines as to
which instrument should be used in which case. These must always be
considered on a case by case approach to ensure that the environmental
goals will be met. The decision-making process for selecting the most
appropriate instrument the necessitates the following steps:
Considering the above questions will lead to a specific instrument or a mix
of instruments which would be appropriate to internalize given
externalities of economic activities.
The overall goal of economic activities on a country level is usually to
increase the country's wealth by increasing the Gross Domestic Product
(GDP). The GDP itself is a measurement of the overall production in a
country over a certain period of time, usually one year. Nevertheless,
economic growth is normally considered as destroying and polluting the
environment and depleting natural resources.
When talking about the use of environmental economic instruments,
politicians and decision makers always express their fear that imposing
such instruments would lead to a lower productivity and therefore a lower
increase of the GDP. Therefore in many countries there is a tendency to
oppose against the use of economic instruments. Empirical evidence for this
argument can be found in the literature. But OECD and other institutions
doing research in this field came to the conclusion that a well balanced
environmental policy would decline GDP by only 0.1 to 0.2 per cent. The
costs of the alternative, which would be no action, would be far higher
then this amount. If externalities are not internalized the result would be
depletion of natural resources and pollution of the environment to a great
extent. In the long run this would lead to increasing expenses for health
treatment and for cleaning the environment. This should obviously be the
best argument for imposing economic instruments, since the costs for doing
nothing will be far higher than the costs for a well balanced environmental
policy.
There is also a very strong belief that economic growth is necessary to
meet the following needs:
If all above statements are right there would be no solution for the
conflict between economy and ecology. But in order to single out the
effects of economic instruments on economic growth it is necessary to
distinguish different stages of economic growth.
Economies at the first stage of economic growth need economic development
to meet the basic needs of their population. This is the case for countries
with a very low GDP, very high unemployment rate, where people are
starving, high illiteracy rate and serious housing situations (e.g. people
have to live in slums or shanty towns). For countries which are in this
stage of economic growth, it is probably difficult, if not even impossible,
to impose one of the above-mentioned economic instruments for
environmentally sound development. It is hard to convince somebody who is
starving, that he has to pay higher prices for water or other basic goods
because the government is cherishing clean environment above the basic
needs of its people. Therefore many economic instruments do not seem to be
appropriate for environmental management in such countries.
This should not mean that countries in this stage of economic development
should not care about the environment at all. However, most of the above
instruments, as earlier noted, were designed for industrialized countries
according to their needs. To address the environmental needs of very low
income countries we must find other, more suitable solutions for
environmental management. (awareness building, trust funds, green loans,
international cooperation, cleaner technology...needs to be further
elaborated)
The second stage of economic growth can be described as a situation where
countries are able to fulfil the demand for basic needs of their
population. For these countries, economic growth is only necessary to meet
the demand for consumption which exceeds basic needs. Such countries are in
a position to take environmental considerations seriously into account for
economic growth and sustainable development. These countries are also in a
position to impose some of the above-mentioned economic instruments.
Nevertheless, in case a country decides to use economic instruments to meet
environmental goals they must be target oriented and tailored to its
specific needs in order to make sure they match with social, economic and
cultural constraints.
The third growing stage can be characterized as a stage of over-consumption
and high demand for luxury goods. Most industrialized countries are
belonging to this group. In conjunction with the over-consumption there is
also a very high awareness on the part of the population of environmental
concerns. In many cases the population or major parts of it are demanding a
higher consideration of environmental impacts from the government. Most of
the economic instruments were designed and used in countries of this group.
But even in this countries a lot of lobbyism against the introduction of
economic instruments occurs, mainly from the industries which would be
concerned by an introduction of such instruments. Their arguments are
again, that such a policy would affect economic growth, employment rate and
international competitiveness. Since such lobby groups have a lot of
influence on decision makers, only little has been done so far to
internalize all social costs of economic activities in such countries.
The question of international competitiveness is also always brought up in
a discussion about economic instruments. Governments or industries
concerned always fear that they would not be able to compete with products
from other countries after a certain instrument is introduced. It is true
that some incentives can reduce the international trade competitiveness of
certain industries. Empirical research indicates that the impact on
competitiveness is difficult to predict and that a case by case approach is
needed. In the short run, in many cases negative impacts of environmental
policies on competitiveness can be expected. But industries are able to
adapt and find technical solutions to meet the environmental constraints
given through economic instruments and produce their products with less
environmental impacts. On a nation wide basis the economy can even benefit
from economic instruments by establishing other economic activities. An
example for such a case would be the creation of a tourist resort at a lake
which was, in the past, heavily polluted by industries surrounding it.
On the other hand the costs of environmental protection are only of minor
concern in the production cycle. Other costs such as for labor, natural
resources, taxation and natural and artificial trade barriers are far more
important.
On the other hand costs of environmental protection can also be seen as a
comparative disadvantage for a country, which seems to have a very
resilient environment. Other countries have to live with far more important
comparative disadvantages, such as lack of natural resources or climatic
constraints. Even countries with such disadvantages managed to adapt and
this implies that it should also possible in the case of environmental
protection.
If economic instruments are inducing a change in the production cycle or
the introduction of cleaner technology of certain sectors, these techniques
could be sold on the world market to countries which do not have such
advanced products but which are willing to catch up. An example is Japan,
where in the mid eighties limiting values for the emission of S02 were
introduced. The Japanese industry adopted this regulation very quickly and
developed sophisticated filter techniques for their plant. These filters
were sold all over the world and the Japanese industry benefitted a lot
from the new regulations.
Nevertheless, some of the most competitive and wealthy nations, such as
Germany, the United States or Japan also have the highest environmental
standards. This shows that economic effects of a well defined environmental
policy seem to be very low, at least in the long run.
It can be concluded, that if the environmental policy is well defined and
economic and social factors are taken into account it is possible to
introduce environmental policies which have only minor effects on economic
growth and international competitiveness.In addition it might be necessary
to seek for multilateral agreements on some form of economic instruments
since this would increase the acceptance of economic instruments for
certain sectors.
In the international community there is growing concern about environmental
problems such as natural resource depletion and pollution and alarming loss
of biological resources. The underlying causes of these problems are a mix
of market and policy failures. There is a strong need to search for
solutions which do not only address the symptoms but focus on the
underlying causes for this problems.
Economic instruments can be viewed as one important tool for sustainable
development. These instruments try to close the gap between resource
scarcity and resource prices by internalizing costs which are external to
the producers and consumers. A lot of different economic instruments are
available. All of them have their advantages and disadvantages and for
imposing them a case by case approach is necessary to select the most
appropriate one for a given environmental problem. This makes it necessary
to look into economic, political, social and cultural effects in order to
make sure that these instruments are target oriented and acceptable by the
public as well as the target group concerned.
It is also necessary to involve the private sector in the design and
implementation of measures to achieve agreements on environmental quality
standards. The private sector should be given the opportunity to come up
with its own ideas to achieve established environmental objectives. Simply
imposing regulations may stifle industry, whereas a flexible approach is
more likely to mobilize sector recommendations and the adaptation of
economic instruments.
Furthering the achievement of sustainable development will require an
integrated consideration of institutional, economy and industry reform.
Economic instruments should play a more important role as part of an
integrated bundle of measures. But it is important to expect not too much
from the use of economic instruments by themselves if the surroundings do
not provide additional assistance from a well defined environmental policy.
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PANAYOTOU, T.: Economic Instruments for Environmental Management and
Sustainable Development. Paper presented at UNEP's Expert Group
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Environmental Management, Nairobi, August 1994.
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Dr. Bernd Schanzenbacher
UNEP
Environment and Economics Unit
P.O.Box 30552
Nairobi, Kenya
Phone +254 2 624053
Fax +254 2 624268
BERND.SCHANZENBACHER@UNEP.NO