APM 12-Economic Instruments-FI · 2004. 2. 10. · Title: Microsoft Word - APM 12-Economic Instruments-FI.doc Author: GTZ-Administration Created Date: 2/11/2004 8:47:43 AM

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Prevention and Control of Industrial Air Pollution in Thailand

AAPPMM--IINNFFOO 1122 Air Pollution Management Info 11/2001 elaborated by: Magnus Staudte, ENVIMA and Markus Karcher, Fichtner Pages: 37

Economic Instruments for Air Pollution Management

Options for Thailand

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Table of Contents

1. Executive Summary 1

2. Why environmental policies are necessary 3

3. The Instruments 3

3.1 Economic instruments 3

3.2.1 Taxes 3

3.3.1 Subsidies 9

3.4.1 Emission Rights 10

3.5.1 Liability schemes 10

3.2 Design issues for environmental policy instruments 11

4. Environmental Management in Developing Countries 12

4.1 Introduction 12

4.2 Why regulations do not work in developing countries 12

4.3 Why regulations remain popular with governments 14

4.4 The potential for economic incentives in developing countries 14

4.5 Conclusions 17

APPENDICES APPENDIX 1: TERMINOLOGY...........................................................................................................................18 APPENDIX 2: ENVIRONMENTAL POLICY ALTERNATIVES.......................................................................20 APPENDIX 3: TYPES OF ECONOMIC INCENTIVES FOR ENVIRONMENT PROTECTION................21 APPENDIX 4: CASE STUDIES FOR THE USE OF ECONOMIC INSTRUMENTS ..................................22 APPENDIX 5: EXPERIENCE OF AID AGENCIES ..........................................................................................36

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APM Info 12 “Economic Instruments – Options for Thailand” 1


1. Executive Summary

The problem The dissociation between costs and benefits of environmental damage reflects a combination of policy failure and market failures:

• policy failure are government interventions which distort the market by influencing prices and/or quantities through taxes, quotas, subsidies and such;

• market failures arise when critical factors remain outside its domain: environmental resources are widely without proprietor and price. In addition property rights are often not established or unenforceable.

While it is considered useful to distinguish conceptually between these failures, in practice they are often closely interrelated and provide a continuum for the formulation of policy responses. Command and Control Regulations have been the mainstay of environmental policies and resource protection in all countries. They enjoy a natural preference by decision makers. Their attractiveness include the following aspects:

• for politicians, regulations offer a way to hide the true cost of environmental protection and thus to avoid distributional conflicts which would arise by imposing new taxes and charges;

• for bureaucracy, command and control policies are a source of power and influence;

• environmental pressure groups, non-governmental organizations and even the public at large often plead in favor of a clear, strictly worded regulatory framework, rather than market instruments, as a sure and predictable way of environmental protection.

The experience in the OECD countries with the effectiveness of regulations is mixed, depending on country circumstances and many other factors. While regulations are the backbone of environmental management, they offer inefficient resource allocation and are thus economically inefficient. In the underdeveloped countries the situation is less clear. Existing regulations often prove legally or practically unenforceable. In many cases, it is technically impossible to monitor pollution standards. There is a political barrier to impose drastic sanctions, such as closing down a plant. Fines are generally too low to change behavior and are easily circumvented through bribes. Besides, the enforcement of regulations is based on the functioning of the legal system, a condition sine qua non that is not met in the underdeveloped world. High bureaucratic cost, large informational requirements and problems of socio-cultural acceptance are thus discerned as important factors which can impair the functioning of a regulatory framework to protect the environment in developing countries.

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Economic Instruments Economic instruments to protect the environment are basically designed to restore the link between resource scarcity and price. The main instruments now in use for environmental protection are charges, environmentally related taxes, tradable permit systems, non-compliance fees, performance bonds, liability payments, and subsidies for environmental protection. OECD countries are increasingly using environment-related taxes for pollution control. The revenues from environmentally related taxes in the OECD is 2.5% of GDP in 1995, or just under 7% of total tax revenues in these countries (arithmetic average). The majority of identified taxes that were levied under a specific tax base relate to transport, energy and waste management. Evaluating the performance of economic instruments is a complex task and few reliable and systematic assessments have been made to date. Evidence of effectiveness is furthermore difficult since most countries apply a policy mix, i.e. introducing a combination of regulations and Market Based Instruments in order to manage environmental protection. Conclusion The cause of natural resource mismanagement and environmental degradation in the developing countries, as in the developed countries, are policy and market failures. Regulations do not correct these failures; they create new ones. The very purpose of economic instruments is to correct policy and market failures. If a developing country does only possess command and control instruments the following steps are recommendable:

• Introduction of an environmental tax: In terms of cost-effectiveness, the superiority of economic instruments over command-and-control regulations cannot be denied at least in the context of developing countries. Yet, there is a considerable resistance against the introduction of economic instruments. The best that can be hoped for is a mutually supporting mix of regulations and environmental taxes. At this stage other economic instruments are too sophisticated and require a sound legal system and adequate enforcement support.

• Abolishment of subsidies: This policy mix has to be based on a government policy which aims at an efficient resource allocation by slashing subsidies and other measures distorting the market prices which reflect the scarcity of the respective good.

• Evaluation of further economic instruments in order to abate pollution.

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2. Why environmental policies are necessary

The costs of environmental depletion and damage must become part of a resource user's economic decision. Environmental pollution means that polluters do not internalize the true costs for using the environmental resources. This has been possible due to undefined, insecure, or non-transferable property rights, as well as open access and non-exclusive resources. The overall objective of policy reform is to re-establish the link between resource scarcity and resource prices that has been severed by unmitigated market failures and policies that subsidize rent seeking behavior. Population growth and economic development are putting additional pressures on a dwindling supply of natural resources and environmental amenities. This pressure, if not allowed to be reflected in higher resource prices or if cushioned through subsidies, will result in accelerated resource depletion, inefficient levels of environmental degradation, and unsustainable development. If the growing resource scarcity were allowed to be reflected in increasing resource prices, it would stimulate a) efforts to reduce the growth of demand through resource conservation, improved efficiency and substitution, b) efforts to expand supply through recycling, exploration, imports and development of substitutes, and c) structural change that restructures the use of natural resources from sources of materials and dump sites for waste disposal to sources of environmental amenities and improved quality of life, consistent with growing incomes and expanding material wealth. This response to growing resource prices results in both economic growth and environmental conservation through increased efficiency in resource use, increased substitution of lower-cost, more abundant sources of supply, and increased investment in human capital and technological development. 3. The Instruments

3.1 Economic instruments

3.2.1 Taxes

3.1.1.1 Why environmental taxes?

The main reasons for using environmental taxes are:

• they are particularly effective instruments for the internalization of externalities, i.e., the incorporation of the costs of environmental services and damages (and their repairs)

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directly into the prices of the goods, services or activities which cause them; contributing to the implementation of the Polluter Pays Principle;

• they can provide incentives for both consumers and producers to change their behavior towards a more 'eco-efficient' use of resources; to stimulate innovation and structural changes; and to reinforce compliance with regulations;

• they can raise revenue. In some OECD countries the contribution of Green Taxes is quite sizeable.

• they can be particularly effective policy tools to tackle current environmental priorities from such 'diffuse' pollution sources as transport emissions (including air and maritime transport), waste (e.g. packaging, batteries), and chemicals used in agriculture (e.g. pesticides and fertilizers).

3.1.1.2 Types of environmental taxes

In order to facilitate measuring the effectiveness of environmental taxes they have been classified into three main types, according to their main policy objectives: 1. cost-covering charges – i.e. designed to cover the costs of environmental services and

abatement measures, such as water treatment (user charges) and which may be used for related environmental expenditures (earmarked charges):

2. incentive taxes - designed to change the behavior of producers and/or consumers: and 3. fiscal environmental taxes - designed primarily to raise revenues. In many cases a mixture of these three functions can be observed in practice. The development of environmental taxes has generally been from cost-covering charges in the '60s and '70s, to combinations of incentive and fiscal environmental taxes in the '80s and '90s, and then their more recent integration into 'green tax reforms', where taxes on 'bads' such as pollution replace some taxes on 'goods' such as labor. 3.1.1.3 Lessons learned

1. At EU-Member State level there has been a continuing increase in the use of environmental taxes over the last decade, which has accelerated in the last years. This is primarily apparent in Scandinavia, but it is also noticeable in Austria, Belgium, France, Germany, Netherlands and the United Kingdom.

2. Evaluation studies of 16 environmental taxes have been identified and reviewed in a report by the European Environment Agency (EEA). Within the limitations of the studies, it appears that these taxes have been environmentally effective (achieving their environmental objectives) and they seem to have achieved such objectives at reasonable cost. Examples of particularly successful taxes include those on sulfur dioxide and nitrogen oxides in Sweden, on toxic waste in Germany, on water pollution

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in the Netherlands, and the tax differentials on leaded fuel and 'cleaner' diesel fuel in Sweden.

3. Most barriers to implementation, especially of energy (particularly on specific sectors or regions); and on low income groups can be overcome by:

• careful design,

• the use of environmental taxes and respective revenues as part of policy packages and green tax reforms

• gradual implementation;

• extensive consultation; and information.

The mitigation of potential negative impacts can be ensured through the above measures, as recent experience in Scandinavia has demonstrated. The overall competitiveness of countries may be improved by well designed taxes which can spur innovation and stimulate structural change, though the latter remains speculative.

4. As environmental concerns move from point-source emissions and problems, such as industrial emissions from pipelines and chimneys, to include more diffuse and mobile sources of pollution, such as solid waste, or from the agricultural and transport sectors, there is increased scope for the greater use of taxes, as well as other market based instruments, at both Member States and EU level.

3.1.1.4 Who is using environmental taxes?

The current trends concerning the environment can be summarized as follows:

• environmental taxes, (non-energy taxes according to the European Commission classification of DGXXI), represented only 1,5% of total EU taxes in 1993; in only a few countries do environmental taxes represent a larger proportion (Netherlands 5.1%; Denmark 4%); taxes classified as energy taxes, however, represented a larger proportion (5,2% for the EU on average) and up to around 10% in Portugal and Greece and 6-7% for Italy and the UK);

• although there has been little progress in implementing environmental taxes at EU level, considerable progress has been made at Member State level, particularly in northern European countries;

3.1.1.5 Do environmental taxes work?

The main conclusions are:

• the taxes evaluated revealed environmental benefits and, in most cases appear to be cost effective within the constraints of the evaluation performed;

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• Examples of particularly effective taxes are those on Swedish air pollution; on Dutch water pollution; and the NOx charge and tax differentiation schemes for vehicle fuels in Sweden.

• incentive taxes are, in general, environmentally effective when the tax is sufficiently high to stimulate abatement measures;

• a significant contribution to the environmental effectiveness of the cost-covering charges is provided by the use of revenues for related environmental expenditures.

• Taxes can work over relatively short periods of time between two and four years, and so compare favorably with other environmental policy tools, though with energy taxes, they can take 10-15 years to exert substantial incentive effects.

• Evaluating a tax and its environmental impact is not easy. Taxes are often part of a policy package that is hard to disentangle: therefore the effectiveness of the tax 'per se' cannot always be clearly identified.

In addition, taxes can have multiple environmental effects and secondary benefits that could improve policy in four key areas the environment, innovation and competitiveness, employment and the tax system.

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Summary of an assessment of selected environmental taxes:

Instrument Environmental effect

Incentive effect

Remarks on overall effectiveness

Environmental taxes

Sulfur tax (S)

+++

+++ Average S-content of fuels dropped considerably (40%) over 2 years and consequently significant S emission reductions were achieved. Although being a fiscal environment tax it had strong incentive effect, probably due to high tax rate.

CO2 tax (S) ?/+

? Shift in district heating from fossil fuel to bio-fuels over 2 years; increased competitiveness of combined heat and power production

CO2 tax (N)

++ ? Partial analyses indicates some effects such as

reduction of total CO2 emissions of 3-4% in 2-3 years from rising trend.

Tax on domestic flights (S)

+

? Some impact on acceleration of replacement of combustion chambers by one airline and on emissions generally over 1-3 years.

Waste Charge (DK)

++ ? Evaluation ongoing; dramatic increase of reused

demolition waste from 12-82% over 6-8 years; and decrease in waste production; tax rate nearly doubles cost of waste disposal

Incentive Charges

Tax differential on unleaded petrol

Tax differential substantially contributed to phasing out of lead over 5-7 years; differential apparently covered costs of unleaded petrol production - strong incentive effect

Tax differential on 'cleaner' diesel (S)

Tax differential induced dramatic increase of market share of 'cleaner' fuel complying with stricter environmental standards in 3-4 years. Tax rebates for such fuels provide strong incentives as they reduced production costs to a level lower than those of standard fuels.

Toxic waste charge (D)

Reduction in waste production of at least 15% in 2-3 years. Planned capacities for incineration were consequently reduced.

N0x charge (S)

Design and tax rate provided incentive for monitoring and abatement measures in liable plants contributing to reduction of NOx emissions by 35% in 2 years; successful strengthening of permit policy.

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Fertilizer charge (S)

One of the factors, within context of the agricultural reform policy, contributing to decreased use of artificial fertilizers over 5-10 years

Water pollution charge (F)

Tax-bounty system and sector contracts may have had some positive environmental impacts over 10-12 years; revenues of charge are modest

Water pollution charge (D)

Positive impact on applying for and issuing of lower-pollution permits. Early announcement contributed to stepping up construction of wastewater treatment capacity.

Cost-covering charges; user charges

Water pollution charge (NL)

Charge created funds for increase of treatment capacity; although the tax incentive was low, use of the revenue for extending treatment capacity contributed to a substantial improvement of water quality over 10-15 years.

Household waste charge (NL)

Fairer distribution of costs of household waste management; variable rates may have provided incentive for reduction of waste (10-20% less waste / head)

Cost-covering charges; earmarked changes

Battery charges (S)

Charge renders recycling of Pb-batteries feasible; collection rate in 1993 was 95% (60% in 1989), for other batteries effect is still unclear.

Aircraft noise charge (NL)

Satisfactory in terms of fund-raising; allowed for covering cost of sound insulation measures around airport.

Legend

* The incentive effect evaluation is based on the evidence found on tax payers being encouraged to reduce pollution, mostly due to significant differentials between the tax rate and the cost of abatement measures (or a proxy). The environmental effectiveness is based on the evidence on environmental benefits derived from the tax. The question marks indicate lack of evidence.

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3.1.1.6 Political Barriers

There are several important political barriers to the introduction of environmental, particularly energy, taxes:

• the perceived impacts on competitiveness, and often on employment, particularly in some sectors/regions;

• the perceived impacts on low-income groups;

• perceptions that the taxes have to be high if they are to work;

• the perceived conflict between changing behavior (i.e. less tax) and maintaining revenues;

• existing subsidies and regulations that provide environmentally perverse effects; and

• other policies and cultures which negate or inhibit environmental taxes. 3.3.1 Subsidies

Subsidies for environmental protection are a widespread measure. Instruments involve concessionary loans, grants or donations, depreciation allowances for the use of environmental technologies, corresponding customs concessions or subsidies for appropriate technologies. From the point of view of economic theory, subsidies distort prices and constitute a sub-optimal resource allocation. Consequently in order to pursue environmental protection targets, subsidies are second best. From a practical point of view subsidies do carry a range of very problematic aspects such as:

• Longevity: It may prove difficult to stop a subsidy once firmly established and integrated into the calculations of the market participants.

• Promotion of rent-seeking behavior

• Administration: Often subsidies are not only difficult to administer but also expensive. The trickle-down effect is distorted by administration costs.

Nonetheless, subsidies are a widespread instrument to influence the environmental protection. The main problems currently facing the public funds for subsidizing are under-capitalization, delimiting recipient groups, definition of promotional criteria and financing modalities. An example for an environmental fund is the Industrial Finance Corporation of Thailand (IFCT), which funds private investments in plants for pollution control through the Environment Portfolio. Since 1991 this has been accompanied by an Environment Fund, which originally had a capital stock of some USD 20 million and also derived revenue from a special charge on petroleum consumption.

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3.4.1 Emission Rights

A further market-based instrument is the creation of emission rights, which relies heavily on the creation of a market for the pollutant. The most popular example will be the carbon emissions trading market whereby producers of carbon can sell and buy carbon emission rights. The basic idea behind the creation of markets is the assignment of positive prices on pollutants and allows polluters with high abatement costs to reduce their emission costs by buying emission rights from other firms with lower abatement costs. Tradable emission rights have a number of advantages over command and control systems as well as emission charges or taxes:

• Least cost alternative. It produces a lower cost solution than even emission taxes because it allows firms with low abatement costs to sell their emission rights to other firms with a high abatement cost.

• New entrants do not increase emissions as number of emission permits has been fixed.

• Opportunities for non-polluters (such as environmental groups) to buy rights to reduce overall emission totals.

• Adjusts accordingly to inflation and the price is determined solely by demand and supply thereby relieving the policymaker of the requirement to set the price.

• Allows technological investment due to lower uncertainty over policy changes. The main drawback or weakness with permits is the initial allocation of permits. First, the level of permits must be determined. Once the number of permits have been set, the next issue involves the allocation of the permits – who gets what and how many. The issue of equity needs to be addressed as an open auction of the initial pool of permits may exclude many of the smaller firms and, thus, drive them away from the market. Policymakers must respond to the possibility of monopolies or oligopolies being created or stimulated by an environmental policy.

3.5.1 Liability schemes

The final category of instruments is that, which fall under the financial enforcement incentives and/or liability schemes. Under this category, polluters are required to pay in advance for the environmental damage that they can cause as a deposit that is refunded once proof has been given that no environmental damage was caused. Proportional costs can be taken if some damage has been shown to occur. This system is becoming common in the mining industry, to guarantee site remediation. Similarly, in the case of another environment-related activity, a deposit can be placed or insurance be taken to cover the risk. The cost of insurance will of course be related to a host of factors similar to normal insurance policies. Under this system, the costs are internalized by the issuance of the insurance. Where an adequate insurance market does not exist, the requirement can be for the provision of an irrevocable letter of credit or deposit of bonds or other instruments.

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3.2 Design issues for environmental policy instruments

Any given policy instrument can be designed to meet a variety of different policy goals. The important challenge in developing an effective instrument is to design it to fit all of the specific requirements of the situation into which it must fit. The following design criteria can be used to both develop instruments and as a basis for comparison among possible alternative instruments. Jurisdiction- Each level of government has jurisdiction over certain facets of the economy and the environment. It would be futile to try address an environmental problem at the provincial level when the federal government has full jurisdiction. Therefore, the first step is to ascertain the degree of jurisdictional control that is available before choosing a particular instrument and to make sure that the instrument take into account the impact of shared jurisdictions and other jurisdictional issues. Environmental Effectiveness- Some instruments are better suited to address certain environmental problems than others, as can be seen from the case studies below. Economic Efficiency- This criterion evaluates if the instrument is able to achieve the environmental objectives in the least cost manner in terms of purely economic costs (production costs). Distributional Effect- Some environmental instruments can cause distributional effects across user groups. For example, a tax on gasoline can have significant income effects on the lower income groups. The supply side distributional effects are related to unemployment issues such as higher costs of production and loss of competitiveness. Harmonization with other Instruments- All instruments must work in concert with the rest of the policy environment. Care must be taken to ensure that the instrument does not conflict with existing instruments. Incentives- Some instruments may provide the incentive for polluters to adopt additional measures to reduce their polluting activities. For example, effluent taxes have the distinct advantage of providing the incentives for firms to find new technologies to reduce their effluent tax bill versus simple command and control systems. Competitiveness- When an environmental policy is being formulated, production costs may go up. If this happens, the design must take into account the loss of competitiveness by industries within the jurisdiction versus similar firms outside the jurisdiction, both domestically and internationally. Institutional Efficiency- All instruments have some form of transaction costs some more than others. Transaction costs relate to costs of operating and maintaining the system required for the successful implementation of the instrument. These are the administration and management costs of the system. This is an element that gets ignored in a majority of economic analysis but is a component that can become significantly large in respect to the economic and social costs. Any successful policy design must consider how much it will cost to implement and operate for all players.

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4. Environmental Management in Developing Countries

4.1 Introduction

Although significant damage from environmental degradation in developing countries has been universally recognized, controversy continues over what kind of government intervention is necessary or justified to counteract it. On the one hand, there are those who argue governments must regulate resource users and polluters by setting controls or limits on levels of resource exploitation or pollution generation. These limits must be backed by fines or other penalties, which are assessed when limits are exceeded. It is believed that this is the only way to assure adequate public safety and environmental protection; businesses cannot be trusted to act in the public interest without these controls. On the other side of the debate are those who believe that government intervention always leads to worse outcomes than having no regulations at all. Free-market economic systems are believed to have a natural tendency to promote efficiency and to maximize social welfare; placing limits on economic activities will only distort an otherwise efficient market. Both extremes are flawed - the first because it neglects the economic costs of policy failures which result from inflexible, unenforceable regulations and inefficient policies, the second because it neglects the social costs of market failures resulting from insecure property rights and negative environmental externalities. Nevertheless, many developing countries continue to exhibit the disadvantages of both extremes. Their failure to force resource users to consider the true costs of scarcity and environmental damage has resulted in socially inefficient allocations that waste environmental assets, and yet the popularity of command and control approach has resulted in wasteful administration costs and a lost opportunity to collect revenues without distorting the economy. The objective is to explain a) why the command and control approach - which fails to recognize the economic costs of market and policy failures - works even less in developing countries than in developed countries, b) why they nevertheless remain popular with governments, c) why Market Based Instruments - rather than laissez-faire or command and control approaches - should be preferred in developing countries, and, d) how they can be implemented in the face of political reluctance.

4.2 Why regulations do not work in developing countries

There are valid reasons why command-and-control regulations do not work in the majority of developing countries and why market-based incentives have a better chance. First, following the developed country model, environmental regulations in developing countries stipulate terms of imprisonment and/or fines for non-compliance or violations. The enforcement of regulations is primarily dependent on the functioning

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of the legal system. However, for cultural reasons, many developing societies, most notably in Asia, are not given to litigation. Courts are used as a last resort, which means they are rarely used. In other regions, the population might be more prone to litigation but the legal system itself is flawed having the same result. Since this is common knowledge, regulations rarely become anything more than "paper tigers". Non-enforcement makes it easy to introduce additional regulations; they appear necessary, and industries rarely object to regulations, which they know are not likely to be enforced. Thus, developing countries amass regulations that have no chance of working. A second reason why regulations do not work in developing countries is because it is virtually impossible to monitor hundreds of thousands of scattered small-scale operations, which individually generate little pollution but taken together account for the bulk of pollution in the country. Even if this was technically possible, economically it makes no sense. Therefore, even when legal systems are established, it remains easy for massive non-compliance by small- and medium-scale operations to occur. A third reason for the unsuitability of command-and-control regulations for developing country is the mismatch between high regulation, monitoring and enforcement costs and budgetary, manpower administrative constraints in these countries. Environmental regulations in developed country presume a degree of devolution of authority and taxation to representative local government, which increases the ability and reduces the cost of regulation, monitoring and enforcement. However, developing countries are overly centralized with the control of central government diminishing in with the distance from the center. A fourth reason is that fines are set at levels that are too low to deter violators. Since the probability of apprehension of violators in developing countries is very low, the fines need to be very high so that the certainty-equivalent fine exceeds the benefits from the violation. This is rarely the case. Not only are fines set too low to start with, but they remain unchanged in nominal terms for years, and become eroded by inflation. The final, and perhaps the most damaging, flaw of command-and-control regulations in a developing country context is the rent-seeking behavior which they elicit. Violators find it in their interest to pay a fraction of the stipulated fine as a bribe to the enforcement official that, being grossly underpaid is often all too willing to accept it. Increased fines or stepped up enforcement of regulations leads predictably to more bribes rather than less environmental degradation. As a visible example consider the gross violations of the town and country law: 30 story buildings which perfectly legal papers dominate in areas where 3 stories is the legal maximum. This is as true in Mexico City and Cairo as it is in Bangkok and Manila. In the face of such obvious violations by the wealthy which immunity, regulations lose whatever moral and legal weight they had to start with.

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4.3 Why regulations remain popular with governments

If regulations are so ineffective why do governments have such a strong preference for them? Rent-seeking behavior is only part of the answer. Even more important is the need to feel in control. Regulations, unlike market-based incentives, are written in tough and rigid language that carries with it the threat of punishment, which provides a sense of authoritarian power and ability to control against harmful activities. Tough laws are attractive to politicians who promise to protect the environment, and industry goes along because it knows the penalties will be easily avoided. Occasionally a big polluter can be treated as a scapegoat, creating the sensation that government is tough on environmental crime. Another advantage that governments see in regulations over economic incentives is that the cost of regulations is usually hidden from the public eye. The costs of regulations include, in addition to direct regulation costs, the cost of compliance by the regulated - which are substantial when there is variability in scale and pollution abatement costs among and within industries. Though substantially higher are those of more effective market-based incentives, regulatory costs are less obvious to the taxpayer and the consumer.

4.4 The potential for economic incentives in developing countries

Economic incentives as instruments of environmental management in developing countries have many advantages over command-and-control regulations. First, they can achieve the desired effect at the least possible cost, which is vital to developing countries with limited resources and a dire need to maintain their competitiveness in world markets. Second, economic incentives are easier to enforce which is important for countries with limited enforcement capability. Third, economic incentives present fewer opportunities for rent-seeking behavior than regulations, and therefore they are likely to be both more effective and more equitable. Finally, unlike regulations that require bloated bureaucracies and large budgets, market based instruments generate revenues, which should be welcomed by countries facing tight budgets and budgetary deficits. Whatever the merits of economic incentives and the experience of other countries with their use, considerable obstacles prevent their wider adoption. First, there is a lack of understanding of how these systems work and their impact on growth and income distribution. Often, they are dismissed as ways to appropriate poor people's resources or to reward polluters with a legal right to pollute. Some fear that economic incentives will raise the costs of production and make local industries less competitive in world markets. Because these systems raise the cost to the public, governments are concerned that they will be unpopular and government stability might be compromised. Command-and-control regulations appear safer, even if they are not as cost-effective. These political concerns constrain not only the introduction of economic Instruments, but also their effectiveness. Their limited acceptance has led to some charges and taxes being introduced with rates set at levels too low to change behavior. While it is necessary

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for initial charges to be set low to elicit wide acceptance by industry and provide time for adjustment, a predictable schedule of escalation to meaningful levels must be provided to shape expectations, influence Investment decisions, and stimulate innovations. The reluctance and tentativeness with which economic incentives are being introduced does not create sufficient confidence in their durability to warrant behavioral changes and long-term Investments. Moreover, economic incentives take time to work simply because it takes time to change behavior. But, by the time incentives begin to work, they lose their forte (face value) due to inflation or political manipulation. Nevertheless, several factors favor economic incentives. Budgetary constraints and deficits impose a rationality of their own. Environmental disasters and crises such as the 1988 landslides and floods in Thailand present political windows of opportunity when new constituencies emerge which make more rational choices possible. Growing environmental awareness and pluralism in developing countries will gradually put environmental and fiscal accountability on the political agenda as these countries increasingly realize the wealth of their own traditional institutions for managing resources. The critical first step is to make the principles that the polluter has to pay or the internalization of external cost acceptable to the industry and the public. In return, governments must recognize the public's legitimate concerns and the need for gradual introduction and adjustment assistance. The next step is a gradual phase-in to direct future investments towards a more desirable mix without penalizing past and current investments made under different rules. Care, however, must also be taken not to institutionalize inefficiency by offering existing firms indefinite protection or exception; instead, a schedule for gradual adjustment must be agreed and adhered to. Once an economic incentive system (such as marginal cost pricing or charges) is introduced, it should not be allowed to lose its value over time either through inflation or political manipulation. When the pressure of economic incentives falls rather than raises over time little change in behavior is accomplished and little investment in new technologies is induced. It is preferable to begin by setting low rates and escalate them gradually based an predetermined and pre-announced formula. A gradualized scheme has several advantages: a) it is easier to get accepted and introduced; b) it allows time for adjustment, thus minimizing resistance and cost; and, c) it gives the connect signal to investors and innovators. Another principle that needs to be observed is the minimization of enforcement and monitoring requirements of the system and of the latitude for discretion by regulators. Compliance should be made in the interest of the resource user or the polluter. The regulators should be indifferent as to whether the polluter pollutes or pays, wastes or conserves water, cuts or plants trees. If the regulator is not indifferent then the price or charge is too low. The need to minimize regulatory, enforcement, and monitoring costs arises from the low enforcement capability in developing countries, and the rent-seeking behavior that high charges and low salaries bring about. The ideal economic incentive is the one, which is incorporated into the price of a resource or product; it can be avoided only by avoiding the use of the resource or product. Other instruments that meet this condition are refundable deposits, performance bonds, presumptive charges at clean-up-cost levels, transferable development rights, property and land-use taxes and transferable quotas. Hazardous waste management is an example where an imaginative combination of presumptive charges, performance bonds and environmental auditing can

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be at least as effective as strong preventive measures and a lot more efficient. Hybrid systems of economic incentives and regulations do exist but they should not be confused with a mixture of the two, arising from unwillingness of regulators to depart from their command-and-control posts. In the hybrid systems the government sets a long-term target (e.g. ambient standard, rate of reforestation, water conservation) and market-based instruments are used to achieve the target at minimum costs. Priorities for implementing economic incentives The first priority under the prevailing circumstances in developing countries is to eliminate policies that have significant environmental cost or which create perverse incentives that encourage the depletion of resources and environmental degradation beyond the free-market level. Reforming policies that distort incentives for efficient resource use is a priority because unless perverse incentives are removed, project investments aiming at improved utilization and conservation of resources are unlikely to succeed and when they do, their impact would be unsustainable, lasting only as long as the project lasts. Reforming policies that are detrimental to both the economy and the environment is an easier point at which to start because no difficult development-environment tradeoffs or budget outlays are involved. If anything, eliminating policy distortions usually reduces government expenditures and may even generate additional budget revenues. The distributional implications are also in the right direction since many of these distortions (e.g., interest rate ceilings, capital subsidies, untaxed resource rents, monopolies, input subsidies, price supports, etc.) are not only sources of inefficiency but also of inequity and perpetuation of poverty. Finally, eliminating policy distortions can be done by adjusting prices, taxes, subsidies, interest rates, and exchange rates, which is easier than introducing new instruments or developing new institutions to deal with market failures. This is not to say that market failures need not be mitigated, but that both the priority and the arid test of successful policy interventions is the elimination of government-induced market distortions. Only then can market failures be seen in the right perspective and only then can interventions for improving the functioning of the market be properly formulated and implemented. For example, there is little rationale for trying to internalize the benefits from conserving biological diversity when the wholesale conversion of tropical forests into cattle ranches or pine plantations is heavily subsidized. Yet, eliminating policy distortions is only the place to start but not the place to finish because without connection, or at least mitigation, of market failures, efficient use and conservation of resources cannot be secured. The economic incentives approach to environmental management could be summed up into three sets of policy reforms:

• Reduction and eventual elimination of policies (taxes, subsidies, quotas, public projects) that distort well-functioning markets or exacerbate market failures. Cases in point are the elimination of die pesticide subsidies in Indonesia or the ranching subsidies in Brazil.

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• Correction or mitigation of market failures such as insecure or absent property rights, unpriced resources, externalities through interventions that improve the functioning of the market or result in outcomes superior to those of the free market. Examples include road pricing in Singapore and the introduction of water pricing in China.

• Consideration and internalization of environmental, social and other side effects of public projects and sectoral and macroeconomic policies. Examples include the Dumoga Irrigation cum national park project in Indonesia and the inclusion of environmental provisions in several structural adjustment programs (e.g. Morocco, Tunisia, Pakistan, Philippines, Nepal and Thailand).

4.5 Conclusions

To sum up, the cause of natural resource mismanagement and environmental degradation in the developing countries, as in the developed countries, are policy and market failures. Regulations do not correct these failures; they create new ones. The very purpose of economic incentives is to correct policy and market failures. In terms of cost-effectiveness, the superiority of economic incentives over command-and-control regulations cannot be denied at least in the context of developing countries. Yet, the resistance to market incentives should not be underestimated. The best that can be hoped for is a mutually supporting mix of regulations and economic incentives. * * *

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Appendix 1: Terminology

User charges: payments for the cost of collective services. They are primarily used as a financing device by local authorities e.g. for the collection and treatment of solid waste and sewage water Product charges: applied to products that create pollution either through their manufacture, consumption, or disposal (e.g. fertilizers, pesticides, or batteries). Product charges are intended to modify the relative prices of the products and/or to finance collection and treatment systems. Product taxes are addressed separately. Taxes for natural resource management are unrequited payments for the use of natural resources. Marketable permits, rights, or quotas (also referred to as “emissions trading”) are based on the principle that any increase in emission or in the use of natural resources must be offset by a decrease of an equivalent, or sometimes greater, quantity. Two broad types of tradable permit systems are in operation: those based on emission reduction credits (ERCs), and those based on ex ante allocations ("cap-and-trade"). The former approach takes a “business as usual” scenario as the starting point, and compares this baseline with actual performance. If an emitter/user performs better than the anticipated baseline, a “credit” is earned. This credit can then either be used by the emitter/user himself, either at the current location or elsewhere, or sold to some other emitter whose emissions are higher than the accepted baseline (and presumably at a lower price than what it would cost the latter to abate on his own). The “cap-and-trade” approach sets an overall emission/use limit (i.e. the “cap”) and requires all emitters to acquire a share in this total before they can emit. Emitters may be allocated their shares free-of-charge by a relevant environmental authority, or the shares may be auctioned. Regardless of how the initial allocation of shares is determined, their owners can then either utilize them as emission permits in current production, save them for future use (if "banking" is allowed), or trade them with other emitters. Deposit-refund systems: payments made when purchasing a product (e.g. packaging). The payment (deposit) is fully or partially reimbursed when the product is returned to the dealer or a specialized treatment facility. Non-compliance fees: imposed under civil law on polluters who do not comply with environmental management requirements and regulations. They can be proportional to selected variables such as damage due to non-compliance, profits linked to reduced (non-) compliance costs and other. Performance bonds: used to guarantee compliance with environmental or natural resources requirements, polluters or users may be required to pay a deposit in the form of a “bond”. The bond is refunded when compliance is achieved.

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Liability payments: payments made under civil law to compensate for the damage caused by a polluting activity. Such payments can be made to “victims” (e.g. in cases of chronic or accidental Neither non-compliance fees nor liability payments can be construed as fines, which are lump sum legal sanctions. They can operate in the context of specific liability rules and compensation schemes, or compensation funds financed by contributions from potential polluters (e.g. funds for oil spills). Subsidies: all forms of explicit financial assistance to polluters, e.g. grants, soft loans, tax breaks, accelerated depreciation for environmental protection. The survey only addresses financial assistance aimed at direct pollution control. Economic subsidies, which do not directly lead to pollution control (e.g. subsidies for energy conservation), were not included. Taxes: The OECD defines taxes as “compulsory, unrequited payments to general government. Taxes are unrequited in the sense that benefits provided by government to taxpayers are not normally in proportion to their payments.” The term “general government” is defined as “supra-national authorities, the central administration and the agencies whose operations are under its effective control, state and local governments and their administrations, social security schemes and autonomous governmental entities, excluding public enterprises”. Note that a tax (unrequited) can be earmarked if it is decided that a certain percentage of the revenue will be affected to a specific purpose (e.g. when part of a gasoline tax is earmarked for road building). Charges/fees: The OECD classification also uses the terms “fees” and “user charges” (as opposed to “taxes”) and “levies” without giving a precise definition of these terms. In practice, the terms charges and fees are often used interchangeably. Therefore, charges and fees will be defined as compulsory required payments to either general government or to bodies outside general government, such as for instance an environmental fund or a water management board. The general term “levy” could be construed as covering all types of compulsory payments. Note that, according to the OECD classification there are “borderline-cases” where a levy could be considered as “unrequited”, i.e. as a “tax” (if the payment is made to “general government” as opposed to a charge or fee):

• where the levy greatly exceeds the cost of providing the service;

• where the payer of the levy is not the receiver of the benefit (e.g. a fee collected from slaughterhouses to finance a service which is provided to farmers);

• where government is not providing a specific service in return for the levy which it receives even though a license may be issued to the payer (e.g. where the government grants a hunting, fishing or shooting license which is not accompanied by the right to use a specific area of government land);

• where the benefits are only received by those paying the levy but the benefits received by each individual are not necessarily in proportion to his payments (e.g. a milk marketing levy paid by dairy farmers and used to promote the consumption of milk).

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Appendix 2: Environmental policy alternatives

Direct Regulation

Engineering Standards Regulate technology (e.g., require scrubbers an smokestacks to reduce gas

emissions.)

Performance Standards Require that plants operate in certain ways or at certain Limes require certain

emission/output ratios.

Quantity Limits A quota an Overall emission levels or harvest levels.

Ambient Standards Standards of environmental quality that must be met, (e.g., BOD of receiving

water or sulfur dioxide concentrations in air)

Prohibitions/Sanctuaries Preclude certain activities or the use of certain inputs (e.g., certain pesticides) or prevent access to certain areas

Economic Incentives

Emission Charges A tax applied per unit of pollution (e.g., carbon tax).

Depletion Charges A tax applied per unit of harvest (e.g., stumpage fee for timber).

Product Charges A tax applied to products used in a polluting activity or to products that result from polluting activity.

Marketable Permits Emission/harvest permits that can be used, sold, or leased.

Information Systems Public disclosure of pollution, naming of polluting fumes, green labeling, etc.

Other Tools

Assurance Bonds A payment that is returned if environmental damage does not occur.

Strict Liability Polluters are liable for paying victims and restoring damage regardless of negligence.

Assign/Enforce Rights Full allocation and enforcement of rights to environmental goods.

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Appendix 3: Types of economic incentives for Environment Protection

Emission Charges For the discharge of pollutants into air, water soil, and on the generation of noise.

Calculated on the basis of the quality and quantity of pollution generated.

Have been used mainly to fund environmental control programs rather than to provide incentives to reduce pollution.

Product Charges Charges on inputs to or outputs from environmentally damaging production processes to encourage change. Examples: a tax on high sulfur coal or on disposable batteries.

Marketable Permits Overall level of emissions is set in an area.

Permits to pollute are allocated to polluting firms in the area.

Firms that keep their emissions below their permitted level may sale or lease their surplus allocation.

Offsets: all new emission sources in the area are offset by a reduction of emissions from existing sources.

Bubbles: allow routine shifts in emission limits among existing plants if total emissions under the bubble do not increase.

Netting: allows changes in emissions from different sources within a plant or firm so long as there is no net change in emissions.

Subsidies Financial assistance or price supports offered as an incentive to encourage pollution abatement or to help defray the costs of complying with regulation.

Usually in the form of grants, loans or tax allowances.

Consider also the removal of government subsidies that promote environmentally unsound activity, e.g., water use, fertilizer application, and "below-cost timber sales."

Other Systems Liability systems -- polluter is liable for damages and restoration.

Assurance bonds -- potential polluter puts up bond that is forfeited if pollution limits are exceeded.

Information systems, consumer education/green labeling.

Reassign rights -- individual or community rights (ownership, easement or access) assigned to resources that are currently open access or publicly held resources.

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Appendix 4: Case Studies for the Use of Economic Instruments

Overview Poland, Switzerland, the USA and a majority of OECD countries report the use of deposit-refund systems. Non-compliance fees are in place in nine countries: Canada (New Brunswick), the Czech Republic, Greece, Hungary, Korea, Norway, Poland, Sweden, and Turkey. Performance bonds are found only in Australia, the US and three of the Canadian provinces. Canada (Quebec), Denmark, Finland, Germany, Japan, Sweden, Turkey, and the USA report the use of liability payments. Subsidies for pollution control are widespread in different forms. The majority of identified taxes that were levied under a specific tax base relate to energy and transport, with waste management taxes also common. The revenues from environmentally related taxes in the countries for which data is available represented 2.5% of GDP in 1995, or just fewer than 7% of total tax revenues in these countries (arithmetic average). The uncertain effectiveness of taxes and charges in meeting environmental quality targets also has limited their appeal. While relatively straightforward to implement administratively within the existing institutional framework, taxes and charges have the shortcoming that they leave considerable uncertainty about whether environmental quality targets will be achieved. Where problems have not yet reached critical proportions, that uncertainty may not pose a serious problem. In the countries studied however, problems have often been neglected until urgent remedial action became necessary. Under the circumstances, governments have needed to bring down pollution levels quickly and decisively, for which purpose a command-and-control approach can be quite effective (as the Japanese experience demonstrates). Taiwan and Thailand are both actively studying the introduction of pollution taxes. In the case of Taiwan, in 1991 the government passed an Air Pollution Control Act which allows for a system of emission charges. It is currently weighing a proposal for air pollution control and energy taxes, to be levied on gasoline and industrial emissions. The revenues from the taxes would be earmarked for environmental use. It is anticipated that once ambient standards have been met, the levies could be reduced or eliminated. A similar system of levies is being considered for water pollution. Since the taxes on both air and water pollution have yet to be implemented, there is currently no basis for evaluating their effectiveness. In Thailand, a pollution tax is being mooted for Bangkok but has not yet been implemented. Subsidies on pollution control investments or on less polluting inputs are much more commonplace than taxes or charges. For example, the Japanese government offers a number of tax incentives for pollution control investments. These include accelerated depreciation for pollution control facilities and for non-polluting production processes; also, exemptions from the fixed asset and business taxes for investments in pollution control facilities. In Thailand, the Ministry of Finance discounts the Standard tariff on, imported capital equipment for end-of-pipe waste treatment technology. The government is considering

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extending the discount to clean process technologies. Also, concessional financing for purchases of anti-pollution equipment is available through the semi-governmental Industrial Finance Corporation of Thailand (IFCT), which recently established an Environment Portfolio, which lends roughly US$8 million annually. Firms, which borrow first from this facility, also receive favorable credit terms should they borrow from IFCT for other purposes. In the case of Indonesia, the Ministry of Population and Environment has recently announced an import tax reprieve for wastewater treatment equipment. Donor agencies are also considering subsidizing the installation of wastewater treatment facilities for certain industrial sectors and possibly the adoption of clean process technologies. The Thai government also subsidizes the purchase price of unleaded gasoline to make it competitive with leaded gasoline, with the subsidy on the former financed from surtax on the latter. Unleaded gasoline was introduced in May 1991 at a discount of 0.30 baht (1.2 US cents) per liter relative to leaded gasoline. Currently unleaded gasoline accounts for roughly one-quarter of the market in Bangkok. As a result of this price differential, a thriving market for refitting of lead-burning engines to bum unleaded gasoline has developed. The evidence from Thailand suggests that even in an economically more advanced economy of Asia - and where markets are subject to relatively modest levels of distortion - the use of economic instruments for environmental management tends to be quite limited. Macroeconomic factors may be as important to the environmental performance of those economies as the choice of environmental policy instruments. Because of high rates of investment and the rapid turnover of the capital stocks of those countries, industries are probably on average less polluting than their counterparts in many OECD countries. Still, there remain serious pollution problems to be addressed, some but not all of which lend themselves to command-and-control approaches. Perhaps the most intractable problems in virtually all the countries involve worsening pollution from mobile sources and the difficulties of controlling emissions from small and medium-sized enterprises. Innovative approaches are clearly called for and to a certain degree are already being tried. Innovations in environmental policy design do not always fit neatly into the CAC versus economic instruments dichotomy. For example, voluntary agreements between polluters and governments or communities have proven effective in some situations. Moreover, while there is vast scope for experimentation with new economic instruments, many if not most such instruments will in practice need to be combined with elements of command and control. Finally, there is also considerable potential for innovation in the design and improvement in the implementation of regulatory measures. 1. SO2 reduction in western Europe With reference to the aspect of cost efficiency, price-based solutions are always superior to regulatory solutions in cases where the emitters have different marginal cost functions for pollution prevention. Against this background, special attention deserves to be paid to empirical studies, which investigate the cost-lowering potential through the use of market-

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oriented instruments on the basis of estimates of the marginal prevention cost functions. Therefore, we wish to outline a study carried out by EWI (Energy Management Institute) in Cologne, which deals with alternative measures for reducing SO2 pollution in Europe. The study relates to: - the pollutant SO2 - the power plant sector - the region of Western Europe. A quite decisive point with regard to the pollutant SO2 is that the geographical distribution of the pollutant is in no way irrelevant. This means that we are no longer able to maintain our simplified assumption that what counts is merely the sum total of the emissions or pollutant concentrations. We must, therefore, deal with this aspect in somewhat greater detail. The core aim of the EWI study is to demonstrate that the same environmental quality, with respect to SO2, can be achieved considerably more cost-effectively with market-oriented instruments (price-based solutions or certificates) than by means of regulatory measures. We must ask ourselves in order to be able to accurately define the term "same environmental quality" for price-based and regulatory solutions. The difficulty is that the cost reductions achieved by market-oriented instruments come about in that – depending on the marginal cost functions – some companies reduce their pollutant emissions more and other companies less than in the case of regulatory measures. However, this implies a different geographical distribution of the emissions, which, of course, also means a different geographical distribution of the pollutant concentrations, something which in contrast to CO2, cannot be neglected in the case of SO2. In order to rule out possible points of criticism in relation to the results, which were very favorable for market-oriented instruments, EWI adopted the following procedure: First of all, the geographical area under consideration (western Europe) was divided into different individual regions. Next, EWI calculated the pollutant concentrations (i.e. the environmental quality) in the individual regions in the case of the regulatory solution. It was then required of the market-oriented instruments (the study explicitly used the instrument of levies; however, the same result could also be achieved with certificates) that in none of the individual regions under consideration the pollutant concentrations must be higher than in the case of the regulatory solution. This means that, given a different geographical distribution of the emissions in the case of the price-based solution, the environmental quality in every region will be at least as good or, in some regions, even better than in the case of the regulatory solution. As this was laid down as a secondary condition for the calculations, one can readily state that a transition to the price-based solution would even represent an improvement with regard to environmental aspects. If, in addition, it can be demonstrated that the costs are lower, this then becomes a very strong argument in favor of market-oriented instruments. Let us now consider in detail, which calculations need to be performed in order to allow a comparison of the regulatory solution with the price-based solution. Both models contain two essential components, firstly, so-called diffusion matrices and, secondly, the estimates

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of the marginal cost functions. We shall now consider these two components in somewhat greater detail. Diffusion matrices With regard to environmental aspects, there are two problems with the pollutant SO2 in comparison with CO2. The first problem is this: it is in no way irrelevant whether the concentration of SO2 in Hamburg and Frankfurt is 10 units each, or whether it is 20 units in Hamburg and zero units in Frankfurt. Since the local pollutant concentrations depend on the local emissions, the local distribution of the emissions must be taken into consideration in the study. The second problem, however, is that the local distribution of the pollutant concentrations, although determined by the emissions, is not identical with the emissions. For example, the English have the advantage that the winds often blow from their island to the continent and that, consequently, the English "export" more pollutants than they "import". Since, however, a comparison of regulatory and price-based solutions must be based not only on the total emissions, but also on the local distribution of the pollutant concentrations, it is also necessary to consider these "complications", such as different wind directions. This is precisely the purpose of diffusion matrices. Such diffusion matrices indicate what average percentage of the emissions from region A become pollutant concentrations in region B over a certain period of time. Of course, this does not provide 100% accuracy, because it is impossible for all air streams to be taken fully into consideration. However, satisfactory data are now available precisely for the pollutants SO2 and NOx. Consequently, the particular significance of diffusion matrices for the present study lies in the fact that they make it possible to calculate what pollutant concentrations in the individual regions are caused by what distribution of the emissions. Let us assume, for example, that there are only three companies and two regions. Let us further assume that, with the regulatory solution, each company emits 10 pollutant units, the total emissions therefore being 30. The local distribution of the emissions between the three companies may thus possibly result in a pollutant concentration of 12 in region A and a pollutant concentration of 18 in region B (of course, the total emissions and total pollutant concentrations must always be identical). Owing to the different marginal cost functions, it may happen that, with the price-based solution, more is emitted in the vicinity of region A and less in the vicinity of region B, with the consequence that, while the total emissions are at the same level, the pollutant concentrations are perhaps 14 in region A and 16 in region B. This, however, would fail to meet the requirement that, with the price-based solution, the pollutant concentration in any region must not be higher than in the case of the regulatory solution, because otherwise the people living in region A would have a case against the changeover to a price-based solution, something which is, of course, important particularly in an international context. Therefore, with the price-based solution, the total emissions would have to be reduced to such an extent that a value of 12 pollutant concentration units is not exceeded in region A. This demonstrates once again that the increased demands on price-based solutions lead to a reduction of the overall emissions

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and that, therefore, with regard to environmental aspects, the price-based solution is ultimately subject to more stringent requirements. Marginal cost functions The second component of the models relates to the marginal costs for pollution prevention. These are important for two reasons: Firstly, the cost functions are required, of course, in order to calculate the overall economic costs associated with regulatory measures or price-based instruments. In addition, however, it is necessary, also for a second reason, to have knowledge of the marginal cost functions for the price-based solution. For, as is known in detail, companies base their pollution reduction on a balancing of marginal costs and tax rate, with the consequence that the marginal cost functions must be known in order to estimate which company at which tax rate will emit or – conversely – prevent how many units. In this connection, it is necessary to estimate the prevention costs of each individual company, because as far as the pollutant SO2 is concerned, what counts is their local distribution. It is necessary, therefore, to estimate prevention for each individual company, and, to do that, we also require the prevention costs for each individual company. The EWI model relates to the western European power plant sector and to the pollutant SO2. A total of 409 power plants were taken into consideration, of which 299 are coal-fired, 36 lignite-fired and 174 oil-fired. In estimating the prevention costs of the individual power plants, account was taken exclusively of end-of-the-pipe technologies (i.e. back-end cleanup technologies and not basic changes of production methods). It was apparent that there are great differences between the individual power plants with regard to the costs of SO2 prevention. The costs are determined by the already existing degree of cleanup (consider the usual costs, i.e. rising marginal costs with increasing prevention), the size and type of plant, the degree of capacity utilization and the fuels used. Using these detailed estimates, it is possible to state which power plant will emit how much pollution at which tax rate. On the basis of the two components "diffusion matrices" and "marginal cost functions", it is now possible to calculate both the (local) environmental quality and also the costs for any level of regulatory measures or levies. For the regulatory solution it was assumed that the stringent German limit value (400 mg SO2/m3 for large combustion plants) is applied to the whole of Western Europe. This was a reasonable and interesting assumption because, at the time of the study, there was much discussion about the German limit value being applied to the European Community. Another variant was to require a 30% pollutant reduction, based on the starting value, for each plant. Using the diffusion matrices and marginal cost functions for pollution reduction, the environmental quality in the individual regions and the overall economic costs were then determined first of all for the regulatory solution. The next step examined the cost-lowering potential of price-based solutions. These had to guarantee that the pollutant concentration is not higher in any region than in the case of the more stringent regulatory solution (for example, if the limit value from the German Large Combustion Plants Ordinance were applied). Calculation was once again based on

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the diffusion matrices and also on the circumstance that each power plant prevents pollution up to the point at which there is a balance between marginal costs and tax rate. Both circumstances – i.e. the guaranteeing of regional environmental quality and the balancing of marginal costs and tax rate – must, therefore, be regarded as secondary conditions, and the main condition with regard to the price-based solution is the minimization of the overall economic costs. Formally, therefore, the calculation of the price-based solution can be pictured something like this: The target function is the minimization of the Europe-wide costs, and the variables by which the target function is maximized are the tax rates. For the tax rates decide on pollution prevention by the individual power plants and therefore both on the costs and also – for given diffusion matrices – on the regional environmental quality. With regard to the minimization of costs via the tax rates, the following must be considered as secondary conditions: - the profit-maximizing behavior of companies, which means that each company will

reduce pollution up to the point at which there is a balance between tax rate and marginal costs of prevention;

- and the guaranteeing of the pollutant concentration standards which are achieved with the regulatory solution.

The cost reductions arising upon changeover from the regulatory solution to the price-based solution differ for the various alternatives (for example, the application of the German limit values from the Large Combustion Plants Ordinance or the 30% reduction per plant); they are, however, considerable and are between 36% and 60%. Consequently, the difference of the marginal cost functions is so great that, despite the guarantee that the environmental quality in all regions must be at least as good with the price-based solution, there is very great saving potential. The great cost-reducing potential as compared with national regulatory policies is attributable equally to international coordination and to the transition to market-oriented instruments. The advantage of international coordination results from the different national starting conditions with regard to the environmental situation and the marginal costs of prevention. Thus, in view of Germany's high SO2 imports from the West and the substantially lower prevention costs in the West (greater initial pollution), it would appear obvious that the cheapest way of achieving a given pollutant concentration target for Germany is not by means of further national reductions of emissions. The advantages of market-oriented instruments result from the different marginal prevention costs of the plants. The EWI study, therefore, clearly confirms the important point that it is by no means the case that the changeover to price-based solutions is only then possible if what counts is merely the sum total of the emissions. Also in the case of pollutants such as SO2, where the regional distribution of emissions is important and is complicated by the diffusion of the pollutant, it is possible for price-based solutions to guarantee the same environmental quality as regulatory solutions. The only thing is that the calculations then become more complicated, with the result that the costs increase. However, it is basically the case that the problems of emissions/pollutant concentrations can perfectly adequately be taken into consideration.

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An exceptionally interesting aspect is that the cost-minimizing internalization of the external effects does not require the tax rates to be identical in all regions. The demand for identical tax rates resulted from the requirement of identical marginal costs for all involved companies as a condition of efficiency. However, such identical marginal costs are only then a condition of efficiency if the local distribution of emissions and pollutant concentrations is irrelevant. Under these conditions, emissions are homogeneous goods, which therefore must also have the same price so that there is cost-efficient prevention. In the case of SO2, however, the situation is more complex and this means that, ideally, there will be regionally differentiated tax rates. For a better understanding, let us assume, that, owing to the localities of the power plants and the directions of the wind, it is particularly difficult with the tax-based solution to achieve the pollutant concentration target in region A. This means that emission units emitted in the vicinity of region A and "blown" into that region A are in especially short supply in the sense that especially little may be emitted there for each plant. Consequently, an emission unit in the vicinity of region A must also be especially expensive, with the result that the optimal tax rates cannot be identical. This is a complication, which is also problematic with regard to the political implementation of international tax-based solutions, because it may well require different tax rates in different countries. The consequence of the different marginal cost functions and the various pollutant concentration situations is that, in an optimized tax-based solution, some countries would emit more, while other countries would emit less, than in the case of harmonized regulatory measures. This implies that cooperation would only then be to the benefit of all participating countries if compensatory payments are made to those countries which, for reasons of efficiency, are required to implement an especially high reduction of emissions as part of the internationally integrated scheme. In the EWI model, this applies, for example, in the case of Belgium, the Netherlands and Austria, while Germany would have to make compensatory payments. Of course, it is possible to come up with a system of compensatory payments under which all countries would save money in comparison with a regulatory solution, because this follows of necessity from the fact that the overall costs are lower. Nevertheless, such compensatory payments represent an additional complication, which makes the scheme more difficult to implement politically. Result As a decisive outcome, however, we can say without doubt that there are empirically highly relevant areas in which the marginal cost functions of pollution prevention are so different that the changeover to market-oriented instruments is capable of resulting in substantial savings. This is still true even if we include the fact that environmental quality is determined not only by the sum total of the emissions, but substantially also by the local distribution of the pollutant concentrations. 2. The Nitrogen Oxide Charge on Energy Production, Sweden General

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Economic Instrument: Emissions charge and fee Problem: Acidification of soil and water due to nitrogen oxide emissions Goal: Reduction of NOx emissions by polluting industries, while protecting industry

competitiveness Description: Any plant that produces more than 25 gigawatts of energy a year must

pay a charge of USD 3.8/kg of NOx emitted. Revenues of charge are rebated to plants in proportion to energy production. Plants with high energy to emissions ratio may earn a net gain from the scheme.

Administering Institution: Swedish Environmental Protection Agency (SEPA) Duration: 1992- present, program extension in 1996 & 1997 Stakeholders: SEPA, large and medium sized combustion plants, other energy

producers, citizens, environmental groups Implementation By the late 1980s, Sweden had begun to suffer severe effects from “acidification” caused by nitrogen oxide (NO) and nitrogen dioxide (NOx), which are collectively called NOx, as well as from sulfur dioxide (SO2). Acidification was blamed for damaging ecosystems, killing organism and altering plant and animal life, damaging forests, and degenerating buildings and historic monuments. The majority of NOx emissions are the product of the transportation sector, but combustion plants that produce energy (i.e.: electricity and heat) are also responsible. In 1988, Sweden and 11 other nations began a multilateral initiative to reduce their NOx emissions 30% by the year 1998. Sweden, with soil composition particularly sensitive to NOx, pledged to do so by 1995. Also in 1988, a Swedish parliamentary commission first asserted the virtues of economic instruments in achieving environmental goals. In 1989, the Environmental Change Commission made a number of specific recommendations, including what became the Act on NOx. Approved by Parliament in 1990, Sweden began to enforce its new charge and rebate system on NOx emissions from large energy-producing combustion plants on January 1, 1992. At the time, plants that qualified as ‘large’ were any with a capacity of 10 megawatts (MW) and annual energy production above 50 gigawatt hours (GWh). Plants that matched these qualifications were primarily heating and power production plants. Also liable were waste incinerating plants, and the pulp and paper, chemical and metal industries, all of which produce energy. Exempt from the charge were any emissions produced in “direct industrial combustion processes”, such as the melting of raw materials, or combustion in ovens for the refining crude oil, since these emissions were “diffuse and too costly to measure.” Plants that produced less than 50 GWh were also exempt, since the cost of monitoring systems to measure NOx emissions were considered too high to merit the benefits of reduced emissions from these small producers.

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After an extensive two-year education and preparation campaign led by the Swedish Environmental Protection Agency, large and liable plants were hit with a charge of USD 3.8 per kilogram of NOx emitted. The revenues received by the Environmental Protection Agency from polluting industries were then pooled, and returned to the firms based on their total energy production in comparison to that of other participating firms. The result was that plants producing a large amount of energy with few emissions paid a low charge and received a large rebate, possibility even profiting from the scheme. Industries that fit into this category included energy production, metal and chemicals. The opposite occurred for those with a low energy to emissions ratio. Examples of “net payers” included the waste incineration and pulp and paper industries. While structurally complex, administration of Sweden’s fee policy is carried out by the Environmental Protection agency with relative ease. At the end of every January, all liable plants must submit a four-page document detailing their NOx emissions, energy production, a calculation of the charge-owed, and a calibration certificate of their monitoring equipment from an independent examiner. To ensure honest reporting, random audits are occasionally carried out. After deducting its administration fees, the Environmental Protection Agency announces rebate total at the end of April. Charges (which are tax deductible) must be submitted by October 1st, and rebates (which are taxable) are paid out by December 1. Any disputes firms may have can be taken before Swedish courts. Results In the two years between the approval and the activation of the Act on NOx, many companies began extensive efforts to reduce emission levels in anticipation of the charges they would face in 1992. Since 1992, most firms have become very “focused” on reducing their NOx emission levels. One plant even offers a bonus salary to operators when emission levels are low. Changing fuels, altering the combustion process, or installing NOx-reducing equipment can all lower emission levels. Overall, the Swedish NOx fee policy can be described as having surpassed the best expectations set when it was introduced in 1992. Emission levels have plunged much faster than was ever anticipated, with the 35% reduction target set for 1995 (from 1990 levels) achieved two years early in 1993. Thanks to the rebate system, for many firms the installation of NOx-reducing equipment has been a profitable venture. In 1996, Sweden broadened the reach of its fee system to include all plants with energy production levels above 40 GWh. In 1997, the scheme was widened again to include firms with production levels above 25GWh. The rate has not been altered since program implementation in 1992. By 1998, emission levels had decreased to 14,000 tones, or 42%, from the 1990 level of 24,000. 38 The social benefits of reduced NOx-caused acidification effects have been substantial. Policy Issues

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The policy chosen by Sweden to provide incentive for firms to reduce their NOx emissions is particularly interesting for a number of reasons. Primarily, because the entire sum of charges paid by polluting firms (minus administration costs) is returned to firms based on their energy production levels, the competitiveness of liable firms was not affected. That is, small, non-liable firms were not handed a competitive edge over large firms with higher pollution levels. High-production, low-emission firms, however, did garner advantage through the scheme. Returning the entire sum also proved that the policy motivation was 100%- environmental, thereby reducing industry opposition to its implementation. Generally, firms have responded positively to the incentive for emissions-reduction provided by the policy, and many have achieved considerable cost reductions. However, because firms are not required to lower emissions, only those producers that have found it cost effective to do so have pursued reductions. The NOx fee is not the only way in which Sweden attempts to control nitrogen emissions. The country also uses a permit system as a regulatory mechanism that puts an absolute cap on the national aggregate emissions level. Any energy plant with a capacity of 10 MW (ie: any large combustion plant), must apply for a permit from Sweden’s National Licensing Board. The permit, which is reviewed at least once a decade, sets the maximum amount of NOx a firm can emit. The regulatory and incentive schemes are complementary. Together they have established an important administrative infrastructure and laid a framework of change in firms’ actions and awareness that could be expanded straightforwardly in the future. Lessons Learned Economic instruments can be effective environmental instruments that need not damage, and can even stimulate, the economy. Earmarking revenues accrued in a polluter-pays system can help increase support from industry and the public. This system, deemed efficient and fair, could be a model to other nations. 3. The Example of German Air Pollution Control Policy The basis of German air pollution control policy is the so-called BImschG (Federal German Pollution Control Act), which was introduced in 1974 and has since been refined by several amendments. BImschG consists of six large parts, of which – in the context of cost efficiency – the crucial ones are parts 2 and 3 as well as their codification in ordinances and implementing regulations, for which BImschG provides the basis in law. Part 2 of BImschG comprises §§4-31 and contains the regulations for the construction and operation of those plants, which are covered by BImschG. Part 3 (§§32-37) is concerned with the nature of plants, substances, products and similar. According to §4 of BImschG, all plants, which are likely to have an adverse impact on the environment, must be approved or licensed. Approval or licensing focuses on three core aspects which are

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regulated partly through ordinances such as the Large Combustion Plants Ordinance and partly through implementing regulations such as the Technical Instructions on Air Quality Control (abbreviated in German to TA Luft). In this connection, three core areas must be observed: 1. The specified air quality standards for the individual regions must be complied with. If approval of a plant poses the threat that the permitted pollution level might be exceeded, the official authority may refuse approval. In order to guarantee compliance with permitted pollution levels, however, the applicant may offer to implement compensatory measures in existing plants, i.e. additionally to cut pollution from existing plants in order to guarantee compliance with the air quality standards. 2. Approval-requiring plants must conform to the state of the art. Initially, the "state of the art" is a rather confused term, which is then spelled out, in clearer detail in administrative practice. On the one hand, the "state of the art" means more than just the conventionally used technology, i.e. if an environment-friendly technology is available at reasonable expense, it is still state of the art even though the large majority of companies employ a more polluting, i.e. less environment-friendly, technology. On the other hand, the term "reasonable" shows that economic factors are also taken into consideration when interpreting the "state of the art". 3. Apart from air quality standards and the requirement that the plant should be state of the art (which frequently indirectly defines the quantities of pollutants permitted for each plant), there are also direct emission limits, which are laid down in ordinances such as the Large Combustion Plants Ordinance or in implementing regulations such as TA Luft. For example, the Large Combustion Plants Ordinance requires all power plants with an output of over 50 MW to comply with a limit of 400 mgSo2/mg3 of air. For all approval-requiring plants outside the scope of the Large Combustion Plants Ordinance, the applicable limits our laid down by TA Luft. The decisive point in this context is different types of plant are subject to the same standards, which therefore also have different marginal cost functions for pollution prevention. In the case of the Large Combustion Plants Ordinance, the limit is independent of the technology used and independent of the fuel (e.g. oil- or coal-fired power plants), although these factors have a quite considerable influence on the costs of prevention. The problem, therefore, is that the same limit applies to a group of plants although the marginal cost functions are not identical and there are, consequently, the above-described inefficiencies. Ultimately, in the interests of ecological accuracy, it is important that the majority of limits for air pollutants should be specified in the form of so-called mass concentrations. This means that a certain level of pollutants per cubic meter of off-gas is permitted. Less usual alternatives are mass flow rate (i.e. the mass of pollutants emitted per unit time) and the mass ratio (i.e. the ratio of pollutants and product units). The difficulty in using mass concentrations is that companies are able to increase their overall emissions by increasing the overall off-gas, because the limit is in a constant ratio to the off-gas. To be sure, this difficulty is alleviated in practice in that plants must at the same time comply with the state

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of the art, with the result that not just any increase in the quantity of off-gas need be permitted. However, this aspect cannot be neglected. Of course, with regard to the incentive effects of regulatory measures, the type of monitoring is decisive, because this is what determines the expected penalty payment. For especially high emissions there are now continuous measurements; this, however, is still the exception owing to the costs involved. Usually, there are isolated measurements, which are announced in advance by the official authority, with the consequence that plant operators are able optimally to set up their plants for the precise time of the measurement. If the limits are then found to be exceeded, it can be assumed that the limits will be exceeded by even more in normal day-to-day operation, with the consequence that the requirements are suitably stringent. 4. Emissions Trading in the UK Emissions trading in the United Kingdom is part of the UK National Climate Change Program. The primary target of the mitigation component is to achieve a 20 per cent reduction in carbon dioxide emissions. This target, which the UK government endorsed after the Labor Party took office in 1997, is even more ambitious than that foreseen under the EU burden sharing agreement, which obliges the UK to reduce greenhouse gas emissions by 12.5 per cent. In order to achieve this target the climate change Program specifies the contributions of the different economic sectors. Policies and measures will concentrate on the major emitting sectors, which are the business sector, the transport sector and the domestic sector. Broadly speaking, these three sectors are expected to contribute almost equally to the reduction target. Of the policies within the business sector a major contribution is expected to result from the climate change levy (CCL). This levy is essentially a tax that is imposed on the industry's energy consumption. An innovative twist of this tax is that the tax of a particular energy-intensive company is related to the amount of 80 per cent if that company enters into a negotiated agreement (NA) to reduce its emissions down to a particular level. Additionally, the government will continue to promote energy efficiency measures and it will therefore target directly the emissions of companies. The third major contribution by the business sector is expected to result from emissions trading among companies. From the UK government's point of view various reasons make the introduction of emissions trading a sensible choice. Firstly, as an economic argument, emissions trading make emissions reductions more cost-effective. Secondly, it provides early experience for UK business of something that will be a major feature of business's life from now on. Thirdly, UK business, especially the City of London, will gain a comparative advantage with regard to the handling of all those commodities that will be created with the emergence of emissions trading schemes. And fourthly, the experience of domestic emissions trading will place the UK in a position to influence the international negotiations. Three types of participants will take part in the scheme:

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The so-called "core participants" have adopted an absolute cap of their greenhouse gas emissions in an agreement with the UK government. As a reward for doing so these companies or groups of companies are either granted a rebatement related to the climate change levy or they are granted a grant incentive. There are no limits to trading of unused emission allowances for these participants.

Other participants are those companies that negotiated an agreement on a per unit of output basis. Although a weaker commitment, this opportunity of adopting specific targets greatly helped the scheme's designers to overcome political resistance and persuade business that it must start to reduce greenhouse gas emissions. In contrast to "core participants", "unit participants" will face a trading restriction. A gateway was introduced in order to avoid that emission reductions achieved against a per unit target swamp the market. Whenever there is a risk that such emission reductions could flood the market the gateway will close automatically. Obviously, this poses to all "unit participants" an additional risk; however, this extra burden can also be viewed as an extra incentive to become "core participants".

The third group of participants carries out climate mitigation projects, which results in the generation of emission certificates. Their role is limited to the sale of emission certificates to "core" and "unit participants", who may exchange them with emission allowances. The system's interfaces have to be compatible with international requirements, in particular EU standards. Firstly, reconciliation UK emissions trading with the Integrated Pollution Prevention and Control Regime is challenging. Secondly, state aid issues are involved. According to the European Commission's Competition directives, creating a system where tradable instruments are made available to companies without making them pay specifically for these instruments can be classified as a "forbidden" state aid. And thirdly, the UK scheme must meet the requirements of the European Commission's own proposal for eventual European-wide emissions trading. Concluding, the UK emissions trading scheme is very much a first step. Difficulties, wrong turnings and delays are inevitable, as is the eventual absorption into a wider international scheme. However, it is a step in the right direction that will hopefully give an indication of what can be done. 5. Conclusions The case studies above have been selected in order to give an overview of the breadth of possible economic instruments and the circumstances in which they can be applied. The highlights of the lessons learned from the policy development and implementation process can be summarized as follows:

Many options exist – There are a wide variety of available instruments, and an almost infinite variety of available detailed design options. Thus almost any policy goal can be dealt with through the use of economic instruments.

Details count – It is essential to design an instrument with a detailed knowledge of the situation in which it will be used. This will help ensure that it will have the intended results.

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It can also be a source of creativity – as shown in the San Joaquin valley example, where what looks like a very complex instrument is basically an addition to an already-existing complex governance structure.

Stakeholder consultation is important – Only if there is consultation and a degree of acceptance (not necessarily agreement) by the key stakeholders, including the public, can an instrument be successful. This is shown in the negative case of the Louisiana Scorecard, which was repealed because the way it was implemented raised such opposition. On the other hand, the ecological lands provisions in the Income Tax Act allow landowners an easy way to do something that they like, by reducing the economic costs and complexities. This is an extension of stakeholder acceptance, where the acceptance was there, but the barriers to action were too high and have now been reduced.

Reassess periodically – It is easy for the rates or other details of an instrument to become outdated, and they should be reassessed for appropriateness on a periodic basis. The weight-based approach discussed as an alternative to the present volume based approach used in Victoria is an example of a policy that could be improved.

Multiple instruments are helpful – In many of the cases, several instruments are used to help ensure that behavior changes in the desired way. Often an economic instrument is reinforced by some sort of command and control instrument, which provides a basic level of environmental protection. The economic instrument then encourages an environmentally efficient way to go beyond the basic level. Economic instruments provide a powerful set of tools that can be used for environmental policy making. They can be effective, flexible, and efficient both for the government as regulator and for the company or person to whom they apply.

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Appendix 5: Experience of Aid Agencies

Policy Leverage The experience of Aid Agencies is still quite limited and uneven among donors as well recipients, largely confined to the project level and sometimes inconclusive as to lessons learned. Donors also felt that aid has only limited policy leverage in this domain. Apart from a few exceptions such as large projects with large demonstration effects, aid projects are unsuitable instruments to change environmental standards in developing countries. Green conditionality is often obscured by the general fungibility of resources and tends to shift aid to environmentally less sensitive, sectors. Aid donors, while partners in the development effort, are sometimes also competitors seeking to finance attractive projects. However, the optimal functioning of market tools depends on important set of conditions, which are themselves difficult to attain. They include, notably, the existence of undistorted competitive markets, efficient price signals indicating true scarcities, secure and transferable property rights. Since some of the conditions do not prevail even in OECD countries, it would be unrealistic to expect them in developing countries. Still, they are useful pointers in the right direction. Tentative conclusions A number of tentative conclusions for development co-operation emerged as summarized below:

• In offering assistance and advice, donors should be guided by patience, realism and understanding of the local cultural and political conditions.

• Whatever reforms emerge as desirable, they should be attempted gradually, avoiding drastic changes and political disruptions.

• There is no need for a dogmatic commitment to particular regulations and market incentives. A prudent beginning would be to improve existing regulations and remove perverse incentives and subsidies.

• A relatively simple first step towards pollution control would be the introduction of product charges (on the price of the polluting products).

• Beyond these individual measures, donors might advise the partner country to gradually introduce incentives, which make it profitable for the actors to comply with environmental standards. To be effective, these improvements must therefore be demand-induced rather than imposed.

• The donor can generally assist through the policy dialogue, adjustment assistance and project aid by offering advice and well-directed financial support. More specifically, it would be useful to promote applied policy research in order to identify prospective areas for policy action.

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• News media and pressure groups have an important role to play in alerting governments to take needed action.

• Despite the current US irritation, the Federal Government will abide by its consistent climate protection policy.

• Emissions trading models are not an ideal solution; however, under the right framework conditions, they may make an ecologically effective and financially efficient contribution to global warming prevention.

• Interaction, which other planned mechanisms and those already effective, must be taken into account.

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