Financing Pollution Abatement: Theory and Practice - … · Environment Department Papers Financing Pollution Abatement: Theory and Practice iv Summary of Pollution Abatement Financing

PAPER NO. 028

E N V I R O N M E N T A L E C O N O M I C S S E R I E S

Financing PollutionAbatement:Theory and Practice

Magda Lovei

October 1995

Environmental Economics Series iii

Contents

Glossary v

Executive Summary vii

1. Pollution Abatement Financing - Theoretical Background 1Market and Regulatory Failures - The Need for Intervention 1Environmental Policy and Implementation Instruments 2Fiscal Policy Framework 4The Role of Financial and Capital Markets 6Micro-perspective of Enterprise Financing 7

2. OECD Countries 9Environmental Policy Framework 9Public Pollution Abatement Financing 10Private Pollution Abatement Financing 11Earmarked Environmental Financing Mechanisms 15Summary of Pollution Abatement Financing in OECD Countries 19

3. Transition Economies 23Macroeconomic Policy Framework 23Environmental Policy Framework - The Legacy of Central Planning 24The Role and Characteristics of Comprehensive National Environmental Funds 27

Revenues 27Public Pollution Abatement Financing 29Enterprise Pollution Abatement Financing 32Disbursement Mechanism 33Institutional Issues 35

Long-term Prospective 36Summary of Pollution Abatement Financing in Transition Economies 37

4. Developing Countries 39Macroeconomic and Environmental Policy Framework 39Public Pollution Abatement Financing 40Private Pollution Abatement Financing 42Environmental Funds 44

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Financing Pollution Abatement: Theory and Practice

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Summary of Pollution Abatement Financing in Developing Countries 45

5. The Role of External Finance 47Economic Policies, Environmental Priorities and External Finance 47Financial Intermediary Loans and the Experience of the World Bank 48The Experience of Donors with Environmental Funds 50Debt-for-Nature Swaps - A Special Form of External Finance 53Global and International Pollution Issues and Donor Coordination 54Summary of External Financing Issues 55

References 57

Tables and Boxes Boxes

Box 1 Costs and Benefits of Pollution Abatement for Investors 3Box 2 Water Quality Management and Financing in the U.S. 10Box 3 Effluent Taxes in the Netherlands and Germany 11Box 4 Public Water Sector Financing in the U.S. 12Box 5 Market-based Financing of Municipal Environmental Investments 13Box 6 Directed Credit and Technical Assistance for Industrial Pollution Abatement in Japan 16Box 7 Federal Environmental Credit Programs in Germany 17Box 8 Liability Issues Financed from Environmental Fund in Japan 18Box 9 Environmental Clean-up Financed from Environmental Fund in the U.S. 19Box 10 Earmarked Financing in the French River Basin Management Agencies 20Box 11 The Consolidation of Earmarked Charges in the Netherlands 21Box 12 Setting Emission Charges in Russia 24Box 13 Industrial Pollution Abatement Financing in China 25Box 14 Emission Charges in Poland 29Box 15 Financing Categories of the Central Environmental Fund (CEPF) of Hungary 33Box 16 Cost-recovery in the Water Supply and Sewerage Services in the Ivory Coast 41Box 17 Financing Municipal Services in Colombia 42Box 18 Pollution Abatement Subsidies in India 43Box 19 Directed Credit for Pollution Abatement in Mexico 44Box 20 Comprehensive Environmental Funds in Turkey 45Box 21 The World Bank’s Experience with Industrial Pollution Control Financing from the 1980s

in Brazil 49Box 22 Types of Externally Financed Fund Mechanism 50Box 23 Financing Pollution Abatement Projects from Parallel Environmental Funds in China 51Box 24 The Polish DNS 53

TablesTable 1 Types of Earmarked Pollution Abatement Financing Mechanism 5Table 2 Pollution Abatement Expenditures in the U.S. (1986-1991) 14Table 3 Main Types of Environmental Subsidies for Private Investments in OECD Countries 15Table 4 Main Characteristics of Environmental Funds in Selected transition Economies in 1993 27Table 5 Sources of Environmental Expenditures in some Transition Economies in 1993 28Table 6 Changes in the Real Level of Emission Charges in Russia (1991-1993) 30Table 7 Projects Supported from NEF Expenditures in the Czech Republic during 1992-93 31Table 8 Expenditures of the Hungarian NEF by Domestic and EC PHARE Sources in 1994 52

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Glossary

BADESP Sao Paolo State Development Bank

BMFT German Federal Ministry for Research and Technology

BMWI Bundesministerium fuer Wirtschaft

BNH National Housing Bank of Brazil

BOD Biological Oxygen Demand

CAC Command and Control

CEE Central and Eastern Europe

CEPF Central Environmental Protection Fund

CCF Capital Construction Fund

COD Chemical Oxygen Demand

DAB Deutsche Ausgleichsbank

DE Water Directorate

DEM German Mark

DFI Development Finance Institution

DNS Debt-for-Nature Swap

EAI Enterprise of Americas Initiative

EAPCEE Environmental Action Programme for Central and Eastern Europe

EF Environmental Fund

EIB European Investment Bank

EPA Environmental Protection Agency

EPM Environmental Program for the Mediterranean

ERP European Recovery Program

EU European Union

FFDU Urban Development Fund of Colombia

FIL Financial Intermediary Loan

FNA National Sanitation Fund of the Ivory Coast

FNE National Water Fund of the Ivory Coast



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FNH National Water Works Fund of the Ivory Coast

FONEI Industrial Equipment Fund of Mexico

FSU Former Soviet Union

GEF Global Environmental Facility

ICICI Industrial Credit and Investment Corporation of India

IDA International Development Agency

IDBI Industrial Development Bank of India

INSFOPAL National Institute of Urban Development of Colombia

KfW Kreditanstalf fuer Wiederaufbau

LDC Less Developed Country

LUST Leaking Underground Storage Tank

MBI Market Based Instrument

MDF Municipal Development Fund

MEPNR Ministry of Environmental Protection and Natural Resources

MOE Ministry of Environment

MPC Maximum Permitted Concentration

NAPA National Academy of Public Administration

NEF National Environmental Fund

NEPA National Environmental Protection Agency

NGO Non-Government Organization

OECD Organization for Economic Cooperation and Development

PAC Pollution Abatement and Control

PHDCPA Pollution-Related Health Damage Compensation and Prevention Fund

PPP Polluter Pays Principle

RSFSR Russian Soviet Federal Socialist Republic

SODECI Ivorian Water Distribution Company

SRP Sector Reform Program

TMPCF Tianjin Municipal Pollution Control Fund

TRF Technology Renovation Fund

UNCED United Nations Conference on Environment and Development

UNDP United Nations Development Programme

Environmental Economics Series vii

Executive Summary

Theory

Market and regulatory failures result inextensive levels of pollution, causing damageto human health, and natural and productiveassets. The prevention and mitigation of theseeffects at local, regional and global levels callfor the proper set of environmental policiesand policy implementation instruments.Pollution abatement financing, the mechanismof raising and allocating financial resourcesfor the prevention and control of negativeeffects due to pollution of the environment, isone instrument of a complex policy approachaiming to correct market and administrativefailures. The first part of the paper reviewstheoretical issues influencing the pollutionabatement financing framework including (i)the need for government intervention tocorrect externalities; (ii) the effects of environ-mental policy and implementation ap-proaches; (iii) the connection with fiscalpolicies; and (iv) the development of capitaland financial markets.

Experience of OECD Countries

Reviewing the experience of OECD countries,the second part of the paper concludes thatheavy reliance on command-and-control-based environmental regulations did not leadto cost effective solutions in the past. Inresponse, OECD countries increased the roleof market-based mechanisms in the imple-mentation of environmental policies. A strongregulatory framework and improved enforce-ment have led to a substantial increase in theshare of privately financed pollution abate-ment and control measures in most OECDcountries. Recently, air pollution abatement

has been financed almost exclusively fromprivate sources, while the role of publicenvironmental services has been significant inwater treatment and waste management. Inthe provision of public environmental ser-vices, there has been a trend towards full cost-recovery through the collection of usercharges. Improved cost-recovery has in-creased the efficiency of collective servicesand facilitated the use of commercial financ-ing mechanisms.

The paper reviews various subsidy schemesthat OECD countries used to speed up privatepollution abatement and to reduce the finan-cial burden of compliance with new regula-tions and standards in the past decades. Mostsubsidy programs operated on a temporarybasis. Some countries provided grants topromote the development and application ofcleaner technologies. In other countries,directed soft loans were used to supportprivate pollution abatement investments.Temporary tax incentives were even morewidely used fiscal instruments of providingsubsidies. These measures included taxcredits, accelerated depreciation, the creationof tax deductible funds, and the use of tax-freebonds by investors. The use of subsidiesdistorted the relative prices, and certain taxincentives created a bias towards the installa-tion of control equipment (end-of-pipe con-trol) as opposed to the application of cleanertechnologies and processes.

Earmarked financing mechanisms that werecreated in some countries, typically tackledlocal, regional, or media-specific environmen-tal problems. In some cases, environmentalfunds were established to finance national

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priority programs on a temporary basis.Environmental charges were frequently leviedwith the purpose of raising revenues neededto finance environmental investments. Gener-ally, the more remote the connection betweentaxation and spending objectives is, the lessclear the advantage of earmarking becomes.The benefits of earmarking are more pro-nounced when direct environmental chargesare earmarked in decentralized programs.The main advantages of that scheme in OECDcountries have been the incentive effect ofcharges, and the increased transparency andpolitical acceptability of the system due to theclose relationship between revenue sourcesand the spending of the revenues. Earmarkedmechanisms, however, have not played adominant role in the environmental financingsystem of OECD countries.

Transition Economies

The third part of the paper discusses environ-mental policy and financing issues in transi-tion economies. The paper concludes thatoverly ambitious environmental qualityobjectives combined with weak enforcementcapabilities characterized the central planningera. The reliance on comprehensive nationalenvironmental funds (NEFs) for pollutionfinancing is another legacy of central planning.The transition to market economy, however, isexpected to generate positive environmentalchanges, and a dramatic increase in the role ofprivate environmental financing in the longrun. During transition, several factors,including weak environmental management,severely curtailed availability of privatefinancing, slow pace of privatization, inad-equacies of banking, underdeveloped capitalmarkets, uncertain political and fiscal systems,inadequate information, and weak publicparticipation constrain the development of aneffective environmental financing system, andNEFs preserved their role in environmentalfinancing. There are numerous problems,however, with the current structure of envi-ronmental funding that relies heavily on NEFsin transition economies:

• Earmarking creates an obstacle to increas-ing charges and fines to more efficientlevels in the long run;

• Subsidies provided through NEFs mayreplace investments from private resources;

• Public and commercial financing functionsare mixed in the operation of NEFs, andcommercial banking functions may over-shadow the main objective of environmen-tal financing;

• Banking operations create a self-perpetuat-ing function for NEFs without a motivationto improve the effectiveness of policyframework;

• Revenue allocation is rarely supported byclear environmental priorities; and

• Transparency, accountability and financialsupervision are inadequate.

Therefore, the role of NEFs should be definedand their relationship vis-a-vis the enterprisesector clarified. NEFs can play a catalytic roleby (i) strengthening the environmental policyframework; (ii) financing priority investmentswhere no alternative to public financing exists;and (iii) accelerating environmental improve-ments in the enterprise sector on a temporarybasis. NEFs should have only a limitedmandate in enterprise financing during thetransition. They should concentrate onpriority areas, help to mobilize private andenterprise resources, improve the effective-ness of environmental regulations, promotecost-effective solutions, improve projectpreparation and assessment techniques, andenhance a constructive relationship betweenthe environmental policy authority and theenterprise sector. NEFs should avoid, how-ever, extending their operation to areas wherethey have no expertise or comparative advan-tage and should minimize exposure to com-mercial risk. Their project preparation,assessment and post-project evaluationcapabilities, decision making procedures, andaccountability should be significantly im-proved.

Improvements in environmental management,a stronger private sector, and tightenedbudget constraints for the public sector cangradually eliminate the need for NEFs. Thecombined impact of a gradual increase in theincentive effects of environmental taxes and

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strengthened enforcement will significantlyincrease the role of private investments, whiletightened budget constraint will contribute toimproved cost-recovery in public services. Asa result, the spending structure of NEFs willshift to the funding of areas where no alterna-tive to public finance exists, such as researchand development of new technologies, educa-tion, and information dissemination. Withimproved political decision making, informa-tion availability and citizen and NGO partici-pation, the routine budgeting process shouldultimately take over the role of earmarkedfunds.

Developing Countries

In the forth part, the paper reviews pollutionabatement financing in developing countries.Besides direct regulations that typicallydominate the selection of environmentalpolicy instruments, MBIs are increasinglyapplied in several countries, and informalbargaining frequently plays a significantsupplementary role. Due to traditions andpolitical considerations in water and wastemanagement, cost-recovery in public environ-mental service provision is generally low, andservice charges levied on industrial dischargesare typically ineffective to encourage signifi-cant industrial pretreatment and wasteminimization measures. As a result, the bulkof capital expenditures and operating costs ofpublic environmental services are financedthrough general municipal revenues andnational budget transfers. In some countries,Municipal Development Funds (MDFs) havebeen established to finance infrastructuralservices. MDFs, however, typically cannotachieve self-sustainability.

Underdeveloped and dysfunctional financialand capital markets constrain the privatesector’s access to financial resources and themenu of financing options. Therefore, di-rected credit programs have been widely usedto enhance lending to priority areas in severalcountries. Typically, directed lending forpollution abatement has been carried out byfinancial institutions responsible for directedindustrial lending. The provision of directedcredit at subsidized rates, however, has beendemonstrated to favor large companies that

Pollution Abatement Financing - Theoretical Background

comply with bureaucratic conditions moreeasily than small borrowers.

Additionally, private pollution abatement issupported by various other types of subsidiesthat try to compensate for the lack of strongenforcement of environmental regulations.Subsidies are sometimes channelled throughenvironmental funds, that have been estab-lished to provide a relatively steady flow ofresources for pollution abatement. Due to thelimited amount of revenues raised by environ-mental charges, EFs frequently rely on budgetallocations and external funding. Allocationof environmental revenues is typically notguided by clear environmental priorities andcost-effectiveness criteria.

External Financing

Finally, the paper reviews the role of externalfinancing in pollution abatement. The papernotes that donor assistance has shifted fromaddressing specific problems to aiming atcomplex policies that support environmen-tally sustainable development. Donor financ-ing supplements domestic resources, butcannot compensate for the lack of domesticenvironmental financing systems. Donorassistance, therefore, should focus on theestablishment of a proper environmentalpolicy framework before large scale invest-ments are undertaken. Investment assistanceshould evaluate all pollution abatementalternatives (including changes in manage-ment practices, the application or cleanertechnologies and processes, and the installa-tion of pollution control equipments) accord-ing to their cost-effectiveness.

The paper reviews the experience of variousmechanisms applied to channel donor assis-tance. The experience of the World Bank withindustrial pollution abatement financing hasdemonstrated that strengthened environmen-tal management and directed financing resultin improvements in private pollution abate-ment, and subsidies could be phased out as aresult of better environmental enforcement.There has been a shift in World Bank assis-tance from the support of end-of-pipe pollu-tion control towards a more complex ap-proach of pollution prevention and theapplication of cleaner technologies.

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provide consistency in lending terms and inresource use to finance environmental priori-ties.

The paper underlines that differences exist inthe valuation of global environmental qualitybetween various countries, and points out thatmismatches occur at the national level be-tween the benefits and costs of investmentsmitigating global pollution effects. Therefore,donor intervention is necessary to identify andsupport the least cost solutions. Despitetheoretical advantages in donor coordinationand in the establishment of “clearing houses”for donor funds, such mechanisms havelimited appeal to donors, and the higher thenumber of donors is, the more narrow thearea of mutually acceptable environmentalobjectives becomes.

The paper also points out that existing NEFmechanisms in transition economies have notbeen extensively used to channel donor funds,probably due to incompatibilities in projectevaluation, selection and decision makingprocedures, the lack of transparency inexisting fund mechanisms, and the lack ofclear division between the public financingand the commercial banking functions ofNEFs. During the transition period, donorsmay be willing to channel funds throughearmarked environmental funds if the opera-tions, project selection and decision makingprocesses, transparency and accountability ofNEFs are significantly improved. An um-brella fund may be useful to channel bothdonor contributions, and domestic resources.Such a mechanism would coordinate variousrevenue sources, integrate them into thedomestic environmental financing system, and

Environmental Economics Series 1

Pollution Abatement Financing -Theoretical Background1

When pollution abatement decisions areintegrated with decisions about productiontechnology, however, such division is nearlyimpossible. Available statistics concentrate onexpenditures that are directly aimed at theabatement of pollution. While relying onthese statistics, this paper will nevertheless tryto address the issue from the broader, morecomplex perspective.

Pollution prevention is frequently less costlythan control. Additionally, the integration ofenvironmental considerations into productiveinvestment decisions by the application ofcleaner technologies and processes may leadto simultaneous financial and environmentalbenefits (“win-win” scenarios). Environmen-tal policy makers, therefore, should adopt acomprehensive approach to pollution abate-ment issues.

Market and Regulatory Failures - TheNeed for Intervention

Most pollution problems are the results ofmarket failures. Economic agents makedecisions about the level of their productionand consumption based on market prices,considering the costs and benefits of theiractions. Environment doesn’t have a marketprice, however, and private costs don’tinclude the external social cost of damagecaused to other members of society by usingand polluting the environment. Althoughoptimally polluters should internalize all thecosts1 of damage caused by pollution, withoutgovernment intervention they have no incen-tive to do so, causing excessive pollution of allenvironmental media.

Pollution abatement financing is the mecha-nism of raising and allocating revenues for theprevention and control of negative effects dueto the pollution of the environment. Some-times, improvements can be achieved bychanging management practices such asmaintenance and industrial housekeeping.The financial requirements of such measuresare usually minimal. Frequently, however,capital investments are needed to reach therequired level of pollution abatement. Rajahand Smith (1993) distinguished three types ofpollution abatement measures: (i) “add-on”control measures (end-of-pipe technologies)installed in the production processes, repre-senting the classical cases of pollution abate-ment; (ii) “add-on” investments with privatebenefits generating some revenue besidespollution reduction, for example by recover-ing useful materials from waste; and (iii)integrated technology choices that are mainlyproductive investments with significantpollution reduction potential, for example byreplacing old technology for newer, moreproductive and less polluting alternatives, orinstalling energy saving technologies. Othercategorizations also exist. In Agenda 21adopted by UNCED, for example, two mainenvironmental protection strategies weredistinguished: (1) end-of-pipe technologies;and (2) the use of cleaner technologies.

Revenue-generating and productive invest-ments are usually undertaken as part ofnormal business operations. Environmentalregulations, however, influence investmentdecisions. Ideally, investments could bedivided by the motivation of investors intoproductive and pollution control components.

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level of pollution, policy makers approximateand substitute it by politically acceptable anddesirable environmental quality objectives(ambient standards).

Compliance with environmental qualityobjectives requires substantial financialresources that may be beyond the financingcapacity of the society. Therefore, intermedi-ate targets and phase-in periods may be buildinto the policy framework to harmonizeachievable, realistic objectives with availablefinancing resources. Further, unless theachievement of objectives is guided by welldefined priorities, resource allocation becomessuboptimal. Therefore, government interven-tion in pollution control should be based onthe careful analyses of (i) the main environ-mental concerns (human health damage,damage to ecosystems, and the productivityof assets); (ii) the main causes of damage; (iii)alternatives for mitigating the damage; and(iv) the cost-effectiveness of alternatives. Theselection of priorities based on such analysesshould provide guidelines for the allocation ofscarce resources.

Policy instruments determine the style andcost-effectiveness of policy implementationand create a framework for financing mecha-nisms. Environmental objectives can beachieved by governments directly regulatingpollution-generating activities (command-and-control (CAC) approach), or indirectly, byinfluencing the decision making process onthe micro level (market based instruments(MBIs)).5 Both CAC and MBIs can inducepolluters to finance pollution abatement fromtheir own sources. The CAC approachconstrains polluting activities for each sourceuniformly by setting standards for technolo-gies, processes or emissions. By setting andenforcing standards, the regulator can beassured that emissions and ambient qualitywill stay at a predetermined level. The cost ofpollution abatement, however, varies acrosspolluters, and the same environmental qualitycould be achieved by making polluters withlower abatement cost to abate more, whileothers with higher costs abating less. Such acost-effective solution can be achieved byMBIs that provide price-based choices.Polluters may decide whether to abate theiremissions, or to pay pollution charges (alter-

Macro policies that support economic growthand development may also contribute toenvironmental problems. Environmentallyharmful subsidies reduce the private costs ofproducers and/or consumers resulting inover-utilization of natural resources. Energysubsidies, for example, lead to energy-inten-sive economic structures and technologies,and wasteful management practices. Theenvironmental consequences are more atmo-spheric pollution, causing damage to humanhealth, properties and natural resources, andcontributing to global warming. It has beenestimated (Shah and Larsen, 1992), that theelimination of energy subsidies world-widewould reduce global carbon emissions by 9.5percent (by reducing carbon emissions in thesubsidizing countries by 21 percent).

The extensive role of the public sector in theeconomy also introduces inefficiencies thatadversely effect the environment. Govern-ments as owners of public enterprises estab-lish production targets, but usually don’t holdenterprise managers responsible and account-able for efficient operation. The result isoutput maximizing, rather than cost-benefitoptimalizing behavior. The inefficient man-agement and operation of productive assetslead to wasteful use of resources and inad-equate housekeeping, contributing to pollu-tion.

Environmental Policy andImplementation Instruments

Environmental policy addresses the correctionof market and administrative failures anddetermines long-term objectives for environ-mental quality. The correction of administra-tive failures through the elimination ofenvironmentally harmful price distortions, forexample, should be an important part ofenvironmental policy objectives2. Ideally,environmental policy should lead to optimallevels of pollution by imposing the social costsof external damage on those who cause thedamage. In practice, the determination of theexternal social costs of pollution and environ-mental degradation is hindered by (i) the lackof precise information concerning the causal-ity of damage3; and (ii) the exact monetaryvalue attached to the damage4. As a result,instead of pursuing the economically optimal


Box 1. Costs and Benefits of Pollution Abatement for Investors

Polluters will undertake pollution abatement investments if their benefits exceed their costs:

PV(P) + PV(p[T]) + PV(p[L]) > (C&I) + PV(O&M) - S

Where: PV(P): present value of profit stream from the investmentPV(p[T]): present value of avoided pollution taxes and other environmental charges

during the lifetime of the investment with p probability;PV(p[L]): present value of the difference between avoided legal costs (due to

environmental liability with p probability) with and without the investment;C&I: capital equipment and installation cost;PV(O&M): present value of operating and maintenance cost during the lifetime of the

investment.S: subsidy.

Environmental authorities can induce abatement by influencing three factors: (i) the probability of taxesand charges levied by strengthened enforcement; (ii) the level of taxes; and (iii) the size of subsidies.Interventions on the left side of the equasion are more efficient ways to influence polluter behavior andshould get priority over subsidies.

grams may vary. From administrative pointof view, grants are more transparent andsimple to handle than soft loans, while thesystem of tax incentives, for example, requiresadministrative procedures and inter-agencycoordination between fiscal and environmen-tal authorities.

Subsidy programs always face the conceptualand practical problems of defining (i) theeligibility of investments; and (ii) the size ofsubsidies. While end-of-pipe control invest-ments are easy to identify, pollution abate-ment investments frequently combine produc-tivity and environmental performance charac-teristics, so the separation of environmentaland profit-oriented components is nearlyimpossible. Defining eligibility criteria verynarrowly (for example end-of-pipe controlonly) creates unjustifiable bias towards theseinvestments, and defining them broadly leadsto unnecessary support of profitable invest-ments. Further, it is difficult to design asubsidy program that relates directly to theactivity to be encouraged and doesn’t crowdout market based financing. Subsidies aretypically applied in combination with policyinstruments (environmental taxes and regula-tions) that also contribute to the correction ofthe same market failures. The necessary levelof subsidies, therefore, would depend on thecombined effect of all environmental policyinstruments (see Box 1.). Further, abatementcosts vary across polluters depending on the

natively, to buy emission permits on themarket). As a result, MBIs are generally morecost-effective than CAC regulations(Tietenberg, 1992). Several empirical studieshave demonstrated that gains from efficientallocation of abatement are substantial whencompared to direct regulation (Atkinson andLewins, 1974, Seskin et.al, 1983). In additionto efficiently allocating abatement acrosspolluters, MBIs may also create incentives forfinding least-cost technologies and measuresfor prevention and control rather than concen-trating on end-of-pipe solutions.

Theoretically, subsidies may be used toachieve incentive effects similar to those ofefficient pollution taxes by equivalent subsi-dies paid for each unit of pollution abated.Practically, subsidies are used to compensatefor the cost of pollution abatement invest-ments (rather than for actual pollution abate-ment achieved), when (i) environmentalpolicies otherwise don’t induce the requiredlevel of pollution abatement; and (ii) othermarket failures, such as dysfunctional finan-cial and capital markets, or access to informa-tion about available technology preventpollution abatement investments. Equal levelsof subsidization can be achieved by providing(i) low interest rate (soft) loans; (ii) grantsblended with commercial credit; and (iii)other forms of subsidies, such as tax incen-tives. However, the costs attached to, as wellas the effectiveness of various subsidy pro-




instrument of environmental policy and thedegree of decentralization of the taxationsystem effect environmental policy decisions.Pigou (1920) recommended the use of correc-tive taxes to eliminate the distortive effects ofnegative externalities. Such taxes would bedesigned to adjust the marginal private costsof economic activity to include its social costs.Taxes levied on measured quantities ofpolluting emissions are Pigouvian taxes that,when they are set right, change the behaviorof polluters by internalizing external socialcosts.

Similarly to Pigouvian taxes, indirect taxes(such as value added or excise taxes) on goodsand services that are associated with environ-mental damage may influence the decisionmaking of polluters. For example, carbontaxes levied on fossil fuels raise the price ofenergy and, as a result, reduce energy de-mand, change the structure of energy demandshifting away from fossil fuels, and reduce theemission of carbon dioxide emitted per unit ofenergy used. Due to the looser connectionwith the source of pollution, these taxes aregenerally less effective than taxes levied ondirect emissions, however, they require loweradministrative costs, since the existing taxcollection and enforcement system can beutilized. There is, therefore, a trade-offbetween lower administrative costs connectedwith indirect taxes and greater incentiveeffects associated with direct environmentaltaxes.

The integration of taxation into environmentalpolicy involves (i) redesigning existing (indi-rect) taxes to reflect environmental concerns;and/or (ii) introducing direct environmentaltaxes (Pigouvian taxes) aimed at correctingnegative externalities. The reform of taxsystems could be carried out in a revenue-neutral way by replacing existing taxes (forexample income taxes) with environmental(direct or indirect) taxes. Several analysts(Pearce, 1991; Terkla, 1984) argue that suchrevenue-neutral tax reforms may offer a“double dividend” by simultaneously improv-ing environmental quality and reducingdistortions and costs of the tax system.Although there has been no scientific proof ofthe existence of double dividend (Goulder,1994), the notion of “greening the tax system”

age of assets, type of processes and location ofplants. Uniform subsidy programs, therefore,cannot achieve efficient allocation of re-sources.

Although theoretically the use of subsidiesleads to the same level of pollution abatementas the use of other MBIs, subsidies could leadto a suboptimal situation in the long run; assubsidies reduce the equilibrium market pricefor industry output, they tend to expand salesattracting more polluters and altogether morepollution to the market (Baumol and Oates,1988, Conrad and Wang, 1993). Subsidiesprovided for industrial pollution abatementalso tend to bias decision making in favor ofcapital intensive end-of-pipe control invest-ments, as opposed to pollution prevention andlow-cost alternative control measures. Thelarger the subsidy element is in pollutionabatement financing, the more serious thelong term negative effects of subsidies can beon the total pollution load. In addition,subsidies also weaken fiscal performance (asopposed to environmental taxes thatstrengthen it). Due to these negative effects,subsidies should be avoided as environmentalpolicy instruments.

Various environmental policy instrumentsapplied in combination is most likely to cost-effectively achieve the desired environmentalquality. Finding the combination of thevarious instruments requires the solution ofcomplex political, economic, trans-sectoraland trans-media issues. Setting sensibleenvironmental objectives, and selecting theoptimal combination of implementationinstruments and financing mechanisms,however, can only be effective if supported byclear regulations and strong enforcementmeasures that, in turn, require certain legaland institutional capabilities. Additionally,public access to information can significantlyenhance, or in some cases supplement policyimplementation by facilitating public partici-pation, informal and formal bargaining, andsocial pressure.

Fiscal Policy Framework

Environmental financing is also closelyinfluenced by the fiscal policy framework.The extent to which taxation can be used as an


Table 1Types of Earmarked Pollution Abatement Financing Mechanisms

local taxation may be needed to supplementuser charges. Central intervention may alsobe necessary if fiscal capacities and the costsof environmental improvements vary acrosslower levels of jurisdictions, and uniformfederal or national regulations impose anuneven burden on regional or local govern-ments. Predictability and transparency ofcentral government support are essentialrequirements to avoid inefficiencies. Sincecentral budgetary allocations may createdisincentives for the generation of localrevenues, the application of matching funds isadvisable.

Various forms of earmarking (see Table 1.)may attempt to secure a steady flow ofrevenues for pollution abatement investments.Such mechanisms operate at national or locallevels, and their revenues come from thebudget or from designated general or environ-ment-related taxes. Politically, earmarkingenvironmental taxes for pollution preventionand control investments is attractive becauseit can lead to environmental improvementsand raise revenues simultaneously. Althougha distinction sometimes is made between

by introducing efficient environmental taxesin a revenue neutral manner is a widelyrecommended policy approach.

Fiscal policies also determine the autonomyand revenue raising capabilities of the variouslevels of governments, and the allocation ofpublic environmental expenditures. Gener-ally, the level of government that is respon-sible for carrying out environmental programsis in the best position to determine fundingneeds, and to choose the most efficient fund-ing source and mechanism. Theoretically,local or regional governments should providethose public services for which local residentsare willing to pay for. Directly charging forservices increases the efficiency of resourceallocation and supports social equity byimposing the costs on those who benefit. Thefailure to recover costs is frequently the resultof considerations that try to protect the poor.Free or highly subsidized environmentalservices are, however, very ineffective meansof addressing equity issues. Less than fullcost-recovery may be justified, however, bythe existence of collective benefits that cannotbe allocated to specific individuals. Therefore,


Revenues Expenditures Characteristics Examples

Media-specific emission Regional/local, media-specific Main purpose is revenue French River Basincharges levied at pollution abatement programs; raising; close connection Management Agencieslocal/regional levels; public and private abatement; between revenue sources and

expenditures; transparency;accountability;

Media-specific emission Media-specific pollution Main purpose is revenue U.S. Superfund; earmarkedcharges levied at national abatement programs at the raising for priority or media- sulfur-dioxide emissionlevels; national level; frequently specific programs; charges in France; earmarked

temporary; mainly public; aircraft noise charges inpollution abatement programs; Belgium, France, Germany;

Various types of emission Wide range of environmental and Dominant sources of national Environmental funds incharges and other pollution abatement expenditures pollution abatement financing transition economiesenvironmental taxes levied at local/regional and national systems; blurred lines of (for example, Bulgariaat the national level; levels; public and private public and enterprise/private Hungary, Poland);

abatement; responsibilities;

General tax (budget Specific pollution control Fixed amount allocated from U.S. State Revolving Fundsallocation); investments; public abatement budget; temporary character;

programs;

General tax; external Wide range of pollution Environmental taxes alone Environmental funds in somefunds; and environmental abatement investments at the don't cover expenditure need; developing countries (fortaxes; national and local levels; public dependent on other funds; example, Sri Lanka, Algeria,

and private abatement; and Thailand).



economic agents. Research and developmentin advanced pollution abatement technologies,or clean-up of past pollution damage, forexample, may be justified on this ground.Mainly due to the public good nature ofknowledge generated by research, publicfinance of basic and applied research isconsidered better policy than tax incentivesthat would be needed in order to compensatethe private sector for the high financial riskand the risk due to changing environmentalregulations. In cases of clean-up, the liabilityfor past damage is frequently impossible todetermine and, as a result, no alternativeexists to public financing. Governments canalso play a catalytic role in mobilizing privateresources and accelerating environmentalimprovements due to changing macro-economic conditions or environmental regula-tions. The government’s role in these areas istemporary by its nature, harnessing the effectsof market conditions and environmentalregulations that induce changes in the behav-ior of private economic actors.

The Role of Financial and CapitalMarkets

Well functioning financial and capital marketsare necessary for an effective pollution abate-ment financing system. Pollution abatementfinancing needs to provide for both currentand capital investment costs. The operationand maintenance of control technology andhousekeeping measures are recurrent coststhat are normally funded from operatingrevenues. The financing of capital invest-ments can come from internally generatedcash or from external financing sources suchas new common or preferred stock issues,debt financing in the form of bond issues, andcommercial borrowing. Under well function-ing financial markets, investors have unre-stricted access to various financial sources,and their choice of financing is mainly deter-mined by their preferred capital structure.

Dysfunctional, underdeveloped financialmarkets, however, may significantly reducethe volume and the allocative efficiency offunds invested. Additionally, restrictionsimplied by governmental regulations of the

environmental charges raised to achieveincentive effects and those levied with rev-enue raising purposes, there is no rationale a-priori to make such a distinction. Even aminimal charge may have incentive effectswhen there are polluters that can decreasetheir emissions at a lower cost (for example,the cost of better housekeeping may be small).

Earmarking (assigning revenues from specifictaxes6 or groups of taxes to specific govern-ment activities or areas) may have seriousdisadvantages, including (i) the loss of fiscalcontrol and accountability; (ii) inefficient useof revenues; (iii) inefficient management anddisbursement due to the lack of public scru-tiny; (iv) mismatch between revenues raisedand the financing need; and (v) the burden ofa separate administrative mechanism (EPM1992). Even if taxes are matched with thefinancing need initially, a mismatch is likely tooccur over time. As a result, pollution abate-ment spending will be determined by the sizeof revenues rather than by economicallyjustified expenditure allocation. Whilegeneral revenues of the budget fluctuate,earmarked funds may attract disproportion-ately large share of revenues compared toother, socially equally or more worthwhilecauses. In certain cases, however, limitationson the reallocation of revenues can be accept-able. Smith (1992), for example, points outthat under imperfect political and administra-tive systems, public support for taxes isweakened by concern that they will be di-verted to undesired purposes, and earmarkingmay generate support. McCleary (1991)similarly underlines that earmarking ensures athe minimum level of financing for causeswhich are considered socially worthwhile, butwould otherwise become neglected. Environ-mental considerations typically becomeneglected during the budgeting process due to(i) the lack of public awareness of the extentand cost of damage due to pollution; and (ii)weak or non-existent political representationof the environmental protection cause.

Public investment in pollution abatement canbe justified only if private investment isunavailable, less economical or the benefits ofinvestments cannot be directly linked to


financial sector may increase the cost oflending by banks and other formal financialinstitutions. Informal money markets maysupplement formal markets in the provision ofcredit. The informal markets, however, areusually fragmented, non-competitive, and notwell integrated with the formal market. As aresult, in dysfunctional financial markets, self-financing frequently constitutes the mainsource of funds, and institutional creditbecomes rationed by governments pursuingtheir own credit policies through designatedfinancial institutions and channels.

Small and medium size enterprises frequentlyface special difficulties in obtaining financing:(i) their internally generated cash funds aregenerally limited; (ii) they are precluded fromcapital markets due to their size; (iii) theirrelative transaction cost of project preparationand assessment is high; (iv) the risk and costof lending to small enterprises by financialinstitutions is perceived to be high due to thelack of conventional credit securities andsmall size of credits; and (v) small enterpriseslack adequate information about applicationrequirements and available financing sources.In order to support small and medium sizedenterprises overcoming these difficulties,national or local governments sometimesintervene in various forms, such as (i) creatingspecial financial institutions that channelfunds through small credit programs man-aged by commercial banks; (ii) setting interestrate ceilings; (iii) creating subsidy programs;and (iv) providing technical assistance andadvisory services. While technical assistanceprograms tackle the root of the problem(information disparities), subsidy programsand special financing institutions can easilylead to misdirected credit, perpetual depen-dence on government subsidies, and ineffi-cient allocation of public resources withoutaddressing the causes of high transaction costsand poor access of credit.

Lending for environmental investments is arelatively new field for financing institutions.A change of lending policy and better under-standing of environmental projects are neces-sary at the level of the (i) management; (ii)owners; and (iii) staff members of the financial

institutions. In addition, staff training inproject evaluation and risk assessment tech-niques is also needed to enhance policychanges. Although the start-up phase of thesenew lending programs may be quite costly,cost-effectiveness improves over time withincreased experience and economies of scale.

Micro-perspective of EnvironmentalFinancing

As long as environmental policies induce theinternalization of external costs caused bypollution, “environmental investments” arenot different from any other investment.Investors will undertake such investments ifthe expected financial benefits of these invest-ments exceed their costs (see Box 1.). Invest-ments with a pollution abatement component,however, introduce a great deal of uncertaintyinto traditional enterprise decision making.This uncertainty originates from (i) thecomplex impact of pollution on human healthand the environment; and (ii) changingenvironmental regulations. A number offactors such as expectations reflecting currentexperience with environmental costs, subjec-tive judgement, and perceptions also influenceproject evaluation. Additionally, proceduresand practices of (i) traditional enterprisedecision making; (ii) capital budgeting; (iii)cost accounting; and (iv) financial accountinginfluence the way environmental costs andbenefits are being considered and evaluated.The organizational structure of enterprises, forexample, may inhibit the participation ofenvironmental management in strategicdecision making and limit information flowamong environmental and financial manage-ment. Limited time horizon of project evalua-tion in capital budgeting may ignore long-term benefits of pollution abatement invest-ments. Financial accounting practices mayprevent the monetary valuation of potentialliability costs. Cost-accounting practices mayalso blur the sources of specific environmentalprotection costs and benefits (White, 1993).Enterprise organizational structure, decisionmaking culture, and capital budgeting andaccounting practices, therefore, are importantfactors that determine the way enterprisesrespond to environmental regulations.




1 These costs include (i) the cost of health damage due to the population’s exposure to harmful substances emittedinto the environment; (ii) the cost of productivity loss elsewhere; (iii) cost of damage caused to nature andbiodiversity; and (iv) lost amenity value due to lost environmental quality.

2 In addition to their environmental benefits, the correction of administrative failures generally contributes toimproved fiscal balance and balance of payment (Gupta et.al., 1993).

3 The human dose-response functions of harmful substances in the environment, for example, are not knownprecisely (however, estimates of such relationships have been established).

4 The costs of health damage, for example, can be estimated by using the cost of illness or willingness to paymethods. The former uses the economic costs of hospital treatment, emergency care, loss productivity days etc.,associated with exposure to pollution, while the latter estimates the costs of damage based on individuals’willingness to pay for improvements in environmental quality, primarily based on the contingent valuationmethod.

5 For a detailed analysis of environmental policy instruments, see Eskeland, and Jimenez, 1991.

6 Although the mechanism of financing through earmarked emission charges and other environmental fees maybe viewed as a “self-financing” mechanism that is outside of the taxation system, there is no conceptual justificationnot to consider these charges environmental taxes that are returned to polluters in the form of subsidies.


2 OECD Countries

Environmental Policy Framework

The increased concern about environmentalquality during the last decades has madepolicy makers of OECD countries search forinstruments that can guarantee the achieve-ment of their environmental goals. CACregulatory approaches appeared to suit theirobjectives for a number of political, adminis-trative and practical reasons, and the applica-tion of MBIs was rejected (see Opschoor andVos, 1989). The U.S. Congress, for example,voted against the Proxmire Amendment to theClean Water Act that proposed the introduc-tion of effluent fees in 1971. The factorsinfluencing the decision included (i) anaversion to new taxes; (ii) a perception thatfees would provide the “right to pollute”; (iii)conviction that regulations were the onlyappropriate legislative means of answering asocial need; (iv) uncertainties regarding theeffects of effluent fees; and (v) strong indus-trial lobbying against the fees claiming that themoney taken away would otherwise be usedon pollution control (Casey, 1988). Potentialeffects on international competitiveness due tonew environmental taxes also frequentlyinvoke opposition from certain industrialgroups. As a result, cost effectiveness consid-erations remained unimportant in mostcountries for a long time. The politicalacceptability of MBIs, however, was notequally low across countries. Effluentcharges, for example, were acceptable in somecountries (for example, in the Netherlands,France, Germany).

Recently, OECD countries have becomeincreasingly concerned about the rising costs

of environmental improvements and theefficiency of resource allocation, and started torecognize the benefits of MBIs and the integra-tion of environmental considerations into theirfiscal policy. As a result, direct regulationsare being gradually supplemented by MBIs(Opschoor et.al., 1993) and taxes are increas-ingly used with the dual purpose of generat-ing revenues and providing incentives forenvironmental improvements. Althoughthere are examples (see Box 3.) of direct taxes(emission taxes), the introduction or increaseof indirect taxes on energy, fuels, and prod-ucts (for example, fertilizers and pesticides)with environmental protection purposes arethe more widely applied instruments. Taxesare frequently levied only on a narrow rangeof commodities such as batteries, plastic bagsor non-recyclable containers. Tax differentia-tion is extensively used, for example, to speedup the introduction of cleaner cars on thedomestic market. Tax differentiation havebeen provided according to air pollutioncharacteristics (Netherlands, Germany), carsize, weight, or age (Sweden, Germany).Different rates apply to imported crude oilaccording to sulfur content in Japan. Sales taxdifferentiation proved to be successful in theNetherlands, for example, where the numberof cars complying with future Euro-standardsincreased dramatically (Bressers andSchuddeboom, 1993). Fuel tax differentiationaccording to sulfur content was similarlysuccessful in Sweden, where diesel fuels weredivided into three environmental classes in1991, and the various classes of fuels weretaxed differently. As a result, large oil compa-nies have shifted their production towardcleaner fuels, and a dramatic increase oc-



Box 2Water Quality Management and Financing in the U.S.

The Federal Water Pollution Act of 1972 established technology-based standards for all sources ofpollution, and aimed to ban all discharges of wastes into public waters regardless of the costs andbenefits of such an approach. By setting overly ambitious quality objectives and imposing uniformstandards, water quality policy required large costs that frequently exceeded the benefits of improvedwater quality (Freeman, 1990). The implementation and enforcement of regulations relied heavily on thethreat of punishment (fines, imprisonment) rather than on inducing polluters to reduce their dischargesto public water bodies. Neither the choice of environmental objectives, nor the means chosen to achievethem were driven by economic efficiency criteria, and the result was the wasteful use of resources. As aresult, large public resistance has developed to unfunded mandates and overly ambitious goals withlittle consideration to the costs and benefits of the implementation of such goals.

curred in the cleaner fuel classes. The existingtax system has been frequently adjusted toaccommodate environmental considerationsin a revenue-neutral way. In Austria, forexample, a tax on car registration was intro-duced in 1992 based on sales price andaverage fuel consumption. Simultaneously,value added tax rates on new vehicles werereduced.

Public Pollution AbatementFinancing

The majority of public pollution abatementand control (PAC)1 expenditures (includingdirect public investments, operating andmaintenance costs of environmental servicesand subsidies to the providers of publicenvironmental services) in OECD countrieswas spent on collective water pollutionabatement (over 70 percent in the U.S. andFinland, and around 60 percent in a number ofother OECD countries in the mid 1980s) andon waste management programs (around 20percent in the U.S., and even higher in othercountries, reaching 40 percent in Norway andSweden in the mid 1980s).

The role of the subsidized public sector in theprovision of water and wastewater treatmentwas justified by the public good nature ofthese services. Public treatment, however,was often less cost-effective than privatemeasures for pollution prevention and con-trol. Also, subsidized public wastewatertreatment usually resulted in a lack of incen-tives for cost effective preventive measures

such as good housekeeping practices or theapplication of cleaner production technolo-gies. Therefore, traditional public approacheshave been revisited and cost-recovery mecha-nisms introduced. In Britain, for example,about 60 percent of the cost of sewerage andsewage treatment was financed by subsidiesthrough the “rate support grant” until 1974(Dangerfield, 1979). Since 1974, a gradualmove towards greater degree of self-financinghas taken place, and now borrowing is fre-quently used to finance the investment costsof wastewater treatment facilities.

Public services including collective pollutionabatement are typically delivered by localgovernments in most OECD countries,therefore, public sector PAC expenditures(both investment and recurrent costs) weretypically concentrated at local levels ofgovernment. Local governments were respon-sible for around 90 percent of total public PACexpenditures in the mid 1980s, for example inDenmark, Sweden and Finland (OECD,1990b). User charges and local taxes consti-tuted the main sources of local public environ-mental service expenditures, however, theywere frequently supplemented by transfersfrom higher levels of governments, typicallyin the form of grants (see Box 4.). Historically,the private sector has played an importantrole in the development of environmentalservices in most OECD countries. Currently,both private and public sectors provide theseservices, for example, in France, the UnitedKingdom and the U.S.


Box 3Effluent Taxes in the Netherlands and Germany

In order to finance the construction of water treatment facilities in compliance with the water qualityrequirements of the Surface Water Pollution Act of 1970, water effluent charges were introduced inaddition to CAC regulations in the Netherlands. The effluent charge system operates through twosubsystems: (i) the State Water Authority levying charges on the pollution of state waters; and (ii) WaterBoards levying charges on industries and households discharging into other than state waters. Inaddition to fulfilling their declared primary financing function, the charges have proven to be effectivepolicy instruments by influencing the amount of industrial effluent discharges. A dramatic decrease inpollution took place in the early 1970s, despite the growth in economic activities. As indicated by theresults of a statistical analysis (Bressers and Schuddeboom, 1993), the reduction of industrial wastewaterdischarges was due to the increased incentive role of effluent charges rather than to CAC regulations.Due to increased voluntary abatement as an unexpected regulatory side-effect, there were signs ofpotential overcapacity in water treatment facilities.

Effluent charges were also introduced in Germany in 1976. Although the level of charges was too low toachieve the desired water quality objectives through incentive effects alone, even these low charges wereshown to have noticeable incentive effects when private abatement costs were lower than the effluentcharge. Brown and Johnson (1984) demonstrated, for example, that BASF (a large chemical firm)achieved low unit abatement costs by a large-scale integrated treatment process that treated not only thecompany's own waste water, but the waste of neighboring municipalities as well. Individual brancheswere subject to implicit effluent charges based on an accounting price per unit of effluent for the branch.The internal charge system resulted in a substantial voluntary decrease in discharge through processchange, recycling, and other management responses.

Municipal Development Funds (MDFs),created to provide financing for localinfrastructural investments (water supplies,sanitation, drainage, waste disposal andcollection), have existed in many countriessince the 19th century (for example in Bel-gium, Denmark, Netherlands, Japan). Typi-cally, the majority of funds have been used forwater related expenditures. Although MDFsare initially capitalized by the central or localgovernments (for example subscription ofshare capital), lending is typically funded bythe financial markets. Pension funds, insur-ance companies and commercial banks havebeen the major financing sources throughbond issues or directly negotiated deposits(Davey, 1988). Due to the ability of borrowersto recover their costs through fees andcharges, loans are reliably serviced, and MDFsare self supporting.

Private Pollution AbatementFinancing

As a result of strict environmental regulations,private expenditures on PAC exhibited asteady increase in several OECD countries

during the last decades, both in absolute termsand as a percentage of GDP. For example,private expenditures for PAC increased by 86percent in real terms between 1972 and 1986in the U.S. (from 0.67 percent of GDP to 0.86percent), and by 67 percent between 1975 and1985 in Germany (from 0.57 percent of GDPto 0.74 percent). Air pollution control, thatwas almost exclusively financed from privatesources, represented the largest share ofprivate sector expenditures (around 60percent of private pollution abatement expen-ditures during the 1980s in the U.S., and 40percent in the Netherlands, Germany andAustria). The share of expenditures spent onwater pollution abatement and waste manage-ment programs varied across countries.Depending on the sectoral composition ofindustries, a small number of industrialbranches (typically the chemical, metalproducts, machinery, paper and pulp indus-tries) represented the bulk of private pollu-tion control expenditures.

Direct regulations are generally enforced by aformal enforcement apparatus supplementedto greater or lesser extent by administrativebargaining between the regulator and regu-

OECD Countries



Box 4Public Water Sector Financing in the U.S.

The provision of straight federal grants between 1972 and 1989 contributed to the inefficiencies of waterquality management under the Federal Water Pollution Act of 1972. The provision of federal grants tocover up to 75 percent of the construction costs of wastewater treatment facilities, together with local andstate budgets available for further subsidies, resulted in large inefficiencies and no incentives to recovercosts. There were indications that municipalities simply substituted federal grants for their own funds(Freeman, 1990) and drastic over-capacities were created (Vaughan, 1983). By subsidizing municipalwaste treatment, subsidies were practically transferred to private polluters creating an uneconomic mixof industrial and municipal wastes (Renshaw, 1974). Even when user charges levied by municipalitieson industries covered operation and maintenance costs, charges were lower than economic costs, and thesystem imposed an excessive burden on the budget. Therefore, large-scale straight federal grant financ-ing was eliminated in 1989.

State Revolving Funds replaced federal grants.2 They reflected the growing financing responsibilities ofstates and encouraged the increase of efficiency and cost-recovery in program implementation. StateRevolving Funds are credit mechanisms capitalized from federal grants and matching state funds (80percent and 20 percent, respectively). They provide low-interest rate loans and other non-grant assis-tance to local and municipal governments to build or improve sewage treatment systems. While in theframework of the construction grant program states typically provided grants up to 10-15 percent ofcosts to municipalities, under the revolving fund program, states typically discontinued this practice(U.S. EPA, 1991). As a result of the change from grant to loan mechanism, the increase in householduser fees was typically around 20 percent (U.S. EPA, 1991), and annual adjustments in charges havebecome common. Additionally, the incentive to construct lower cost facilities to minimize the impact ofcapital costs on user fees has increased (U.S. EPA, 1991). As a result of shrinking federal funding, statesand municipalities had to find alternative channels of financing, and were forced to require greaterefficiency and greater cost-recovery in service provision. With increased cost-recovery, market-basedfinancing schemes (see Box 5.) gained larger acceptance. Earmarked funds have been established insome municipalities. In Los Angeles, for example, all wastewater system costs are financed from sewer-related revenues accruing to the Sewer Construction and Maintenance Fund. Such revenues includesewer service charges, industrial waste quality surcharges, inspection and other fees.

schemes were frequently of transitory charac-ter, introduced to tackle specific environmen-tal problems with a pre-set time limit foroperation. During the 1970s, most assistanceto industries was directed to air and waterpollution abatement investments, while in the1980s, several schemes aimed at specificindividual pollutants, and the assistanceprovided to research and development of newtechnologies was also increased (OECD,1990a). In the United Kingdom, for example,the government provided up to 50 percent ofthe cost of industrial research projects aimedat improving environmental standards.Subsidies were also used to tackle problemareas where long-term pollution effectscreated policy concerns. Such an area was, forexample, the protection of groundwaterresources from irreversible damages (and thereduction of related health threats) due toagricultural activities in Denmark. The

lated sector. Bargaining can significantlychange the cost of pollution abatement forpolluters by influencing (i) the stringency ofregulations; and (ii) the effectiveness ofenforcement. The role played by bargainingdoesn’t always depend on the style of admin-istrative system and the traditional role oflaw. In Germany, for example, regulatoryagencies widely apply bargaining in air andwater pollution control despite the authoritar-ian Prussian tradition of control (Hucke,1978).

Various subsidy programs have supportedprivate pollution abatement investments inmost OECD countries. These programs weregenerally aimed at speeding up the implemen-tation of environmental programs and as-sisted those industries that faced sudden cashflow problems due to abnormally high costsrequired by new regulations. Assistance


Agricultural Investment Support Act of 1987introduced subsidies to farmers who wereobliged to undertake investments to reducenitrate, phosphorus and organic mattercontamination of surface and ground watersin order to comply with more stringentenvironmental requirements.

Direct grants were typically provided for theinstallation of clean production technologies.Such a program was introduced, for example,in the Netherlands under the Air PollutionAct of 1970. Surveys found that the compen-sation program indeed induced businesses toinvest more extensively in environmentalmeasures than they would have done other-wise (Bressers and Schuddeboom, 1993).Several of these programs were graduallyphased out or terminated. In Denmark, forexample, up to 50 percent of eligible invest-ments by existing firms were compensated bygrants from 1975. The ceiling was laterreduced to 25 percent, and the program wasfinally abolished in 1986 (OECD, 1990a).

Directed soft loans were extended to indus-tries in several countries. Such loans weretypically channelled through state owned

banks at interest rates ranging from zero tojust marginally below commercial interestrates. In Japan, for example, interest-freeloans up to 50 percent of capital expendituressupported technology updates during 1973-75,and loans at lower-than-market interest rateshave been provided for other pollutionabatement investments (see Box 6.). InFinland, subsidized loans were provided at3.25 percentage points below market ratesbetween 1974 and 1976 for water pollutionabatement projects. The interest rate subsidywas reduced later, and the scope of eligibleenvironmental projects was extended to airpollution control and waste recycling in 1979and 1983, respectively. In the U.S., the SmallBusiness Administration provided long-termlow interest loan programs for financingpollution control facilities for marginallyviable firms (however, excluded profitablefirms that were able to obtain financingthrough commercial sources). Governmentguarantees for environmental investmentloans were also provided, for example, inFinland under the State Guarantees forIndustrial Pollution Control Act of 1973(revised in 1984) for both normal commercialloans and for already subsidized environmen-

OECD Countries

Box 5Market-based Financing of Municipal Environmental Investments

Equity financing. In publicly owned utilities, equity is simply the net worth of the utility (assets lessliabilities), while in investor-owned utilities, equity can be divided into common capital stock, paid-incapital and retained earnings. Equity financing may be preferred to debt financing when the cost of debtis high or the capital structure is overly leveraged.

Long-term debt financing. Municipal governments can raise funds to cover capital costs by issuinggeneral obligation or revenue bonds. General obligation bonds are backed by the issuer’s financialpower, while debt service under revenue bonds is provided from user fees generated by the project itselfafter completion. Higher level governments can offer bond issues with lower interest rates due to theirbetter credit rating. In the U.S., for example, states support smaller communities or municipalities withlower or no credit rating by selling their own bonds, and use the proceeds to purchase local communitybonds. Alternatively, small communities can create bond banks by pooling their smaller long-term loanstogether into a large issue. In either case, small communities have to finance interest and principalpayments through the application of user charges.

Leasing. Leasing may be attractive to utilities as a means of acquiring the use of needed equipment andfacilities if debt limitations restrict direct purchase. Based on the lease agreement, the lessor purchasesthe equipment or constructs the facility, while the lessee (utility) pays rental and, typically, O&M costs.Main sources of lease financing include large banks, equipment manufacturers, real estate developersand leasing companies.

Privatization. Privatization may extend to the financing, construction, ownership and operation of afacility that provides public environmental services. Frequently, privatization is supported by govern-ment incentives provided through the tax system.



Table 2Pollution Abatement Expenditures in the U.S., 1986-1991

credits are usually claimed against positivetax liability. In order to mitigate potentialinequities among enterprises with and with-out taxable profits, credit carry-over andtransfer schemes have been introduced (forexample in Canada).

Other tax incentives have allowed the depre-ciation of certain assets at higher than normalrates or over shorter periods (or both), post-poning tax liabilities in the early years of thelife of the asset, and reducing the net presentvalue of future tax liabilities. Germany, forexample, allowed the accelerated depreciationof water, air and soil pollution abatementtechnology, as well as noise control equipmentbetween 1975 and 1980 (60 percent was theallowed depreciation rate in the first year, and10 percent per annum in the following fouryears compared to the 6.67 percent standardstraight-line depreciation extended over 15years). Investments in capital equipmentqualified for the accelerated depreciation until1991, if the pollution-abatement aspect of theinvestment accounted for at least 70 percent ofthe cost of investment. In the U.S., the TaxReform Act of 1969 provided rapid amortiza-tion of eligible pollution control facilities overa five year period for the first 15 years ofdepreciable life of the pollution controlequipment at old industrial facilities for a

tal loans. Finally, directed environmentalcredit lines were also established on a revolv-ing basis. The European Recovery Program(ERP) in Germany, for example, was capital-ized from the Marshall Plan to provide loansfor small and medium sized enterprises toaccelerate economic development, as well asto support special priority areas. In 1993, 14percent of ERP loans were directed to invest-ments in environmental protection (BMWI,1993). The original capital has remainedintact, while interest revenues and repaid loanamounts are used for subsidized credit (seeBox 7.).

Temporary investment tax incentives havebeen the favored fiscal instrument for pollu-tion control in many OECD countries. Rajahand Smith (1993) pointed out that temporaryincentives may have larger effects on invest-ments than permanent ones by changing thetiming and level of investments. Besidesenvironmental considerations, tax incentivesoften corresponded to concerns about indus-trial competitiveness and promoted employ-ment, productivity improvements and techno-logical progress. Investment tax credits thatprovide an outright tax reduction by subsidiz-ing the purchase price of an asset have beenwidely used, for example, in Canada, theNetherlands and Norway. Investment tax

Source: U.S. DOC, 1993.

1 Including payments to the government.

Year Total industrial Industrial Share of pollution Industrial Total industrial Change fromcapital expenditures pollution abatement abatement in total pollution abatement pollution previous year(U.S. $M) capital expenditures industrial capital recurrent costs1 abatement cost (%)

(U.S. $M) expenditures (%) (U.S. $M) (U.S. $M)

1986 76,354 2,847 3.7 12,258 15,105 NA

1987 78,648 NA NA NA NA NA

1988 80,572 3,423 4.2 14,008 17,431 NA

1989 97,187 4,309 4.4 15,626 19,935 14

1990 101,953 6,031 5.9 17,071 23,102 16

1991 98,916 7,390 7.5 17,387 24,777 7


Table 3Main Types of Environmental Subsidies for Private Investments in OECD Countries

Grants Soft loans Accelerated Tax reduction Tax deductible Earmarked taxesdepreciation funds

Austria X

Canada X X

Denmark X

Finland X X X X

France X X X

Germany X X X

Japan X X X X

Netherlands X X X

Norway X X X X

Sweden X X

U.S. X X X X X

limited time. In Luxembourg, assets acquiredduring 1984 and 1992 that contribute toenergy saving may qualify for accelerateddepreciation. In Canada, water and airpollution control investments at sites thatstarted operation before 1974, and energy-saving equipments can qualify for accelerateddepreciation or “capital cost allowance”.Japan tax authorities similarly allow investorsof pollution abatement, recycling, solar andenergy-saving equipment to use accelerateddepreciation of such assets.

Tax deductible funds (used, for example, inJapan) have similar effects than accelerateddepreciation: when company income is setaside for environmental investment, suchfunds become tax exempt. Once the funds arewithdrawn for environmental investments,they are subject to taxation. The main advan-tage of the system is derived from the deferralof taxes. In other cases (for example in theU.S.), large industrial corporations could oftensave 1.5-2.0 percentage points on the cost ofborrowing to cover pollution abatementinvestments by issuing tax-free industrialdevelopment bonds (Renshaw, 1973)3. Yet inother examples, (in Louisiana), businessproperty tax rates have been linked to theenvironmental records of enterprises(Schneider, 1991).

In most countries, tax incentive schemes havebeen available principally for equipmentpurchases, that may have led to a bias againstthe adoption of cleaner production processes.Additionally, some analysts (Jenkins andLamech, 1992) pointed out that tax incentivesdistorted the relative price signals and, insome cases, the removal of subsidies couldhave reduced pollution levels allowing a moreeffective use of economic instruments. Differ-entiation in eligibility and conditionality thattry to account for differences among pollutersin abatement costs has been demonstrated tohelp improve the environmental cost-effec-tiveness of incentives (Jenkins and Lamech,1992). Such differentiation has been intro-duced, for example, in Canada, where acceler-ated capital cost-recovery incentives areprovided only to older plants (commissionedbefore 1974), that are likely to achieve highercost-effectiveness in marginal pollutionabatement than newer ones.

Earmarked Environmental FinancingMechanisms

In some countries, special earmarked financ-ing mechanisms are used to secure a steadyflow of revenues for certain environmentalprotection objectives. Typically, they have

OECD Countries



Box 6Directed Credit and Technical Assistance for Industrial Pollution Abatement in Japan

The Environmental Pollution Control Service Corporation, later renamed Japan Environment Corpora-tion (JEC) was established and capitalized by the government of Japan in 1965. JEC has become asignificant financial instrument of the government to promote pollution abatement. JEC has three mainareas of operation: (i) it provides basic infrastructure for industrial development providing open space,municipal services and measures to reduce the impact of industrial pollution (for example, developmentof green belts and parks); (ii) it provides long-term loans for industries at lower-than-market interestrates for pollution abatement investments; and (iii) it provides technical assistance and guidance toindustrial enterprises.

JEC played a significant role in financing private pollution abatement investment during the 1960-70s,when commercial banks were reluctant to lend for nonproductive investments. Since then, its role vis-a-vis enterprise investments has shifted to the provision of technical assistance. In 1991, JEC loans contrib-uted to 6 percent of private pollution control investments.

In addition to JEC, other governmental lending institutions finance about 18 percent of the total privateinvestment costs. These include: (i) loans by the Funding System for Modernization of Facilities ofMedium and Small Businesses that are extended for pollution prevention facilities specified by thegovernment; (ii) loans by the Small Business Finance Corporation for People's Finance Corporationassisting small and medium-sized businesses to relocate; (iii) loans by the Japan Development Bank forpollution control representing a small share of total lending, mainly for general industrial development;and (iv) other institutions such as the Metal Mining Agency of Japan and the Hokkaido and TohokuDevelopment Corporation.

Source: MEIP, 1994.

maintained through normal budget alloca-tions. Similarly, earmarking budgetaryrevenues provided a stable source of financingfor public wastewater treatment facilities inthe U.S. in the framework of ConstructionGrants program during 1979-89, and the StateRevolving Fund program from 1989 (see Box4.). Besides revenues coming from the exist-ing tax system, additional revenues may beraised specifically with the purpose of ear-marking for environmental protection. Fre-quently, sin-taxes levied on tobacco andalcohol appear to be the least difficult waypolitically to raise funds for environmentalprotection programs. Washington State in theU.S., for example, levies a cigarette tax to beearmarked for financing water quality pro-grams.

Environmental funds (EFs) have been createdby earmarking environmental levies at thenational level in some countries to provideguaranteed financing for priority publicprograms. Not economic efficiency, but thepolitical priority assigned to certain environ-mental issues has been the primary criteria ofestablishing these funds. Very frequently,these priority programs are connected withenvironmental liability issues. Since the

been used to finance investments in publicenvironmental services to achieve compliancewith regulations. The more direct the connec-tion between the revenue source and its use isthe more politically acceptable the earmarkingsystem becomes. Earmarked mechanisms thatuse revenues from non-environment relatedtaxes, or the budget, have neither directconnection nor the incentive effect thatearmarked environmental charges may have.The only purpose of earmarking non-environ-mental revenues is the provision of funds thatwould not be available through the generalbudgeting process.

Earmarked environmental funds capitalizedfrom the budget were established on a transi-tory basis in Sweden in the early 1970s, forexample, where environmental funds ex-tended grants to industries, municipalitiesand water companies up to 75 percent ofinvestment costs. Besides accelerating envi-ronmental improvements by providing publicsupport through the funds, policy makers alsointended to have an incentive effect on em-ployment. Although these earmarked fundswere abolished after a few years of operation,grant financing from the general budget forpollution control investments have been


OECD Countries

Box 7Federal Environmental Credit Programs in Germany

Most federal environmental credit programs are carried out by two public financial institutions in Germany: theKreditanstalt fuer Wiederaufbau (KfW) and the Deutsche Ausgleichsbank (DAB). While the main objective ofKfW and DAB is the promotion of economic development, both banks have gradually developed an environmen-tal protection lending program:

The European Recovery Program (ERP). ERP is a revolving fund mechanism that was capitalized by the MarshallPlan after the Second World War. The ERP program was carried out by KfW until 1992, when it was taken over byDAB. ERP credits have supported small and medium size private enterprises (with less than 500 million DEMannual revenues) by providing funding up to 50 percent of the investment costs at fixed interest rates. Pollutionabatement credits are provided for (i) sewage treatment; (ii) waste management; (iii) air pollution abatement; and(iv) energy conservation investments, carrying favorable interest rates, loan maturity, grace period, and nopenalties for early repayment. After the unification of Germany, differentiated credit terms were awarded to theEastern States (0.25 percentage points lower interest rates, 5 years longer maturities, and 2 years longer graceperiods). The credit program is executed through commercial banks that bear the credit risk, provide advisoryservices, and carry out financial assessment for a one percentage point margin.

Municipal Credit Program. The program is available for municipalities and communities in the former EastGerman territories. Investments supported by the program cover environmental and infrastructural improve-ments. One of the maine objectives of the program is the support of water supply and water treatment projectsthrough credits extended directly by KfW or DAB. KfW's primary field is lending for water treatment, watersupply, noise reduction, air pollution abatement, and traffic infrastructure investments, while DAB specializes inlending for waste management, energy saving, waste recovery and hospitals. Besides communities, investorsproviding public environmental services can borrow from this credit line up to two-thirds of the investment cost.KfW and DAB raise the capital needed in the capital markets, while the Federal Government reduces the interestrate on the loans to municipalities by 2 percentage points from the budget. KfW and DAB lend to municipalities attheir own risk.

Environmental Guarantee Programs. Since the introduction of new products is frequently constrained by the lackof sufficient securities, the Guarantee Porgrams support the introduction of innovative environmentally friendlyporducts through guarantees porvided for up to 80 percent of the amount of environmental assessment ofprojects carried out by the MOE.

KfW/MOE Environmental Demonstration Program. The program was developed in 1992 to be carried out by theMOE and Federal Banks. The objective of the program is to accelerate the adoption of cleaner technology inenvironmental protection through supporting demonstration projects. Noise, air, and water pollution abatement,energy saving, waste management, waste recovery and integrated and cross-media pollution abatement projectsare supported. Large enterprises in metallurgy, electronics and chemical industries have been the largestbeneficiaries of the program. Currently, interest rates are fixed for maximum 10 years at 6.5 percent. The interestrate subsidy provided by MOE is 5 percentage points during the 5 years of the program's lifetime.

In addition to environmental credit programs carried out by KfW and DAB, several other federal programs existwith significant environmental objectives:

Federal Environmental Endowment Program. The federal environmental endowment was capitalized by the saleof the previously state owned Salzgitter Ltd. DEM 200 million is available annually to support the introductionand transfer of environmental technology, and the protection of cultural heritage from environmental damage.Small and medium size enterprises have priority in obtaining support from the program.

Regional Economic Improvement Program. Water treatment, energy saving, and waste management investmentsare supported through 12 to 18 percent contributions to project costs (23 percent in the new territories). Theprograms are financed jointly from state and federal funds. A special contribution is provided from the federalbudget for the new states.

Energy Saving Program of the Federal Ministry for Research and Technology (BMFT). The BMFT providessupport for the wider use of solar and wind energy utilization programs. Investment contributions of 50 percent(60 percent in the new states) of project costs are extended, while additional subsidies can be provided for theproduction costs of wind energy generation. BMFT provides additional support for the development of newenvironmental technologies under the Environmental Research and Technology program.

Source: KfW & DAB documents.



Box 8Liability Issues Financed from Environmental Fund in Japan

In 1973, a law was adopted on the compensation of pollution-related health injuries. The law categorizedeligible victims into two groups; (i) those suffering from illnesses that cannot be related to specificpollution sources, although nonspecific, pollution-related statistically significant correlation betweenpollution and disease has been established; and (ii) those suffering from specific pollution-relatedillnesses traceable to individual sources. In the latter case, victims could be compensated directly by thecompanies responsible. In order to finance compensation for the first group of pollution victims,pollution levies were directed to a fund administered by the Pollution-Related Health Damage Compen-sation and Prevention Association (PHDCPA). PHDCPA proved to by highly effective in collectinglevies, based on detailed statistics on fuel use by industries. The levies were based on sources of sulfur-dioxide emissions.

used at the local level. Usually, effluentcharges provide the revenue base for thesefunds. In most cases, however, the chargesare set too low to significantly influence thepolluters’ behavior, and the financing functionof these systems is more important than theirincentive function. The level of chargesreflects a compromise between the affectedmain stakeholders (industries, municipalities,agriculture) and local environmental protec-tion agencies. With growing acceptance of thefunds, however, there has been a gradualincrease in the charge levels (Opschoor andVos, 1989). Since the link between expendi-ture and revenue in these arrangements is aclose one, the danger of a mismatch betweenthe amount of revenues raised and the financ-ing need (a serious drawback of earmarking)is greatly reduced. Earmarking at the locallevel is more likely to gain political supportand compliance (beneficiaries are easier toidentify). The local nature and transparencyof these models contribute mainly to theiracceptability. Best known systems are theFrench River Basin Management Agencies thatlevy effluent charges in order to cover thecosts of water supply, as well as water qualitymanagement in the river basin (see Box 10.).Similar mechanisms also operate in Germanyand the Netherlands.

In most cases, environmental taxes (charges)are levied with only revenue raising purposes.Earmarked mechanisms established fromenvironmental charges for air quality controlexist, for example, in Canada, Portugal,France and the U.S. (Opschoor et al., 1990). Inthe U.S., states levy air emission charges

liability for pollution is often hard or impos-sible to determine when (i) the pollutionoccurred in the distant past; or (ii) causalrelationship between pollution and damagecannot be proven with certainty, governmentintervention may be necessary to providecompensation for the victims, and/or financethe cleanup. In Japan, for example, an EF wascreated to provide compensation to thosevictims of pollution related health injuries,who could not be compensated by individualcompanies (see Box 8.).

Due to the marginal role of these funds in theenvironmental management system, the fundsseldom have significant impact on the effi-ciency of the national environmental financingsystem. In many cases, the priority programsare of temporary nature. In the U.S., forexample, the Superfund and the LeakingUnderground Storage Tank Funds werecreated to mitigate contamination fromhazardous waste sites (see Box 9.). Aftercleaning up the most health threatening sites,the role of the funds was envisaged to dimin-ish.

In case of earmarking direct environmentaltaxes, incentive effects are important by-products (see Box 3.). As a result, someearmarked financing systems achieve simulta-neous revenue raising and pollution abate-ment functions. The benefits of earmarkinghave been most pronounced when directenvironmental charges were earmarked indecentralized programs. Most pollutionproblems are local in nature, and revenuesfrom charges on local pollutants are very often


Box 9Environmental Clean-up Financed from Environmental Funds in the U.S.

In the late 1970s it became apparent that uncontrolled environmental contamination from hazardouswaste sites was a nationwide problem. The Comprehensive Environmental Response Compensation andLiability Act of 1980 created an earmarked federal fund, known as Superfund, to finance the cleanup ofthose toxic waste sites that (i) present threats to public health or the environment; and (ii) create liabilitythat cannot be assigned to individual polluters. The Superfund was originally conceived as a short-termprogram. In 1986, by the Superfund Amendments and Reauthorization Act (U.S., 1992), Congress askedEPA to develop permanent remedies for Superfund sites. The Superfund is financed from petroleum andfeedstock chemical excise taxes, environmental taxes, and by appropriation from general revenues.

Responding to an increasing threat of groundwater contamination through leaking storage tanks ofpetroleum and other hazardous substances, the U.S. Congress created another earmarked financingmechanism in 1988, the Leaking Underground Storage Tank (LUST) trust fund. LUST was assigned tofinance corrective and remedial actions at abandoned sites or in cases where liability could not bedetermined or enforced. The revenues of the fund are generated from gasoline taxes.

earmarked to support air quality programs(Shields, 1989). Air emission charges havebeen typically levied on certain types ofpolluters or on a limited number of pollutants.In France, for example, only industrial enter-prises that generate power beyond certaincapacity, or emit sulfur oxides or nitrogenoxides beyond certain volume are charged.Aircraft noise charges are also typicallyearmarked to cover noise abatement costs(Belgium, France, Germany, Switzerland), andwaste disposal taxes are directed to treatmentand recycling expenditures in a number ofcountries (Opschoor et al., 1993). Frequently,the connection between the source andallocation of tax revenues is distant, and directincentive effects are not detectable. Generally,the more remote the connection betweentaxation and the objective of the fund is, theless clear the advantage of earmarking be-comes. Product charges, for example, are lessdirectly connected to the sources of pollutionthan emission charges. Additionally, theproliferation of earmarking reduces theefficiency of the environmental financingsystem (see Box 11.).

Summary of Pollution AbatementFinancing in OECD Countries

• Environmental financing mechanisms inOECD countries have been significantlyinfluenced by the dominance of CACinstruments that did not lead to cost

effective solutions of environmental prob-lems, and the environmental financingsystems frequently reinforced policyinefficiencies. More recently, however,environmental considerations increasinglyinfluenced the taxation system, and MBIshave become more widely applied tosupplement other policy implementationinstruments. Although the main purpose ofMBIs has been revenue raising, their effectsof influencing polluter behavior increasedthe cost-effectiveness of environmentalprotection measures.

• Due to improving environmental manage-ment, the share of the private sector in totalPAC expenditures has been increasing.Industrial pollution abatement is typicallyfinanced from private resources in OECDcountries. Air pollution represented thelargest share of private sector PAC expen-ditures.

• Various forms of subsidy schemes havebeen used in most OECD countries tospeed up the process and reduce thefinancial burden of compliance with newregulations and standards. Investment taxincentives have been the favored type offiscal subsidies. The use of certain incen-tives created bias towards end-of-pipecontrol investments as opposed to theapplication of cleaner technologies andprocesses. Typically, these schemes haveoperated on a temporary basis that changed

OECD Countries



Box 10Earmarked Financing in the French River Basin Management Agencies

Six river basin agencies11 represent the main hydrographic basins of France. The river basin agencies aremanaged by Basin Committees, the Boards of which are representing the main stakeholders (national,regional and local governments, industrial and agricultural interests and citizens). The Basin Commit-tees, supported by technical and financial basin agencies, prepare five-year environmental actionprograms based on (i) the analysis of problems in the basin, (ii) selection of projects and their costs andbenefits; and (iii) amount of fees necessary to ensure the projects' financing need. The fees collected areearmarked for these purposes.

Effluent charges that represent the largest part of the agencies' annual revenue sources (close to 70percent) have been levied for various water pollutants (suspended solids, oxidizable matter, solubleslats, BOD, organic/ammonia nitrogen and total phosphorus) since 1969 (Bernstein, 1993). These chargesare paid by industries, municipalities and households (Hahn, 1989). The level of effluent charges isgenerally low, and rarely based on actual performance. Instead, the charges are based on expected levelsof discharges by various industries. The number of pollutants on which charges are levied has grownsince the initiation of the program.

In addition to the effluent charges, resource fees (representing roughly 14 percent of the agencies' annualrevenues) are collected for water withdrawal, based on the volume of water abstracted (measured orestimated) and on coefficients of various types of water usage. Resource fees vary depending on thegeographic area, seasonality of usage, etc.

Grants provided by the basin agencies range from 15 to 50 percent of the capital costs, while low interestrate loans range from 20 to 50 percent (Bower, et al, 1981). The size of subsidies depends on the type ofproject, the beneficiary and the zone in which the project is to be implemented. In addition to subsidiesfrom the basin agencies, the national government may also provide subsidies or grants to public entities.Investments in water quality improvement represent the majority (about three fourths) of financialoutlays. Typical projects financed from the funds are municipal and industrial waste treatment, toxicpollution control, and interceptor sewers. Municipalities receive the bulk of the subsidies.

the timing of investments and acceleratedpolluter response to environmental regula-tions.

• The main contribution of the public sectorto PAC expenditures has come from publicenterprises, whose revenues are financedfrom user charges, occasionally supple-mented by central government subsidiesdirected to municipalities. There has beena trend towards greater cost-recovery. Thishas increased the efficiency of collectivetreatment services, and led to the use ofmarket-based financing mechanisms.

• Financing schemes through earmarkedenvironmental taxes have been createdwith the purpose of tackling media-specificor local/regional environmental problems.These earmarked mechanisms have notplayed a major role in the environmentalfinancing systems of OECD countries. Insome cases when direct environmentaltaxes have been earmarked, incentiveeffects also appeared supplementing theprimary revenue raising functions. Theadvantages of earmarking have beengreater in local/regional financing schemes,when a close relationship exists betweenthe source and spending of revenues.


1 PAC expenditures data refer to investments and current expenditures directly aimed at environmentalprotection. Due to difficulties estimating the share of expenditures that is due to PAC requirements, differences ininterpretation, definition and data collection, reported figures may not be comparable across countries.

2 The program came into effect in 1989, with a five-year mandate.

3 The Revenue and Expenditure Control Act of 1968 effectively eliminated industrial revenue bond financingexcept for small issues and pollution abatement financing.

Box 11The Consolidation of Earmarked Charges in the Netherlands

Charges for air pollution, chemical waste, traffic and industrial noise were formerly earmarked in theNetherlands to finance environmental programs in the area where the revenues were raised. The practiceof different environmental programs, each charge financing only part of the environmental investments,led to a nontransparent, fragmented, inflexible environmental finance system. In response to the need fora more integrated financing system, the various types of product charges were consolidated in 1988 intoa single charge levied on fuels (in 1990, the sulfur-dioxide tax was also incorporated into the fuel charge)that was considered to provide a general link with pollution. Clearly, the purpose of the fuel charge wasrevenue raising rather than creating pollution abatement incentives. Since the previous taxes on airpollution and traffic noise were already based on the same fuels, the transition was carried out with littlechange in the country's energy policy or in the effect the taxes had on polluters. The more general thecharge became, however, the less sustainable the earmarked system was. Additionally, the character ofthe charge changed from a specific financial instrument to a taxation instrument. Therefore, earmarkingwas eliminated in 1992. The revenues of the previously earmarked fuel charge now accrue to the generalbudget, and the allocation of funds for environmental expenses takes place in the normal budgetingprocess.

OECD Countries


3 Transition Economies

Macroeconomic Policy Framework

Central planning severely restricted anddistorted the function of markets. The gov-ernment as the owner of production meansconcentrated in large public enterprises,established production targets but didn’t holdenterprise managers responsible and account-able for technically and commercially efficientoperation. Cost-plus price controls generallyassured profits for public enterprises withoutthe risk of being displaced by less costly ormore innovative competitors. Inefficientmanagement and operation of productiveassets led to stoppages, breakdowns, andinadequate housekeeping practices, contribut-ing to excessive levels of pollution. Theemphasis on heavy industries combined withhighly subsidized energy and raw materialprices led to very low energy-efficiency,wasteful use of resources and high pollutionintensity. In order to support domesticindustrial development, high import protec-tion was introduced and external price signalsdidn’t reach domestic economies. Underde-veloped financial systems relied on a domi-nant central bank that, as an agent of thegovernment, allocated credit according tocentral plans.

The transition from central planning tomarket-oriented economies that started inmost countries of Central and Eastern Europe(CEE), the former Soviet Union (FSU) andChina in the late 1980s, introduces complexmacroeconomic reforms that are expected togenerate positive environmental changes:

• Public sector reforms decrease the dominanceof public enterprises, reduce state interven-

tion in public enterprise autonomy, breakup large state monopolies and promotecompetition that improves managementpractices and resource use;

• Monetary reforms introduce tight controlover money supply and eliminate interestrate subsidies, resulting in a reduction incapital-intensive investments, more realisticvaluation of resources, and changes in theeconomic structure in the long term (par-ticularly the decline in the share of theheavy industry);

• Fiscal policy reforms reduce subsidies andprice controls, and create a more efficienttax system, resulting in more efficientresource use and less pollution intensivepractices; and

• Trade policy reforms change protectionistforeign trade policy, by eliminating theover-valuation of exchange rates andreducing trade restrictions, resulting inefficiency increases due to increased importcompetition and increased import ofcleaner technologies.

Not all the effects of economic restructuringand macro-policy changes are environmen-tally positive. The environmental effects ofmacro-policy measures greatly depend on thecoherence of structural adjustment. Negativeenvironmental affects occur when reforms arenot fully coordinated1, and market failures arenot addressed comprehensively (Munasingheand Cruz, 1994) — for example, clarificationof property rights concerning natural re-sources such as forests and fisheries.



Box 12Setting Emission Charges in Russia

Ambient standards (maximum permitted concentrations (MPCs)) were established during the formerSoviet regime, based on the requirement of zero damage from pollution sources to human health,demonstrating the idealistic objectives of Soviet-type legislation. In practice, the permanent emissionlimits determined to achieve MPCs had to be supplemented by temporary emission limits correspondingto the technological and economic capabilities of the society.

Environmental damage calculations undertaken from the early 1970s created the basis for the emissioncharge system, that was gradually introduced starting from 1988 (NAPA, 1994). During the experimen-tal phase, large differences existed between regions in the methodologies of calculating charges, and alsoin actual charge levels. Emission charges for carbon-monoxide, for example, showed variation in theorder of several hundred between the cities of Perm and Dnepropetrovsk (Ukraine).

The national charge system introduced in 1991 included some 200 base rates for both air and waterpollutants (Lvovsky et al, 1994). The rates were determined by using MPCs, and reflected the desire tocentrally evaluate and mitigate environmental health and other pollution risks. Regional characteristicssuch as background pollution and the assimilative capacity of the ecosystem were expressed by coeffi-cients determined by national regulations (MEPNR, 1993). Despite the intention to create correctivetaxes that induce optimal pollution levels, charge rates were calculated merely to yield enough revenuesfor mitigating damage.

The present system of charges in Russia is a combination of noncompliance penalties and emissioncharges. The base emission charge system applies when discharges are within maximum permittedlevels, set according to MPCs. Charges increase considerably (up to 5 times) for discharges between themaximum permitted and temporary permitted levels, and yet even higher are the penalty charges foremissions beyond the temporary permitted levels (up to 25 times the base rates). The level of charges,however, is still very low (even in the highest category), and doesn’t meet the objective of inducingoptimal pollution levels.

Since 1992, agreements between polluters and the environmental protection authorities create the legalbasis for the collection of pollution charges. Such agreements specify (i) the permitted level of dis-charges; (ii) base rates and penalty rates for each pollutant discharged; and (iii) the schedule of chargepayments.

Source: NAPA, 1994; Averchenkov, 1994

Environmental Policy Framework -The Legacy of Central Planning

Transition economies inherited a uniqueenvironmental policy framework that empha-sized overly ambitious and strict environmen-tal quality objectives (ambient standards),supported with relatively weak capabilities ofpolicy implementation and enforcement. Thecombined effects of market and administra-tive failures during central planning increasedthe social costs of pollution and excessive useof natural resources, and led to seriousenvironmental deterioration. Environmentaldeterioration contradicted the environmentalquality objectives manifested in strict ambientstandards and basic environmental lawsenacted in some countries as early as in the1950s. These environmental quality objectivesand laws represented a set of idealistic

principles rather than guidelines to set priori-ties and resolve conflicts. Their implementa-tion and enforcement were less importantthan the declaration of commitment to theseideals. The good intentions frequently re-mained unfulfilled and laws unenforced.

The need to address the problem of environ-mental degradation in a more effective wayand provide a financing mechanism forenvironmental protection became acute in the1970s-1980s. In response, several countriesincreased the responsibility of enterprises forpollution abatement. Some countries (Bul-garia, Hungary) introduced non-compliancefines, and others created a framework ofcorrective taxes. In Poland, for example,environmental fees were introduced in the1970s with the declared intention of motivat-ing polluters to adjust their behavior. Thesystem of environmental fees in the Soviet


Box 13. Industrial Pollution Abatement Financing in China

Financial resources for industrial pollution abatement come from various earmarked sources inChina:

• Capital Construction Funds (CCFs) accumulated from 7 percent of new investment costs designatedfor pollution control;

• Technology Renovation Funds (TRFs) or depreciation funds that carry out the rehabilitation ofexisting technologies, 7 percent of which should be spent on pollution control;

• Comprehensive Utilization Profits gained from utilization of waste are allowed to remain in theindustry instead of being transferred to local finance bureaus;

• Environmental Funds (EFs) accumulated from pollution charges and fines at local environmentalprotection bureaus. Eighty percent of total environmental levies is earmarked for industrial pollutioncontrol investments.

The largest share of industrial pollution abatement investments (45 percent in 1990) is financed fromCCFs and TRFs. Other environmental investments are financed from industrial bank loans, and alsofrom grants or loans from EFs. Since 1986, the role of soft loans as opposed to grants has increasedamong the expenditures of EFs. However, upon completion of pollution abatement projects, manypolluters have been given exemption from repaying the loan.

The system of pollution control financing in China exhibits the characteristics of revenue allocationunder central planning. Enterprise resources are designated to centrally determined purposes. Thepractice of legally mandating the use of 7 percent of investment and amortization funds for pollutionabatement, for example, (i) leads to inefficient resource allocation among polluters; (ii) favors capitalinvestments over other pollution abatement measures; and (iii) doesn't promote the effective operationand maintenance of abatement technology.

Source: NEPA, 1992


integral part of a public financing system thatprovided all the capital needs of enterprisesby centralizing and redistributing enterpriserevenues (see Box 13.). Typically operating asoff-budget mechanisms, NEFs blurred thedistinction between the budgetary tasks of thegovernment and the financing tasks of enter-prises. They became supplements to thebudgetary revenues of the central environ-mental protection authority, with a complexmandate to finance (i) institution building andstrengthening of the environmental protectionauthority; (ii) R & D activities in pollutioncontrol technology and development; (iii)environmental education, information collec-tion and dissemination; (iv) nature andbiodiversity conservation; (v) public environ-mental services (such as wastewater treat-ment); and (vi) pollution abatement invest-ments in commercial activities.

The development of the private sector, publicenterprise restructuring, and tightening

Union was based on a complex economicvaluation methodology trying to estimate thevalue of environmental damages, and settingcharges accordingly. Under central planning,however, enterprise managers had verylimited authority. Inputs and outputs in theproduction process were externally deter-mined, and profits centralized and reallo-cated. Decisions about investments weremade centrally, and enterprises became mereexecutors of the central plans. In addition,political pressure discouraged environmentalprotection authorities from introducing trulyincentive charges. As a result, pollutioncharges couldn’t effectively change thebehavior of polluters, and served merely asrevenue raising mechanisms, earmarkedthrough comprehensive national environmen-tal funds (NEFs).

NEFs, as one of the numerous earmarkedmechanisms operating in the fiscal systems ofcentrally planned economies, became an



poor understanding of cost-effectivesolutions make decision making subopti-mal; and

• Weak NGO movements and citizen groupsdon’t influence effectively the politicaldecision making process.

Due to these difficulties, environmentalfinancing through private sources and normalbudgetary allocations remains insufficient toachieve socially desired environmental qualitygoals, and comprehensive NEFs have pre-served their role in the environmental policysystems as important factors in environmentalfinancing of most transition economies. Evennew NEFs have been established in somecountries. Earmarking environmental levieshave made them politically more acceptabledue to the connection between tax paymentsand environmental expenditures.

The role of NEFs in pollution abatementfinancing varies widely. More mature NEFs(for example in Poland) with large revenuesources finance the bulk of environmentalinvestments, while others appear to be lessdominant, but still significant. The impor-tance of NEF in environmental expendituresappears to be growing in most countries. InRussia, for example, the share of NEFs incapital investments for pollution abatementincreased from 6.6 percent in 1990 to 29.6percent in 1991. In Poland, the share of NEFsfrom total environmental expendituresincreased from 2 percent in 1990 to 22.3percent in 1993 while the contribution ofregional funds to total expenditures showed asimilarly strong increase. The significantshare of municipalities in environmentalexpenditures indicates the low cost-recoveryof public environmental services, and share ofenterprise and private pollution abatementfinancing is generally low.

Due to similarities of history, institutionalframework, and economic and environmentalproblems in transition economies, the opera-tion of NEFs exhibits similarities. Differencesare determined, among other factors, by (i) thestate of domestic economy; (ii) the develop-ment of private sector; (iii) the politicalcommitment to address environmentalproblems; (iv) the development of domesticfinancial and capital markets; (v) the sources

budget constraints are changes that shiftfinancing decisions from the center to theenterprises. Environmental improvements areincreasingly financed from private resourcesin response to the combined effect of incentivepolicy instruments, environmental regulationsand enforcement. Commercial banks aretransforming themselves from passiveallocators of credit who simply follow govern-ment instructions into real financial institu-tions. As a result, the role of enterprises infinancing environmental investments isexpected to increase dramatically in the longterm. In the early stage of transition fromcentrally planned to market economies,however, there are several factors that con-strain the evolution of an effective environ-mental financing system:

• Changes in enterprise behavior typically lagbehind the introduction of macro-economicchanges and incentives;

• Weaknesses of the environmental policyframework: taxes, regulations and enforce-ment are not effective enough to induceprivate and enterprise investments to reachthe desired level of pollution abatement;

• The failure to recover full costs of publicenvironmental services creates largefinancing need;

• Severe financial constraints at industrialenterprises delay the replacement ofoutdated, polluting technology;

• The slow pace of privatization hinderspositive changes in management practices;

• Insufficiencies of the banking system createcredit shortage and rationing, severelylimiting access to financial resources;

• Underdeveloped capital markets constrainthe use of advanced financing instruments;

• Environmental issues are frequentlyneglected in the political decision makingand budgeting process;

• Changing fiscal systems result in uncertainrevenue raising capabilities at variousgovernment levels;

• Inadequate information on the extent andsocial costs of environmental damage, and


Table 4Main Characteristics of Environmental Funds in Selected Transition Economies in 1993

Sources of revenues Size of Contribution Main expenditures Disbursement(% of total revenues) revenues to total (% of total mechanism

(U.S. $M) environmental expenditures) (% of totalexpenditures (%) disbursement)

Bulgaria pollution fines (58); 2.3 7 monitoring (40); grants (68);import tax on used cars (33) loans to enterprises (32); interest-freeother (9); public services (19); loans (32);

Czech water charges (41); 107 10 water projects (58); grants (71);Republic air emission charges (30); air pollution control (33); soft loans (29);

waste charges (13); other (9);land charges (12);

Estonia water pollution charges (35); 1.7 10 public environmental grants (50);waste disposal charges (35); services (50); soft loans (25);air pollution charges (18); loan guarantees for loanother (12); enterprises (25); guarantees (25);

other (educationenforcement) (25);

Hungary fuel tax (44); 27.7 11 air pollution control (70); grants;traffic transit fee (20); waste management (15); interest-free loans;PHARE grant (19); water pollution other soft loans;pollution fines (17); control (11);

other (4);1

Poland air pollution charges; 515 58 air pollution control (47); grants (17);water pollution charges; water pollution control (35); soft loans (77);water use charges; other (soil protection, loan interestwaste charges; monitoring, eductation, etc.) (18); subsidies (6);

Russia pollution charges (83); 84 NA capital expenditures for grants;claims for damages (7); pollution control (24);fines (2); current expenditures (11);other (8); R&D (7);

institution building (28);bank deposits (22);other (8);

Slovak state budget (37); 34.7 20 water pollution abatement (48); grants (99);Republic water pollution charges (30); air pollution abatement (27); loan interest

air pollution charges (25); waste management (8); subsidies (1).other (8); other (17);

Sources: Averchenkov, 1994; REC, 1994; Personal interview with Eva Krav, Chairperson of the National Board of theEstonian NEF.

1 Doesn’t include the Water Management Fund.


and size of NEF revenues; and (iv) the matu-rity of NEFs.

The Role and Characteristics ofComprehensive NationalEnvironmental Funds

Revenues

The sources of NEF revenues are non-compli-ance fines (for example in Bulgaria and

Hungary), and emission charges (in China,Czech Republic, Estonia, Poland, SlovakRepublic and the Russian Federation). Addi-tional revenues are raised from productcharges (for example, fuel tax in Hungary),other environment-related taxes and levies(for example, transit traffic tax in Hungary,import tax on used cars in Bulgaria), andother sources (for example, external sourcesfrom the PHARE program in Hungary, statebudget in the Slovak Republic). Although



fines and charges are set in proportion to thedamage caused, their level is rarely highenough to achieve more than raising revenues.In Estonia, for example, the charge for sul-phur-dioxide emissions below permittedlimits is set at $0.05 per ton, for carbon-monoxide at $0.008 per ton (Kallaste, 1994).The Polish example shows, however, thatcharges can be increased considerably if thereis a political will. At $72 per ton, emissioncharges for sulphur-dioxide (Zylicz, 1994), forexample, are likely to have substantial incen-tive effects in Poland (the marginal abatementcost in the U.S. set by the market is about $150(Selling..., 1994), and enterprises in Polandmay be at a flatter part of the pollutionabatement curve due to the large potential formanagement, operation and maintenanceimprovements).

Emission charges are typically levied for alarge number of pollutants, making theadministration of the system overly compli-cated. In Russia, for example, charges are setfor 217 air pollutants, and 198 water pollut-ants. Although such a complex set of chargesmay try to effectively approximate the dam-age caused, the large administrative costscompared to the current low levels of chargesand revenues make the system inefficient.

Even if emission charges were increased tohigher, more efficient levels, the cost-effective-ness of the system would be questionable.Increased real level of charges levied on asmaller number of pollutants would be moredesirable. Direct regulations would be moreeffective for other pollutants that are hard todetect and monitor (for example, heavymetals).

The principle of measuring and charging foractual damage is further compromised by (i)the centralized determination of charges withlimited differentiation among regions; (ii)severely constrained capabilities to reliablymonitor even a limited number of pollutantdischarges; (iii) ineffective tax collection; (iv)widespread exemptions; and (v) the dilutioneffect of inflation. Centrally determinedcharges are incapable of reliably approximat-ing environmental damage and, there ismismatch between revenues and the financingneed at local and regional levels even withdecentralized revenue allocation schemes.Given the serious constraints of monitoringcapabilities, most typically, charges are basedon discharge estimates rather than actualmeasurements, that greatly reduces theireffectiveness. Due to economic hardship andlax enforcement, the efficiency of revenue

Table 5Sources of Environmental Expenditures in some Transition Economies in 1993 (percent)

Bulgaria Czech Republic Estonia Hungary Poland

State budget 46 29 201 48 5

Municipalities 2 612 30 10

Enterprises 343 8 23

NEFs 7 10 10 114 58

Other 115 706 3 4

100 100 100 100 100

Source: REC, 1994

1 Includes municipal and enterprise expenditures.2 Includes enterprise expenditures.3 Mainly state-owned enterprises.4 Excludes expenditures from the Water Management Fund.5 EC PHARE program.6 Foreign assistance.


collection is low. In Poland, for example, only65 percent of imposed charges were collectedin 1993 (REC, 1994). Another characteristic ofNEFs is the ability of polluters to negotiate thepayment of pollution charges. Polluters inmany countries may be totally or partiallyexempt of taxes if they undertake pollutionabatement investments. Considering theoutdated technology of many industrialenterprises in these countries, investments intechnology update lead to considerablereduction of pollution and qualify for pollu-tion tax exemption. Consequently, collectedtax revenues are substantially reduced (inRussia, for example, about one-fourth of thetaxed amount is not collected due to exemp-tions). Finally, since many transition econo-mies experience high rates of inflation and thepollution fee systems are generally not in-dexed (Poland is the only exception), thedilution of revenues creates another problemfor NEFs (Table 6).

Public Pollution Abatement Financing

The transition from central planning to marketeconomies, facilitated by institutional reformprocess, changes the role of government.Traditional revenue sources, expenditurestructures and the organizational frameworkof financial flows are changing dramatically.Tax administration, accounting, auditing, taxcollection and enforcement procedures,compatible with requirements of market

Box 14Emission Charges in Poland

Environmental charges were introduced in Poland in the 1970s, with the intention of influencing thebehavior of polluters. Although fee levels were increased several times during the central planning era,their effects were counterbalanced by the lack of financial motivation of economic actors, mainly stateowned enterprises facing budget constraints.

Environmental authorities utilized a political opportunity during the collapse of the old regime tostrengthen the role of environmental charges by increasing their real levels, pegging them to the officialinflation index (later changed to predicted inflation rate pegging), and changing collection frequency. Asa result, some charges have the potential to provide significant incentives to abate. In most cases,however, charges are below the estimated damage functions, and site-specific damages are not reflectedin a satisfactory way (Zylicz, 1994).

Charges are levied on a high number of water and atmospheric pollutants, the reliable monitoring ofwhich exceeds available capacities. As a result, levies are frequently challenged by polluters. However, italso provides motivations to monitoring agencies to upgrade their capabilities.

economies are being introduced. The budget-ing process is slowly changing, however, andstill shows the characteristics of centralplanning in many countries. The lack offunctional and economic classification ofexpenditures, for example, often skewstransparency and economic analysis. Addi-tionally, extensive political and fiscal decen-tralization is taking place.

The autonomy over local matters is increas-ingly being decentralized. However, despitethe expenditure autonomy assigned tosubnational levels of governments, theirautonomy on the revenue side is frequentlycurtailed. Additionally, the adjustment ofuser charges in the public environmentalsector depends on national reforms of socialprotection systems due to the traditionaldistributional functions of these charges.Setting charges right is further constrained bypolitical resistance and weak accountingsystems. The adjustment of prices for publicsector services has been very sluggish even incountries where national price reformsliberalized private sector prices and publicsector pricing appears likely to be one of thelast areas to be reformed in most countries(Bird and Wallich, 1993). It has been esti-mated that in some transition economies,raising the prices of public utilities to costrecovery levels could cost households morethan 50 percent of their average householdincome (Schiavo-Campo, 1994). Therefore,




system, monitor and enforce compliancewith regulations, and collect taxes. Up-grading monitoring systems in priorityareas, where high ambient concentrationsof certain pollutants expose the populationto high health risks, and the monitoring ofthe disposal of hazardous, toxic andnuclear wastes should receive high priority.Improvements in the maintenance andoperation of existing equipment should becarried out before new investments arefinanced. Improvements in informationanalysis and reporting should involvecoordination with various levels of govern-ment agencies. Applied research should befunded in high priority areas to find cost-effective solutions to environmental prob-lems (for example, groundwater protectionfrom nitrate contamination, prevention ofecological damage caused by large-scaledevelopment projects).

• Financing of high priority public pollutionabatement programs and services.

Abatement of pollution from non-point sources.NEFs may play a significant role in areaswhere private benefits of pollution abate-ment are not enough to compensate for thefull cost of investments, or pollutionabatement is hard to measure and control.Such area is, for example, the protection ofgroundwater reserves from contamination.Solutions to this type of problems generateboth public and private benefits, andhousehold resources available to pay forthe private benefits can be effectivelymobilized by NEFs supporting theseenvironmentally beneficial investments.

while responsibilities for providing serviceshave been transferred to local levels, fre-quently, the central governments set uniformprices due to equity considerations.

As extra-budgetary funds, NEFs are notaffected by the fluctuations of normal budgetrevenues. By design, NEFs can tackle a widerange of environmental problems in a compre-hensive way at various levels of governments.Realistic environmental objectives and clearfinancing priorities should, therefore, guideNEFs to allocate resources to those areas thatmost effectively speed up positive environ-mental processes. The following areas,therefore, are expected to receive high priorityin NEF spending structures:

• Improvement of the environmental policyframework.

Strengthening of enforcement capabilities.NEFs should ensure that environmentalimprovements are sustainable. In order toimprove enterprise compliance withenvironmental regulations, and increase therole of environmental financing fromprivate sources, NEFs should contribute tothe development of an effectively operat-ing, independent environmentalinspectorate system. The organization ofinspectorates should ensure their freedomfrom political influence and isolation ofindustrial pressures.

Upgrading of information systems. Reliableenvironmental information is necessary foran effective environmental policy frame-work: information is needed to set priori-ties, design a well functioning emission tax

Table 6Changes in the Real Level of Emission Charges in Russia (1991-93)

1992 1993

Adjustment of Emission Charges (1991=1) 5 25

Ruble/U.S. $ Exchange Rate (1991=1) 12.50 48

Ratio 0.4 0.52

Source: Averchenkov et al., 1994


Table 7Projects Supported from NEF Expenditures in the Czech Republic During 1992-93

Number of projects Value of projects (U.S. $M)

Wastewater treatment plants 154 (30%) 113 (51%)

Municipal fuel conversion program 116 (22%) 22 (10%)

Fuel conversion in district heating 88 (17%) 30 (13%)

Air pollution abatement 34 (7%) 13 (6%)

Solid waste management 19 (4%) 5 (2%)

Waste incinerators 5 (1%) 6 (3%)

Other 96 (19%) 34 (15%)

Total 512 (100%) 223 (100%)

Source: REC, 1994

Reinforcement of the impact of macroeconomicpolicies. In response to the incentive effectsof macroeconomic policy reforms, behav-ioral changes are expected to result inpositive environmental impacts. Fuel pricechanges and technical development, forexample, have led to the replacement ofcoal for gas in households, district heatingsystems and small-scale industries in manylarge cities in the world, contributing tosignificant improvements in urban airquality. However, behavioral changes inresponse to market incentives (for example,the reduction of fuel price subsidies leadsto energy saving investments) may besluggish. Therefore, NEFs can play acatalytic role in accelerating the adjustmentof polluter behavior by mobilizing privateresources.

Priority public pollution abatement services.Most public environmental services areprovided locally and are expected to beincreasingly financed from user charges.However, due to slow changes in cost-recovery and the uncertain revenue raisingand allocating capabilities of local adminis-trations, increased pressure is put on NEFsto support investments in public environ-mental services such as the construction of

wastewater treatment and solid wastemanagement facilities. However, largepublic investments are seldom cost-effec-tive solutions to environmental problems inCEE (see EAPCEE, 1993) and, therefore,should be supported by NEFs on an excep-tional basis only. Such support can bejustified if (i) investment in public facilitiesis a cost-effective alternative to solve anenvironmental problem; (ii) NEF funding isthe best available alternative2; (iii) matchingcontribution is provided from the munici-pality or locality; and (iv) cost-recoverycriteria can be satisfied.

In practice, NEFs don’t appear to support themost stressing environmental problems intransition economies. Although air pollutionin big cities is the a main health threat in mostCentral and Eastern European countries(EAPCEE, 1993), a large proportion of fundresources are used to finance capital invest-ments in water pollution control (for example,58 percent in the Czech, 48 percent in theSlovak Republic, see: Table 7, and REC, 1994).Few NEFs seriously support the improvementof environmental policy framework. Nationalenvironmental strategies (if they exist) fre-quently fail to provide practical guidance forNEFs to set their spending priorities. As a




result, long “wish lists” are created and anyproject with some positive environmentalimpact may receive support. Some fundsallocate their resources on a “first-come-first-served” basis. Cost-effectiveness criteriadon’t appear to have much influence on theselection of projects.

Enterprise Pollution Abatement Financing

In the central planning system, enterpriseinvestments were financed from designatedsources, and blurred responsibilities charac-terized government-enterprise relationships.In this system, NEFs served as one of thedesignated financing channels fulfilling a dualrole of budget and enterprise financing. Aslong as state ownership of enterprises domi-nated, and resources were centrally controlledand allocated, the contradiction between theseroles did not become apparent. The reformprocess, however, increases the role of theprivate sector, changes government-enterpriserelationships, and increasingly delegatesinvestment decisions to the micro level. Dueto tightening budget constraints, enterprisesare expected to rely more on their ownretained earnings and on the financial marketsfor investment resources. As a result, thecontroversial functions of NEFs vis-a-vis theenterprise sector have to be clarified andstreamlined during the transition.

Transition economies have a large portfolio ofinefficiently operating public enterprises.Although privatization of the public sector isunder way, it is clear that (i) the process ofprivatization takes much longer than previ-ously anticipated; and (ii) several large, highlypolluting industrial complexes will stay instate ownership for long periods of timewithout sufficient financial resources toundertake investments. Most economies intransition attempt to restructure and providebudgetary support to these enterprises. Inmany cases, liquidation is rejected due tosocial reasons (mainly to avoid large unem-ployment). State-owned holding companieshave been established in some countries tomanage the portfolio of public enterprises andto restructure individual companies to in-crease their efficiency. While most of thebudgetary support for the restructuring ofstate owned enterprises are channelled

through sector ministry budgets, pollutionabatement investments are being neglecteddue to the weakness of environmental man-agement framework. For these enterprises,support from NEFs, therefore, may be justi-fied on a temporary basis.3 However, NEFshould only have a limited mandate in enter-prise financing during the transition periodwith the following conditions:

• Clear environmental priorities shouldguide revenue allocation focussing onhighly polluting industries or “hot spots”only;

• NEFs should contribute to the strengthen-ing of enforcement capabilities parallel withenterprise support to change enterprisebehavior;

• With their financing role, NEFs shouldfacilitate a long-term partnership betweenindustries and the environmental policyauthority using a carrot-and-stick ap-proach;

• NEFs should mobilize enterprise resourcesby requiring matching investment funds (i)to ensure the commitment of enterprises;and (ii) to avoid the moral hazard ofenterprises deferring investments inanticipation of support;

• Eligible enterprises should be financiallyviable with positive net present values offuture operations;

• NEFs should facilitate changes in themanagement and operation of enterprisesby (i) co-financing environmental auditsthat identify low-cost solutions; (ii) requir-ing the assessment of alternative solutionsin project evaluation; and (iii) emphasizingcost-effectiveness in project selection;

• NEFs should require the use of environ-mental assessment methods in projectpreparation, enhancing enterprise capitalbudgeting;

• Specific environmental improvementsshould be conditions of financing and theirattainment and maintenance should bemonitored;

• Enterprise support should be temporary.



In addition to their public financing role,several NEFs have shifted their operation toquasi-commercial banking by financingprofitable investments with positive environ-mental impacts. During a period when theeconomy is restructuring and obsolete tech-nologies are replaced by new, modern andenvironmentally cleaner ones, a large share ofprofit-maximizing investments have signifi-cant environmental benefits (“win-win”investments). Such investments, however, aremainly driven by market forces, rather thanby environmental requirements. By financing“win-win” investments, NEFs are simulta-neously (i) correcting financial system failures;and (ii) subsidizing certain environmentallyfriendly investments. Although public outlaysin order to compensate for market imperfec-tions (for example the failures of the financialsystem) can be justified during the transitionto support private initiatives, NEFs are not thebest choice since:

• NEFs have no special expertise or advan-tage in carrying out banking activities;

• NEFs handle public money that should notbe exposed to commercial risk;

• NEFs are not subject to banking supervi-sion and regulation, therefore, there arelimited checks and balances built into theiroperation;

• Commercial banking operations mayovershadow or overtake NEF’s mainfunction of environmental financing;

• Banking operations create a self-perpetuat-ing function for NEFs without improvingthe effectiveness of environmental policyand financing.

Therefore, the finance of profitable invest-ments and commercial banking operationsshould not be undertaken by NEFs and betterbe left to the banking system.

Disbursement Mechanism

In the early stage of NEF operations, enter-prise subsidies were distributed mainly asgrants. The reforms immediately before andduring transition intended to increase thefinancial independence of enterprises, andtheir awareness of the costs of capital. Subsi-dies that didn’t cover the full amount ofinvestment costs, had to be supplemented byown resources or commercial bank loans.However, the immaturity of the commercialbanking sector in central planning and duringtransition have constrained access to borrow-ing, and soft loans were used to supplementor replace grant financing. In China, forexample, soft loans increased their share from5 percent in 1986 to 68 percent in 1991 (NEPA,1992), and in the Czech Republic, from 6

Box 15Financing Categories of the Central Environmental Protection Fund (CEPF) of Hungary

The CEPF categorizes environmental investments into four groups:

• Profitable investments are environmental investments that generate profit. These are eligible for acredit guarantee up to 70 percent of commercial credit amount from CEPF;

• Cost-saving investments that save costs (for example, by reducing emission charges or fines) to coverpart of the investment and operating costs. These can be financed by interest free or low-interestcredit from CEPF (CEPF interest rates vary from 60 to 120 percent of the central bank base rate);

• Revenue-generating investments that cannot cover the costs of investments and operations. Environ-mental impacts rather than financial return are the main criteria of project evaluation in these cases.All types of support can be extended.

• Not revenue-generating investments are generally eligible for grants or interest-free loans or theircombinations up to 60 percent of the investment costs.

Source: CEPF, 1994



percent in 1992 to 28 percent in 1994 (REC,1994). The share of soft loans is highest inPoland (77 percent in 1993, see: REC, 1994).

However, there is no a-priori advantage inusing soft loans as opposed to grants toallocate public resources. The same amountof subsidies can be provided either way. Theprovision of soft loans rather than grants havereduced the transparency of NEFs and re-quired banking expertise that NEFs lackedbadly. In response, some (for example, theHungarian) NEFs delegated their bankingoperations to the commercial banking system.Others (for example, in Bulgaria), havedecided to undertake the task themselves.This has imposed large administrative bur-dens on the NEFs, and created numerousinefficiencies. Setting up a lending programrather than providing grants has also unneces-sarily tied up financial resources, as thesubsidy had to be spread over the lifetime ofthe loans (in the form of the difference be-tween market and subsidized interest rates).

Generally, banking operations should not beundertaken by NEFs, and better be left to thebanking system. If NEFs decide to providesoft loans rather than grants, they shouldminimize their exposure to commercial risk.For example, reimbursing the differencebetween commercial and subsidized interestrates to the commercial banks that extendloans for environmental projects, is preferableto direct loans. Seconding lending operationsto commercial banks (i) helps to spin offbanking functions where NEFs have noexpertise; (ii) introduces environmentalevaluation techniques into bank projectassessment; and (iii) imposes more rigorousregulations and supervision on the financialoperations.

Some NEFs have made steps to separate someof their commercial banking functions byfounding ecological banks. In Poland, forexample, the NEF was co-founder of theEnvironmental Protection Bank, in the RussianFederation, 80 percent equity contribution wasprovided from NEF resources to the capitali-zation of the National Bank for EnvironmentalProtection (Econatsbank). Eco-banks mayfacilitate investments in priority areas, for

example, in environmentally friendly tech-nologies or in the acceleration of conversion tocleaner fuels in households. The experience ofOECD countries shows that directed creditprograms have been frequently used indeveloped countries to temporarily support,for example, the introduction of new technolo-gies in the private sector. Such programs,however, should be connected to strongenforcement of environmental regulations inorder to change enterprise behavior andmobilize enterprise resources. Further,environmental improvements don’t necessar-ily require large capital investments. Oldcentral planning practices that tended toemphasize the role of investments and ig-nored the importance of efficient operationand management, have to be re-evaluated andlow-cost alternative measures identified. Eco-banks are not strongly motivated to supportthis process and facilitate a change in invest-ment-biased enterprise behavior. Addition-ally, backed with the steady revenue flow ofenvironmental funds, eco-banks don’t face thesame scrutiny as normal banks do. Besidesone-time capitalization, equity contribution ofNEFs to Eco-banks should be restricted.Finally, without clearly defined mandate andfinancing objectives, sub-optimal resourceallocation and distortions in the financialsystem may occur. Eco-banks, therefore, arenot a preferred form of pollution abatementfinancing, should have a limited mandate, andtransform into normal commercial bankinginstitutions.

The proliferation of earmarking is characteris-tic of the operation of most NEFs. Revenuesderived from certain groups of polluters areearmarked to be returned to the same group,or sub-funds are established for furtherearmarking. In Poland, for example, re-sources transferred to the NEF from provincesare kept on separate sub-accounts, whilefunctional earmarking exists for charges to berecycled for pollution abatement concerningsaline coal mining waters, and atmosphericsulphur dioxide and nitrogen oxide emissions.In Hungary, revenues from the fuel tax canonly be spent on investments in traffic-relatedpollution abatement, and several windows areestablished for different spending categories.In the Czech Republic, revenues are pre-


Institutional Issues

Most typically, the management of NEFs isassigned to the central environmental protec-tion body. In Russia, for example, the Minis-try of Environmental Protection and NaturalResources has control over the funds throughits committees at various government levels;in Hungary, the NEF is one of the depart-ments of the MOE; in Bulgaria, the work ofthe NEF is carried out by various departmentsof the MOE with one department functioningas coordinator. The role of the environmentalminister is generally significant in appointingthe directors of NEFs, approving the guide-lines for NEF operation, and making finaldecision about resource allocation. Even inPoland, where the NEF was established by theparliament as a structurally independentinstitution, members of the supervisory boardare appointed (and can be recalled) by theenvironment minister.

Close connection to the MOE underlines thepublic financing functions of NEFs. Althoughit facilitates the integration of national envi-ronmental policy objectives and priorities intothe operation of NEF, it may blur the lines ofresponsibilities for budgets and operations.Some degree of separation, therefore, isnecessary between the management of theenvironmental protection body and that of theNEF, in order to clearly distinguish betweentheir roles, budgets and decision makingprocedures, and to reduce potential politicalpressure and conflicts of interest.

Parallel with the gradual decentralization ofpolitical and fiscal systems, NEFs establishednationally may decentralize their revenues toregional or local levels. The collection anddisbursement of revenues, then, are carriedout regionally or locally, however, the rules ofrevenue generation and regulations of opera-tion are still determined nationally. In theRussian Federation and Belarus, for example,environmental funds receive 90 percent oftotal environmental revenues (10 percent isaccrued to the budget) that is divided amongnational (10 percent), regional (30 percent) andlocal (60 percent) levels. In Bulgaria, 70percent of the revenues from non-compliancefines are transferred to national, and 30percent to municipal levels. The greater

earmarked according to their origin both bymedia and geographic regions: charges for airpollution are used to support air pollutionabatement programs, and 60 percent of thefunds are returned to the area or region wherethe revenues originated from (REC, 1994). InChina, enterprises are entitled to receivesubsidies from the fund up to 80 percent ofthe emission charges paid. Such close ear-marking prevents the funds to reallocaterevenues according to immediate priorities,while potential advantages (political supportof charges, matched revenues and expendi-tures, transparent allocation) of close relation-ship between revenue sources and uses (acharacteristic of the French River BasinManagement Agencies) are largely lost due to(i) the complicated bureaucratic process ofrevenue collection and reallocation; and (ii)the lack of transparency in decision makingand revenue allocation.

Frequently, NEFs don’t spend all the revenuesavailable to them. Averchenkov (1994)reported, for example, that large parts of theearmarked resources of NEFs at the regionallevels in the Russian Federation remainedunspent in 1993. The unused amount was 67percent of the total resources, for example, inTyumen, 62 percent in Tver, and 54 percent inMurmansk regions. Similar situation wasreported from Poland (REC, 1994): despiteincreasing revenues of the NEF during 1992-93, its expenditures decreased. While 92percent of NEF resources were spent in 1992,only 70 percent was disbursed in 1993. Suchphenomenon may be the result of the lack of(i) clear priorities and spending strategies; (ii)viable investments under current conditions;or (iii) information about investment options.Unspent NEF resources create a serious cashmanagement problem, especially under highinflation conditions. The practice of the PolishNEF of equity investment in “environmentallyfriendly” ventures may indicate an attempt toinvest excess cash rather than being theoutcome of an established strategy for rev-enue allocation. The practice of not fullyspending NEF resources also points out one ofthe main weaknesses of earmarked financingmechanisms: NEFs manage idle funds orinvest suboptimally while other, sociallyworthwhile programs may remain unfunded.




freedom is provided to regional and localauthorities in operating the funds, the closerthe relationship between the source and use ofrevenues is. With decentralized revenueallocation, the spending structure of NEFs atthe national level are likely to shift towardsinternational and global environmentalproblems, while funds at local and regionallevels may become more involved in financingenvironmental programs of local and regionalcharacter.

When national NEF systems decentralize theallocation of revenues, local and regionalauthorities have no control over the determi-nation of charges (although there are incen-tives to increase collection efficiency). In thissense, they remain executing bodies of acentrally regulated financing system. InRussia, for example, Ministerial Order No. 151on “Standard Regulations of EnvironmentalFunds” approved in 1992, recommended thatlocal and regional governments adopt com-mon procedures for operating the funds.Consequently, mismatches between local/regional financing need and revenue sourcesare inevitable. The extent of real decentraliza-tion depends, besides political considerations,on the degree of decentralization in the fiscalsystem. Strictly centralized fiscal systemsresist the allocation of revenue raising capa-bilities to local and regional authorities.Decentralization also requires that NEFs atvarious levels possess capabilities to set clearpriorities and operate efficiently. Suchcapabilities are frequently missing.

Funds frequently measure their effectivenessin the amounts of pollutants controlled ornumber of projects completed rather than byimprovements achieved in environmentalquality or costs saved in achieving environ-mental improvements. However, investmentssupported by NEFs don’t necessarily lead toenvironmental improvements. In China, forexample, the operation and maintenance ofpollution control technologies are not moni-tored, and the equipment is frequently notoperated to save operating costs that typicallyexceed emission charges. Post-project evalua-tion and monitoring capabilities of NEFs areusually non-existent or weak. Only the

Hungarian NEF requires the repayment offinancial support and interest charges by NEFbeneficiaries if expected environmentalimprovements are not achieved.

The movement toward market economy isfrequently associated with a trend towardmore political freedom and democracy. In thepublic finance and budgeting process, twofeatures are expected to be strengthened: (i)transparency ensuring that main stakeholdersare involved in decision making; and (ii)accountability ensuring that services aredelivered in an efficient and effective mannerby creating a system of checks and balances.The operation of NEFs should reflect thisprocess. The representation of major interestgroups in the decision making process ofNEFs can also (i) increase the acceptance ofpollution charges; (ii) facilitate the develop-ment of a consensus between polluters and theregulating authorities; and (iii) help to setpriorities.

Several NEFs established administrativeframework for inter-ministerial consultationsand more transparent decision making. InBulgaria, for example, the board of directorsconsists of representatives of the Ministries ofFinance, Construction, Industry, Agriculture,Environment, Energy and Health, the Com-mittee of Geology and Mineral Resources,Committee of Tourism, Institute of Ecology,and a private insurance company (the invita-tion for an NGO was, however, revoked). InHungary, an Interministerial Committee(representing the Ministries of Environment,Transport, Telecommunications and Water,Industry, Agriculture, Finance, Welfare andInternal Affairs) participates in the decisionmaking process. Although considerableprogress has been made in the coordinatingfunction of NEFs, still no public participationis built into NEF operations. NGO and citizenparticipation has been minimal or non-existent.

Long-term Perspective

The majority of spending for pollution abate-ment should come from private sources in thelong run, while public spending should be


part of the budgetary process, competing withother public expenditures. The proliferationof earmarking, as it was demonstrated by theDutch example, leads to inefficiencies in thefiscal system and distortions in environmentalfinancing. NEFs, therefore, should be viewedas temporary instruments to correct imperfec-tions during transition.

In order to increase the role of private pollu-tion abatement, the environmental policyframework should be strengthened consider-ably. CEE countries have a unique opportu-nity to build on the existing system of emis-sion taxes, and establish a policy frameworkthat gives a significant role to market incen-tives. Environmental taxes can induce volun-tary private pollution abatement and, supple-mented by a carefully selected set of directregulations where incentives are insufficient toachieve environmental quality objectives,could result in environmental improvementsin a cost effective way. With the transition tomarket economies, constraints created byunderdeveloped, dysfunctional financialmarkets are expected to disappear, and manyfinancing channels become available forprivate (and public) direct investments.

Strengthening the environmental policyregime requires a serious effort of consensusbuilding with the decision makers responsiblefor financial and fiscal policy, and is likely totake a long time. NEFs can effectively contrib-ute to this process. A gradual approach ismost realistic, during which NEFs support thedevelopment of strong environmental policyframework, and mobilize private financialresources. NEFs can be politically attractive,since voters (and polluters) are more willingto support taxes if a direct connection isprovided between tax payments and environ-mental improvements. Earmarking, however,not only creates inefficiencies in fiscal policy,but also hinders the introduction of a moreeffective environmental policy instruments,since the combined effect of environmentaltaxes, regulations and financial supportthrough NEFs would lead to excessive levelsof pollution abatement. Therefore, the ear-marked share of environmental tax revenuesshould be gradually reduced over time,

parallel with increasing the real level andincentive effect of emission taxes, and improv-ing the environmental management frame-work. A timetable for this should be negoti-ated with fiscal authorities. As the role ofprivate environmental financing increases,and greater cost-recovery is achieved in theprovision of public environmental services,NEFs are expected to shift their investmentpriorities to areas where no alternative topublic finance exists. Under improvedpolitical systems, information availability, andincreased role of NGOs, these traditionalpublic finance functions, however, should beovertaken by normal budgeting in the longrun.

Summary of Pollution AbatementFinancing in Transition Economies

• Macroeconomic reforms introduced duringthe transition from central planning tomarket economies are expected to generatepositive environmental changes. Thedevelopment of the private sector, publicenterprise restructuring, and tighteningbudget constraints gradually shift financingdecisions from the center to the micro level.As a result, the role of enterprises inpollution abatement financing is expectedto increase dramatically in the long run.

• Comprehensive NEFs that currentlyconstitute an important source of environ-mental financing in CEE countries, arelegacies of central planning. In the transi-tion period, they should be considered astemporary financing instruments that canplay a significant role in speeding uppositive market processes and financingenvironmental priorities by redistributingand allocating revenues to investments inpriority areas that reduce environmentaldamage in a cost-effective way. Theoperation of NEFs, however, should reflectthe long-term objective of creating a sus-tainable environmental financing system.NEFs are expected, therefore, to (i) improvethe environmental policy framework; (ii)finance high priority public environmentalprograms and services; and (iii) provide




1 If price subsidies are lifted, for example, on hydrocarbons but not on coal, adverse pollution affects occur.

2 Besides NEFs, other earmarked funds are also frequently used to finance public environmental investments. InHungary, for example, wastewater treatment facilities can be financed from (i) the NEF; (ii) the Water ManagementFund established from earmarked water charges and fees; (iii) Regional Development Funds mainly designated forinfrastructural investments; and (iv) directed municipal support programs. There is inadequate coordinationamong the various sources and, as a result, there are overlaps and inconsistent eligibility criteria and financingconditions.

3 Priorities may include as (i) the installation of dust collection systems in metal smelters; (ii) investments inequipment to reduce toxic pollutant discharges where large populations are exposed; and (iii) pre-treatment ofwastewater in small- and medium-sized industrial plants where water contamination by heavy metals and toxicchemicals is a serious environmental threat (EAPCEE, 1993).

priorities and cost-effectiveness criteriashould guide their project selection, sup-ported by increased transparency andaccountability in the decision makingprocesses. Post project evaluation func-tions should ensure the sustainability ofenvironmental improvements. Institutionalcapabilities of NEFs at regional and locallevels should be strengthened and theseparation of roles, management andbudgets of NEFs from those of the environ-mental protection body should be ensured.

• With a stronger private sector, the restruc-turing of the public sector, tightenedbudget constraint, and improved environ-mental regulations and enforcement, theburden of environmental financing isexpected to shift to the enterprises andimproved cost-recovery can be achieved inpublic environmental services. Therefore,the role of NEFs in pollution abatementshould diminish, the share of earmarkedenvironmental charges reduced, theirspending structure shift to traditionalpublic finance roles, and eventually takenover by normal budgeting.

temporary support to the enterprise sectorby mobilizing enterprise resources inpriority areas.

• NEFs should have only a limited mandatein enterprise financing. NEFs should play acatalytic role by (i) focussing on priorityareas only; (ii) facilitating a long-termpartnership between industries and theenvironmental policy authority; (iii) mobi-lizing private financial resources; (iv)influencing enterprise behavior by focus-sing on cost-effective solutions; and (v)ensuring the sustainability of environmen-tal improvements. The role of NEFs inenterprise financing should be temporary.

• NEFs should improve their revenue raising,resource allocation and decision makingprocedures. The current practice of levyingvery low emission charges on a largenumber of pollutants should be evaluatedand revised; revenue collection should besignificantly improved, exceptions reducedand charge levels automatically adjusted tothe rate of inflation. Clear environmental


Macroeconomic and EnvironmentalPolicy Framework

In order to protect their “infant” industriesduring the process of industrialization, mostdeveloping countries increased the role ofpublic sector in their economies, introducedcentral planning, price and interest ratecontrols, and strict import protection. Finan-cial markets have been often characterized bydistortions due to controlled interest rates,credit ceilings, and selective credit policies.Subsidized interest rates encouraged capital-and pollution intensive investments andcapital structure. By the 1970-80s, complexstructural inefficiencies led to low rates ofproductivity, slow economic growth, budgetdeficits, and serious balance of paymentproblems in many developing countriesaround the world, and adjustment programsbecame necessary to restore macroeconomicstability. The environmental effects of centralplanning and macroeconomic reforms, as wellas the constraints of developing an effectiveenvironmental financing system are verysimilar to those described in chapter III.

The system of environmental regulation andthe institutional framework are still evolvingin most developing countries. Environmentalpolicy formulation and regulatory functionsare not well defined. Environmental protec-tion functions are typically dispersed amongseveral line ministries even if a separateenvironmental protection body is established,or one of the line ministries is assigned tocarry out the main environmental protectionfunctions. Further, the regulatory agencies’ability to monitor pollution and enforce

regulations is generally inadequate, largelycurtailing their choice of policy instrumentsfor pollution control. Environmental manage-ment, therefore, frequently relies on sectoralself-control and self-regulation.

CAC instruments such as emission standardsand licensing dominate the choice of environ-mental policy implementation instruments. InMexico, for example, federal laws created aframework for the establishment of minimumindustrial emission discharge standards bymajor industries for the main pollutants. InBrazil, state licensing of polluting activitiescreates a framework for establishing indi-vidual emission limitations. The issuance ofcompliance certificates and authorization toconstruct and operate industrial plants are themain regulatory instruments in the Philip-pines. In Thailand, source-specific emissionstandards are applied. However, the enforce-ment of environmental regulations in mostdeveloping countries is generally weak,frequently relying on self-regulation andwarnings. The level and collection probabilityof non-compliance fines are typically low, andplant closures, even if legally allowed, areextremely rare due to the lack of political willto seriously tackle industrial pollution. Incases (for example in Turkey and Mexico)where fines have been set according to theseverity of the pollution damage, they wereeffective in reducing pollution at the source(Bernstein, 1993).

In many countries, MBIs are increasingly usedto supplement direct regulations, and taxationis increasingly used with the purpose ofachieving environmental improvements. Tax

4 Developing Countries



differentiation policy on gasoline in Mexico,for example, successfully contributed to thereduction of traffic-related pollution. Addi-tionally, direct environmental taxes and otherMBIs have been introduced in several coun-tries. For example, an air pollution permittrading system supplemented CAC measuresin Santiago, Chile to curb point source emis-sions. In Korea, emission charges and non-compliance fees are applied for dischargesover effluent limits, and product charges anda deposit-refund system supplement wastemanagement regulations. In Malaysia,effluent-related license fees are charged on theBOD load discharged to waters. Some statesin Brazil (Sao Paolo and Parana) introducedeffluent charges based on pollutant content inorder to cover the costs of public watertreatment. The tariff imposed on polluters hasresulted in an impact on pollution abatementbehavior, reducing pollution coefficients(World Bank, 1993b).

Informal regulation through bargainingbetween polluters and the environmentalprotection authority frequently supplementslaws and regulations. In Brazil, for example,agreements between the State EnvironmentalProtection Agencies and polluters are formal-ized to determine implementation schedulesfor pollution abatement plans. In countrieswhere formal regulation is missing or weak(for example, in Bangladesh and Indonesia),information dissemination about the pollutionrecords of large polluters facilitates informalbargaining between polluters and affectedcommunities. Community pressure is gener-ally able to tackle highly visible and easilyidentifiable pollution sources. Informationasymmetry between negotiators, transactioncosts and social considerations such as em-ployment, however, create constraints to thesole use of informal regulation.

Public Pollution AbatementFinancing

The process of urbanization and industrializa-tion resulted in the degradation of the waterquality of rivers and reservoirs, uncontrolleddischarging of solid wastes, untreated munici-pal and industrial sewage and runoff thathave adversely effected the health of popula-

tion and created a need for sustainablestrategies for water resource, water qualityand waste management. Traditional waterownership rights and political and socialconsiderations, however, frequently preventthe water sector from establishing an efficientmanagement and financing system. Wastewa-ter treatment, waste collection and manage-ment are frequently considered basic socialservices that governments should providefree. Charges, therefore, are typically too lowto cover costs. Sewerage tariffs are generallyset as a certain percentage of the applicablewater tariffs (in Colombia, for example,sewerage tariffs are set at 60 percent of thewater tariff in Cali, 50 percent in Cartagena,30 percent in Bogota (Bahl and Linn, 1992)).

Sewerage charges levied on industrial dis-charges into the sewerage system are typicallylow on the (incorrect) assumption that therewill be significant pre-treatment of industrialwastewaters. Higher levels of seweragecharges, however could significantly influencethe treatment level and the volume of emis-sions. Bernstein (1993) cited, for example, thecase of Suzano in Sao Paolo state where hightariff levels set by the state sanitation com-pany induced the local paper mill to constructits own treatment facility. The treatment costsof the facility were lower than the seweragecharge, demonstrating that industrial treat-ment is frequently cheaper than collectivetreatment.

Management and operating practices in thepublic environmental services sector are poorand, as a result, service levels are low. Watersupply and sanitation systems only rarelyachieve high levels of cost-recovery. There area few exceptions where cost-recovery allowedthe involvement of private sector in waterservice provision (see Box 16.). Typically,however, most expenses are financed throughmunicipal general revenues and nationalbudget transfers, supplemented in some casesby external financial resources. Significantdecentralization of public expenditures andresponsibilities have taken place in mostdeveloping countries in the past decade.Frequently, decentralization of governmentfunctions has been the reflection of democrati-zation processes marked by the adoption ofnew constitutions (for example, in Brazil,


Box 16Cost-recovery in the Water Supply and Sewerage Services in the Ivory Coast

According to the National Water Supply Program of 1973, pricing policies in the water supply andsewerage sector were aimed to provide full cost-recovery of operating costs and debt service. Twofunds, the National Water Works Fund (FNH) and the National Sanitation Fund (FNA) were set up tomanage water sector finances. The Ivorian Water Distribution Company (SODECI), operating all urbanpiped water systems, maintaining rural water facilities and also the sewerage and drainage systems inAbidjan, collected the fees for water services. A fixed amount of the fees were periodically retained tocover O&M costs, while the balance of revenues were transferred to the sector funds.

While SODECI’s compensation from the collected revenues remained fairly constant, the portiontransferred to FNH and FNA contributions varied substantially. Additional difficulties emerged in thelate 1980s, when arrears of unpaid public water bills have started to threaten the survival of SODECI,and the financial sources of FNH. Due to the limited amount of cash FNH could generate, it had toborrow money from the Central Bank, contributing to the increasing indebtedness of the sector. WhileFNH was running a deficit, however, FNA showed surplus.

The sector funds were used to finance water supply and sanitation projects. Although FNH and FNAhad the responsibility to manage sector finances, they were never in full control, since investmentdecisions were left to the Water Directorate (DE). Recognizing the negative effects of fragmentedresponsibilities for investment programming and finance, the Government decided to rationalize thefinancial management of the sector. In 1987, FNH and FNA were replaced by the National Water Fund(FNE). The function of FNE is to (i) keep an account for the surcharges on water sales levied bySODECI, the sanitation tax collected by the Treasury and the user charges paid by operators of privatewells; (ii) pay for the operation and maintenance of sewerage networks in Abidjan to SODECI; and (iii)service the debt used to finance investments. Over time, unlike most water supply and seweragemanagement systems in developing countries, the Ivorian system has achieved a high level ofsustainability and self-financing.

Source: World Bank, 1990b.


Colombia and the Philippines), redefining theroles of various government levels andproviding more authority to local governmentlevels. In some cases, local governmentsreceived authority to create new tax bases andcharges (for example, in Venezuela) or toadjust existing tax bases. In other cases,revenue raising responsibilities remained withthe national or federal government, but largerproportions were shared with lower govern-ment levels (for example, in Argentina, Brazil,Venezuela). In many countries, centralgovernments require a large part of theirrevenue transfers be dedicated to local capitalinvestment in infrastructure facilities. In somecountries (see Box 17.), central governmenttransfers were coupled with increased lendingto municipalities to stimulate local spendingon infrastructure. The reliance on nationalbudget transfers for environmental serviceprovision has been especially significant incountries where the authority of the munici-palities to set tariffs remained curtailed (forexample, in Mexico).

Municipal Development Funds (MDFs) havebeen created in several countries to providethe financing need for municipal infrastruc-ture management. MDFs are managed by thecentral government (Kenya, Tunisia, Uganda),or by autonomous institutions with separatelegal and financial identity. Autonomousinstitutions may be municipal developmentbanks, whose primary objective is municipalinvestment financing (for example, Hondurasand Jordan), or they may be part of lendinginstitutions with broader scope of operations(for example in Mexico and Colombia). Insome cases, they are part of lending institu-tions established to manage state controlledpensions, insurance and saving funds (inBrazil and Morocco). Many of the specializedMDFs also provide technical assistance.Generally, the management of these institu-tions is appointed by the central government,however, municipal governments are fre-quently represented. Due to low cost-recov-ery, MDFs are dependent on budgetarycontributions, while service provision quality



Box 17Financing Municipal Services in Colombia

A revolving fund managed by the National Institute for Urban Development (INSFOPAL) served as theprincipal financial mechanism in Columbia for many years. INSFOPAL’s responsibilities included thedistribution of Government grants and other financial resources. Cost-recovery, financial viability, andadministrative and operational efficiency played secondary role in its operation. Loans were the generalform of financing provided by INSFOPAL for the execution of sanitation works, however, grants wereawarded under special circumstances decreasing financial discipline and opening the possibility formore lenient financing terms. Due to unsatisfactory debt service, the revolving fund never developedinto a viable source for sector investments, and INSFOPAL had to rely on contributions from thenational budget.

As part of the Sector Reform Program (SRP) adopted in 1989, responsibilities for decision making andadministration were transferred from the central Government to municipalities. INSFOPAL wasabolished, and Findeter, an independent financing institution took over the financing role for sectorinvestments, with responsibilities for mobilizing domestic and external resources, and identifying,preparing, evaluating, approving and supervising sector projects. One of the most important objectivesof SPR was to promote the establishment of autonomous, operationally efficient and financially viablemunicipal or regional water supply and sewerage utilities. Institutions eligible for SRP loan fundsshould comply with the cost-recovery principle.

Findeter is operating through the banking sector financing up to 70 percent of public works, requiring 30percent counterpart contribution. Onlending rates are pegged to the market interest rates, covering thecosts of funds. In lack of competition in retail banking, a cap on interest rate spread of 2.5 percent hasbeen set to prevent excessive rates charged by intermediary commercial banks to municipalities andutilities. Positive cash flows of utilities used as collateral make the lending program viable. Findeter hasdemonstrated a significant impact on the preparation and management of investments, and contributedto the development of municipal credit market and banking relations.

Source: World Bank, 1988.

is low. Selective credit policies frequentlysupport the poorest areas through grants orlow interest rate loans.

Private Pollution AbatementFinancing

Compliance with emission standards andpermits requires extensive monitoring that isbeyond the capabilities of most developingcountries. Therefore, environmental protec-tion authorities frequently pursue a selectiveapproach concentrating on the largest pollut-ers. In the Philippines, for example, due tolimited resources available for the enforce-ment of environmental regulations, the twelvemost polluting industrial units in each regionwere targeted by the “Dirty Dozen” program(World Bank, 1993c). Such approach imposesthe burden of financing on a selected group ofpolluters without regard to the cost-effective-ness of pollution abatement. Additionally, theinitial enforcement of compliance is rarelyfollowed by the continued monitoring of the

proper maintenance and management ofpollution control equipment, contributing tofurther inefficiencies in the use of financingresources.

The menu of financing options available forindustries is typically severely limited indeveloped countries due to underdevelopedand dysfunctional financial and capitalmarkets. The absence of open markets forsecurities (such as bonds, stocks, mortgages,commercial bills), combined withmacroeconomic instability inflicts more riskon the financial system. Therefore, stronggovernment regulation was generally intro-duced to ensure the safety of the bankingsystem. Although several countries experi-mented with financial liberalization by rapidly(for example, Chile and Argentina) or gradu-ally (for example, Korea and Indonesia)abolishing interest rate ceilings, central creditallocation and market entry barriers in the late1970s and early 1980s, the full liberalization offinancial markets has been constrained byvarious macroeconomic imbalances. Con-


trolled interest rates for directed governmentlending and free rates for other lendingfrequently coexist. The cost of collectinginformation to screen and monitor debtors isvery high. As a result, a large portfolio ofnon-performing loans and the high adminis-trative costs of the banking system have raisedinterest rates substantially in many countries,restricting borrowing for investments withmoderate returns (for example, average reallending rates in the 1980s were over 20percent in Argentina, Chile and Uruguay(Morris et al, 1990)).

Institutional financing appears to be especiallyconstrained for small-scale enterprises. Banksfrequently play a more significant role infinancing larger firms, while the use of creditby smaller firms is limited, indicating dis-criminatory credit rationing practices. As aresult, small-scale enterprises are frequentlyforced to turn to more costly, informal creditsources. Due to the high cost, such sourcescan only be used, however, for financinginvestments and operations with relativelyhigh returns.

Under these conditions, financing pollutionabatement investments through normalcommercial banking channels is considerablylimited. Therefore, directed credit programshave been established in order to supportpollution abatement financing in several

countries. The most common channels ofdirecting credit to priority areas have been (i)commercial bank loans rediscounted by theCentral Bank; (ii) lending by state-ownedfinancial intermediaries; (iii) regulationsmandating banks to lend certain share of theirportfolios to specific purposes; and (iv) easingthe banking regulations applicable to lendingto priority sectors (for example, by requiringlower reserves).

Typically, directed lending for pollutionabatement has been carried out by financialinstitutions responsible for directed industriallending. In Mexico in the 1980s, for example,the earmarked environmental lending mecha-nism of the Industrial Equipment Fund(FONEI) was capitalized by the government(see Box 19.). In India, development bankswith majority state ownership such as ICICIand the IDBI provide directed credit toindustries for various priority projects,including pollution control. The provision ofdirected credit at subsidized rates has beendemonstrated to favor large companies thatcomply with bureaucratic conditions moreeasily than small borrowers (Morris et al,1990). Such loans suppress competition anddiscourage the development of commercialbanking and credit markets.

Other types of subsidies also frequentlysupplement environmental regulations and


Box 18Pollution Abatement Subsidies in India

Fiscal incentives for pollution abatement financing have been widely used in India:• Soft loans are provided for technology upgrade by the Industrial Development Bank of India

(IDBI) and the Industrial Credit and Investment Corporation of India (ICICI);

• Depreciation allowances are higher (50 rather than 30 percent) for certain pollution controlequipment;

• Excise taxes are reduced (from 15 to 5 percent) for certain pollution control equipment;

• The maximum customs duty is reduced from 85 to 40 percent for all pollution control equip-ment; and

• The income tax exemption is extended to private contributions to environmental organizations.

Incentives, however, should be combined with strong environmental management and enforce-ment in order to be effective. In India, subsidies have only a limited effect stimulating pollutioncontrol measures. Entrepreneurs try to maximize government subsidies, and minimize theirindividual contribution to environmental investments, even if that requires the delaying of plannedinvestments.




Box 19Directed Credit for Pollution Abatement in Mexico

The Mexican Government set up several trust funds in the 1970s to provide long-term financing topriority sectors. Trust funds were typical in a highly fragmented fiscal system. FONEI, established in1971 and administered by the Central Bank, provided financing for industrial projects through the entirenetwork of Mexican investment and multipurpose banks. In the 1980s, FONEI started to promotelending for pollution control financing.

FONEI's highest decision making body, the Technical Committee, consisted of high level governmentofficials (finance, commerce and industrial ministries, banks and the private sector). The Committeedefined the types of projects, terms and limits of loans, interest rates, criteria for project selection andprocedures for authorization of financing. FONEI's pollution control loans were eligible for 2-5 percent-age points below market interest rates. The majority of FONEI's pollution control loans supported airpollution abatement investments. After FONEI was abolished, the National Finance Institution took overlending for pollution abatement investments.

inadequate without earmarking. Sinceemission charges and other environmentaltaxes do not play an important role in mostdeveloping countries, the revenue sources ofthe EFs are usually derived from or supple-mented by (i) designated, not directly environ-ment-related levies (the National Environmen-tal Fund in Algeria, for example, has been setup to raise its revenues from internationalairline tickets); or (ii) external sources (thePollution Abatement Fund in Sri Lanka wascreated with the help of donor contribution).In some developing countries (see Box 21), thecreation of EFs reflects the failure of the fiscalmechanism, leading to the proliferation ofearmarked funds as means of public revenueallocation.

The characteristics of EFs, disbursementmechanisms and use of resources vary amongdeveloping countries. In cases when EFs areestablished to correct failures in the fiscalsystem (for example, in Turkey), funds financea wide range of environment-related projectsincluding investment in pollution abatementequipment, environmental cleanup, naturalresource protection, as well as education andtraining programs. The majority of theseinvestments are classic public expenditures inthe form of grants. In other cases, especiallywhen environmental charges are earmarked,the scope of eligible use is narrower. InThailand, for example, the EF is designatedfor investments in wastewater treatment andsolid waste disposal facilities; in Nigeria, themajority of EF resources are used for disaster

charges that are typically not effective enoughto induce the level of private pollution abate-ment investments necessary to achieve therequired environmental quality. In India, forexample, tax and interest rate incentives areused (see Box 18.). In Malaysia, subsidies areprovided for companies that establish facili-ties to store, treat and dispose of their wastes,and import duty and sales tax exemptions areextended for technology used for the storage,treatment and disposal of hazardous wastes.In Thailand, import duties are reduced tobelow 10 percent on pollution control andtreatment equipment. A law enacted in 1977in the Philippines allowed the waiver ofimport tariff on pollution control equipmentfor a period of ten years, and rebates fordomestically produced equipments were alsointroduced. Subsidized credit has beenprovided in some countries to support therelocation of highly polluting industries. InTurkey, for example, loans at negative realinterest rates were extended to leather tanner-ies that relocated from Izmir. Subsidies havealso been frequently justified by politicalconsiderations such as the promotion ofindustrial development and trade.

Environmental Funds

Environmental funds have been established insome developed countries, mainly whereeconomic growth was accompanied by seriousenvironmental degradation that led to govern-ment intervention, and outlays from generalbudget for the environment sector were


Box 20Comprehensive Environmental Funds in Turkey

The Turkish fiscal system is highly fragmented with numerous earmarked financing mechanisms.Several environmental funds exist with a broad range of mandate.

• The Pollution Prevention Fund was set up in 1985 from the collection of environment-related taxesand levies including taxes on motor vehicles and transportation (for example, motor vehicle inspec-tion fees and vehicle purchase tax), as well as pollution permit fees and fines.

• The Environmental Protection Fund was created in 1989 from earmarked shares of property, incomeand corporate income taxes.

• The Special Protection Fund derives its resources from various charges in connection with recre-ational activities in environmentally sensitive areas.

Spending priorities are broadly defined and include (i) research activities in pollution prevention; (ii)environmental cleanup; (iii) education and training; (iv) purchase of technology; (v) nature conservation;and (vi) provision of credit for pollution abatement investments. However, EF resources have been usedmainly for capital transfers to municipalities and to the Ministry of Finance. EF mechanisms in Turkeyare fiscal, rather than environmental policy instruments.

relief, environmental cleanup and floodcontrol projects; in Sri Lanka, loans, as well astechnical assistance are financed from the EF.Frequently, especially in cases when revenuesources are not directly related to environ-mental damage, eligibility criteria and rev-enue allocation mechanisms are not clearlydefined (for example in Egypt or Algeria).

In addition to institutional weaknesses, themanagerial capability, technical, economic andadministrative expertise available in develop-ing countries are also inadequate to properlyassess, quantify and prioritize environmentalcosts and benefits. Comprehensive environ-mental policy and clearly defined environ-mental priorities and strategies are typicallymissing. Consequently, the use of EFs is oftenbased on ad hoc decisions, emergencies, orpolitical priorities. Although EFs may func-tion as catalysts to mobilize private andenterprise resources, without significantlyincreasing the level of environmental chargesthe role of these financing mechanismsremains marginal.

Summary of Pollution AbatementFinancing in Developing Countries

• The evolving environmental policy andregulatory framework is inadequate indeveloping countries to induce substantial

levels of private pollution abatementinvestments. Dominantly CAC policyapproaches are supplemented with MBIs,but monitoring capabilities and the enforce-ment of regulations are typically weak.

• Due to traditions, social and politicalconsiderations, cost-recovery in publicenvironmental service provision is typicallylow. User charges are not high enough toencourage industrial pre-treatment orwaste-minimization measures, furtherincreasing the demand for public services.Municipal and national budgets are themain sources of funding. Due to thelimited availability of these funds, how-ever, the quality and coverage of theseservices are low. Public environmentalservices may be financed through speciallending institutions, such as municipaldevelopment funds. Their sustainabilityand success depends on the financialviability of environmental service sector.

• Due to underdeveloped and dysfunctionalfinancial and capital markets, the privatesector has limited access to financingresources. Therefore, directed credit hasbeen extended in several countries tofinance priority investments. Directedlending for pollution abatement invest-ments is typically channelled through




financial institutions responsible for di-rected industrial lending. Private pollutionabatement financing is supported byvarious types of subsidies such as grants,tax incentives and soft loans to compensatefor the lack of strong enforcement ofregulations.

• Subsidies are sometimes channelledthrough environmental funds that have

been established to provide a relativelysteady flow of resources for pollutionabatement. The reliance of EFs on budgetallocations and external funding is largelydue to the limited amount of revenuesraised by environmental charges. Withoutclear spending priorities and adequateinstitutional capabilities to evaluate expen-diture alternatives, EF resource allocationdecisions are frequently suboptimal.


5 The Role of External Finance

Before substantial environmental investmentsare undertaken, a proper framework forcomprehensive environmental policy needs tobe established and financing priorities deter-mined. Without this approach, investmentsmay be directed suboptimally (see Box 21.).Integrated environmental management andcoordinating mechanisms should be devel-oped by strengthening institutional capabili-ties. In order to set clear and cost-effectiveenvironmental priorities and financing mecha-nisms, technical assistance is often needed to(i) contribute to the improvement of environ-mental management systems, regulatoryframework, and institutional capabilities(including monitoring and enforcementcapabilities and cost-recovery mechanisms);(ii) support environmental education, trainingand research; and (iii) facilitate informationdissemination that promote pollution preven-tion and the application of cleaner technolo-gies. Donors may assist in the preparation ofnational environmental strategies, reviewsand action plans that also serve as guides forinvestment assistance.

Investment assistance in pollution abatementshould promote sustainable development.Traditional emphasis on end-of-pipe controlhas, therefore, been supplemented by greaterreliance on the application of technologies,processes and management practices thatimprove the efficiency of environmentalresource use and reduce the damage causedby pollution. Less developed countries(LDCs) generally lack financial, technical,institutional and human capabilities to initiatesignificant technological change. Donor

Economic Policies, EnvironmentalPriorities and External Finance

Donor assistance has gradually shifted fromaddressing problems to aiming at complexpolicies that support sustainable development.Environmental considerations and policyimplications have become integral part ofmacroeconomic stabilization, structuraladjustment, and sectoral development pro-grams. Most stabilization and adjustmentprograms have generated substantial environ-mental benefits, however, additional externalassistance was sometimes needed to mitigatepotential environmentally harmful effects dueto unaddressed market failures (Munasingheand Cruz, 1994). Most donor agencies haveestablished mechanisms in their projectpreparation processes specifically aimed atreducing potentially negative environmentalimpacts using environmental guidelines andimpact assessments. Additionally, sectordevelopment programs have frequently beensupplemented by environmental components.

External funds in the form of grants, softloans, commercial loans or equity investmentsmay supplement domestic resources availablefor pollution abatement financing. These areexogenous factors, however, that cannotcompensate for the lack of a comprehensiveenvironmental financing system based prima-rily on domestic resources. Grants and loansfrom bilateral and multilateral organizationsmay serve as catalysts to establish domesticenvironmental financing mechanisms and toattract additional funding from commercialsources.



investments at market terms; (ii) should notcreate a bias towards certain types of pollu-tion control investments; (iii) should besupplemented with measures to correctmarket failures, and strengthen environmentalmanagement; and (iv) should be graduallyphased out.

Financial Intermediary Loans and theExperience of the World Bank

In order to avoid large inefficiencies of directlending due to the large number of finalborrowers and small amounts of individualloans, World Bank funds have been frequentlychannelled through financial intermediaries(FIs). FIs not only operate as mere executiveagencies of the Bank but, strengthened bytechnical assistance, they also serve as devel-opment financing institutions (DFIs) that canplay a catalytic role in domestic developmentand domestic resource mobilization. Theirobjectives frequently include a mix of com-mercial and development goals. When DFIsare expected to correct not only financialsector failures but also market, administrative,or regulatory failures, directed credit andinterest rate subsidies are frequently used.The goal of financial intermediary loans (FILs)is to supplement domestic investment re-sources without crowding out domesticfinancing credit mechanisms or underminingthe efficiency of domestic financial markets.

Typically, pollution abatement FILs simulta-neously attempt to correct the failures of thefinancial sector and the failure and inad-equacy of the environmental managementsystem. However, when seriousmacroeconomic, real sector or financial sectordistortions exist, FILs are not likely to succeedunless these distortions are removed. When,for example, high inflation rates prevail, long-term borrowing is crowded out, and whengovernments directly allocate credit, FILs arelikely to fail in creating a market-based creditmechanism. Therefore, FILs should not beextended under severe macroeconomic andsectoral instability and should be preceded byand coordinated with complexmacroeconomic, real sector and financialsector reforms. Market failures and theinadequacy of environmental management are

assistance, therefore, may facilitate the trans-fer of cleaner technologies1 to LDCs. Thefeasibility of the transfer of technology de-pends on (i) the adoptive capabilities of therecipient country; and (ii) the extent of marketfailures in the recipient country.

Recipient countries may not be able to adoptnew technologies efficiently if, for example,human capital constraints the effective opera-tion, management and service of the technol-ogy, or there is a lack of capability to integratenew technology to other areas of the economy.The application of cleaner technology iseffective if it contributes to the improvementof environmental quality at the least cost.Cost-effectiveness requires the combination ofend-of-pipe control and the application ofcleaner technology approaches. Marketfailures may also constrain investments inpollution abatement and the diffusion ofcleaner technologies in LDCs:

• When environmental regulations andenforcement capabilities are non-existent orweak, the social costs of pollution are notbuilt in the cost of production, and inves-tors face no incentives to pay a premiumfor clean technologies;

• When protectionist trade policies supportdomestic industries, the import of cleanertechnologies is discouraged;

• When the public sector is dominant in theeconomy, enterprises are not motivated toimprove performance;

• When financial markets are underdevel-oped or dysfunctional, access to credit isseverely limited, frequently rationed andalso very costly;

• When the dissemination of informationcarries high transaction costs, investors arenot able to make optimal decisions.

Donors frequently support the correction ofthese market failures through assistance withmacro-economic restructuring and sectordevelopment programs. Additionally, policymakers in LDCs may decide to use temporarysubsidies in order to accelerate environmentalinvestments. Such subsidies, however, (i)should not crowd out commercially viable


Box 21The World Bank’s Experience with Industrial Pollution Control Financing from the 1980s in Brazil

Several Bank projects have been designed to channel resources through FIs for industrial pollutionabatement investments in Brazil. The objectives of Bank projects have been to (i) provide financialsources for pollution control investments; and (ii) strengthen the environmental management system.Basic environmental regulations, standards, environmental institutions and permit systems had been putin place before lending started. However, monitoring and enforcement mechanisms operated ineffi-ciently. As a result, private sources and the banking system played a marginal role in environmentalfinancing, and industrial pollution control investments relied heavily on grants from the budget.

The early industrial pollution control projects did not attempt to address environmental problems in acomprehensive way and, as a result, the lack of comprehensive environmental strategy and priorities ledto suboptimal revenue allocation. The Sao Paolo Industrial Pollution Control Project, for example,successfully reduced industrial dust emissions, however, the city’s ambient dust levels didn’t improvedue to the dominant role of mobile pollution sources (World Bank, 1987). Recognizing the need to setpriorities and base lending on well defined environmental policy, the Brazil National Industrial PollutionControl Project (World Bank, 1992a) made the existence of Bank-approved environmental strategies as acondition of credit eligibility.

The success of industrial pollution abatement credit programs also strongly depended on the environ-mental management capabilities and the enforcement of environmental regulations. Inadequate enforce-ment was one of the main reasons why the credit lines for pollution control investments remainedunder-utilized during the first Sao Paolo project (World Bank, 1989). Improved monitoring and enforce-ment also reduced the need for subsidies extended through lower-than-market interest rates. Whilesubsidized interest rates were offered during the first two industrial pollution control projects in Brazil(World Bank, 1980 and 1987), the third project (World Bank, 1992a) has eliminated the subsidies bymatching subloan interest rates with longterm market rates.

Bank projects considerably strengthened the environmental assessment capabilities of the financialintermediary (BADESP), creating a special expertise in environmental lending, and BADESP graduallytook over most project evaluation functions from the environmental protection bodies.

usually addressed by directed credit forpollution abatement investments, frequentlyat concessional credit terms. The subsidiesprovided this way supplement private re-sources committed for pollution abatementthat are insufficient to achieve socially desiredenvironmental quality objectives. Subsidies,however, are suboptimal environmentalpolicy instruments, therefore, with the im-provement of the environmental managementsystem that increases private abatementmeasures, subsidy programs should begradually phased out.

Multilateral and bilateral donor agencies arerarely ready to soften their lending terms toprovide subsidies for their borrowers, andgovernment contributions to the capitalizationof DFIs have been frequently encouraged tosoften lending conditions for final borrowerswithout jeopardizing the financial viability ofDFIs. Donor lending blended with other

sources can achieve the desired financingconditions. As the World Bank’s experiencewith industrial pollution control credit linesshowed, subsidies could be gradually elimi-nated and normal commercial lending couldtake over subsidized environmental lendingas environmental management and theenforcement of environmental regulationswere strengthened (see Box 21).

The first World Bank credit lines (World Bank1975, 1980, 1987) limited assistance to directpollution control investments. In the firstfree-standing pollution control project (WorldBank, 1975), for example, project selectioncriteria strictly excluded alternatives to end-of-pipe pollution control investments. In thefirst Brazilian pollution control project (WorldBank, 1980), the identification of alternativepollution abatement solutions was not dis-couraged, however, project preparation andselection criteria were biased against alterna-

The Role of External Finance



Box 22Types of Externally Financed Environmental Fund Mechanism

Trust Funds are created by legally allocating financial resources to be used for specific purposes anddesignated beneficiaries. The assets of trust funds are invested to earn interest and appreciate marketvalue, while the income earned is distributed for the beneficiaries of the fund.

Foundations are similar to trust funds. While trust funds typically operate in countries with commonlaw systems, foundations are mechanisms allowed by civil law. Foundations are legally independententity under government supervision.

Endowments are grants or gifts provided by multi- or bilateral donors. They can be designated forfinancing specific projects or areas and can be managed by trust funds or foundations.

Sinking Funds are designed to disburse their principal amount over a specified period of time. Trustfunds or foundations may also operate as sinking funds.

Revolving Funds have a steady source of revenues either by continuous replenishment of the assets or bypreserving the value of core assets and disbursing only the income earned. Trust funds and foundationsare frequently established as revolving funds.

Source: Mikitin, 1995.

Bank 1993a), subsidies were awarded accord-ing to estimated social costs saved by pollu-tion abatement but not internalized by pollut-ers due to failures of environmental manage-ment.

Due to their cost-recovery capabilities, “win-win” investments with simultaneous financialand environmental benefits are more suitablefor investment lending than end-of-pipecontrol investments that do not generaterevenues. However, if this preference istranslated to an eligibility criterion thatexcludes end-of-pipe control investments (forexample, World Bank, 1994b), the objective ofsupporting least-cost solutions to environmen-tal problems may not be met. Such approachcould be justified only to correct existing biasin the financing system towards end-of-pipeinvestments (for example, when other chan-nels exist that are more suited to finance end-of-pipe control investments).

The Experience of Donors withEnvironmental Funds

Donor contributions capitalized several EFs indeveloping countries. Although the majorityof externally funded EFs tackle nature andbiodiversity conservation issues, several EFswere also established with pollution abate-ment objectives. In Sri Lanka, for example, arevolving pollution abatement fund wasestablished by a contribution from the Gov-

tive approaches. The financing of subprojectswas limited to the costs that would have beenrequired to achieve required performance bythe least-cost direct control option. Althoughthis criterion was aimed at safeguardingagainst financing (subsidizing) investmentsnot directly associated with pollution control,it led to a time-consuming, bureaucraticproject selection process that increased loanprocessing costs and discriminated againstalternative pollution abatement solutions.

Recently, the Bank’s approach has shiftedfrom the support of direct pollution control topollution prevention and alternative solutionsof abatement. Most recent projects did notexpress preference to one type of pollutionabatement investment as opposed to others(World Bank, 1992a), or specifically empha-sized investments in cleaner technologies,waste recovery, energy conservation, recy-cling and other “win-win” measures (WorldBank 1993a, 1994a, 1994b, 1994c). In theseprojects, credit is allocated to final borrowersat market (or near-market) rates, however,limited subsidies in the form of grants havebeen maintained in some cases. In India, forexample, grants were allocated for invest-ments in innovative technologies and pro-cesses that didn’t qualify for commercialfinancing, but showed potential for wide-spread use of the proposed pollution abate-ment or cleaner technology (World Bank1991b). In other cases (for example, World


Box 23Financing Pollution Abatement Projects from Parallel Environmental Funds in China

Revenues generated from pollution charges have represented the major source of pollution controlfinancing in Tianjin municipality. The earmarked charges are typically provided as grants or, since 1986,as soft loans for the installation of pollution control technology. However, the demand for soft loans hasbeen low and repayments sluggish. In practice, loans are frequently converted to grants. Beneficiarieshave little incentives to choose the most efficient pollution abatement alternatives and to maintain thepositive environmental effects of investments.

In the framework of the Tianjin Urban Development and Environment Project, the Tianjin MunicipalPollution Control Fund (TMPCF) was established in 1992 as an autonomous legal entity capitalized frompollution levies and from IDA credit (40 to 60 percent, respectively). Its board of directors includesrepresentatives of various government agencies, and the day-to-day operations are carried out bypermanent staff. The main objective of TMPCF was the creation of a sustainable pollution abatementfinancing mechanism. Forty percent of the pollution charge expenditures accruing to the municipalenvironmental fund are transferred to TMPCF, creating a steady flow of revenues.

TMPCF finances investment projects that are financially viable and reduce pollution at existing industrialplants. Loans are extended at market interest rates (similar to rates charged by local banks for similarmaturity), however, a small part of resources is designated to be provided as grants (up to 30 percent ofproject cost) in order to encourage projects that don't generate enough returns, but significantly reducepollution.

While the domestic EF is essentially a financing instrument of the municipal government, TMPCF is afinancial development institute. TMPCF simultaneously attempts to correct the failures of financialsector to provide adequate credit for financially viable investments and to achieve environmentalimprovements.



besides existing domestic earmarked financ-ing mechanisms in China (World Bank, 1992b,1993a, 1994a), and the Russian Federation(World Bank, 1994b). By creating separatelegal entities, own professional staff, andproject selection procedures, these funds mayduplicate already existing ones. The establish-ment of parallel earmarked financing mecha-nisms may lead to the proliferation of EFsresulting in inefficient resource use and thedisintegration of environmental objectives.Further, differences in the financing condi-tions (for example, interest rates and loanapplication mechanism) between the existingEFs and those created by Bank projects maycontribute to the segmentation of domesticenvironmental financing and create inconsis-tencies in lending terms. In China, for ex-ample, Bank-supported funds offer environ-mental loans at interest rates considerablyhigher than those offered by the domesticcounterpart. Coordination between domesticand Bank-assisted EFs is minimal, however,Bank resources have been supplemented bypollution charge revenues from domestic EFs

ernment of the Netherlands in order tosupport enterprise pollution abatementinvestments with loans and technical assis-tance. Similarly, OECD funding and budgetallocation capitalized the EF in Thailand.Externally founded EFs encourage the partici-pation of a wide range of interested partiesand the public review of EF operations.Externally capitalized EFs are typicallyestablished through multi-or bilateral grantcontributions or debt-for-nature swaps. EFscan also be created as trust funds (see Box22.), however, this arrangements are mosttypical for nature conservation funds. Al-though many of the externally capitalizedpollution abatement EFs have their owndesignated domestic revenue sources, thesesources are generally inadequate, andsustainability of EFs typically depends onfurther donor contributions.

So far, limited experience and success havebeen achieved in channelling donor fundsthrough existing EFs in transition economies.Several Bank projects have established EFs



Table 8Expenditures of the Hungarian NEF by Domestic and EC PHARE Sources in 1994 (%)

Domestic PHAREAir pollution control:

industrial emission control 12.6

traffic-related emission control 22.6

household-related emission control 11.8

reduction of ozone-depleting substances 0.4 31.0

energy saving investments 8.0

transport-related environmentally friendly solutions 21.2

abatement of air emissions from incineration and hospital waste 0.6

Waste management:

waste neutralization 0.9 15.0

waste utilization 15.0

transport-related waste management 7.1

Water quality protection:

protection of vulnerable water resources 1.5 31.0

Infrastructure and environmental protection: 17.6

Nature conservation: 1.2

Noise and vibration control: 0.4

Public awareness programs: 2.1

Total: 100.0 100.0

Source: Adopted from REC, 1994

requirements and prudent financing practicesthat external donors require in order tochannel their resources through a financialintermediary.

Channelling donor resources in the form ofgrants has shown similar difficulties withharmonizing the financing objectives, resourceallocation criteria and procedural require-ments of existing EFs and donor organiza-tions. In Bulgaria, for example, a separatestructural unit was established within theMOE to manage resources provided by the ECPHARE program. So far, external (PHARE)resources have been channelled successfullythrough an existing NEF only in Hungary.Channelling donor resources through the

in some cases (for example, World Bank1992b, 1993a), to cover the cost of subsidies(see Box 23.).

The main reasons why NEFs have appeared tobe incompatible with donor lending objectivesand procedures originate from the nature ofNEFs inherited from the central planning era.Their public financing role dominates overtheir commercial banking functions. Eligibil-ity criteria for the various types of financingforms (grants or soft loans) are frequentlyskewed. In China, for example, the forgive-ness of loan repayment is standard practice.As a result, NEFs, as quasi-lending operationsdon’t have clear project selection criteria,rigorous operational procedures, appraisal


Box 24The Polish DNS

Creditor countries of Poland (the Paris Club) agreed in 1991 to reduce the country's debt by 50 percentwith optional bilateral DNS agreements to cover further 10 percent of the original debt. Such deals werecompleted with the Governments of Finland (1990), the U.S. (1991), Switzerland (1993), and France(1993), capitalizing the Ecofund from the proceeds (a total of 481 million U.S. dollars).

The Environmental financing criteria of Ecofund represent a mix of pollution abatement and natureconservation objectives:

• Greenhouse gas emission abatement;

• Transboundary air emission abatement;

• Pollution abatement in the Baltic Sea; and

• Biodiversity conservation.

Pollution abatement projects financed from the Ecofund included the conversion of coal to gas in theheating system in Zakopane Valley, a pilot project for the use of geothermal energy in an urban heatingsystem, desulphurization of flue gases in power plants and investments in various waste water treat-ment facilities along the coast of the Baltic Sea.

Hungarian NEF has resulted in significantimprovements in project appraisal, selection,and post-project evaluation procedures indecision making processes, and in the trans-parency of operations. It has also demon-strated that donor objectives and financingpriorities can be harmonized with existingNEF operations (see Table 8.), and that NEFscan restructure their operations and proce-dures to accommodate donor requirements.Clearly, the flexibility and willingness toadjust NEFs to donor requirements depend onthe size of donor contribution. Even in theHungarian case, however, there are inconsis-tencies in the lending terms between thedomestic and PHARE resource allocationprocedures. For example, municipalities canreceive straight grant support from thedomestic funds of NEF, while PHARE pro-vides interest-free loans to the same beneficia-ries.

EFs may offer an administrative framework,expertise and financing for donors who wishto finance small-scale pollution abatementinvestments without direct involvement in therevenue allocation process. In order to (i)provide a consistent and coherent policyframework; (ii) facilitate improved informa-tion flow and use; and (iii) utilize existing

mechanisms for project-level coordination ofassistance, an umbrella EF may be an attrac-tive mechanism for pooling donor resources.In Bolivia, for example, the National Fund forthe Environment provides a framework for anumber of sub-funds that have been set up bydonors with various financing and fundmanagement objectives.2 Through the sub-funds, each donor’s specific requirements canbe taken into account, while the umbrella fundprovides coordination and ensures the inte-gration of funds into the national environmentprogram.

Debt-for-Nature Swaps - A SpecialForm of External Finance

Debt-for-Nature Swaps (DNSs) represent aspecial form of debt conversion programs, aswell as a special form of external financingthrough EFs. DNS programs have dualfunctions to (i) reduce the debtor country’sforeign debt obligations; and (ii) attract capitalfor environmental investments that otherwisecouldn’t be funded. In a typical DNS deal, aninternational environmental agency (usuallyan NGO) raises funds to buy the debt of adeveloping country on the secondary marketat a deep discount, then exchanges the debt




DNS transactions are, however, not withoutproblems. In order for such transaction totake place, both debtor and creditor countrieshave to acknowledge that the debtor’s out-standing foreign exchange obligations cannotbe serviced. Consequently, DNS deals areappropriate only for those countries, thatotherwise would be seeking debt reschedulingor other debt reduction schemes. Further-more, swapping foreign exchange obligationsto local currency outlays doesn’t relievegovernments of the fiscal burden of debtservice, and such deals may increase thecountry’s inflation rate.3 Finally, creditors arenot willing to release very large amounts oftheir debt holdings at deep discount rates, andthe amounts involved in typical DNS dealshave been rather small: the average face valuehas been around $6 million (World Bank,1993-94).

Global and International PollutionIssues and Donor Coordination

Although most pollution problems are local innature, some have serious transboundary andglobal effects. The mitigation oftransboundary and global environmentalproblems receives increased donor attention.Priorities assigned to the solution of interna-tional and global environmental problemsmay differ among countries due to (i) differ-ent values assigned to the same internationaland global environmental quality; and (ii) amismatch between benefits and costs at thenational level. Global and internationalenvironmental problems, however, have to besolved nationally, at the level where the least-cost solution can be found. Domestic pollu-tion abatement measures that simultaneouslycontribute to the mitigation of internationaland global problems produce generally themost environmental benefits. Global interven-tion may be justified to finance the incremen-tal costs of investments that are needed tomitigate global environmental problems.

Since the same level of global environmentalimprovement can be achieved by implement-ing projects with different marginal abatementcosts, cost-effectiveness considerations call forthe joint implementation of international

with the debtor country for a commitment ofthe country to spend the equivalent amounton nature protection. The funds raised byNGOs are typically capitalized from dona-tions of private parties or of commercialbanks. DNS deals have been carried out innumerous Latin American countries (Bolivia,Costa Rica, Ecuador etc.), in Africa (Nigeria,Niger, Zambia) and in Eastern Europe (Po-land).

The majority of DNS arrangements involvedcommercial debts for which well functioningsecondary markets exist. Recently, however,official creditors have also started to initiatesuch programs. In 1990, the Paris Club ofofficial creditors introduced a range of newrepayment conditions for lower middleincome countries, including the possibility ofDNS transactions on a bilateral basis. Suchtransactions have been announced, for ex-ample, between the Swedish and the TunisianGovernments in 1992 and 1993. Canada alsoinitiated a program in 1992 to convert debtowed by Latin American countries into localfunds to finance environmental and othersustainable development programs. In theU.S., the Enterprise of Americas Initiative(EAI) opened the way for DNS transactions.Under this initiative, concessional debt owedby Latin American and Caribbean countries isexchanged for new and restructured debt withreduced face value. The principal on the newdebt is to be paid in hard currency, however,the interest is payable in local currency, and isdeposited in an Environmental Fund. Thefirst debt write-down and DNS arrangementsunder the EAI programs were carried out inChile, Bolivia and Jamaica.

DNS transactions, similarly to other externallyfunded programs, usually target specificprograms or areas. Donor organizations oftenwish to choose “high profile” programs todemonstrate their commitment to environ-mental protection. Although the majority ofDNS deals completed so far, has targetednature or biodiversity conservation, pollutionabatement financing has not been excluded(see Box 24.). Global and transboundarypollution abatement is likely to gain largerrole in the objectives of DNS transactions.


obligations and the solution of internationaland global environmental problems (forexample, using carbon offsets). Transitioneconomies and developing countries maybenefit from such opportunities. Joint imple-mentation has already been agreed betweenNorway and both Poland and Mexico (withinthe GEF framework). Norway will finance aconversion programs from coal to natural gas.According to the U.S. Government’s Forest forthe Future Initiative, carbon offset agreementswill be negotiated between the US and othercountries including Russia, Mexico, Guate-mala and Indonesia. In another example, thestate electricity generating board in theNetherlands has established a non-profitenterprise to invest in forest rehabilitation inCzechoslovakia and several other countrieswith the purpose of absorbing carbon dioxide(Pearce, 1994).

Donor coordination of various aid programswas initiated decades ago in the form ofconsultations and roundtable discussions. Ithas been suggested recently that donors set up“clearing houses” by placing their funds in ajointly managed pools. Although the idea of a“clearing house” is a logical response to thecoordination problem, it is not withoutdifficulties. Donors often have strong politicalmotivations when providing support tospecific projects or countries. They focus ondifferent sectors, countries or regions. It hasbeen demonstrated (Arnold, 1982), thathistorical factors such as previous colonialrelationships, and foreign policy and foreigntrade considerations significantly influencedonor orientation. Informal agreements arefrequently negotiated between donors andbeneficiaries, together with associated politicalcommitments. A “clearing house” of donorfunds, therefore, may lead to the loss ofindividual donor control over the use offunds, and, consequently, may weaken thepolitical support in donor countries leading tothe overall reduction of contributions. Also,due to varying donor interests, the scope ofassistance provided by a “clearing house”would need to be reduced to areas agreeableto all donors. The greater the range of donorsis, the narrower the scope of mutually accept-able priorities and objectives is going to be.

This has been demonstrated during theestablishment of the Global EnvironmentalFacility (GEF); after several years of negotia-tions, participants could agree only on fourglobal environmental objectives (Sjoberg,1994). Regional “clearing houses” of donorcontributions are likely to agree on a morecomplex set of priorities and strategies thanglobal ones. Altogether, institutionalizeddonor coordination has limited appeal fordonors.

Summary of External FinancingIssues

• External financing supplements domesticresources. Environmental considerationsare increasingly becoming part ofmacroeconomic, structural and sectoral aidprograms with the aim of achieving envi-ronmentally sustainable development.

• External lending for pollution abatementhas been frequently channelled throughfinancial intermediaries. Borrower govern-ments have supplemented funds when thesoftening of the credit terms for finalborrowers was considered desirable.Intermediary lending for pollution abate-ment demonstrated that strengthenedenvironmental management, parallel withpollution control lending could result inimproved compliance with environmentalregulations, and subsidies could be elimi-nated over time.

• Donors have established environmentalfunds in some countries in order to supportpollution abatement financing. The existingenvironmental funds, however, have beenfrequently unable to meet donor require-ments. In order to avoid the proliferationof earmarked lending mechanisms, incon-sistencies in lending terms, fragmentationof financing mechanisms and inefficienciesof resource use, it is proposed to establishnational umbrella fund mechanisms. Theseumbrella funds would integrate donorpreferences with domestic financingmechanism and environmental policyobjectives.




• Debt-for-nature swaps represent a specialform of external environmental financingthat has been mainly used to solve natureconservation problems. Although the roleof global pollution abatement programs isexpected to increase in DNS in the future,the volume and applicability of DNSarrangements will remain limited.

• Donor intervention is necessary to solveinternational and global environmental

problems due to differences among nationsin the values assigned to international andglobal environmental quality and a mis-match between the cost and benefits ofglobal pollution abatement investments atthe national level. Although severaladvantages may come from coordinateddonor assistance through “clearinghouses”, the possibility and scope for suchinstitutional coordination is limited.


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