Environment Policy and Public Expenditure ANIL MARKANDYA WORLD BANK Public Expenditure Analysis and Management Washington DC January 12, 2004

KEY QUESTIONS Why should the government be involved in financing environment-related infrastructure? How should this financing be organized? How should the role of the government be evaluated? What can we say about current performance in this area in non-OECD countries?

A. Why should the government be involved? The private sector will not provide enough to meet social objectives of e.g. the MDGs. But why does the private sector not provide enough? Social benefits cannot be captured by the private sector (externalities, social objectives) Access to finance for such investment is limited in developing countries Returns to such investment are lower than for other private sector investments Industry cannot afford the required investment. (PPP cannot be applied in all cases).

Why should the government be involved? But these reasons for low private sector involvement are not sufficient to justify state provision. Externalities can be internalized via fiscal incentives Access to funds can be facilitated by special financial agencies The problem is that, in many developing and transition countries, these instruments are not adequately developed and take time.

Why should the government be involved? Hence government financing should be seen as an evolving process, where direct provision declines over time and indirect instruments are used to increase private provision. Smaller government share can be enhanced by increased leveraging of public funds. Nevertheless, there will always be a core of financing that will be needed from the government, to cover management and regulation, protection of pure public goods (water sources on public land), and financial support for social objectives.

B. How should the role of the government be organized? Main issues are: Financing from general taxation versus earmarked funds. Expenditure from central versus local budgets Use of government department, specialized agency (e.g. environment fund, water agency), public utility?

General Versus Earmarked Funds Case for earmarked funds is strongest when Revenues are raised from charges levied on environmental services and used to provide the services (e.g. protection of water sources) When an environmental charge that is environmentally and economically desirable can politically only be levied when revenues are earmarked. In many cases pollution charge revenues are earmarked in OECD and developing countries (e.g. carbon levy, landfill taxes in the UK, EU).

General Versus Earmarked Funds Case against earmarked funds is: They make fiscal discipline more difficult (i.e. control of overall spending). But note that earmarking is not the same as making the funds extra budgetary. Allocative efficiency is less (spending on the environment is determined by revenues, not by the return on the investment relative to other investments.

General Versus Earmarked Funds In general the case for having some earmarked funds for the environment is strong. On grounds of linking spending on environmental services to payments made for those services. On grounds that fiscal instruments such as taxes can only be levied successfully if they are earmarked.

Central Versus Local Budgets If the revenues are to be closely connected to the expenditures (the benefit principle), local control of the spending is more desirable. On the other hand if expenditures are to be based more closely to national priorities, central control is better. In practice both are needed and a compromise has to be reached. Central budgets also tend to be used more cost effectively (see below).

Type of Institution Budget institutions versus specialized institutions. The budget institutions apply budgetary control rules, which are easier to track, and facilitate fiscal discipline and transparency. Specialized institutions such as environmental funds are often found to have lower levels of transparency. The cost effectiveness of budget institutions is considered to be higher but this should not be exaggerated – some other bodies can also work effectively.

C. Evaluating the Role of the Government The OECD has proposed a number of criteria for evaluating this role in the environmental area: Environmental Effectiveness Fiscal Prudence Management Efficiency But all these are predicated on sound data collection, which remains a serious problem!

Environmental Effectiveness Public funds should not be used for investments that would have been made anyway. Nor should they be used when the same objectives can be achieved through policy reforms (e.g. removal of subsidies) The program of expenditure should be clear, consistent and open to scrutiny. The environmental objectives should be defined and monitored. Cost effectiveness indicators should be used to design and monitor the program The funds should be leveraged as much as possible.

Fiscal Prudence All public funds (even if earmarked) should be subject to the same fiscal discipline. Earmarked funds should be required to adopt allocation rules as close as possible to those for other funds. Spending by environment funds is subject to control to avoid quasi fiscal deficit Spending is subject to audit and transparent ex-post reporting All revenue collection is only done by the same authority and national procurement rules apply to the environmental funds.

Management Efficiency Expenditure program is governed by clear, written rules, is based on consultation with civil society and carried out by a body representing all key stakeholders. Day to day management is undertaken by a separate technically competent body. A sound project cycle is adopted, laying out how project are prepared, appraised and selected. Communication policy ensures that all applicants have equal access to information on funding opportunities and equal opportunity to have their projects impartially reviewed on a merit basis. Those who prepare the projects do not appraise them. Financial products used are based on capacity to manage the risks. Grants are the simplest, followed by subsidies, loans, loan guarantees etc.

D. Actual Experience With Environmental Finance What do studies carried out by the Bank tell us about the actual experience in environmental finance? Recent studies include: Dominican Republic India Ukraine

Actual Experience First and foremost we have a real problem finding out what has actually been spent on the ‘environment’! Public spending has to be analyzed in the wider context of all environmental spending as the public/private division is changing over time. In Indian study private sector data were not available In DR data only partial public spending data were available In Ukraine public and private data were available but private spending looks too high.

Actual Experience Given the problems of measurement it is difficult to assess the environmental effectiveness, fiscal prudence and management efficiency. Both the DR and Indian studies could not make a real estimate of these factors, except in a few ad hoc cases. In the Ukraine study a more detailed estimate of these effects was made.

Reality Check: Ukraine Case Study

In Ukraine: Background Data At aggregate level, environmental expenditures have fallen from around US$1 billion in 1996 to US$600 million in 2000. Total expenditure in 2000 as % of GDP is comparable to other CEE and OECD countries, but share of investment in total is less. In OECD it averages 27% and is much higher in countries ‘catching up’ (e.g. Portugal). In Ukraine it is 22%. Budgetary resources amounted to US$35 million in 2000, making only 6% of total environmental expenditure. This is very low and much lower than in OECD countries and CEE countries.

Assessment of Environmental Effectiveness

Environmental Effectiveness By and large public funds are being used for the environment where other funds are not available. Enterprises and utilities could not afford to make the investments on their own. Other policies that achieve environmental targets are being pursued (e.g. pollution charges are being raised to make up for inflation, integrated permitting is being introduce) but more can be done w.r.t. compliance on environmental standards and on leveraging public funds.

Environmental Effectiveness National environmental policy has not been formulated in terms of specific environmental targets against which one can measure achievement. The policy statements are mostly declarative in nature and do not provide priorities within the broad goals. There are some specific goals related to environmental policy articulated in the national and regional “Environmental Programs”.

Environmental Effectiveness The biggest problem with all these programs: under funding. They contain much more than can be funded and the % actually implemented is mostly <10%. There is no way of knowing whether programs actually implemented are the ones with the highest priority. Tendency is to start a large number of projects and programs then argue for funds to complete them. (a practice common in the Soviet Union). The bulk of state spending is on ‘water resources protection’, This is broadly consistent with national priorities.

Related Question on Environmental Effectiveness: Is Overall Environmental Expenditure on Environmental Protection Adequate?

Environmental Effectiveness Data show that while overall level is consistent with other countries, public share is too low and investment share is too low. Composition of environmental expenditure has important implications. For example: The low share of public expenditure means that not enough is being spent on public goods -- such as monitoring of environmental quality, and protection of nature reserves and forests. In transition countries the state also, rightly, supports investment in water supply and sewerage, in other key areas of infrastructure and in key industrial enterprises, on public good grounds

Recommendations on Environmental Effectiveness Link priorities with specific environmental goals and outcomes Link expenditures more closely to priorities Increase overall public investment on the environment. Increase flexibility in allocation between public investments at different levels.

Assessment of Fiscal Prudence

Fiscal Prudence The level of prudence is good in that: Environmental expenditures do not contribute to macroeconomic problems Environmental funds are subject to audits Environmental charges are collected by national tax authorities The same procurement rules apply for the environment funds as for other government spending.

Fiscal Prudence The level of prudence is less good in that: Decisions on environment spending are not always made in a manner consistent with other areas of spending (but other areas of public spending are also not that clearly and transparently done).

Assessment of Management Efficiency

Management Efficiency Ample evidence: expenditures are not efficient in the sense of selecting the programs and projects with the highest net benefits or obtaining the maximum improvement in any physical indicator per dollar spent. Assessing efficiency is not easy; benefits, especially from better protection of natural resources are difficult to quantify. Also the use of cost effectiveness criteria, well established for investments in sectors such as health and education, are less so for the environment. Nevertheless, tools and techniques for such assessments are increasingly becoming available and should be used in Ukraine.

Management Efficiency Efficiency is of course not simply a matter of using CBA/CEA. Are policies based on proper consultation? Ukraine has a reasonable system of consultation in deciding its environmental programs but it can be improved. Is it easy to track expenditures by category and know when a spending unit has not delivered or has overrun the cost? The monitoring of environmental expenditures is quite weak and accountability, especially at the local level, needs to be strengthened. Does the method of allocation prioritize items within a program, so that when funds are inadequate the highest priority items are included? It does not.

Management Efficiency Ukraine’s principal sources of public environmental expenditure = state and local budgets, and special, earmarked environmental funds linked to revenue from pollution charges. The contributions from the Environment Funds can be in the form of direct investments or grants on a matching basis. The system of environmental funds is extensive and includes over 1,600 regional and local funds

Management Efficiency The sheer number of these funds is clearly inefficient. On the other hand, local government control is valued since decisions about how to spend resources can be made closer to where environmental problems exist. Compromise is needed. The income of the funds comes primarily from pollution charges on emissions of air, water and waste. The highest revenues collected were for air pollution while the greatest expenditures are on mitigating water pollution.

Management Efficiency Data disaggregated by region show that compliance rates with charges and fines are lower in the regions where pollution is higher; and in these same regions, fines are less likely to be imposed on firms. In some regions, this may be an indication that where charges become too high, firms have more problems paying. Most likely however, lack of payment is a result of corruption in the system. The empirical analysis is at least consistent with a picture where large firms lobby successfully for exemption, while smaller firms bribe tax officials or simply do not pay the charges.

Management Efficiency The purpose of the pollution charges is not to reduce pollution; given their low levels, they do not provide an incentive to make investments in environmental improvement. Rather it is to raise revenue for environmental protection. Over the last five years or so, these charges, which were fixed in nominal terms, have had their real value eroded. Since there is a continued need to maintain this expenditure, and there is no other clear source of financing, some restitution of their real value is justified.

Management Efficiency More generally, are Environmental Funds an important way to finance environmental expenditures? For the time being, yes. To ensure a minimum level of funding for the environment, there is no alternative available now and the present system has some features to commend it. The National Environment Fund does operate relatively effectively; projects are properly processed and it is open to adopting better methods of appraisal. It can also act as a source pf leveraging of funds for pollution abatement, if appropriately designed and if banks see support by the Fund as an indication that the project is justified. At the same time, there is a need to overhaul the system of local funds – there are too many of them – and to change the system of subsidization across regions.

Recommendations on Efficiency In the longer term, however, the program of comprehensive public finance reforms that ends all earmarking and subjects all revenues to integration into the public finance system implies that the Environment Funds will be phased out. Some ‘sunset’ provision is therefore needed.

Recommendations on Efficiency Increase transparency and public disclosure Consider introducing international expenditure standards to better monitor environmental expenditures Enhance accountability Introduce economic appraisal techniques for environmental projects and programs

Recommendations on Efficiency Refine the institutional and legal structure for environmental funds: Reduce the number of funds: Spend resources close to where they collected Introduce more rigorous guidelines for use of funds Evaluate the success of funds with respect to outcomes

Recommendations on Efficiency Phase out Environment Funds in the Long Run Increase pollution charges to make up for some of the lost value due to inflation (400% since 1996) Eliminate exemptions Streamline the pollution tax structure (jump at Max. allowable emissions is too sharp). Strengthen oversight to reduce corruption Reduce charges if most enterprises in a region cannot pay Simplify pollution tax procedures