Ill-considered experiments: the Environmental Consensus and the developing world. (Perspectives).

Bell, Ruth Greenspan ; Russell, Clifford

For a brief period between the end of the Cold War and September 11, 2001, an opportunity arose to consider global concerns beyond East-West politics and nudear threats. The connection between states' failed environmental policies and the devastation wreaked on the health and stability of their people suddenly became a frequently discussed subject in foreign policy, no longer consigned to specialized journals.

However, though the foreign policy debate has shifted, the potentially disruptive environmental conditions still persist. One solution to pollution and depleted biodiversity has come in the form of development assistance. International financial institutions' (IFI) environmental advice to the developing world and transitioning counties sounds familiar. Its components--principally market solutions--parallel what the institutions and their advisors (dubbed the Washington Consensus) tell the same counties to do to reform their economies. The environmental policies therefore suffer from the same failings as the economic advice.

The IFIs, in a form of Environmental Consensus, preach that counties can only clean up badly polluted environments by adopting management systems based on economic incentives. Elements of the institutions' mantra include tradable emissions permits and effluent charge systems. Advice arrives in a flood of papers from the Organisation for Economic Co-operation and Development and the World Bank.

The difference between the economic and environmental programs is that IFI environmental advice flies under the radar. The Washington Consensus has become a brawl among economists, lawyers, sociologists, and politicians who fight publicly over what went wrong in Russia and how best to manage Argentina's meltdown. In contrast, the Environmental Consensus has received little public attention.

As a result, the countries most in trouble are not hearing the whole truth. What the Consensus does not say is that the institutions, infrastructure, and human capital needed to support the sophisticated environmental instruments the West promotes are not present in much of the developing world. Although the advice sounds appealing, it will not lead to clean air or drinkable water where it is badly needed. For the most part, the IFI investments have not improved environmental quality in any significant manner. It is time to end the silence and initiate a public discussion. The stakes are too great to cede the conversation to economists.

Western Origins

The story starts with the use of market-based instruments in the United States, the model for dissemination elsewhere. Economists were developing incentive-based approaches to environmental control at the same time that many of the basic environmental laws were being written in the United States, but none of those early laws used economic tools. Economists' suggestions began to make inroads when US Environmental Protection Agency (EPA) regulators realized that they could help resolve difficult Clean Air Act implementation problems using incentives. Accordingly, the EPA set up a system that gave industry the opportunity to bank or sell emission reduction credits.

This policy worked well enough that credit trading was written into a 1990 law to control acid rain. Firms that can control their pollution more cheaply may accumulate credits and can then sell the credits to others, who must otherwise spend more to reduce pollution. Trading has clearly accelerated the goal of reducing sulfur dioxide discharges in the United States and has saved money. Business, not government, decides the most cost-effective way to comply.

The entire system, however, rests on the rule of law. The government firmly manages system integrity, expensive monitoring equipment assures that genuine reductions are being sold, and every credit (called an "allowance") is assigned a serial number, which allows the EPA to record transfers and ensure that a units emissions do not exceed the number of allowances it holds. All transactions are online and completely transparent, and non-compliance is vigilantly prosecuted.

Despite its success, trading is not the dominant approach to environmental protection in the United States. Most regulatory programs use traditional methods, such as statutory prohibitions, because doing otherwise poses technical challenges and generates political fights. Some public advocates oppose economic instruments because they fear that emissions trading cannot be adequately enforced; others mistakenly think these programs sanction pollution.

Many European states benefit from environment-protecting economic instruments, such as deposit-refund systems, which pay people for dropping recyclable material at a center. Taxes on fertilizer, gasoline, and other polluting agents are also widely used. Germany, France, and the Netherlands charge industry for certain kinds of emissions, but the charges are designed to raise revenue for infrastructure investment rather than to discourage pollution. Surprisingly, many communist bloc countries used market instruments, such as imposing fines on emissions of certain compounds. But pollution charges were not an incentive to reduce pollution because they were paid out of the soft budgets of state enterprises.

Banking on Markets

Domestic environmental policy-making in the developing world is dominated by a unique and unlikely 800-pound gorilla: the development banks. It is almost unthinkable that these institutions could have any role, much less a significant one, in shaping domestic US environmental policy. The introduction of market-based instruments in the United States, like other contentious issues of domestic policy, took place after messy battles in and between Congress, the EPA, the media, and various interest groups.

Yet in the developing world, financial donors wield disproportionate power on matters of environmental policy. Bank environmental departments, staffed by Western analysts trained in efficient markets, use grant-funded studies and reports to communicate their views. Money and prestige make them the ally of marginalized environment ministries, but their understanding of institutional issues is less complete. Although IFIs today have departments that interact with nongovernmental organizations (NGOs), these serve as facilitators, not policy advisors.

The 1992 World Development Report marked the opening salvo of the World Bank's endorsement of economic instruments as a means to resolve the tension between growth and its environmental consequences. Additionally, the breakdown of the Soviet Union intensified interest in harnessing markets. The former Soviet bloc countries, with their impressive histories of environmental activism, seemed like the most receptive audience for this message. They were more like industrialized economies than developing countries. They had technically trained civil services, high rates of literacy, excellent universities, and existing, frequently forward-looking, environmental laws. Central Europeans in particular reacted strongly against anything that smacked of central planning. The phrase "command and control," typically used to describe traditional forms of environmental regulation, hit an emotional chord, especially when contrasted with the glittering "free markets."

Advisors and audiences eager to be seduced by markets joined to take up the tantalizing idea that the mistakes made in the name of environmental protection in the West were easily avoidable. The pitch rarely mentioned the considerable history and experience that allow markets to work in the Western democracies.

Transition Road Bloc

Economic instruments have not taken hold in Kazakhstan, Poland, the Czech Republic, and other transitional countries because the prescriptions simply did not fit the conditions for which they were suggested. The intuition that these countries were stronger candidates than developing countries was wrong for two major reasons. First, they lacked the institutions that serve as the cornerstone of sophisticated market-based instruments. Second, actors in complex market transactions need considerable skills that did not exist in the countries of the former Soviet bloc.

Before 1989, Soviet economists and planners studied non-Marxist systems, but the people who ran state enterprises operated in an economy structured under the rules of state socialism. They knew nothing about Western accounting principles and stock markets; profit and loss were unimportant.

Former communist countries lacked four main ingredients that would have facilitated the success of economic solutions to pollution concerns. First, they did not have institutions to deal with failure. People who trade emissions represent a right to pollute in the future; it is difficult to imagine a more complex and intangible property right. Donor advice on emissions trading rarely mentions the possibility that transactions might fail. In such an event, some authority, administrative body, or court must police trades and ensure their integrity. Yet the same advice was peddled in countries with working legal systems and those without similar institutions. Some of these transitional countries recently have begun to restore an European legal system, free of political and economic safety valves, but in parts of the former Soviet Union, there was no rule-of-law tradition to revive.

Citizens of Central Europe have experienced many years of corruption and under-the-table differential treatment. Today, they need to know that grants of discretion will not be hijacked to serve the purposes of people in power. Confidence in emissions-trading transactions has developed in the United States through a high level of transparency. Competitors, NGOs, and public interest groups can monitor and know relatively quickly whether or not industry is meeting its commitments. The "trust but verify" approach has helped build an enthusiastic constituency in the United States.

In Western Europe, the public is more tolerant when industry and government sit down to negotiate, so Central European trading programs may work without as much transparency as the United States demands. On the other hand, architects of any trading program cannot ignore the legacy of the Soviet period, especially in countries struggling with endemic corruption.

The third problem facing former Soviet countries is a lack of experience with the real costs of compliance. When firms grapple with actual, rather than theoretical, environmental regulations and genuine enforcement, they develop an awareness of the real costs of compliance. Economic pain is a great motivator. Western firms know that emissions trading is a cheaper way to comply because they have had a century of experience with cost accounting.

Industry in the Soviet bloc countries had never confronted the hard realities of environmental compliance. When production goals conflicted with environmental requirements, it was clear which would win. Even today, regulatory bodies are still weak in many of the successor countries. Now the challenge is to make laws work.

States in the former Soviet bloc also faced an absence of a tradition of monitoring--knowing what amounts of what pollutants are released into the environment by particular plants--which is an essential part of any regulatory program. It is especially important for market-based instruments, since trading sanctions vary in the amount of permitted discharge from each source.

Monitoring is not reliable in the former Soviet bloc, but there are alternative ways to prevent cheating. One is to make estimates of emissions amounts by using the sulfur content of coal. But the accuracy of the estimates depends on the dubious assumption that the plants have maintained and used their pollution control equipment. Firms in countries with rampant corruption and many incentives not to comply with the rules often save money by turning off their control equipment unless they know the inspector is coming.

The Environmental Consensus has never admitted the importance of these issues. The experts vaguely caution that market-based instruments are effective only if implemented properly and under the. right conditions. They are reluctant to acknowledge that there is little experience with market instruments outside the Western democracies.

Developing Advice

If transparency, accurate monitoring, a working legal system, and realistic incentives to trade are scarce in transitioning economies, the problems run much deeper in the developing world. There are fewer people to design and implement these sophisticated programs, the available talent is generally concentrated in capitals rather than field posts, monitoring equipment is in short supply, basic data are unreliable, and informal and even institutionalized corruption is rampant.

In spite of these unfavorable conditions, the most vocal proponents of the Environmental Consensus say that if the countries of the developed world were to adopt economic instruments, they would eliminate the need for regulatory bodies and enforcement programs. In a paper financed by the United Nations Environment Programme, Theodore Panayotou of Harvard University argues that economic instruments take full advantage of the self-interest and superior information of producers and consumers "without requiring the disclosure of such information or creating large and costly bureaucracies."

Panayotou's extravagant claims fly in the face of empirical evidence from the United States when he argues that economic instruments substitute for efforts to enforce compliance and that they "tend to have lower institutional and human resource requirements than command and control regulations."

These claims look suspect when environmental economics is examined in the context of the realities of the developing world. Proponents claim that market-based instruments almost automatically bring a region or country to a solution that optimally resolves the problem of achieving desired levels of environmental quality. They also say this cheap solution will be reached without the regulating agency needing to know anything about the costs of pollution control at the sources it is regulating.

Unfortunately, these two claims are at odds with each other. When there are multiple sources of pollution, the regulator will need complete knowledge of costs and a complex mathematical model to determine the cheapest solution. If the location of sources does not matter, as in the effect of global carbon dioxide emissions on climate, a single charge applied to all sources, the simplest sort of tradable permit scheme, suffices to reach the cheapest solution. Then it is conceivable, though not realistic, that environmental ministries could use costly, time-consuming trial and error to find the appropriate charge or permit a total that exactly meets the desired standard.

The proponents of market-based instruments go on to argue that these tools can also produce revenue for perennially overburdened governments that are saddled with inefficient and distorting tax systems. Moreover, the revenue can be obtained without distortions of the kind caused by taxes on income or sales. While there is truth in these claims, there are also qualifications. The first is that the amount raised is likely to be small. The second is that it is difficult to collect this revenue in a reliable way. In countries that have difficulty collecting even income taxes, taxes on pollution discharges, which must be measured by special equipment in a real-time monitoring system, present a greater challenge.

A third caveat is that if the desire for revenue comes to dominate the government's thinking, the charge will be chosen to maximize revenue rather than to limit pollution, and the argument about lowest-cost solutions no longer holds. Finally, if the charges become too costly, the long-run result will be erosion of the tax base.

The proponents' own claims make this last point explicit. Invoking an old argument, they say that market-based policy instruments spur technological advance for pollution control, while traditional regulatory choices, such as non-marketable permits, do not. Economists have agreed for some time that there are different incentives to develop new technologies created by different policy choices. Traditional, non-marketable permits produce a smaller incentive than do charges on emissions or regularly auctioned marketable permits. Yet the incentives created by traditional approaches, if they are enforced, are not negligible.

The more fundamental question is whether or not the governments of the developing world have the political will to impose and actually collect charges significant enough to force industry to seek new technology. Specifically, doubts exist regarding government willingness to target firms insulated from market pressures by the equivalent of soft budget constraints or those who benefit from loans made on the basis of connections and favoritism, rather than sound business principles and sober assessment of credit. Using the market to spur technological change is only plausible if there are safeguards against the many ways that market forces can be undermined.

In the final analysis, market-based instruments do offer some highly desirable features when appropriate conditions exist, but the package is being oversold. Some of the features are in conflict with each other, and achieving any subset of them demands very large institutional commitments. The data gathering, mathematical modeling, and monitoring or auditing of emissions required are all nearly impossible in the small, understaffed, and under-funded environmental ministries of the developing world. The Environmental Consensus is not telling the entire story when it presents economic incentives as a cure-all solution to pollution in the developing world.

Prescription for Change

What harm has the effort to promote market-based instruments done? Most developing world governments are too distracted or uninterested to pay any real attention to their environmental problems. The few experiments have largely been memorialized in academic journals.

One answer is that these were not mere suggestions but rather the considered advice of prestigious institutions. When money influences policy, full disclosure is essential. Instead, the development banks have treated the developing countries like environmental laboratories. Many of the ideas they and their advisors have imposed have only been tested in models and in the minds of the people who thought of them, where confounding facts and poor conditions can be assumed away.

Theory has much to offer environmental protection, but in the end, local culture, institutions, and infrastructure will determine the success of any policy. In this complex situation, policy selection should not be a function of fads or ideology. Like good doctors, the Environmental Consensus should examine the patient before, not after, prescribing the cure. It would help to acknowledge that a long learning curve lies ahead. International donors should support rather than disparage incremental improvements and pragmatic goals.

Since institutions are the springboard for any leap forward, donors should support a transitional or tiered approach that will take into account existing capabilities and institutions. Only the most developed countries should be encouraged to attempt difficult environmental policy instruments like emissions-trading schemes. The most important thing donors can do is to help developing countries create behavioral rules, mechanisms for checking and encouraging compliance, and norms that make compliance the first, rather than the last, choice of action.

Taking more measured steps does not have the same sense of adventure as a great environmental leap forward. But it will result in real environmental gains and can be accomplished without losing sight of the ultimate goal of developing the most sophisticated methods of managing the environment.

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RUTH GREENSPAN BELL is Director of Resources for the Future's International Institutional Development and Environmental Assistance program, and CLIFFORD RUSSELL is Director of the Vanderbilt Institute for Public Policy Studies.