Win-win finance
THEODORE PANAYOTOU
suggests new and innovative ways
to finance sustainable development
Sustainable development is grossly underfinanced. It will continue to be so, because the world is relying on
conventional means to finance an unconventional idea. Official development assistance fell from $60 billion in 1992 to
$55 billion in 1995 (in constant 1994 prices). The public sector in developing countries is underinvesting in
environmental sustainability because of severe budget constraints, public sector deficits and more pressing
expenditure needs. So is the private sector because, under prevailing institutional arrangements, it cannot recover
costs and earn a decent rate of return from providing public goods.
This financing gap will persist and grow unless we begin to think of new and innovative ways to mobilize resources.
Even the concept of sustainable development financing may have to be defined unconventionally since many of the
changes needed may not involve investments, but simply a change in the incentive structure to induce less wasteful and
more environmentally and socially sound behaviour.
While funds are sought through higher taxes or from far afield, often at unfavourable terms, countless win-win
approaches to sustainable financing at home are left untapped.
A brief discussion of some of them follows: they are feasible and immediately available to most countries, and are
only constrained by inertia and lack of political will to experiment and innovate.
Removing or phasing out costly subsidies that distort the economy and subsidize wasteful consumption and
environmental degradation is the single most cost-effective means of financing sustainable development. Despite
significant reduction in subsidies in recent years, over $500 billion is spent worldwide on environmentally
destructive ones every year - including on fossil fuels, electricity, water, pesticides, logging, land clearing,
construction materials and capital-intensive industries. Removing them would not be easy because of vested interests
and political economy considerations. But the phasing out of pesticide subsidies in Indonesia, of energy subsidies in
Mexico, and of ranching subsidies in Brazil offers grounds for optimism.
Improvement before expansion
Demand-side management for public utilities and services - such as electricity, municipal water supply,
irrigation and public transport - is another cost-effective way of 'financing' sustainable development without raising
additional resources. For example, meeting growing energy demand by improving energy efficiency and conservation
(through full-cost pricing), rather than by expanding supply, reduces the need both for new power plants and
installing scrubbers to reduce SO2 emissions and planting trees to offset CO2 emissions. The savings could be
enormous, while the economy is guided closer to sustainable development. Had Thailand pursued energy efficiency rather
than build the Moe Moh Lignite power plant, it would have saved $400 million from not having to install anti-pollution
equipment. Water pricing that improves efficiency and conservation in use similarly reduces the need for construction
of additional reservoirs, water treatment plants and wastewater disposal sites - and the cost of mitigating the
environmental impacts of the dams.
Better capture of resource rents from exploiting such natural resources as forest, minerals, petroleum and
fish, would generate additional resources, while reducing depletion. Governments, for example, are only capturing 10
to 50 per cent of the scarcity value or stumpage of tropical timber, and much of this is returned to logging companies
through public construction of roads and subsidies for log processing which encourage increased felling. A more
efficient resource concession and taxation system could yield billions of dollars a year in additional foreign
exchange earnings and government revenues. This would provide for longer-term concessions, awarded through competitive
bidding and taxed efficiently through area-based taxes. Wasteful logging would be reduced, and there would be more
government revenues to invest in forest protection and reforestation. At a conservative estimate, Indonesia could
increase net earnings from timber by over a billion dollars a year (with more than half accruing to the Government as
unrestricted revenues) in this way while reducing deforestation.
Many environmental improvements generate private values (and public or social ones) in capital gains or property
value appreciation. For example, environmental neighbourhood clean-ups, new road infrastructure, rehabilitating
urban slums, establishing parks, and relocating industry all raise the value of nearby properties. Part of this
appreciation can be captured through such mechanisms as betterment charges, impact fees, property taxes, land
redevelopment schemes, with the proceeds used to finance the investments. Yet, in many countries, developed and
developing, environmental investments are financed from general taxation while the direct beneficiaries enjoy huge
windfalls or capital gains. This is neither efficient nor equitable, and results in too few environmental investments.
Studies show that most rural roads near towns, urban parks, slum upgrading and industrial relocation projects can more
than pay for themselves by extracting part of the property appreciation. The land redevelopment scheme of the Republic
of Korea is an example of such self-financing local road construction.
Improved definition and security of property rights to land and other natural resources can improve the access
of farmers and small businesses to capital markets enabling increased investment in land improvement, soil
conservation, tree planting and sustainable resource management. This would reduce environmental damage, improve
incomes and increase tax revenues for further investments in reducing poverty and conserving resources. Issuing secure
land titles to farmers with insecure ownership in Thailand doubled or tripled the value of the land: the necessary
surveys, title registration and other related expenses cost only 2 to 3 per cent of the pre-title value. Estimates of
productivity gains from issuing titles to land range between 10 and 30 per cent; investments in land improvement, soil
conservation, and tree planting range between 60 and 200 per cent.
Differential taxation of products and activities according to their environmental impact would discourage
damaging practices and encourage environmentally friendly ones. Thailand promotes the use of unleaded petrol, for
example, by taxing it more lightly while increasing taxes on leaded petrol. Indonesia taxes logging and subsidizes
replanting, though unfortunately at too low a rate to limit logging and encourage replanting, especially in the
absence of secure ownership or long-term land concessions. Taxing coal or petroleum and using the revenues to
subsidize conversion to the more benign natural gas or solar energy, is another example where cross-subsidization can
bring the economy closer to sustainable development. Environmental investments like reforestation, soil conservation
and cleaning up pollution can be financed from taxes on logging, mining, soil erosion and emissions - without the need
for higher general taxation or increased foreign borrowing. Such cross-subsidization - if introduced gradually
and designed to be revenue-neutral - is likely to make the structure of the economy more environmentally sound without
hindering growth.
Linking supply with demand
Many environmental problems - including traffic congestion, water pollution, energy brown-outs and water shortages -
arise from a growing mismatch between private investment and public infrastructure. During the 1980s infrastructure
investment in Bangkok, Jakarta and Manila grew less than one-third as fast as private investment; the result has been
severe water pollution and growing congestion that brings traffic to a standstill. Cities from Cairo to Mexico City
demonstrate similar unsustainable development. Public services are underpriced and there is a disassociation between
demand and supply, between those who benefit and those who pay. Only by directly linking the supply of public
infrastructure to the demand generated by new investments can adequate and timely support and a more efficient use
be assured: demand would be lower, supply higher, and environmental quality better. Private investors, and public
project programmes, can be required to pay into a special fund for environmental investments at a high enough level
sufficient to maintain existing (or improved) levels of service. Again, this is a form of self-financing, a cost of
doing business, consistent with sustainable growth, requiring the full social costs of each activity to be paid by
those who generate them and can therefore control them.
Privatizing state enterprises is likely to save a substantial proportion of national budgets for sustainable
development investments, while improving economic efficiency and reducing waste in providing public services and other
products. The environment has suffered as much as the economy in the hands of state enterprises as the experiences of
Eastern Europe, the former Soviet Union, and socialist developing economies demonstrate. Privatization would guarantee
three direct sources of funding: additional government revenues from the sales of state enterprises; savings in
government expenditures from no longer having to finance state enterprise deficits; and additional tax revenues from
the expanded tax base brought about by more efficient production. Private provision of public services - such as water
supply, wastewater treatment, solid waste collection, power generation and telephone services - would generate similar
savings as long as competitive bidding and adequate safeguards against monopoly pricing are adopted, as the recent
experiences of Argentina and the Philippines demonstrate.
A reform of the fiscal system to reduce conventional taxes and replace them with environmental ones leaving the
total tax burden unchanged, would bring the economy closer to sustainable development by stimulating economic growth
and conservation and discouraging resource depletion and pollution. The existing system of taxing social benefits
introduces market distortions: a reformed system that taxed social costs would remove market distortions and mitigate
market failures. This reform could not generate additional revenues but would save government expenditures on
environmental regulation and pollution abatement; it would indirectly advance the Agenda 21 objectives of more
economic growth with less environmental destruction; and, in the long run, it would increase the tax base - and hence
tax revenues - without increasing the tax burden. The 1991 Swedish tax reform has successfully reduced the marginal
tax rate from 50 to 30 per cent for 90 per cent of earners, replaced the revenues through CO2 and SO2 taxes, and
achieved significant efficiency gains and environmental improvements. In Norway and Portugal, environmental taxes now
provide more than 10 per cent of total tax revenues.
Inducing self-regulation
The government can reduce its share of the clean-up and restoration bill (and its overall size) by instituting
deposit-refund systems, environmental bonds and bank guarantees for complying with environmental rules.
Industrial associations for specific industries (e.g. agrochemicals, sugar mills, electroplating plants) or for
specific areas (e.g. around a lake, on a river, on a section of coast or in an industrial estate) can be given the
choice to attain a certain ambient level of water or air quality on their own or to be regulated by a government
agency. Experience with factories operating on the Ruhr river in Germany, with sugar mills in Thailand and with
factories in Japan, suggests that a well-identified community of industries will choose self-regulation and
self-enforcement if they are convinced that they cannot otherwise evade environmental regulations. Induced
self-regulation is more efficient and cost-effective than direct government regulation because industries know
best how to control their own waste, because self-enforcement is induced by the desire to be accepted by other members
in the association and by the community and because the costs of policing and monitoring are significantly reduced and
assumed directly by the source.
Command-and-control regulations such as end-of-the-pipe standards and mandated pollution control technologies have
been the standard approach in developed and developing countries alike. A move towards increased use of economic
instruments - either supporting or replacing regulations - is an indirect way of financing sustainable
development: both growth and environmental protection are advanced cost-effectively, budgetary resources are saved and
new sources of revenues established for investing in sustainable development. Of course, if they are to be effective,
charges and taxes must be set at high enough levels to reflect marginal damage and to induce a change in behaviour -
and protected against inflation and political manipulation. There are grounds for optimism in Malaysia's successful
experience with effluent charges, Singapore's with congestion fees, Poland's with a pilot tradable permit scheme, and
Turkey's with industrial relocation incentives.
Potential beneficiaries of environmental goods or services like village water supply, slum upgrading or conservation
of tropical forests, are willing to pay to ensure that they are provided. Even poor people are willing to pay up to 20
per cent of their income for a reliable clean water supply. Farmers in dry parts of India pay as much as one-third of
the value of their crops for water. People in developing countries are willing to pay more than is widely assumed for
forest protection and nature conservation. The willingness to pay of urban elites in developing countries remains
largely unexploited. For example, the possibility that high-income residents, commercial establishments and industries
in Colombo, Sri Lanka, might be willing to pay the full cost of electricity supply, including the protection of the
watershed area of the Mahaweli system, rather than suffer frequent brown-outs, has not been considered. Governments
often fail to act for lack of funds - or they seek funds from taxpayers or foreign donors at unfavourable terms - when
direct beneficiaries would be more than willing to foot the bill if they did not have the option of receiving the
benefits of public investments free of charge.
The demand for conserving tropical forests, preserving biodiversity and reducing greenhouse-gas emissions and
protecting the ozone layer emanates mainly from developed countries, which have sufficiently high incomes and low
discount rates to be concerned with environmental amenities and distant threats to their living standards. Their
willingness to pay for the conservation of such 'global commons' is unlikely to match their pronouncements, but it
must certainly be larger than what they now contribute. There is a need to measure people's willingness to pay
for conserving resources and then to devise appropriate mechanisms to tap and use it effectively. Assuming an average
willingness to pay of 0.3 per cent of per capita incomes in the developed countries, $50 billion a year should be
within reach. Instruments for tapping this range from joint implementation, eco-tourism and
debt-for-sustainable-development swaps to more sophisticated mechanisms such as internationally tradable CO2 permits,
biodiversity patents and transferable development rights.
Encouraging signs
Despite slow progress, there are encouraging signs from countries as diverse as Chile and China, Madagascar and
Malaysia, that policy makers are beginning to explore the vast but uncharted territory of innovative financing of
sustainable development. International organizations have an opportunity, and a responsibility, to encourage
developing countries to move more aggressively along this path and share experiences. This could prove to be far more
critical to sustainable development than any additional financial transfers that could possibly be mobilized from a
reluctant donor community that is long in pronouncements and short on delivery.
Professor Theodore Panayotou is Director of the International Environment Program, Harvard Institute for
International Development, Harvard University, United States of America.
