Journal Issue

Are Economywide Policies Good for the Environment?

International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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THE DYNAMICS between economywide policies and the environment are complex—policy reforms hold the potential to either help or hurt the environment. Typically, liberalizing moves help both the economy and the environment, so there are “win-win” gains to be had. But when the opposite occurs, the negatives can be held in check by more specific mitigating measures.

Until recently, when governments made decisions on foreign exchange rates, international trade, agricultural subsidies, and other broad economic measures, little attention was paid to the potential environmental consequences. But now, with environmental concerns taking a higher priority, governments all over the world are beginning to rethink their economic strategies. For industrial countries, where the quality of life has hitherto been measured mainly in terms of growth in net material output, pollution in particular is recognized as a serious threat. For developing countries, where economic development and poverty alleviation take center stage, both pollution and natural resource degradation are seen as serious impediments.

At root is a desire for “sustainable development”—that is, the pursuit of strategies that will permit continuing improvements in the present quality of life at a lower intensity of resource use. Sustainable development necessarily involves the pursuit of economic efficiency, social equity, and environmental protection. In particular, it requires policies and projects to be designed and implemented in such a way that environmental degradation (much of which hits the poor the hardest) is anticipated and minimized, rather than just reacted to after the damage has occurred. But to do this, policymakers and project planners would need a good understanding of how economywide policies, not just specific projects, affect the environment, and on this score, very little work has been done.

For that reason, the World Bank recently launched a study to better understand the complex interactions between economywide policies and the environment. A typical question might be: If farm crop prices rise in the context of an adjustment program that involves either liberalization of the entire economy through a general devaluation or more targeted agricultural price reforms, would this help or hurt the environment? Generalizations are hard to make—indeed, each situation needs to be examined on a case-by-case basis. However, the evidence does show that in most cases, macroeconomic reforms help the environment, and when they do not, specific or localized mitigating adjustments can be made to limit or offset any environmental damage.

Environmental economics

The field of environmental economics, although relatively new, has been able to adapt and extend conventional economic principles to decisionmaking at various levels in modern society, ranging from the local to the global. By adapting and extending such standard methods—especially to identify options for the efficient use of natural resources and the management of pollution—environmental economics plays a key bridging role between the economic, ecological, and social approaches to sustainable development. Among these techniques, the most advanced is the valuation of microlevel environmental impacts, which helps to improve conventional cost-benefit analysis of projects. As a result, through its environmental assessment procedures, the World Bank has made a start in incorporating environmental concerns into project design—potentially affecting an annual pipeline of more than 200 investment projects worth over $11 billion. Continued progress in this area is extremely important, given that conventional development projects often have serious environmental effects.

However, economic policies that go beyond the local project level frequently have even more potent effects, something the Bank has recognized for a long time. In particular, for many decades policy reforms contained in the adjustment process—particularly in sector adjustment lending—have included elements that affect natural resource use and the environment. For example, rationalizing of electricity and water prices and removing subsidies for pesticides have been standard objectives of project and sector lending.

Even so, there is no question that the general lack of knowledge about links between economic policies and the environment serves as a real handicap for the Bank. It delays attempts to gradually expand the application of environmental assessments to cover policy-based lending—the second largest use of Bank resources (about $5.8 billion annually, or 27 percent of total lending). It also hampers efforts to develop more effective national Environmental Action Plans (these are prepared by borrowing countries, with Bank assistance, to help determine priority activities to address national environmental issues).

In an effort to better understand how economywide policies affect the environment, the Bank conducted a series of case studies, which were carefully selected to reflect a wide range of country situations and environmental problems. The studies examined two basic types of policy reforms: efficiency-oriented sectoral pricing reforms, and sectoral and economy-wide changes that alter both prices and the basic structures of the economy.

What the study found

Although no simple generalizations can be distilled, a few key patterns did emerge—some of which imply that policymakers may need to rethink their economic strategies.

Getting prices right helps the environment—but it is not enough. The studies reinforced the long-held belief that improving the price system and correcting for market failures will help the environment because it decreases the incentive to exploit resources wastefully. This is important for the Bank because it has traditionally advocated reducing subsidies in key sectors, such as energy and water, on efficiency grounds.

In Sri Lanka, for example, as in most developing countries, electricity prices have been well below the incremental cost of ensuring future supplies. This means that there is a wasteful use of energy, which, in turn, will result in excessive emissions of particulates and sulphur dioxide. Thus, a more efficient use of energy induced by energy prices that reflect marginal cost would result in lower air pollution. This is further supported in the India study, where growing demands for water in agriculture and industry in Jamshedpur is a critical resource management problem. Water is increasingly scarce, but is substantially undervalued. Most subsidized industrial users pay only $.07 per cubic meter of water when the going rate from private suppliers is $.13. The answer to better water use lies in adjusting prices to reflect either the cost of supplying the water or the benefits foregone by diverting it to other uses.

While prices that reflect baseline economic costs are clearly important, the ideal environmental pricing approach requires accurately valuing environmental degradation and imposing equivalent additional taxes on those who cause the damage. However, such a “pure” approach is often not feasible because of weak institutions and administrative constraints in many developing countries. This means that blunter instruments or combinations of pricing and regulation may be more practical—something that may come as a surprise to many economists. The study on Mexico City showed, for example, that a “taxation-only” or “regulation-only” approach is not practical; instead, Mexican officials might want to combine the two approaches.

Exploit the “win-win” cases. Although the results on the environmental implications of sectoral and macroeconomic reforms were case specific, some basic lessons emerged. The studies showed that because the main patterns of resource or environmental degradation are caused by market failures, or long-standing policy or institutional distortions, the environmental implications of economywide reforms will be generally beneficial for both the economy and the environment.

First, take the issue of subsidies. Although these are typically imposed to promote an investment or social goal, they often encourage wasteful resource use. A well-known example is the system of tax breaks and cheap credit that promoted cattle ranching and the conversion of Amazonian forests to unsustainable pasture. The Mexico case study shows that industrial subsidies can have similar negative environmental effects in terms of pollution. Between 1970–89, industrial pollution intensity in Mexico increased by 25 percent, induced by government investments and subsidies in the petrochemical and fertilizer industries. Energy intensity of industry also increased by 5.7 percent in the same period. Moreover, these subsidies are costly. Broad subsidies for fuels and electricity absorbed $8–13 billion, or 4–7 percent of GDP, from 1980–85.

The same pattern can be seen in the agricultural sector. In Tunisia, the government tried to protect herders from wide income fluctuations during drought by subsidizing feed imports. This allows herders to increase the number of livestock continuously, breaking the cycle where, during droughts, herd sizes contract. But it also leads to greater pressures on limited grazing lands, such as in the southern arid region, and thus land degradation. Of the 10.6 million hectares involved, more than half are already moderately to severely degraded. Thus, replacing such subsidies with more direct transfers could continue to protect the poor in the short term while reducing the long-term degradation of pastures.

The environment and adjustment lending

For many years now, the World Bank has advocated integrating environmental concerns into economic reforms, and as a recent study shows, the rhetoric is being translated into action.

A review of Bank adjustment lending operations over the period FY88-FY92 found that about 60 percent of the sampled loans explicitly included environmental goals or loan conditionalities addressing environmental concerns in agriculture, forestry, energy, trade, and industry. This was up sharply from only 37 percent during the FY79-FY87 period. Moreover, the recent loans encompassed a much wider range of policy instruments or sectoral strategies (e.g., from energy and resource pricing reforms to institutional capacity building).

For the study, the Bank selected 81 loans, which represented about 65 percent of total adjustment lending during the FY88-FY92 period. This included 47 structural adjustment loans and 34 sectoral adjustment loans in 58 countries spread throughout the developing world. The rest of the loans were excluded, because they were mostly financial sector adjustment programs considered to have no direct—or traceable—implications for the environment.

One caveat, however. It is important to note that such lending operations have specific, fairly short-run objectives, and the loans are meant for rapid disbursement. While environmental objectives can, and increasingly are, built into loan conditions, there are many other environmental goals that require long-term institutional and capacity reform and for which adjustment lending is not an appropriate instrument.

Source: “The Evolution of Environmental Concerns in Adjustment Lending: A Review,” by Jeremy Warford, Adelaida Schwab, Wilfrido Cruz, and Stein Hansen, World Bank, February 1993.

A second issue involves broader policy reforms, such as liberalizing foreign exchange. In Zimbabwe, wildlife-based tourism contributes substantially to the economy. This sector grew at the rate of 13 percent in 1991, comprising 5 percent of GDP. Wildlife-based activities, unlike cattle ranching, with which they compete for limited land resources, are better suited to the country’s semi-arid climate and poor soils. The direct advantage is that economically viable systems can be maintained with lower stocking rates than those associated with commercial cattle ranching. Equally important is the indirect environmental benefit of conserving a natural habitat that appeals to visitors.

However, for many years, the government’s foreign exchange and trade policies have penalized this sector. Overvaluation of the Zimbabwean dollar (50–80 percent from 1981–90) meant that export-oriented sectors were implicitly taxed, among them wildlife and nature tourism concerns. Foreign exchange earnings were diverted to other sectors, depressing incomes and investment in wildlife. In 1990, the currency was devalued by 25 percent as part of an adjustment package, and more liberal access to foreign exchange was allowed. These moves were beneficial on both economic and ecological fronts. Exports increased; at the same time, the profitability of the wildlife sector increased, leading to an expansion of land allocated for wildlife—an environmentally desirable outcome.

Trade liberalization in Indonesia also illustrates the “win-win” principle, but points to the urgent need for regulation as a complement to policy reform. Accelerated industrial growth, while clearly desirable for poverty reduction, often brings with it increased pollution. The Indonesia study shows how reforms can mitigate some of the pollution problems associated with growth. In terms of emissions per unit of output, or pollution intensity, the study found that processing industries (e.g., food products, pulp, paper) tend to be dirtier than assembly (garments, furniture) industries. Liberalization in the 1980s promoted a surge in assembly industries, thereby reversing the 1970s pattern of more rapid growth in “dirty” processing sectors.

In addition, industry expanded rapidly outside densely populated Java, reducing the health impact of industrial concentration. However, industrial output growth has been so rapid that general pollution levels have nevertheless increased. Thus, reduced pollution intensity and industrial decentralization are not enough to control pollution; formal regulation will still be required to avoid severe health and environmental damage in the future.

Break the negative links. Clearly, reducing market failures and policy distortions should be both economically and ecologically beneficial. But sometimes this is not the case because policy reforms are undertaken while long-standing distortions or institutional problems persist (e.g., where trade reforms are implemented while resources continue to be underpriced, or resource ownership remains uncertain). However, even in these instances, conventional economic benefits may still be substantial. This means that policymakers should still proceed with the economic reforms and mitigate the adverse environmental impacts by adopting complementary environmental measures.

In particular, property rights or tenurial problems can undermine the contribution of certain reforms. In Western Ghana, as in many regions in Africa, agricultural lands are governed by traditional land use institutions, where farms are communally owned by the village or tribe. These common property regimes may have been sufficient in allowing sustainable use of agricultural lands when populations were much smaller. However, with rapid population growth and lack of employment opportunities, there is increasing pressure on land resources.

Under these conditions, increases in domestic agricultural prices, associated with trade reforms, have accomplished the expected goal of increased rural output. However, they have also led to an expansion of cultivated area, reduced fallowing, and consequently a decline in land fertility and productivity. Explicitly incorporating the effect of this environmental change reduces the otherwise substantial positive effect of the reform on agricultural output. In this case, complementary institutional reforms will be needed to ensure that the current income improvements from adjustment reforms will be sustainable.

Pricing reforms can also be undermined, as is the case in Eastern Europe, by a need for more privatization. The former centrally planned economies of this region have been burdened by the legacy of low energy prices and the lack of an incentive system for efficient resource utilization. But with the massive economic restructuring underway, in recent years energy prices and pollution charges have been rising. In Poland, for example, energy prices doubled in 1988 (although they still remained only about half of Western European prices); coal prices increased from $6 per ton in 1989 to $37 per ton in 1992.

While there has been some decline in pollution and energy intensity, there is a concern that price increases have not had as large an impact as would be expected in a market economy. The study found that soft budget constraints have allowed firms to pass on additional input costs or taxes to the government or consumers. This means that promoting budget accountability through privatization and banking reforms is important to increase the effectiveness of price rationalization.

Policy relevance of studies

The challenge presented by these studies is the need to increasingly incorporate environmental components in policy reform efforts. Since the mid-1980s, environmental issues have been more important in Bank structural adjustment loans and sectoral adjustment loans, and this trend is expected to continue (see box on page 41).

For developing country policymakers, who always have to balance environmental concerns with economic and social benefits, these studies suggest how the environmental assessment of policy reforms might be initiated. In a country specific context, a matrix such as that presented in Table 1 would be very useful from the viewpoint of economic planners, especially those involved in the ministry of finance, ministry of planning, or key sectoral ministries.

Table 1Critical environmental links for economic planners
Policy issuesPolicy reformsDirect objectives/effectsIndirect (environmental) effects
Trade deficitsFlexible exchange ratesPromote exports; reduce importsExport promotion may lead to more deforestation (or export, but it could also lead to substitution of tree crops for annual crops. In addition, industrial job creation may reduce pressures on land resources
Food security and unemploymentAgricultural intensification in settled lands and resettlement programs for new areasIncrease crop yields and acreage; absorb more rural laborMay reduce spontaneous migration to ecologically fragile areas. However, there is potential for over use of fertilizers and chemicals
Lack of industrial competitivenessReduction of tariffs and special incentivesPromote competition and industrial efficiencyMore openness may lead industry to adopt more energy-efficient or less pollution-prone technologies. However, it may also lead to influx of hazardous industries

Policy changes—such as industrial protection reform—can have both positive and negative implications, depending on the nature of intervening conditions. Thus, to properly evaluate broad policy reforms, decision makers need to first identify the direct and indirect effects, as well as assess any trade-offs between conventional development contributions and environmental effects. Then they would be in a good position to design remedial measures that would help mitigate any negative effects or enhance the positive impacts of the economywide policy on the environment.

The results would also be useful from the viewpoint of environmental policymakers, such as environment ministry officials charged with preparing the national Environmental Action Plan. For them, the key question is which policies would substantially affect a high priority environmental issue. Here, it is possible to identify specific policies that typically affect certain types of environmental issues (Table 2). For example, if air pollution is a major concern, then the relevant policy would involve energy prices; for deforestation, foreign exchange and agricultural price policies; for water availability and quality, domestic price policies; and for energy efficiency, trade and exchange rate policies.

Table 2Critical economic policy links for environmental planners
Resource/environmental management issueSectoral economic characteristicsRelevant policy reforms
Agricultural expansion and deforestationMany small, competitive decisionmakers are involved

Outputs, inputs are mostly internationally traded

Government implements substantial production subsidies and trade intervention
Reduction of taxes and subsidies

Exchange rate and trade reforms

Poverty and income distribution policies

Property rights reform
Water depletion and degradationSupply side is dominated by government or monopolies; bulk of resource use goes to large commercial enterprises and irrigation systems

Resource is not internationally traded but sectoral use and productivity for main user groups substantially differ

Prices are highly regulated
Intersectoral pricing

Reduction of subsidies and introduction of charges for resource degradation
Energy use and air pollutionAs with water, supply side dominated by government and monopolies

Inputs (coal, oil) are generally traded; output broadly linked to all production activities

Sectoral investment and pricing highly centralized
Exchange rate reforms

Reduction of cross-subsidies

Privatization programs for generating and distributing activities

Ideally, both of these assessments should be undertaken within the same comprehensive framework of national decision-making. However, in practice, institutional rigidities often prevent such coordination, which in turn leads to different priorities among economists and environmentalists, and sometimes to the adoption of conflicting economic and environmental policies.

The World Bank study on economywide policies and the environment included these studies:

Ghana: Effects of trade and employment policies on agricultural extensification (Ramon Lopez)

India: Intersectoral water pricing issues (Ramesh Bhatia and Rita Cestti)

Indonesia: National economic policy and industrial pollution, 1975–1989 (David Wheeler)

Mexico: Fuel taxation and industrial pollution issues (Gunnar S. Eskeland and Adriaan Ten Kate)

Poland: Economic restructuring and energy use (Robin Bates and Shreekant Gupta)

Sri Lanka: Effects of global climate-related constraints and national energy policies on resource management (Peter Meier and Mohan Munasinghe)

Tunisia: Livestock policies and environmental impacts during economic adjustment (Zeinab Partow and Stephen Mink)

Zimbabwe: Economic policy and wildlife management (Jan Bojo, Kay Muir, and Rob Cunliffe)

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