Trade And Environment: Theory And Policy in the Context of Eu Enlargement And Economic Transition (The Fondazione Eni Enrico Mattei (Feem) Series on Economics and the Environment)

Trade and Environment

THE FONDAZIONE ENI ENRICO MATTEI (FEEM) SERIES ON ECONOMICS AND THE ENVIRONMENT Series Editor: Carlo Carraro, University of Venice, Venice and Research Director, Fondazione Eni Enrico Mattei (FEEM), Milan, Italy Editorial Board Kenneth J. Arrow, Department of Economics, Stanford University, Stanford, California, USA William J. Baumol, CV Starr Center for Applied Economics, New York University, New York City, USA Partha Dasgupta, Cambridge University, Cambridge, UK Karl-Göran Mäler, The Beijer International Institute of Ecological Economics, The Royal Swedish Academy of Sciences, Stockholm, Sweden Ignazio Musu, University of Venice, Venice, Italy Henry Tulkens, Center for Operations Research and Econometrics (CORE), Université Catholique de Louvain, Louvain-la-Neuve, Belgium The Fondazione Eni Enrico Mattei (FEEM) was established in 1989 as a non-profit, nonpartisan research institution. It carries out high-profile research in the fields of economic development, energy and the environment, thanks to an international network of researchers who contribute to disseminate knowledge through seminars, congresses and publications. The main objective of the Fondazione is to foster interactions among academic, industrial and public policy spheres in an effort to find solutions to environmental problems. Over the years it has thus become a major European institution for research on sustainable development and the privileged interlocutor of a number of leading national and international policy institutions. The Fondazione Eni Enrico Mattei (FEEM) Series on Economics and the Environment publishes leading-edge research findings providing an authoritative and up-to-date source of information in all aspects of sustainable development. FEEM research outputs are the results of a sound and acknowledged cooperation between its internal staff and a worldwide network of outstanding researchers and practitioners. A Scientific Advisory Board of distinguished academics ensures the quality of the publications. This series serves as an outlet for the main results of FEEM’s research programmes in the areas of economics, energy and the environment. Titles in the series include: The Endogenous Formation of Economic Coalitions Edited by Carlo Carraro Climate Change and the Mediterranean Socio-economic Perspectives of Impacts, Vulnerability and Adaptation Edited by Carlo Giupponi and Mordechai Shechter Game Practice and the Environment Edited by Carlo Carraro and Vito Fragnelli Analysing Strategic Environment Assessment Towards Better Decision-Making Edited by Pietro Caratti, Holger Dalkmann and Rodrigo Jiliberto Trade and Environment Theory and Policy in the Context of EU Enlargement and Economic Transition Edited by John W. Maxwell and Rafael Reuveny

Trade and Environment Theory and Policy in the Context of EU Enlargement and Economic Transition

Edited by

John W. Maxwell Kelley School of Business, Indiana University, USA and ZEI, Germany

Rafael Reuveny School of Public and Environmental Affairs, Indiana University, USA

THE FONDAZIONE ENI ENRICO MATTEI (FEEM) SERIES ON ECONOMICS AND THE ENVIRONMENT

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© John W. Maxwell, Rafael Reuveny, 2005 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library

ISBN 1 84542 164 7 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents vii ix xi xii

List of figures List of tables List of contributors Acknowledgements 1 Introduction John W. Maxwell

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PART I THE TRADE–ENVIRONMENT DEBATE IN CONTEXT: THE US DECISION ON KYOTO 2 The Kyoto Protocol: a flawed concept Richard N. Cooper 3 You’re getting warmer: the most feasible path for addressing global climate change does run through Kyoto Jeffrey A. Frankel

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PART II TRADE AND ENVIRONMENTAL POLICIES 4 Trade, the harmonization of environmental policy and the subsidiarity principle Charles Perrings

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5 Trade and the environment in the perspective of EU enlargement Alexey Vikhlyaev

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6 Can environmental regulations be compatible with higher international competitiveness? Some new theoretical insights Savas Alpay

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PART III

Contents

ENVIRONMENTAL POLICY CONCERNS IN THE CONTEXT OF EU ENLARGEMENT

7 Environmental implications of EU enlargement: lessons from the southern member states and preliminary evidence from Poland 143 Onno J. Kuik and Frans H. Oosterhuis 8 Strategic environmental policies with foreign direct investment: implications of European enlargement M. O¨zgür Kayalica and Sajal Lahiri

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9 External actors and their prospective roles in environmental cleanup in Central and Eastern Europe Matthew R. Auer and Rafael Reuveny

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10 How can economies in transition pursue emissions trading or joint implementation? Fanny Missfeldt and Arturo Villavicenco

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PART IV ECONOMIC AND ENVIRONMENTAL POLICIES IN TRANSITION ECONOMIES 11 Energy and sustainability in Central Europe: a decade of transition in review Diana Ürge-Vorsatz, László Paizs and Radmilo Pesic 12 Reorganization of environmental policy in Russia: the decade of success and failures in implementation and prospective quests Vladimir Kotov and Elena Nikitina

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13 Policy in transition: a new framework for Russia’s climate policy 293 Vladimir Kotov Index

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Figures 7.1 Indices of economic activity and emissions in Poland 9.1 Twenty largest point sources of arsenic pollution in the Czech Republic, 1993–97 9.2 Standardized mortality due to malignant neoplasm in the Czech Republic, 1996–99 average 9.3 Long-term unemployment as a percentage of total unemployment in the Czech Republic (31 December 2000) 9.4 Average monthly gross wages (kroons) in Ida-Viru County versus all Estonian counties

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191 192 193 195

10.1 Carbon intensities in EITs in 1999 10.2 Public versus private perspectives on CO2 reduction costs

214 218

11.1 Per capita SO2 emissions in selected countries, 1989 11.2 CO2 emissions per unit of economic output in selected countries and OECD, 1980, 1989 and 1999 11.3 Per capita primary energy supply in selected countries and country groups, 1989 11.4 Energy intensities in selected countries and country groups, 1989 11.5 The development of electricity prices for industry in selected countries and OECD, 1990–2000 11.6 The development of electricity prices for households in selected countries and OECD, 1990–2000 11.7 GDP of Hungary, Poland, the Czech Republic and Russia 11.8 The development of primary energy supply in selected CEE countries, 1985–98, as a percentage of 1989 values 11.9 TPES per capita in selected countries and country groups 1989–98 11.10 The development of electricity consumption in selected CEE countries, 1985–99 11.11 Index of industrial production in selected CEE countries 11.12 The development of energy intensities in CEE countries, 1989–98

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230 231 232 243 244 245 246 247 247 248 250

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Figures

11.13 The development of energy intensities in selected countries and other country groups, 1983–97 11.14 The development of energy intensities in selected countries and OECD, 1983–99 11.15 Development of the structure of TPES in Poland, 1988–99 12.1 New Russian environmental facilities, 1976–2000 12.2 Sources of capital investments in environmental protection and natural resources conservation in Russia, 2000 (%)

251 251 255 283 285

Tables 7.1 Macroeconomic and environmental indicators for southern accession countries in 1975 and ACs in 1990, in relation to the EC-9 and EU-12, respectively 7.2 Growth of Greek agricultural activity by enterprise prior and post accession 7.3 Annual GDP growth (%) in Greece, Portugal, Spain and the EC in constant 1990 prices 7.4 Revealed comparative advantages by sector, 1997 7.5 Foreign direct investment in Cohesion countries, 1987–96 7.6 Growth of the economy and environmental pressures in Spain, 1985–93 7.7 GDP per capita and regional disparities, purchasing power standards (EU-15=100) 7.8 Share of main sectors in value added and employment in Poland and the EU-15 7.9 Selected environmental indicators for Poland and the EU-15 7.10 Composition of household consumption by major spending categories (as % of total household expenditure), 1997 9.1 Environmental characterization of FDI inflows to CEE in 1997 and 1998 (%) 9.2 Rate of increase in unemployment in fourth quarter 2000 versus November 1997 across Polish Voivodships 10.1 Fulfilment of eligibility requirements for the Kyoto Mechanisms 10.2 Quantifying ‘hot air’ 11.1 Policy agenda to reduce high energy intensities and unsustainable energy practices in CEE 11.2 The status of the implementation of the policy agenda outlined in Table 11.1 in the three CEE countries discussed 12.1 Dynamics of environmental indicators and GNP in Russia 12.2 Dynamics in greenhouse gas emissions in Russia ix

147 150 151 152 153 155 156 158 159 161

186 196

210 213

239 257 271 272

Contributors Savas Alpay, TOBB Economy and Technology University, Turkey Matthew R. Auer, Indiana University, USA Richard N. Cooper, Harvard University, USA Jeffrey A. Frankel, Harvard University, USA ¨ zgür Kayalica, Sakarya University, Turkey M. O Vladimir Kotov, Russian Academy of Sciences, Russian Federation Onno J. Kuik, Vrije Universiteit, The Netherlands Sajal Lahiri, University of Essex, UK John W. Maxwell, Indiana University, USA and ZEI, Germany Fanny Missfeldt, Risø National Laboratory, Denmark Elena Nikitina, Russian Academy of Sciences, Russian Federation Frans H. Oosterhuis, Vrije Universiteit, The Netherlands László Paizs, Central European University, Hungary Charles Perrings, University of York, UK Radmilo Pesic, Belgrade University, Serbia Rafael Reuveny, Indiana University, USA Diana Ürge-Vorsatz, Central European University, Hungary Alexey Vikhlyaev, UNCTAD, Switzerland Arturo Villavicenco, Risø National Laboratory, Denmark

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Acknowledgements We would like to thank FEEM, Milan and ZEI, University of Bonn for financially supporting the two workshops that led to this volume. We thank Marialuisa Tamborra for ogranizing these two workshops and for her early efforts in developing this volume. We also thank the following individuals for their copy-editing assistance: Andrea Burtaski, Clara Cao, Dong Chen, Susan Chen, Keith Larsen, and Jing Li. We especially thank Luisa Rovetta for her administrative assistance.

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Introduction John W. Maxwell

The discovery of the ozone hole over Antarctica in 1982 and its subsequent connection to the production and use of Chlorofluorocarbons (CFCs) represented an important link between industrialization and its impact on the global environment. Today, the debate over how best to manage the interplay between trade, industrialization and their impacts on our global environment (known as the trade–environment debate) is commonplace in the academic and popular press. Much of this debate has been concerned with the scientific evidence on the impact of industrialization on the environment, the economic evidence concerning the creation of wealth and its impact on the demand for a cleaner environment, and the ethics concerning how burdens should be shared by industrialized and developing nations. Given the multiplicity of issues and perspectives, this debate could be endless. The 1997 Kyoto Protocol has brought some immediacy to the trade– environment debate. The Protocol, concerning the reduction of greenhouse gas emissions, placed in a specific context all of the issues of the general debate. The European Union nations became the chief advocates of the Protocol, while the United States, under the administration of George W. Bush, became its chief opponent. A sufficient number of nations have pledged to ratify the proposal, and a number of nations are presently debating ratification. Even if the protocol fails the ratification stage, it is unlikely that the European Union will abandon its greenhouse gas emission reduction targets.1 Thus, the situation now faced by the European Union (EU) provides us with a concrete example of how policy must be developed in order to constrain the impact of industrial production on the natural environment while at the same time ensuring acceptable rates of economic growth. Indeed, in the context of the trade–environment debate, the European Union provides us with a microcosm of the world. With the accession of Central and Eastern European (CEE) countries to the EU, the union now contains both developed and industrializing nations. As such, EU policy must adapt to the different realities of these two types of economies.

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In the initial phases of the Protocol, the EU might benefit from their industrializing members. The collapse of the Soviet Union, and the subsequent collapse of CEE economies, means that those economies are likely to produce fewer emissions than their targeted levels. This should ease the burden on the developed EU economies, which are already exceeding their targeted emissions levels. The Protocol, however, is simply an initial step in achieving what scientists argue are required emissions reductions. Consequently, the pressures of rapid economic development and continued development of large economies, in the face of a goal to reduce their environmental footprints, must be met by EU policy. This volume contains a series of essays that deal with numerous issues in the trade–environment debate, with a particular focus on EU enlargement. Two non-EU-based perspectives, American and Russian, are included as well. The papers in this volume have been selected from several papers presented at the Fondazione Eni Enrico Mattei (FEEM) in Milan, Italy in the summer of 2002 in two workshops on Trade, the Environment and Carbon Flows in Europe. The sessions, co-sponsored by FEEM and the Centre for European Integration Studies (ZEI) in Bonn, Germany, produced lively debates and important feedback for the presenters. The papers selected for this volume have been revised and updated so as to incorporate this feedback and incorporate present policy conditions. The book begins with articles from two prominent American scholars who present each side of the debate over the Kyoto Protocol. With this debate firmly in mind we turn, in Part II, to a review of the broader trade–environment debate by undertaking a critical analysis of the interplay between current World Trade Organization (WTO) and EU economic policies and how those strategies conflict with courses of action aimed at environmental protection. In Part III we focus on the economies of the EU accession countries. Several articles provide an economic and environmental history of these economies, while others provide policy suggestions regarding how EU policies and actions can best strike a balance between necessary environmental improvements while at the same time promoting trade and economic development. Part IV is devoted to three papers detailing various impacts of economic transition on environmental institutions, policies and outcomes of CEE nations and Russia. While not an EU member, Russia will play an important role vis-à-vis the EU in the area of trade and the environment. As a means of meeting its Kyoto obligations, it is likely that the EU will rely on imports of natural gas from Russia. Recent large investments from EU energy companies, most prominently BP, will help to fully develop Russia’s energy potential. In addition, the Soviet collapse has left Russia producing greenhouse gas emissions that are well below its Kyoto targets. While reliance on foreign nations to meet one’s own national Kyoto obligations,

Introduction

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through the use of, say, tradable emissions credits, is less popular in the EU than with other large greenhouse gas emitting nations (such as the US, Canada, Australia and Japan), reliance on Russia’s ‘emissions gap’ may grow in popularity if internal solutions fail and if targets become more stringent. The final paper in this volume, however, offers a warning in this regard. In Russia the financial attractiveness of the Protocol is fading, and with it the chances of ratification. Finally, the precarious state of Russia’s environment is of great importance to the EU as Russia is now a neighbouring country. This fact is illustrated by the general unease within the EU at suggestions that Russia may engage in the development of nuclear power generating facilities along its western boarder in order to free up natural gas reserves for sale to EU nations.

THE TRADE–ENVIRONMENT DEBATE IN CONTEXT: THE US DECISION ON KYOTO The first two chapters in this volume provide different American perspectives on the US government’s decision not to support the Kyoto Protocol. The chapters are included in this volume since they help to illustrate, in context, the broader debates over the science and economics of environmental policy and its interplay with economic development. In his chapter, Richard N. Cooper outlines the case against the Kyoto Protocol. After stating that the Bush administration’s decision not to participate in the Protocol was unnecessarily vague, he goes on to argue that failure of the Protocol would constitute no great loss for society. In short, Cooper argues that the Protocol is flawed in several aspects, including its limitation on participants, its vagueness concerning the means by which nations should achieve their goals, and the fact that the Protocol’s design delivers short-term political costs with gains occurring only over the longer term. Cooper begins his condemnation of the Protocol by noting that the problem of global warming is, as its name suggests, global in scope. He argues that the problem must be tackled globally, and is particularly critical of the exemption of larger developing countries such as China and India from the Protocol. He argues that in its present form the Protocol is weak and unlikely to contribute significantly to solving the global warming problem. Next, he argues that at the time of the supposed entry of developing nations into the Protocol, they will surely demand further concessions, further weakening it. The vague nature of the Protocol is noted in relation to supposed markets for tradable emissions permits. At present it is unclear who the

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participants in these markets will be. Will they be national governments or the multitude of firms residing in the nations that sign the Protocol? If it is the latter, how will trade between firms be monitored and required emissions reductions be appropriately enforced? The imposition of a trading system also brings to light problems with excluding some nations from the Protocol. It may be the case that trade involving firms residing in nations that are non-signatories is the most efficient course to achieve greenhouse gas emissions reductions. Other problems associated with any possible trading system include how to deal with firms that have been grandfathered into the system and then go bankrupt. Cooper closes by suggesting the alternative approach of having nations commit to actions rather than targets. In particular, he suggests a universal agreement to impose a carbon tax. Although nations may face differing degrees of opposition to such a tax, Cooper argues that taxes carry the political benefit of generating short-term gains for governments in the form of general revenues. The idea of a common carbon tax could then be extended to other greenhouse gasses such as methane. Finally, Cooper notes that in light of the fact that some nations may fail to pass taxes on greenhouse gasses, all nations should position themselves for adaptation to climate change in the event that the world fails to coordinate sufficient actions to avoid impending global warming. Jeffrey A. Frankel defends the Clinton administration’s version of the Kyoto Protocol in dealing with global warming through his own experiences as a member of President Clinton’s Council of Economic Advisers on global climate change. He starts with the scientific evidence (for example, the IPCC report) showing that the Earth is getting warmer, and argues that the approach to addressing global climate change must be multilateral due to the free-rider problem. Frankel then reviews the specific US principles upon which the Clinton administration’s proposal presented at the third conference of the UN Framework Convention on Climate Change (UNFCCC) in 1997 in Kyoto were based. First, he believes that the traditional cost–benefit methods such as Integrated Assessment Models and Business as Usual path were constrained in the Kyoto Protocol application, because of tremendous uncertainties involved in any model and difficulty in assigning probabilities on catastrophic scenarios. The economists at the Council of Economic Advisers used estimates by Alan Manne and Rich Richels and found that the most efficient paths involved heavy cuts below current levels of emission only in the second half of the 21st century. Second, Frankel notes the importance of the political environment in which the Kyoto Protocol was set up. Any US policy to address climate change has to contend with four political chasms: (1) the gap between

Introduction

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environmentalists and the Congress in understanding the climate change issue and willingness to bear some economic costs to address it; (2) the gap between the US and the European Union; (3) the gap between the US and developing countries; and (4) the chasm between engineers and economists. Third, Frankel emphasizes the flexibility mechanisms embedded in the Kyoto Protocol, namely, ‘when flexibility’, ‘what flexibility’ and ‘where flexibility’. ‘When flexibility’ refers to the fact that countries are allowed to average over the five years of the budget window (2008–12) and to bank any reductions beyond the target for future budget periods. ‘What flexibility’ implies that individual numerical targets for six different gases were replaced by a numerical target of a linear combination of the six. ‘Where flexibility’ is the most contentious issue. It loosened the constraint regarding within whose borders physical reductions in emissions occurred. Specifically, it allowed international trading of emission permits, and includes developing countries. Fourth, Frankel explains the Council of Economic Advisors (CEA) estimates of the economic costs of the policy to show the legitimacy of allowing the international trading of emission permits. Lastly, he explains why the Kyoto Protocol set quantitative targets rather than relying on the price mechanism: the price mechanism is not politically feasible.

TRADE AND ENVIRONMENT POLICIES Part II contains three chapters. The first two chapters offer overviews of the interplay between supranational policies governing international trade, and supra- and subnational policies governing environmental protection. The final chapter offer theoretical investigations of this policy interplay. Charles Perrings examines the linkage between trade and environmental policies, and the role of harmonization of environmental policy. From the discussion, useful implications about trade and environmental policies in the enlarged EU and WTO are provided. Perrings first reviews the literature on the linkage between trade and environment. In particular, the author discusses a strand of literature which explores the impact of trade liberalization on the environment. The common view is that as a result of the composition effect, liberalization of global markets is environment-improving. The counter-argument, that liberalization increases environmental damage, is also presented. Perrings claims that the impact of trade liberalization is an empirical question, and that it depends on people’s preferences between environmental quality and consumption possibilities.

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Perrings then considers the importance of country differences. Differences in economic structures, income levels, labour market conditions, technological development and environmental resource endowments create an incentive to negotiate the linkage between environmental institutions and trade pacts, given that environmental policy may be used as a surrogate for trade policy in place of subsidies or tariffs. Next, the discussion focuses on issues related to coordination, harmonization and subsidiarity within the EU. In particular, the characteristics of the Sanitary and Phyto-Sanitary Measure (SPS) and Article XX measures associated with trade pacts are considered. Perrings indicates that harmonization of environmental policy is driven by a trade agenda, and that it will be inefficient if environmental conditions and preferences are different between different locations. Harmonization also tends to be incompatible with the subsidiarity principle. Coordination of policy, instead of harmonization, is needed in the above setting. The above arguments are illustrated by a particular problem, the problem of invasive alien species (IAS). Perrings uses the specific case of foot-andmouth disease (FMD) to extend the discussion on the linkage between trade and environmental policy. The chapter concludes that it is inappropriate for environmental policy to be driven by trade policy. Harmonization induces an inefficient and environmentally inappropriate use of local resources in that it ignores local conditions and local preferences. Perrings claims that it would be a mistake, for both economy and the environment, to apply harmonization to countries with very different socio-economic and environmental conditions across the enlarged EU. In Chapter 5, Alexey Vikhlyaev examines how various trade measures relate to domestic health, safety and environmental protection policies in the context of a multilateral trading system and regional integration arrangements. Based on the discussion, he provides valuable recommendations for policy makers. First, he reviews broad issues concerning trade measures for environmental purposes in the WTO and EU. In general, not only do international instruments address risk, lack of certainty and action, but also regional integration agreements incorporate the notion of precaution in situations of uncertainty. In detail, he reviews issues related to two core trade and environment concerns in both the WTO and the EU: (1) different balance between market access, and (2) environmental protection and regulatory tensions between jurisdictions with differing environmental standards. In particular, he focuses on domestic, extra-jurisdictional and institutional aspects of trade and the environment in the WTO and the EU.

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WTO, Article XX, the SPS and the Technical Barriers to Trade (TBT) determine the levels of domestic health, safety and environmental protection. The evolution of these three sets of rules is also discussed with applications. The discussion of extra-jurisdictional activities deals with the scope of trade measures for environmental purposes. Finally, the WTO institutions have very limited directives on domestic health, safety and environmental protection, and the relationship between the provisions of the multilateral trading system and trade measures for environmental purposes. Conflicts in the process of trade–environmental rule making between developed and developing countries are specified as well. The EU adopts similar rules to restrict imports from other member states that do not comply with domestic levels of health, safety and environmental protection. In contrast to the WTO, the EU offers upward harmonization of domestic standards at a high level of protection. The EU also goes further than the WTO on extra-territorial activities and provides a regime of minimum production process or methods standards (PPMs) and a large number of directives to address air, water, waste and chemicals. Furthermore, the absence of a unanimity requirement contributes to better environmental standards and harmonization in the EU, compared with the WTO. In conclusion Vikhlyaev argues that trade and environmental rule making is a function of economic integration that cannot succeed without each other. The comparative discussion on trade and environmental issues within the GATT/WTO and the EU indicates a rationalization of trade and environmental rule making. Savas Alpay explores the Porter hypothesis, which has not been given much credit in the academic environmental economics literature. The Porter hypothesis concerns the relationship between environmental regulations and international competitiveness of the domestic firms subject to higher environmental standards. Specifically, it argues that environmental regulation can augment regulated firms’ international competitiveness under the conditions that these firms engage in innovation and that the environmental regulation is incentive-based. This view is contrasted to the conventional one that claims stricter environmental regulations at home have an unambiguously negative effect and regulate firms’ international competitiveness. Alpay’s theoretical work is of interest because the considerable amount of empirical work in this literature has not been able to generate evidence for either of these two views. Alpay presents a two-country model which incorporates a Tradable Emissions Permit system as the environmental regulatory regime. He starts with a closed economy, where two Cournotoligopolists produce a good that causes pollution. In such a model, firms

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subject to stricter environmental regulation can offset regulatory costs through innovation and/or permit revenues by abating more and selling extra permits, conditioned on the features of the permit market, such as the price elasticity of permit demand and firms’ R&D behaviour. For example, if the permit market is sufficiently inelastic and investment in R&D results in innovation with some known probability, stricter policy may lead to increased competitiveness for the regulated firms. Alpay extends the model into the open economy case where there is a second country with two Cournot-oligopolists producing the same good. He presents the conditions for when regulation decreases international competitiveness (the conventional view) and when it does not (the Porter hypothesis). Similar to the closed economy case, the main determinants are the probability of innovation, the cost of R&D, returns to innovation and the price elasticity of permit demand.

ENVIRONMENTAL POLICY CONCERNS IN THE CONTEXT OF EU ENLARGEMENT In Part III we examine the trade–environmental debate in the context of EU enlargement with a particular emphasis on how development and environmental policies will impact economic growth and environmental conditions in CEE accession countries. Onno J. Kuik and Frans H. Oosterhuis examine how the accession of Greece, Spain and Portugal to the EU in the 1980s affected their natural environment. Their analysis helps us understand the impact of present-day eastern enlargement of the EU upon entrants’ environment, since certain economic and environmental characteristics of Greece, Spain and Portugal were comparable to these new entrants from CEE countries. In analysing the environmental dimensions of southern enlargement, Kuik and Oosterhuis focus on the impact of the economic changes that took place in Greece, Spain and Portugal after their accession to the EU. Specifically, the authors analyse the changes in foreign trade, the composition of agricultural production, the share of agriculture in GDP and employment, and foreign direct investment. The authors use the framework often used in studies of the impacts of trade liberalization on the environment and decompose the environmental effects into scale, composition and technique effects. The authors find, first, that the opening-up of trade raised the levels of economic activity in these countries, which led to growth in transport and air pollution. Second, trade liberalization affected the relative prices of final and intermediate goods in different sectors to such an extent that capital and labour may

Introduction

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be induced to shift between sectors, thereby affecting the structure or composition of industry within these countries. Moreover, rising incomes and more consumption goods from the EU have affected the spending patterns of households in these countries. Finally, trade liberalization influenced production methods. All three countries exhibited improvements in the technical aspects of production and consumption due to the application of EU policies and standards, and these countries’ autonomous modernization of products and technologies. As a check of the validity of their analysis to Central and Eastern European countries, the authors also present evidence concerning the environmental impact of Poland’s process towards accession. The analysis of environmental changes during the accession process is also taken up by M. Özgür Kayalica and Sajal Lahiri. The question these authors consider is whether easier access to EU markets actually helps bring environmental policies closer to each other. To answer this question, the authors develop a Cournot Oligopoly model, where a number of identical foreign firms located in a host country compete with a domestic firm for the market of a homogeneous product in a consuming country. According to the model, the host country represents a candidate for EU membership and the consuming country is viewed as the EU. Pollution is created as a by-product of production in both countries. Pollution from the host country is also transmitted across the border to the consuming country as a spillover. For simplicity, the model only considers an emission standard in the form of a maximum amount of pollution that a firm is allowed to emit per unit of its output. The consuming country charges a tariff for each unit of imported good produced in the host country. Both countries set their own emission standards to maximize their respective welfare. The firms maximize their profit net of production cost, pollution abatement payment and tariff. In the benchmark model, the number of foreign firms in the host country is exogenous. Unemployment in the host country is assumed, and the host country benefits from FDI only through the employment generated by foreign firms. The analysis of the optimization problem shows the following. A larger market implies a stricter emission standard by the government of the host country. The same is true in the consuming country if the marginal disutility from pollution is significantly greater than the unit abatement cost in that country. A reduction in the tariff leads to a stricter emission standard in the host country. The same is true in the consuming country if the spillover parameter for cross-border pollution is sufficiently large. Compared to the non-cooperative equilibrium, a small uniform reduction in the emission standards in the two countries makes the host country unambiguously better off. The same is true for the consuming

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country if the marginal disutility of pollution there is sufficiently high. With free entry and exit of foreign direct investment (FDI) captured by allowing the number of foreign firms to be endogenous, similar results to those from the benchmark model are obtained. Matthew R. Auer and Rafael Reuveny examine the issue of where foreign financial aid to accession countries should best be directed. The authors contend that external public sector actors, such as international financial institutions and the EU, need to shift attention and financial aid from preventing prospective pollution to cleaning up past pollution in Central and Eastern Europe. The authors begin by describing the patterns of FDI inflows to CEE countries. These inflows grew steadily in the 1990s, but only 15 per cent of them were directed to pollution-prone industries, much less than the more than 30 per cent share in industrializing Asian countries. Next they summarize the costs and benefits of FDI in general and in the context of CEE. The authors note that FDI has failed to promote environmental quality in CEE as expected; a large fraction of FDI went to greenfield investments, partly because of investors’ concerns about liability for past pollution. In response to the liability concern, the CEE governments established generous liability schemes as incentives to reassure investors. But this led to various problems and failed to accelerate FDI inflows to pollution-prone industries and areas. The authors thus argue that liability schemes were not sufficient to reactivate the brownfields in CEE. Why? The authors contend that enduring economic problems and persistent environmental ills occur in concert in CEE. Thus economically and environmentally poisoned areas of CEE are distinctly disadvantaged and deserve attention from external actors. The authors thus suggest that multi-faceted western-style brownfield revitalization programs be adapted to solve the above problems in CEE. It is noted, however, because of financial constraints, that CEE governments will not be able to exactly copy the Western counterparts to play a major role in paying for cleanup. In this case, external actors, such as private investors, bilateral aid agencies and international financial institutions, are the most promising sources of financing for brownfield revitalization. The authors propose a prospective plan to revitalize depressed sub-regions of CEE, and explain why and how the four external public actors, that is, the International Finance Corporation (IFC), the European Bank for Reconstruction and Development (EBRD), the Instrument for Structural Policies for Pre-accession (IPSA), and the Objective 1 funds at EU, can help expedite cleanup of past pollution in CEE. The main thrust of their arguments is that funds from these sources, and others, should be directed more to cleanup of past pollution instead of prevention of future pollution in CEE.

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Chapter 10 examines the allocation of FDI via joint implementation projects under the Kyoto Protocol and the role that they could play in improving the environment of transition economies. The sale of tradable emissions permits by these economies is also examined. Under the Kyoto Protocol, economies in transition are eligible for both emission trading and joint implementation. It is expected that these countries may benefit substantially from those mechanisms if they are implemented appropriately. These benefits include additional revenue, project finance, knowledge and technology transfer, and synergies with existing policies. Fanny Missfeldt and Arturo Villavicenco suggest that a key criterion on whether a country should undertake emission trading is the comparison of their projected emissions up to 2012 with their targets under the Kyoto Protocol. Only if there exists a sufficiently wide gap between the projections and the target should the country undertake emissions trading mainly because of the high level of uncertainty in the economic development in transition economies. The prospect for financial gain from emission trading for transition economies became less encouraging with the departure of the US, the largest potential buyer of emission permits, from the agreement. To increase revenue, it is suggested that transitional economies reserve their emissions quota until the second commitment period rather than selling quota at a low price in the first period. The authors argue that for successful joint implementation projects, the domestic investment climate and the emission reduction potential of specific projects are of particular importance. A country’s investment climate is reflected in the general performance of the economy and also the enforcement of business laws, and so on. It is suggested that setting up a clear institutional structure is important for the success of joint implementation. Specifically, an organization solely in charge of joint implementation is necessary.

ECONOMIC AND ENVIRONMENTAL POLICIES IN TRANSITION ECONOMIES In Part IV three chapters provide us with an inside look at economic transition and its impact on the national environments and environmental policy institutions of CEE countries and Russia. In chapter 11 Diana ÜrgeVorsatz, László Paizs and Radmilo Pesic note that post-communist countries and CEE countries have some of the most obsolete, polluting, economically and environmentally inefficient energy industries in the world. The purpose of their chapter is to review the progress that has been achieved in selected CEE countries’ energy sectors during the 1990s and to

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develop a policy agenda aimed at establishing a sustainable restructuring of the energy sector in these countries. The authors describe the major characteristics of the national energy sectors in CEE in the post-communist era. Key features include: energy intensities, wasteful production and use of energy, and high environmental emissions. The authors believe that the key to a more sustainable energy sector in CEE is the reduction of the high energy intensities by restructuring the sector. They go on to identify the weak points of the centrally planned economy that led to intensive energy usage. These include: no reward for efficiency, no penalty for inefficiency, highly subsidized energy prices, flat rates independent of actual energy consumption, and dominance of heavy industries in the economic structure. The authors also note several aspects of the centrally planned economy that can be viewed as environmental strong points, such as efficient public transport, the high share of district heating and high levels of reuse and recycling, and argue that these should be preserved. Based on these observations, the authors develop a concrete policy agenda aimed chiefly at a reduction in the intensity of energy usage. The authors then summarize the progress that has been made over the first decade of transitions, using the electricity industries in Hungary, Poland and the Czech Republic as examples and Russia as a contrast. Their analysis concludes that, overall, there is no significant improvement in the energy efficiency gap between the EU and CEE. It is shown that Poland has achieved the most significant progress in energy efficiency among the above four countries, while the energy efficiency gap between the EU and Russia has only broadened. The authors demonstrate that, although economic reforms and energy sector restructuring are keys to the improvement of energy intensities, they are not sufficient alone. Other reasons, such as the understatement of previous energy intensities data and a gradual change in consumer behaviour and technical organization, explain the lack of progress. The authors argue that in order to reach the levels of energy efficiency in the current EU, CEE countries need to consistently implement energy efficiency policies and establish or reinforce the relevant institutional and educational reforms. The ideal timing for pursuing these reforms is the beginning of the transition process. In conclusion, the authors note that even if the most radical policy, legislative and institutional reforms, are implemented, it will still take time for the energy efficiency gap to close. In Chapter 12 Vladimir Kotov and Elena Nikitina provide us with a history of the economic and environmental changes that have been undertaken in Russia since the early 1990s. Since then Russia has seen a series of changes in its environmental policies. These include the adoption

Introduction

13

of new environmental legislation, the creation of domestic environmental management systems, the decentralization of environmental management with the transfer of authority from the central government to the regional level, the introduction of economic mechanisms as a tool of environmental management, and participation in international environmental agreements. These new policies defined a framework to address the environmental degradation that was largely inherited from the Soviet period of extensive and unsustainable use of the environment. The authors note, however, that the implementation of these policies was not successful. Several factors are identified as barriers to new policy implementation. First, due to institutional reorganization, Russia’s environmental agencies were gradually degraded to a weak position in the Russian power structure. This led to poor enforcement of environmental legislation, difficulty in acquiring funds and the subjugation of environmental concerns in the face of economic objectives. Second, the decentralization of environmental management caused overlaps of control and power at the federal and regional levels, which led to a state of confusion over enforcement obligations. Third, serious misapplication of economic mechanisms occurred. In particular, pollution taxes were not set at appropriate levels and their collection was often poorly enforced because of the pressure from economic development. Hence, these taxes failed to provide the polluting firms with the right incentive to invest in environmentally efficient technologies. Fourth, the general lack of funding severely affected the capability of environmental agencies to carrying out their programs. Major reasons leading to the under-financing of environmental programs include the economic crisis that Russia experienced in the 1990s and the utilization of environmental funds for other purposes by local administrations. The authors conclude with the observation that the main lesson learned from Russia’s experience in the 1990s is that the success or failure of environmental policies depends not only on the design of the policies as such, but also on the domestic economic and political institutions. In the final chapter of this volume Vladimir Kotov discusses the present state of Russia’s climate policy. Russia’s climate policy was formed in the 1990s during the period of economic transition. This fact has impacted some of the basic characteristics of Russia’s climate policy as well as its evolution. Kotov notes that Russia’s climate policy is currently going through some fundamental institutional changes. The organization in charge of Russia’s climate policy, The Interdepartmental Commission on Climate Change (ICC), is undergoing a transition of its basic functions and method of management. Due to Russia’s transition to a market economy, the old methods

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that ICC used (based on a planned economy) were no longer appropriate and new methods had to be developed. Corresponding to ICC’s low position in the Russian national power hierarchy, the legal support that is essential for the implementation of climate policy is still absent. While the emission trading promised by the Kyoto Protocol has turned Russia’s climate policy into a potentially huge business, the institutional capacity building has been delayed partially due to the lack of a balance in interests between different agencies for the control of future climate business. Due to the prolonged recession, economic development has become the Russian government’s number one priority in its political agenda. As a consequence, climate policy is subordinate to the policy of economic growth. As such, Russian climate policy is determined by economic goals, rather than environmental constraints. The main parameters determining the greenhouse gas emissions in Russia are largely beyond the control of Russia’s climate policy institutions. Instead, they are under direct control of the institutions controlling Russia’s economic growth policy and its energy policy. These institutions are also undergoing a great deal of change. With this institutional backdrop in mind, Kotov speculates on the likelihood of passage of the Kyoto Protocol by the Russian government. He is sceptical for two main reasons. First, the absence of the United States has considerably diminished the economic attractiveness of the Protocol for Russia. This attractiveness is being driven mainly by the sale of emissions rights to US companies or the US government. Second, the increase in Russia’s rate of economic growth has brought with it more industrial and consumer-driven pollution. As such, the amount of pollution rights at Russia’s disposal for sale has diminished, further reducing the economic attractiveness of the protocol.

NOTE 1. Indeed, even in the United States, the main non-signatory, major corporations are in the process of documenting their reductions in greenhouse gas emissions so as to obtain early reduction credits should laws mandating emissions reduction be passed.

PART I

The Trade–Environment Debate in Context: The US Decision on Kyoto

2.

The Kyoto Protocol: a flawed concept Richard N. Cooper

In 2001 the Intergovernmental Panel on Climate Change (IPCC) issued its Third Assessment Report on the prospects for and likely impact of increases in global average temperature over the next century. The summary report of Working Group 1 (WG 1), on science, widened the range of likely temperature increase, compared with the IPCC’s Second Assessment Report five years earlier, to 1.4–5.8 degrees centigrade, with the increase in the upper end of the range receiving wide public attention. The summary report of Working Group 2, on impacts, sketched a somber picture of how both human settlements and non-human ecologies might be adversely affected by the rise in temperature and an accompanying rise in sea level. A close reading of the WG 1 Report, however, reveals that the wider range, and in particular the increase in the upper end of the range, was not at all due to a reassessment of the scientific evidence accumulated and closely studied since the mid-1990s. Rather, it was due to a change in the way that emissions over the next century of greenhouse gases (GHG), mainly carbon dioxide (CO2) from fossil fuel consumption and deforestation, and methane (CH4) from agriculture and waste disposal, were characterized. Instead of the single ‘business as usual’ emissions trajectory used in the Second Assessment Report (SAR), the Third Assessment Report (TAR) produces six different scenarios, depending on the evolution both of the world economy and of its energy system over the next 100 years. This refinement is in some respects an improvement over the single assumed trajectory, but to present the outlook as likely more serious than the previous assessment is, to say the least, misleading. The judgment about the likely temperature effect of a given GHG ‘forcing’ was actually narrowed modestly in the Third Assessment Report, not widened. Shortly after the release of the latest IPCC summaries, but presumably not because of them, newly elected President Bush of the United States

17

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The trade–environment debate in context

announced, in an especially clumsy way, that his Administration would not support the Kyoto Protocol to the Framework Convention on Climate Change (FCCC) adopted in 1992. The Kyoto Protocol, negotiated in late 1997, established emissions ceilings on six specified greenhouse gases for 38 countries, with the 15 members of the European Union treated as a single unit, to be reached on average in the five-year accounting period 2008–12. It is not yet in force, in that the requisite countries (55, covering at least 55 per cent of the established ceilings) have not yet ratified it. But it established a specific framework and timetable for the countries covered (those listed in Annex B) to reduce their GHG emissions. The Protocol contained a number of other features, such as possibilities for emissions trading, cooperation across national boundaries in emissions reduction, and sequestration of GHG in ‘sinks’, some of which will be described further below. But it lacked many operational details, which were left to be worked out following Kyoto, and over which there was still substantial disagreement at a follow-up conference in the Hague in November 2000, three years after Kyoto. President Bush gave as his reason for dropping Kyoto that achieving the targets would be too costly to the American economy, and to American workers, without elaboration or analysis. He left entirely open how his administration would approach the problem of global climate change, or indeed whether it considered this to be a problem that needed to be addressed. Bush’s rejection of Kyoto caught off guard both foreign governments and American environmentalists, including some of his own senior officials, since when campaigning for the presidency he had signaled his concern with global climate change and his commitment to limiting emissions of CO2. However, for reasons I hope to make clear, dropping the Kyoto Protocol represents no great loss to the international community, since it is fatally flawed as an instrument to deal substantively (as distinguished from symbolically) with the potential problem of global climate change. The faster this is recognized, the better, so work can begin on alternative, prospectively more successful, approaches. The chapter is organized as follows: the next section analyzes the basic structure of the task of mitigating global warming. The following section evaluates the Kyoto Protocol in terms of the structural issues. Then comes a section on the advantages of permit trading, combined with the conditions that must be met to achieve it. This is followed by sections on an alternative approach to that embodied in the Kyoto agreement, and on contingency plans for action in case the international community discovers that it has moved far too slowly to deal with climate change. A final section offers brief conclusions.

The Kyoto Protocol

19

STRUCTURE OF THE PROBLEM Concerns about global climate change have led to pleas and indeed to some national commitments to slow or reverse the growth of greenhouse gas emissions. It is useful to identify the structural characteristics involved in attempting to mitigate global warming through formal collective action. There are three key features. First, climate change brought about through an increased atmospheric concentration of greenhouse gases is a global issue, since whatever their earthly origin the gases are widely dispersed in the upper atmosphere, and CO2 is long-lived. Effective restraint must therefore involve all (actual and prospective) major emitters of greenhouse gases. The rich industrialized countries account for most of the emissions today, but the Soviet Union was a major contributor before its dissolution and economic collapse in 1991, and with economic growth its successors can be expected again to become a major source. Rapidly growing developing countries will become major contributors within a time frame that is relevant for managing the issue. Second, the rewards from restraints on greenhouse gas emissions will come in the (politically) distant future, while the costs will occur in the political present. Moreover, the rewards are highly uncertain. Much controversy still surrounds the expected impact of further greenhouse gas emission on the earth’s ecological system, and in particular on conditions of habitability for humans. The residents of some of today’s states, for example, Canada, Russia, and perhaps the United States, may even expect to benefit from moderate climate change. It will thus be difficult to persuade publics that they should make sacrifices in living standards in the near future for the sake of uncertain gains to their grandchildren and greatgrandchildren, much less for the grandchildren of people living at remote distance. The wide distribution of expected but distant benefits in response to collective action today provides an incentive for every country to encourage all to act, but then to avoid acting itself – the so-called free-rider problem. Third, the pervasive sources of greenhouse gas emissions – notably use of fossil fuels, rice cultivation and raising cattle – imply that restraint will involve changes in behavior by hundreds of millions if not billions of people, and not merely restraints by 180 or fewer governments, as in the typical treaty. Thus the most important part of an effective regime to limit climate change involves not the relationships among states, but the effective influence of governments on the behavior of their domestic publics. Moreover, the pervasive sources of CO2 and methane are at the heart of modern economies, which depend intimately on productive agriculture and on non-animate sources of energy.

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No major legally binding regulatory treaty involves all of these characteristics to the same degree. Typically either governments themselves, or a few firms in a handful of countries, as in the cases of halting nuclear testing or limiting production of CFCs are the major actors. These three structural factors make collective decisions regarding actions to mitigate global climate change exceptionally difficult. The benefits of mitigation actions encompass the adverse impacts of climate change that are thus avoided. Serious mitigation necessarily involves major reductions in the actual and prospective consumption of energy based on fossil fuels (especially coal-fired electricity generation and use of oil products for heat and motive transportation). Since such consumption is at the very heart of modern industrialized economies, the costs of mitigation are both the economic and the psychological adjustments that must be made to move away from current energy systems; and, secondarily, the adjustments that must be made to move away from wet rice and cattle production, the main man-made sources of methane (in addition to methane leaks from gas and oil refining and distribution systems). Moreover, the likelihood that the distribution of costs and benefits will be greatly uneven across nations complicates further the task of reaching international agreement.

EVALUATION OF KYOTO The emissions targets of the Kyoto Protocol, as noted above, cover only 23 countries, plus the 15 members of the European Union taken together. These countries in 1996 accounted for nearly 64 per cent of world emissions of carbon dioxide, leaving over one-third uncovered.1 Moreover, the uncovered portion is expected to grow more rapidly in the coming decades than the covered portion. By 2010 developing countries are expected to contribute 45 per cent of total greenhouse gas emissions, and China and India together will experience greater growth in emissions than all OECD countries combined. China alone in 1996 accounted for over 13 per cent of CO2 emissions, second after the United States, and on plausible projections for the two economies can be expected to reach US emissions in 2013, with no allowance for US compliance with the Kyoto Protocol; sooner if the US attempts to comply. The rest of Asia (minus Japan) exceeded China in emissions; Latin America and Africa, taken together, emitted about half as much as China. Thus effective action cannot be taken by a small group of countries alone, as was possible for example with agreement to cease atmospheric testing of nuclear weapons. Here, while the same requirements need not be imposed

The Kyoto Protocol

21

on all countries from the beginning, the agreement needs to be structured so that all countries will eventually participate. On one estimate, for example, full implementation of the Kyoto Protocol and continuation at the prescribed lower emission levels of Annex B countries would, on IPCC SAR (1996) main assumptions, reduce the increase in average global surface temperature in 2050 by approximately 0.05 °C, from an increase of 1.4 to 1.35.2 It was such considerations that led the US Senate, which must ratify treaties for the United States by a vote of two-thirds, to insist before the conference at Kyoto, by a vote of 95–0, that there must be ‘meaningful participation’ by developing countries in any treaty to limit GHG emissions. Lack of comprehensive coverage creates another potential problem: economic activities might re-locate from countries with GHG emission ceilings to countries without ceilings. Through such ‘leakage’ even the impact on GHG concentrations of effective action by the Annex B countries would be reduced. Apart from weakening the effectiveness of the Kyoto agreement on climate change, such leakage would also involve costly adjustments by workers, firms and towns that would be brought about not by changes in economic efficiency, but by a regulatory system with incomplete coverage. Proponents of the Kyoto Protocol would not deny the fundamental point that key developing countries must eventually participate. They would argue, however, that someone must start the process, and it is natural that the world’s richest and most heavily emitting countries do so. Kyoto is only a first step toward a serious approach to the problem. If Kyoto is acknowledged to be only a first step, we must anticipate what the next step might be. For those covered in Annex B, the natural next step is to lower the emissions ceilings now set for 2012, to achieve, for example, 80 per cent of 1990 emissions by 2022. But if the Kyoto targets are reached, developing countries as a group (those not covered by Annex B) on plausible assumptions will have CO2 emissions equal to those of the Annex B countries by 2013, while continuing to grow. How are these countries to be brought into the Kyoto framework, as they must be if climate change is to be avoided? The answer, in brief, is that they cannot be brought into the Kyoto framework without compromising its purpose. The Kyoto framework for setting national targets is base-weighted, focused on emissions in 1990. This is in fact standard practice when allocating quotas, to choose a ‘representative’ year and allocate them according to the activity of the relevant agents (for example, fishermen, banana importers) in that year. Kyoto deviated slightly from normal practice in that the target reductions are modestly differentiated among agents, ranging from 92 per cent of 1990 emissions for the European Union and some Eastern European countries to 108 per cent for Australia and 110 per cent for

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Iceland. This differentiation reflected in part special circumstances in 1990 (for example, recent unification of West Germany with the collapsed East German economy), in part different reliance on fossil fuels (for example, heavily geothermal in Iceland, which cannot easily be used for mobile transport), and in part different expected growth trajectories (for example, recovery of the collapsed Russian and Ukrainian economies). Moreover, Kyoto involved the usual political bargaining, with targets adjusted to ensure adherence of each of the Annex I countries of the 1992 FCCC. Developing countries insisted at Kyoto on their exemption from targets, as already foreshadowed in the FCCC; a provision of the Kyoto Protocol actually prohibits targets being set for developing countries. Base-weighted targets, even with some differentiation, are completely unacceptable to poor countries with high aspirations for economic development. It is well-known that modern economies rest on the consumption of much energy, and in practice most of this energy is provided by fossil fuels. Even major sources of non-fossil fuel energy, such as hydro and nuclear generation of electricity, have become controversial, at least among some environmentalists in rich countries. Indeed, those given to conspiracy theories suggest that the modern environmental movement in Europe and America purposefully wants to keep poor countries poor – a position given credence by the apparent environmentalist opposition to all forms of inexpensive energy accessible on any scale. Developing countries insist that their first priority should be economic development. They are not against environmental improvement, and indeed some island countries are fearful of global climate change, particularly if it entails higher sea levels or more serious storms. But relative priority is accorded development, and indeed developing countries insisted that the Rio conference, which was seen by its initial supporters as a follow-on to the Stockholm conference on the environment of 1972 (which established the UN Environmental Program, UNEP), be devoted to development as well as to environment. This raises the question of whether the priorities of the developing countries can be accommodated in the next step after Kyoto. A natural way to do this would be to agree on ‘business as usual’ (BAU) emissions trajectories for each developing country, which would of course reflect the process of development with its dependence on higher energy consumption. Targets could then be defined in terms of agreed reductions from each national BAU trajectory. If the trajectories themselves adequately reflected the special circumstances of each country, the targeted reductions could even be uniform, for instance, 2 per cent a year. At Kyoto the European Union negotiated an overall target for the EU. But it faced the problem of how to allocate this target among agents within

The Kyoto Protocol

23

the EU. Instead of adopting a uniform policy for all firms within the EU, as it might have done, the EU members elected to allocate the overall EU target to member states, leaving each member state the task of achieving its target in its own way, within constraints imposed by EU policy. The result of this European negotiation was even greater differentiation than at Kyoto, with national targets ranging from 72 (Luxembourg) and 79 per cent (Denmark and Germany) to 125 (Greece) and 127 per cent (Portugal) of 1990 emissions. Again, the differentiation reflected different initial conditions and different expected growth trajectories for member states. Luxembourg steel production was already in extensive decline. Germany could accept a deep cut because of its artificially high 1990 base, including the collapsed high-energy-intensive East German economy; and Denmark wanted to demonstrate its green credentials by accepting a similarly deep cut. Acknowledgement was given to high initial reliance on nuclear power by France (no cut required) and by Sweden, which was committed to phasing out its nuclear power (a 4 per cent increase over 1990 was allowed). The poorest members of the EU – Ireland, Spain, Greece and Portugal – were all allotted generous increases in emissions over 1990 levels, of 13, 15, 25 and 27 per cent respectively, all higher than any country received at Kyoto itself. A similar negotiation at the global level, outside a common framework for discussion and deciding on economic policy, presents a mind-boggling challenge. The suggestion that uniform reduction targets from differentiated BAU trajectories be established is easy to state, hard – probably impossible – to execute, at least while preserving the ultimate objective of Kyoto, which is to forestall serious climate change by controlling GHG emissions. The problems are twofold. First, given the high priority accorded to development, developing countries will want to ensure that under no circumstances will the targets impede their development. They will insist on a generous BAU trajectory, either by pleading special circumstances or by aspiring to an ambitious rate of growth, or both. Several countries in East Asia have demonstrated an ability to grow in excess of 8 per cent a year for several decades. Many countries would like such success, even though few will achieve it. But they will certainly not agree to forego the possibility in the name of their contribution to mitigating global GHG emissions. To gain their agreement, they must be given generous BAU trajectories. Yet if all developing countries are given generous trajectories, the objective of limiting atmospheric concentration of GHGs, which is necessary to forestall serious climate change, will not be achieved. Some hypothetical but plausible numbers can be associated with the argument above. Suppose, as suggested above, emissions from developing countries equal those of Annex B countries in 2013. Suppose further that

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they insist as a condition for accepting national targets that they have growth trajectories of 8 per cent a year; and suppose that the GDP-growth elasticity of demand for primary energy is 0.75 (historically it has been closer to unity), implying an allowable growth in emissions of 6 per cent a year.3 Assume further that the Annex B countries hold to their Kyoto targets in subsequent years, that is, they continue to grow economically without any increase in GHG emissions. Under these circumstances, CO2 emissions will be 10.9 billion metric tons (bmt) a year by 2025, 83 per cent above global emissions in 1996, the year before Kyoto.4 Reduction targets could be set from this level for both Annex B and developing countries, but given their priorities developing countries are not likely to agree to severe targets – unless new technologies make possible rapid growth without GHG emissions – and political ‘equity’ will then prevent the Annex B countries from agreeing to severe targets for themselves. In short, the ultimate objective will not be achieved, either without the participation of developing countries, or with participation on such terms as are likely within the Kyoto framework. There is a second problem with the Kyoto framework. It envisages establishing a market for emission rights (more on this below), a necessary condition within the framework of national targets for reducing GHG emissions at lowest real cost. Such a market should be established and in effective operation well before 2008, the first year of the agreed five-year accounting period. Emission permits will command a value in the market, and will be traded. Firms or countries that find it more costly than the price of the permit to reduce emissions further will buy permits from other Annex B countries that have reduced their emissions below their targets. Firms or governments will plan their actions taking into account this market, and their estimates of future prices of permits. If in a post-Kyoto phase II many more countries are to be admitted to the scheme, with targets yet to be negotiated but likely to be generous, that will lower the prospective value of emission permits and discourage firms (or governments) from investing aggressively to reduce their future emissions. Firms will be discouraged from holding unused permits. Kyoto is base-weighted, as noted. But the problem of allocating valuable resources through global negotiation is a more general one. Emission rights will have value – not just hypothetical value, but an actual money value under a system of tradable permits. This value is created by virtue of placing binding limits on emissions. The value commanded will of course depend on how severe the limits are, on the real costs of reducing emissions and on any conditions imposed on the tradability of the permits. We require some principle for allocating scarce resources. Kyoto elected the principle of a historical base, but as we have seen that is unsatisfactory

The Kyoto Protocol

25

to countries with high aspirations for growth and development. In sharp contrast to reliance on recent history, some observers have suggested that simple distributive justice would require that emission rights be based on population. Such an allocation would favor heavily populated poor countries such as China, India, Indonesia, Bangladesh and Nigeria. To be meaningful in limiting climate change they would require drastic cutbacks in emissions by today’s rich countries, implying radical reductions in living conditions there if implemented quickly. Targets based on population would of course be insensitive to varying resource endowments (for example, for hydro-electric power) and to the fact that countries depend on vastly different fuel mixes as well as different levels of fuel consumption. Reductions in living standards could be mitigated, but not avoided, by the sale of unused emission rights from poor to rich countries. Trading emission rights will be discussed further below. But the financial transfers involved if emission rights were based on population would be immense relative to foreign assistance today, far more than is likely to be politically tolerable. If carbon emissions were to take a plausible value of $100 a ton, for instance, a typical American family of four would have to pay $2000 a year to sustain its current (direct and indirect) average level of emissions of about 24 tons a year, 20 tons over its per capita allocation (roughly 6 billion tons of carbon emissions a year divided by a world population of roughly 6 billion people). Total US transfers to the rest of the world would amount to $120 billion a year, roughly ten times current US foreign aid expenditures. Moreover, the transfers in practice would be made to governments, not individuals, despite the underlying moral rationale for basing targets on population, and many these days would question the desirability of transferring large sums to governments whose responsiveness to the needs of their own citizens has been indifferent or worse (think of contemporary Iraq or Burma). A natural compromise has been suggested: base the national targets on GDP (or recent past emissions) initially, and gradually convert them to targets based on population over, say, 25 years, to avoid the wrenching impact on life styles in the rich countries and the implausibly large transfers to governments of developing countries. Here, however, we encounter some unpleasant arithmetic with respect to population-based emission rights. In 1995 India’s per capita income (on a purchasing power basis) was about 5.2 per cent that in the United States. Suppose that per capita income in India grows at 5 per cent a year over the next 25 years, and per capita income in the United States grows at 1 per cent a year (this is a plausible scenario, although in reality the gap in growth rates is not likely to be so wide). Under those assumptions, Indian per capita income 25 years later (in 2020) would still equal only 14 per cent of per capita income in the United States, and

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per capita consumption of energy would be many times higher in the United States than in India. Thus under national emission targets converging on population after 25 years either India would not be effectively constrained or the United States would be very tightly constrained or (under tradable emission permits) there would be huge transfers from the United States and to India. The sense of global community is not likely to be great enough by 2020 to sustain such large transfers – it is not that great within the United States today – and in any case such large transfers either to governments or directly to citizens, by fostering a rentier mentality, would probably not be desirable, as some of the highly oil-dependent countries have discovered. My general conjecture is that there is no widely acceptable basis for allocating scarce resources – here, emission rights – among all countries by international negotiation. The fact that the resource is known to be valuable will lead many countries to hold out for generous treatment as a condition for their binding agreement, and the sum of such generous treatment will undermine the purpose of the agreement, namely to limit significantly the growth in atmospheric concentration of GHGs.

INTERNATIONAL TRADING While climate change is indifferent to the source of GHGs, because of rapid mixing through the upper atmosphere, the costs of reducing emissions of CO2 and other GHGs differ greatly from one place to another, and from one activity to another. So long as resources are scarce, we need to be concerned with the costs of GHG mitigation, and in particular we should reduce emissions at least cost, wherever that might be. Thus, if the costs of CO2 reduction are higher in Sweden than in Poland, there should be some way for Sweden to help achieve its national target by reducing emissions in Poland, so long as Poland is within its national target. Indeed, Kyoto envisions the possibility of ‘Joint Implementation’ to take account of such possibilities, without, however, specifying how joint implementation is to be implemented. This notion of cross-border cooperation in reducing emissions, so long as the targets are met collectively, is an excellent one. But to be effective it requires careful accounting. One way to achieve joint implementation automatically is to create a market in emission rights. Kyoto is couched in terms of setting national ceilings for GHG emissions; but the same framework can be interpreted as allocating emission rights to the Annex B countries, not to be exceeded. Each country ‘owns’ the right to emit a certain maximum of greenhouse gases. Then Sweden, in the example above, can buy some of these emission rights from Poland; Poland’s rights would of course decline by the amount it sold to Sweden.

The Kyoto Protocol

27

Creating an effective trading regime in emission rights poses a host of practical problems. First, who exactly is to participate in the market? In particular, should it be 38 governments, or should it be thousands of firms? Markets work best if there are many participants, none of them dominant. But if firms are to trade, each relevant firm needs to have a clear and unambiguous right to emit GHGs.5 Thus each country with an emission quota under Kyoto needs to develop a system for allocating these rights to participating firms. Three principles of allocation are known (and of course combinations among them): on the basis of historical emissions (the principle used for countries at Kyoto, with modest differentiation), on the basis of political favoritism (with the strong temptation to bribe, directly or indirectly, the officials who control the process of allocation), and competitive auction, whereby the highest qualified bidders acquire the emission rights, and the sales revenues accrue to the government, or to some party designated by the government. If the principle of allocation is based on historical performance, as it almost always is in practice, should the historical basis last forever? The issue of global climate change is a long-term issue, not a transitory one; a scheme to deal with it must have great durability. Are those with emission rights based (say) on 1990 emissions to keep their rights forever? Even if they go out of business? Indeed, if the permits command a sufficiently high price, it may make economic sense for some of the owners to go out of their original (emitting) business, and sell all of their permits. They, and their distant descendants, could become rentiers, living off the earnings of sales of perpetual emission rights, earned on the basis of activity way back in 1990. If the emission rights are not to be perpetual, that is, they are to decay over time, how often should they be reallocated, and what should be the principle of reallocation? Simply re-basing the allocation, for example, from 1990 to 2000, would create a perverse incentive not to reduce emissions. In short, public authorities will be allocating valuable resources (emission rights) within countries, either forever or from time to time, and any historical basis will have some perverse or anti-social effects. These can be avoided by auctioning the rights, with revenues accruing to the government. So as to mitigate the economic costs to those parties who will be required to have emission rights, the revenues could initially be used in some form of compensation, so long as the compensation is not based on actual emissions. The compensation could then be gradually phased out over time, for example, a decade.6 Of course, similar problems of allocation and reallocation arise among countries, as discussed above. Bringing new countries into the scheme will require a principle of allocation to new entrants. And even Annex B countries will require a new allocation beyond 2012: should it still be based on 1990, or should a new principle be introduced, and if the latter what should it be?

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A market in emission permits would establish a price for them, for example, per ton of carbon emissions. That price would then provide useful information for all emitters covered by the scheme: if they can reduce emissions at a cost below the permit price, they should do so, and sell their rights in the market. If the costs of reducing emissions by a particular firm exceed the permit price, the firm will be better off continuing to emit, and buying a permit to do so. The price of the permits would fluctuate with overall net demand for them. Various estimates have been made of the price of such permits. The estimates inevitably involve much conjecture, particularly about the schedule of costs associated with different levels of reduction of emissions. Because costs can plausibly be expected to differ sharply from one country to another, the price of the permit will also depend on the nature of the trading scheme, and in particular on what countries are included and what restrictions are placed on trading – as well as on the severity of the overall emissions target.7 In general, the more countries that are included, the lower will be the price for any given overall target; and the tighter the restrictions on trading, the higher will be the price. The US Council of Economic Advisers (1998) estimated that the price per ton of carbon under the Kyoto targets would be about $200 in 2012 if the trading scheme were confined to the United States, but would decline to $56 if all Annex B countries were included in the scheme, and to $23 if China, India and other key developing countries could be brought in under reasonable terms.8 Under the latter two conditions, Americans would not meet their Kyoto target in the United States, but would buy permits from other Annex B countries, or from developing countries if they were brought into the scheme. One concern with this arrangement is that Russia and Ukraine were granted emission rights at Kyoto that they are unlikely to use fully. (Kyoto was negotiated before Russia’s financial crisis of 1998, which set back Russia’s prospects for economic growth by several years. Even then, the Russian and Ukrainian targets were on the generous side, designed no doubt to ensure the participation of those two countries in the Kyoto commitments.) If this is so, an unrestricted trading regime would lead to higher emissions by the Annex B countries in 2012 than would occur if all countries met their targets domestically. The European Union has therefore proposed that countries be allowed to buy from abroad permits no greater than the GHG abatement they have actually achieved, in effect allowing trading for no more than half of a country’s target (with an analogous rule to apply to sellers). Ironically, under the intra-EU country allocation reached in 1998, 10 of EU’s 15 members would violate the rules the EU proposes for other countries (CEA, 2000, p. 271). Moreover, the EU proposal could have the consequence, by restricting the trading market,

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of much lower permit prices than would obtain without the restriction, thus discouraging some abatement that would occur under an unrestricted trading regime (see Victor, 2001, p. 115). Cross-border purchases of emission permits of course would involve corresponding transfers of funds from the buying country to the selling country, or from firms in the buying country to firms in the selling country. Assume that the EU proposal was adopted, and that American firms purchased from Russia and Ukraine permits amounting to half the reductions the United States required to meet its Kyoto target. At the CEA estimated price, that would imply transfers from Americans to Russians and Ukrainians in excess of $13 billion annually to buy emission rights. Given the recent history in those two countries, the allocation of emission rights to domestic firms is likely to be riddled with corruption. Foreign purchasers would be complicit in sustaining and (given the values involved) possibly enhancing this corruption. Would such transfers, or even the prospect of them, be politically acceptable in the United States, or in Europe? I strongly doubt it. So here is another flaw of Kyoto: the ceilings are too stringent to be applied nationally – at least in the United States, given its rapid growth in 1990–2000; but the flexibility allowed by Kyoto is likely to result in politically unacceptable large transfers among countries, in particular to Russia and Ukraine. The Kyoto Protocol requires a system for monitoring emissions of GHGs, and for enforcing compliance with the targets. Monitoring fossil fuel emissions in the Annex B countries perhaps poses no insurmountable problems. But monitoring net CO2 emissions from other sources (for example, soils and forests), and emissions of the other five GHGs will be much more problematical, as Victor (2001) has emphasized. How will we know whether or not the targets have been reached? Suppose a country by its own acknowledgement has not reached its target, or, worse, claims to have reached its target but on impartial assessment has not? What, if anything, will be done about it? The problem arises especially with a trading regime, under which a country has sold some of its permits to others, and then claims unconvincingly to have cut its own emissions below its target by the amount of the permits sold. How can the money be recovered? Again, Russia and Ukraine come to mind, but the problem could arise with any selling country. Suppose in the meantime the selling firms have disappeared? Should the government be liable? Can we anticipate future analogues of the debt crises of the 1980s and 1990s, in which country debts were rescheduled, under painfully negotiated conditions? Victor (2001) ingeniously suggests that the buyers should be liable, implying that the permits would be continually labeled by the seller (like bonds). Thus some permits could sell at a discount to others, depending on

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the reputation of their source. But he does not explain how past wrongdoing would be rectified. And buyer liability would fragment and make much less liquid the market in emission permits, which at least in its early years might be fatal to its basic purpose. Taken together, the flaws of the Kyoto Protocol – incomplete coverage, inappropriate basis for allocation of valuable emission rights, inadequate provision for monitoring and enforcement, politically unacceptable transfers under (necessary and desirable) trading – render that agreement fatally flawed, and therefore functionally moribund.

AN ALTERNATIVE APPROACH9 There is an important alternative to setting national emissions targets. That is to agree internationally on a set of actions, calibrated to achieve the desired emissions (ultimately, as stated at Rio, set to stabilize the atmospheric concentration of greenhouse gases, an objective that is too radical for specification in the near future). Since to accomplish their quantitative objectives governments must in any case create the appropriate behavioraltering incentives for their citizens, and since, as we have seen, setting a national allocation of global emission rights is likely to prove so contentious as to be impossible, it may be far easier simply to agree on a common use of instruments. For problems such as reducing emissions, the favorite instrument of economists is to tax the offending activity. All countries would agree to impose a common carbon tax, which would increase the price of fossil fuels in proportion to their carbon content (with possible tax exemptions for uses that do not produce carbon dioxide, such as production of some plastics). Such a tax would have at least two major advantages. First, it would encourage reduction of emissions to take place where that can be done at least cost, since all emitters would have the same incentive to reduce emissions, but only those who saved more in tax payments than it cost to reduce emissions would undertake reductions; others would simply pay the tax. It would provide encouragement everywhere for fuel switching toward natural gas, and more importantly to conserve generally on the use of fossil fuels. Second, it would generate revenues for governments. All governments have trouble finding sources of revenue that do not have negative effects on economic incentives to work, save, or undertake commercial risks. Here is a tax with the right incentives. That should make a carbon tax attractive to finance ministries everywhere. Where the revenues are large, as they eventually would be, the new tax should be phased in gradually, and growth

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could be encouraged by reducing other taxes, for example those on foreign trade or on earnings. Taxes on fossil fuels would of course have some undesirable effects, such as delaying the switch from fuel wood to fossil fuels in poor countries. But it would be impractical in most cases to tax fuel wood. In principle, it would be possible to extend the idea of a common carbon tax to methane as well, covering wetland rice production, decomposable refuse, gas pipeline losses and cattle raising, but that more difficult step could perhaps wait until a later stage, or even be treated in a different way (see Victor, 2001, chapter 4). Differential treatment could be extended to developing countries by allowing them more time to phase in the carbon tax, although those with a growing need for revenue might choose to introduce it earlier than required by the agreement. The imposition of a common carbon tax would be easy to monitor. Enforcement of the tax would also be possible to monitor, since 183 countries (which, however, exclude Taiwan, Hong Kong, North Korea and Cuba) hold annual consultations with the International Monetary Fund on their macroeconomic policies, including the overall level and composition of their tax revenues. The IMF could by agreement provide reports on energy revenues collected to the monitoring agent of the treaty governing greenhouse gas emissions. Such reports could if necessary be supplemented by international inspection both of the major tax payers (for example, electric utilities) and the tax agencies of participating countries. Large emitters such as generating stations could be monitored by satellite. Imposition of taxes by international agreement imposes a major problem for democratic countries, however, since taxation goes to the heart of parliamentary prerogative, and most will not welcome taxation by international agreement, even with a requirement for parliamentary ratification. Moreover, as 1993 experience in the United States with a British thermal unit (BTU) based energy tax illustrates, even modest energy taxes can be politically unpopular. In 1992 the European Commission proposed a somewhat more ambitious tax for energy, rising to the equivalent of about $10 a barrel (roughly 50 per cent) of oil by 2000. That tax was never enacted. Moreover, the EU proposal paradoxically but not surprisingly gave special preference to coal (which is produced at high cost in a number of EU countries), the most carbon-intensive of the fossil fuels, and would also have levied a tax on nuclear power, the least carbon-intensive major source of energy. Several European countries have introduced energy taxes, usually, however, taxing industrial uses at significantly lower rates (see, for example, Kirkpatrick et al., 2001, on Germany, and parallel OECD studies on energy policies in other European countries).

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But this political calculus could change dramatically. If we are to act seriously to reduce GHG emissions, a rise in the price of emitting activities is necessary to encourage large-scale conservation. It is better that the revenues from the price increase go into the hands of governments that represent the entire public than into unnecessary economic inefficiency, such as would be brought about by a command and control system, or into the hands of the owners of large corporations that are allocated emission quotas. Furthermore, the imposition of carbon taxes would not necessarily imply additional revenues for governments. One possible disposition of revenues from emission taxes would be to reduce other taxes, such as income taxes or payroll taxes, that arguably discourage useful economic activity. Each country would be free to dispose of the emission tax revenues as it judged best. In the United States, introduction of emission taxes would be easier if coupled with the reduction of other taxes. Other countries, particularly developing countries, might need the additional revenue and welcome these taxes in lieu of having to raise additional revenues in other ways. Negotiation along these lines has no assurance of success. But since the national target approach of Kyoto has no prospect of accomplishing its ultimate purpose, it is better to abandon the impossible for the merely difficult. We do not know how responsive economies will be to any given tax level. The cuts in emissions could be either greater or less than initially projected. Thus a regime based on mutually agreed emissions taxes must allow for subsequent adjustment in tax levels, up or down, as new scientific evidence on the significance of GHG emissions for climate change becomes available, and as we learn how effective a given level of taxation is in reducing emissions. The latter effects will become clear only after the passage of some years, so the taxes could be adjusted, by mutual agreement, at five-to ten-year intervals. That is not a decisive disadvantage when the objective concerns decades and perhaps centuries.

CONTINGENCY PLANS Many adverse developments could occur as a result of global climate change. It is much more difficult – today, impossible – to forecast with confidence what will happen. Some analysts have projected benign effects from global warming, and easy adaptation to the adverse effects – especially for those whose income is enough above subsistence to give them room for maneuver. Thus for this among many reasons developing countries give higher priority to economic development than to averting climate change if the latter in any way inhibits development.

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The great uncertainty about impacts, the prospect of serious gainers as well as losers, the high apparent cost of near-term actions to reduce emissions significantly, for benefits both more distant in time and more uncertain in magnitude, and the need for eventual wide participation by countries with substantially different initial circumstances and hence greatly different priorities – all these factors make early action to stop growth of greenhouse gas emissions, much less to lower them, highly problematic. Suppose the best guesses about climate change turn out to be too optimistic; or suppose that despite accurate forecasts the international community is unable to reach agreement on costly, effective mitigation actions; or suppose that despite international agreement countries prove unable to implement the agreements. What then will the community of nations do if accumulating experience suggests the climate change is likely to be great and clearly adverse? This possibility suggests the need for some contingency planning to supplement research to develop cheap low-emitting sources of energy and ways to satisfy human wants with lower requirements for energy. Such contingency planning can take two broad paths. The first concerns how best to adapt to more serious climate change. It means inter alia pushing ahead with both the basic science and applied research for genetic engineering in many areas, especially agriculture, but also providing potential substitutes for possible useful species that may be lost. That could be supplemented by a systematic program for collecting, cataloguing and storing genetic material, mainly but not exclusively from plants, in the form of seed banks and DNA. The second concerns how to slow further warming as rapidly as possible. One route involves sequestration and even withdrawal of greenhouse gases, mainly carbon dioxide, from the atmosphere on a scale at least equal to continuing emissions. That will involve good stack absorbers and storage depositories of carbon dioxide. But it also might involve mobilizing the biosphere. Rapidly growing trees could be planted on a massive scale, especially as climate change extends the areas that can support them, for example by dropping seeds by air. More unconventionally, barren portions of the oceans could be fertilized with the requisite minerals (the main deficiency is thought to be iron) so that microscopic carbon-loving plants can thrive. A different approach would involve reducing the incidence of sunlight on the earth’s surface, for example by placing reflecting surfaces in space or by increasing the albedo by altering cloud formation or by placing particulates in the atmosphere, for example, through jet engine exhaust or by using cannons or rockets from the surface.10 Other possibilities will no doubt emerge over time. It is of course premature to commit to any particular method for rapid mitigation. Some suggestions will be impossibly expensive, and others will have unacceptable

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side effects. The point here is merely to encourage imaginative work on possible emergency actions.

CONCLUSIONS Proposition 1 The problem of global warming cannot be solved without the cooperation both of China and of the United States, where ‘China’ here is a metaphor for all large, growing developing countries, and ‘USA’ is a metaphor for all large and prosperous rich countries. Proposition 2 There is no formula for quantitative national targets for GHG emissions, under existing technology and knowledge about global climate change, that will be acceptable both to China and the USA that will address satisfactorily the problem of global climate change, where that issue is defined by preventing atmospheric GHG concentrations from rising above, say, 720 ppm carbon dioxide equivalent (⫽ 2.5 times pre-industrial levels, and twice current levels, implying an increase in global average surface temperature of 2.1–6.6 °C based on current scientific knowledge). Proposition 3 If propositions 1 and 2 are correct, no scheme based on binding national targets can succeed in dealing with the problem, at least in the next decade or two. Therefore if anything is to be done soon at the international level, an alternative approach to Kyoto is required. Proposition 4 The approach most likely to succeed is international agreement on common actions, in particular agreed taxes on GHG emissions. Proposition 5 Tax policy is sensitive in every country; success at negotiating common actions based on taxation is not assured of success. Proposition 6 In view of proposition 5, countries should position themselves for adaptation to climate change; and the world should position itself for emergency actions, mainly involving the rapid sequestration of GHGs, if climate change seems to seriously threaten society.

NOTES 1.

Detailed quantitative information is not available for the other GHGs, which together accounted for an estimated 30 per cent of the increase in atmospheric GHG concentration since the beginning of the industrial era. Figures here will focus on CO2, and on its major sources in fossil fuels, deforestation and cement making, as is usually done. But

The Kyoto Protocol

2. 3. 4.

5.

6.

7.

8. 9. 10.

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the other GHGs should not be neglected. CFCs are also important greenhouse gases, but are not covered by Kyoto because they were already being phased out under the Montreal and London Protocols dealing with stratospheric ozone depletion. Private communication from Fred Singer. An elasticity of 0.75 seems to be implied in the EU target for Greece, based on Greece’s actual growth in the 1990s. It is about 0.5 for Portugal. The literature on GHG emissions is confusing with respect to units of measurement. GHGs other than CO2 are usually converted into CO2 equivalents in terms of their warming potential, itself a somewhat uncertain exercise because of imperfect knowledge of the atmospheric lives of different gases. CO2 is then measured in metric tons. But some sources (for example, the Kyoto Protocol) use the weight of CO2, while others (for example, the work of the IPCC) use the weight of the carbon in the CO2. I will adopt the latter practice. Oxygen is heavier than carbon: the carbon content in CO2 is about 27 per cent, such that the 1990 base of the Kyoto Protocol (Annex B) is 14.5 billion metric tons (bmt) of CO2 from fossil fuels, which translates into 3.96 bmt carbon content. This measurement ambiguity must be borne in mind when addressing carbon taxes. The US Administration under President Clinton made clear its intention to create a domestic market for tradable permits by 2008, and urged other countries to do likewise, arguing that an international mixture of permit trading in some countries and command and control systems in others could significantly weaken the efficiency advantages of a system of permit trading. See CEA (2000), pp. 270–72. Ironically, one of the advantages alleged for the national targets set at Kyoto is that they would allow each country to pursue the common objective in its own ways. Under the US sulfur dioxide (SO2) emissions control program, tradable and bankable permits were allocated initially to 263 high emission generating units at 110 power plants (with fewer owners), on the basis of energy use in 1985–87, adjusted through the very political process of congressional negotiation. Phase II, covering 2000–2009, which extended coverage to all fossil fuel generating units over 25 MW, also involved allocation on the basis of a formula focused on historical emissions as adjusted by political bargaining, with a consciousness that valuable permits were being issued. Emission permits are issued annually, but can be saved for future use. The SO2 trading system so far has worked well within the United States, with permit prices being much lower than originally estimated. See Ellerman et al. (2000). See Dean and Hoeller (1993), p. 153, where the results of several studies of a hypothetical reduction of GHGs by 2 per cent a year from BAU trajectories are compared, across five regions of the world. The cost of a further reduction in 2050 ranges from a low of $67 (1990$) per ton of carbon (in China) to $2245 (in the Former Soviet Union). These differences suggest both major uncertainty (across models) in the costs of mitigation, and major efficiency gains (across regions) from allowing cross-border permit trading. These prices are per ton of carbon; the equivalent price per ton of CO2 would be about 27 per cent of these prices. This and the following section draw on Cooper (2000). A study by the National Research Council (1991) suggested that placing reflectors in space would be very costly compared with alternative ways to reduce the incidence of sunlight, but relative costs might be very different in three or four decades.

REFERENCES Cooper, Richard N. (2000), ‘International Approaches to Global Climate Change’, World Bank Research Observer, 15 August, 145–72. Council of Economic Advisers (1998), ‘The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis’, processed.

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Council of Economic Advisers (2000), Economic Report of the President, Washington: US Government Printing Office. Dean, Andrew, and Peter Hoeller (eds) (1993), The Costs of Cutting Carbon Emissions, Paris: Organization for Economic Development and Cooperation. Ellerman, A. Denny, Paul L. Joskow, Richard Schmalensee, Juan-Pablo Montero and Elizabeth M. Bailey (2000), Markets for Clean Air: the US Acid Rain Program, New York: Cambridge University Press. Kirkpatrick, Grant, Gernot Klepper and Robert Price (2001), ‘Making Growth More Environmentally Sustainable in Germany’, Economics Department Working Paper No. 276, Paris: OECD. National Academy of Sciences (1991), Policy Implications of Greenhouse Warming, Washington: National Academy Press. Victor, David G. (2001), The Collapse of the Kyoto Protocol, and the Struggle to Slow Global Warming, Princeton, NJ: Princeton University Press.

3.

You’re getting warmer: the most feasible path for addressing global climate change does run through Kyoto Jeffrey A. Frankel

When I first arrived at the White House in September 1996, I had no idea that one of the issues on which I would spend a great deal of time during my period as a member of President Clinton’s Council of Economic Advisers was global climate change. But Under Secretary of State Tim Wirth had the month before announced a major change in policy: that the United States would in multilateral negotiations now support ‘legally binding’ quantitative targets for the emission of greenhouse gases. This left less than 16 months for the US Administration to decide what kind of specifics it wanted, at the Third Conference of Parties of the UN Framework Convention on Climate Change (UNFCCC), scheduled for December 1997 in Kyoto. Because other countries take their cue from the superpower (whether it is to support or oppose US positions), this countdown engendered a certain amount of suspense: what specifically would the US propose at the Kyoto Conference, most notably regarding how the numerical targets should be determined? Outsiders demanded to know – with particular tenacity in the case of the US Congress, who feared the worst. I was a member of a large inter-agency group that worked intensively on what was to become the Kyoto Protocol. I never thought that the agreement had a large chance of being ratified by the US Senate or of coming into force in a serious way. There were too many unbridgeable political chasms, as I will explain. Furthermore I understand the reasons why almost all economists, at least in the United States, disapprove of the Kyoto Protocol. Nevertheless, I am prepared to defend the Clinton version of the treaty, and I believe it was a step in the right direction. I will begin by noting that the weight of scientific opinion seems indeed to have concluded that the Earth is getting warmer, that increasing concentrations of carbon dioxide and other greenhouse gases are the major cause, and that anthropogenic emissions are in turn responsible. I am not 37

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a scientist. But the latest IPCC report concludes, ‘The globally averaged surface temperature is projected to increase by 1.4 to 5.8 degrees Celsius’ over the period 1990 to 2100, and ‘global mean sea level is projected to rise by 0.09 to 0.88 metres’.1 The evidence has become clearer over the last ten or twenty years. President George Bush, the Second, made a big mistake when he initially allied himself with the minority of disbelievers. It was a political mistake if nothing else. Even granting that the incoming administration in 2001 did not want to pursue Kyoto, it was foolish and unnecessary for the White House to dismiss the climate change problem. This chapter will take as given that the problem of global climate change is genuine, and is sufficiently important to be worth addressing by steps that are more than cosmetic. Because the externality is purely global – a ton of carbon emitted into the air, no matter where in the world, has the same global warming potential – the approach must be multilateral. Individual countries will not get far on their own, due to the free-rider problem.2 Multilateral negotiations have since the Rio Summit of 1992 proceeded specifically under the UNFCCC. The chapter will summarize major decisions that the Clinton Administration had to make, and why it made them. What were the quantitative limits on emissions to be? How would greenhouse gases other than carbon dioxide be treated? Would trading across time or across countries be permitted? And so on. In my time in the government, I was surprised to discover that policy makers often must make such decisions with relatively little help from the body of technical knowledge and opinion outside the government. It is not just that academic research is too abstract to be of much direct help with the minutia of specific policy decisions. The pronouncements of think tanks and op-ed writers also ignore practical complexities, because they seek to make big points for general audiences. We were largely on our own. Some years from now, the world may be politically ready for a more serious treaty, one that requires some sacrifice of sovereignty and wealth. Those who design this future treaty will have to grapple with some of the same issues that we did. An explanation of the thinking that went into Kyoto might help. As I see it, the Kyoto Protocol, particularly its flexibility mechanisms, is a good foundation on which to build. The subtitle of this chapter is: ‘The most feasible path for addressing global climate change does run through Kyoto’. This is also the second meaning of the chapter’s main title, ‘You’re Getting Warmer’. In the American game, a child looks for a hidden object, being told ‘you’re getting colder’ whenever he or she looks in the wrong vicinity, and ‘you’re getting warmer’ when coming closer to the objective. Kyoto was a step closer.

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TARGETS AND TIMETABLES The economist’s approach to designing a strategy to address an environmental problem, of course, is to take into account economic costs. In principle, cost–benefit analysis is the right way to do this, along the lines of the Integrated Assessment Models pioneered by Bill Nordhaus.3 The prescription that often emerges is a very long-term plan of emission reductions relative to the Business as Usual path (BAU) – with cuts that are very small initially, but that become larger late in the 21st century – implemented by a price mechanism such as a global carbon tax. Although academic research can and should proceed with such models, the problem faced by policy makers in 1997 was more constrained in a number of ways. In practice, full cost-benefit analysis in the case of global climate change is less helpful than is at first apparent, for two major reasons. The first reason is the tremendous uncertainties involved in any model. The range of uncertainty about the proper discount rate, alone, can give every answer from large immediate cuts to a path that begins with no cuts.4 Further, it is impossible to put probabilities on the catastrophe scenarios (an end to the Gulf Stream current, melting of the Antarctic ice shelf, an unstable feedback loop through release of methane from thawing permafrost, and so on). One is thus led to accept an arbitrary environmental goal, such as limiting the increase in carbon dioxide to twice pre-industrial levels by 2100 (from 270 ppm to 550 ppm), and to seek the cost-minimizing path to achieve this goal. We at the Council of Economic Advisers used estimates by Alan Manne and Rich Richels.5 According to their estimates, the most efficient paths involved heavy cuts below current levels of emission only in the second half of the 21st century. It was assumed that new technologies, now unknown, could be developed so far into the future. In the early decades, the most efficient path featured emissions that would continue to rise, though at a rate modestly below the BAU path. To see why heavy cuts in the early decades would be too expensive, consider electric power generation. Today’s fuel mix relies heavily on the dirtiest fuel, coal. Power plants have a natural life of at least 40 years. To cut domestic emissions of carbon dioxide heavily in the first two decades would require shutting down coalfired power plants before the end of their useful lives, at great expense, replacing them for example with natural gas. Waiting three or four decades to begin the heavy cutting below the BAU path is far cheaper, provided firms know that they need to begin planning for the change now. The Manne–Richels least-cost path for achieving the specified goal of 550 ppm showed global emissions peaking in the decade 2040–50, and rich-country emissions peaking several decades earlier.6

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As we became more familiar with the politics, we soon realized that even the cost-minimization solution would not serve. These 100-year paths were of little use to political leaders. Politicians have short horizons, for very good (electoral) reasons. Once in a great while, a leader can try credibly to commit to a project with a ten-year horizon, even though the public knows he will not still be in office to see its completion. President Kennedy, for example, committed the US to reach the moon by the end of the 1960s. Some attempts have been made to ‘fix’ social security on a ten-year horizon. But it is out of the question for political leaders to commit to policies 100 years in advance. Even 30 years is too long a horizon. A president who proposed to cut emissions 30 years in the future would be laughed out of Washington. Everyone would think ‘it’s just words’, and they would be correct. None of the countries participating in Kyoto, neither the Europeans and others who were arguing for very ambitious targets, nor those arguing for gradualism, proposed setting targets far into the future. All the discussion concerned targets for the period 2008–10. Most of those participating (though not all) understood that, for this reason, the cuts under discussion would make only minute contributions to reducing greenhouse gas concentrations, temperatures, and sea-level rises later in the century. We estimated that if participation were limited to the countries undertaking commitments at Kyoto, then the effect of the agreement would be to reduce the temperature in 2050 by only roughly 1/10 of one degree Celsius (relative to a baseline increase of 1.15 degrees). Even so, the longest journey begins with a single step.7 The implication of these considerations is that the targets had to involve a concrete non-fudgeable commitment of some sort within a horizon of ten years or so. My personal choice was a commitment that emissions should reach a peak – that is, that they be observed to level off – in the decade 2010–20, with absolute reductions to follow in later decades. Climate mitigation under this proposal was almost the same as the plan to return to 1990 levels by 2010, and yet the impact on energy prices would be only about one eighth as much. But peaking two decades hence was not a sufficiently ambitious goal for the environmentalists and was thought – correctly, I am sure – to be a non-starter with the Europeans. They were all thinking in terms of the (voluntary) goals that had been set at Rio, which were phrased in terms of 1990 levels of emissions. The Europeans thought they would achieve 1990 levels by 2000, that is, that they were already peaking (as called for at Rio). True, the United States could have told the Europeans ‘take it or leave it’; but President Clinton wanted an agreement. A good solution, in terms of economics, would have been an early ‘downpayment’ policy measure to demonstrate sincerity, such as a substantial energy tax. But such tax increases are extremely unpopular, and were ruled

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out on political grounds. The Clinton Administration had proposed a BTU tax in its first year, and felt severely burned by the experience. An alternative, if the desire to be more ambitious was genuine, would have been to set a target path in which emissions peaked in some year earlier than 2010. But such proposals were too concrete and immediate; they ran into the paradoxically simultaneous brick walls of being too ambitious economically and insufficiently ambitious environmentally.8 In October 1997, the President decided that the US position going into Kyoto would be to return carbon emissions to 1990 levels by 2008–12. In the end, in order to break a negotiating deadlock at Kyoto in November, the US gave some ground, agreeing to reduce a combination of six gases to 7 per cent below 1990 levels. The US team figured that the flexibility inherent in tradeoffs among the six gases made the cost almost equivalent to that of the President’s October position. Other countries agreed to similar cuts, some larger and some smaller, totaling 5 per cent relative to BAU.

POLITICAL CHASMS The small inter-agency group that met frequently in the White House office of the Director of the National Economic Council developed its own ways of speaking of the political constraints of climate change policy. It was decided that nobody around the table was allowed to dismiss someone else’s proposal on the grounds that ‘it is politically impossible’. All options were politically impossible. Rather, you had to identify an alternative proposal that was less politically impossible than the one you were arguing against. I also noticed that an option where the political impossibility was immediate and certain would be dominated by another that was also ‘politically impossible’ but where the constraint would be encountered in the more distant future and with less certainty. In Butch Cassidy and the Sundance Kid, Butch (Paul Newman) proposes that the only way out for the two outlaws, who are trapped on a rock ledge, is to jump off the cliff into the river far below. Robert Redford confesses, ‘I can’t swim’. Paul Newman replies, ‘Are you crazy? The fall will kill you anyway!’ Any US policy to address climate change had to contend with four political chasms. Each was so deep as to be virtually unbridgeable, and also so wide that the constituents living on the opposite sides were barely communicating with each other. Each of the gaps remains wide today, although some progress has been made. (1) The first was the gap between environmentalists and the Congress on understanding of the climate change issue and willingness to bear some economic costs to address it. The Congress in 1997 passed the Byrd–Hagel

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resolution, which opposed a treaty along the lines of Kyoto, by a vote of 95–0. At the same time, environmentalist NGOs considered the agreement and related Clinton policies inadequate. Many environmentalists pronounced the Administration a profound disappointment, and support for the Green Party’s Ralph Nader in the year 2000 election turned out to be (one of many things) great enough to deny the presidency to Al Gore, the candidate with the most knowledge and concern regarding the environment of any political leader in US history. Where did the median American citizen stand? On both sides of the chasm. On the one hand, polls say that a heavy majority of Americans are concerned about the environment in general, and global warming in particular, and want to do something about it.9 On the other hand, I think most of them could not answer correctly whether global warming is scientifically the same phenomenon as the greenhouse effect, stratospheric ozone depletion or acid rain. In a poll, 59 per cent responded that it was either definitely true or probably true that the greenhouse effect was caused by a hole in the earth’s atmosphere, while only 26 per cent thought this was probably or definitely not true.10 The polls also show that the median American voter opposes substantial energy taxes to address climate change.11 The United States will not address the issue seriously until public awareness rises. The negotiation and debate over the Kyoto Protocol itself has helped raise the visibility of the issue a great deal. A very hot summer, and some natural catastrophes, would help more. Some say the American public will never accept a substantial increase in the price of energy, whether in the form of taxes or otherwise. But I would not completely rule out a major shift in attitudes at some point in the future. It may have to be tied in part to other objectives such as other environmental goals, and reducing dependence on oil for national security reasons. Political saleability of an energy tax would be enhanced if it came at a time of falling world energy prices (because avoiding a decline in price is much less damaging politically than causing an increase), and if the tax revenue were visibly seen to be recycled directly back to the public in another, popular, form. (2) The second wide political chasm lay between the United States and the European Union. The EU, correctly pointing out that it had already reduced the ratio of energy use to GDP while the United States had continued its profligate policies, insisted that cuts in domestic emissions be sufficiently severe to impose economic costs on the United States. In the negotiations, this translated both into support for aggressive targets for reductions in emissions, and opposition to schemes whereby members could pay other countries to do the cutting for them. The United States favored ‘flexibility’ mechanisms such as international trading of emission permits, to reduce the economic costs of achieving a given target. Many Europeans felt that such

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trading was immoral. The US response was that if the Europeans opposed such market-oriented mechanisms to reduce the economic costs of achieving a given environmental goal, they must have a sinister ulterior motive. Their goal must be scoring debating points with their domestic green parties or inflicting pain on the United States for its own sake,12 rather than achieving an agreement that would lead to a better environment. The gulf between the EU and US became even clearer in the wake of Kyoto, never more so than at the Sixth Conference of Parties at the Hague in November 2000. The EU made a mistake symmetric in nature and comparable in magnitude to the mistake made a few months later by the incoming Bush Administration in rejecting Kyoto out of hand. The EU refused to agree to the Clinton–Gore position on flexibility mechanisms (particularly unrestricted international trading of emission permits, and use of sinks), even though the known alternative was dealing with the far more hostile Republicans. The symmetry arises in that both the EU and Bush passed up the chance to offer apparent concessions, secure in the knowledge that the other side would not agree, and thereby able to pin the blame for the failure of multilateral negotiations on the unreasonableness of the other. (3) The third political chasm lay between the United States and the developing countries. Many Americans opposed taking any costly steps unless the developing countries were participating as well.13 This was also the gist of the Byrd–Hagel resolution. After Kyoto, industry ran prominent advertisements that showed a map of the world with the non-participating countries cut out, as giant holes in the system. The most commonly articulated reason why the absence of developing countries was considered fatal was the adverse impact on American economic competitiveness. Although competitiveness is not the proper way to articulate the concern, I will argue below that we do indeed need the developing countries in. The developing countries, for their part, argued, quite reasonably that the rich countries should have to go first, since they created the problem and the poor countries should not be forced to forego their own industrialization to solve it. In this they were supported by the Berlin Mandate, wherein the UNFCCC negotiators had already agreed in 1995 that the developing countries would be exempted in the first round. (4) The fourth chasm was intellectual rather than political – between the engineers and the economists. Engineers promised that new technologies were already available that could save energy and save money at the same time, and that reducing emissions thus need not entail any economic costs. Their favorite example was so-called ‘green light bulbs’, though many other technologies had their proponents (low-flow shower heads, fuel cells, solar and wind power, cogeneration, and so forth). The engineers used so-called

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‘bottom-up’ models, essentially large-scale linear programming exercises that used technical coefficients from laboratory experiments, with little allowance for human behavior. A prime example was the ‘five-labs’ study that the Department of Energy (DoE) produced to back up claims that the Kyoto reductions could be achieved at very little economic cost.14 They called ‘lemon-suckers’ those who argued that an increase in the price of carbon was necessary to induce the desired shift in the amount and composition of energy that consumers and firms use. The economists – the lemon-suckers – in turn called their opponents techno-optimists. They asked why such energy-saving technologies were not already in use, if they were so profitable.15 It is probably in fact a poor tactic for economists to deny the possibility that any money-saving technologies could exist unused. The claim that everyone is rational alienates non-economists unnecessarily. But there are other problems with the argument that technologies already exist that have the potential to save us. One is the difficulty in knowing which of the many candidate technologies are the winners. Another is in overcoming whatever social barriers currently exist to the use of the techniques – some of which result from irrational or inefficient ‘market barriers’ (incomplete information, incorrect discount rates), but others of which may be perfectly rational given the absence of economic incentives (many consumers are genuinely averse to fluorescent light, low-flow shower heads and small toilet tanks, no matter how much environmentalists wish the truth were otherwise). In either case, it is foolish to think that people will start using new technologies that they were not previously using merely because the President gives a speech, the Senate ratifies a treaty or Economic Planning Agency (EPA) bureaucrats hand out leaflets on street corners. People need incentives to change their ways. In this light, it makes little difference whether the people have been acting fully rationally or not. It should go without saying that technology is part of the solution. But technology is not a policy lever. Only measures like taxes, tax breaks, research subsidies, permit requirements and other forms of regulation are policy levers. To make an analogy, we can agree scientifically that burning calories is the way to lose weight. But this is not a prescription for avoiding the hard work of getting exercise. Exercise is the policy lever and burning calories is the intermediating variable, to cut weight. Similarly, creating incentives to save energy is the policy lever and use of cleaner techniques is the intermediating variable, to cut energy use. The economists’ models were called ‘top-down’ models, because they relied on econometric equations estimated from aggregate data on energy use, income, price and so forth. It was not precisely correct to say that these models were pessimistic. The models said that little progress could be made

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reducing carbon emissions if there were no increase in the price of carbon, especially in the short run. But, based on the data of past history such as the response to the 1970s oil shocks, the models predicted that substantial adjustments were possible in response to an increase in price, especially in the long run. The patterns of behavior implicit in the estimated equations included the development and implementation of new technologies not currently contemplated, given generous enough incentives, and in that sense could actually be more optimistic than the engineers’ approach. Why do I list the conceptual gap between techno-optimists and economists as one of the chasms that needs to be bridged if climate change is to be seriously addressed? I do not believe that it does the environment any service to pretend that greenhouse gases can be reduced without raising the price of emissions, without paying any economic costs or without making any special effort. If it is so easy, then why would we need a treaty? An agreement that resulted from such a pretense would prove to be cosmetic. People need to realize that there will be some price, even if it is only a moderate one, and need to decide that it is worth paying, not just because it is the truth, but also because the effort will not be sustained if it is based on unrealistic promises.

FLEXIBILITY MECHANISMS Techno-optimism might be good enough for the DoE or the EPA, or even, if the truth be told, the President and Vice President. But the White House wanted the Council of Economic Advisers (CEA) to be able to testify to Congress that the economic costs of Kyoto would be modest. There was pressure on the economists, from some parts of the government, to accept estimates made by the bottom-up modelers, that technology would achieve large reductions in domestic emissions at low cost. The CEA was not prepared to accept these estimates, or to testify at all to any propositions that were contradicted by the leading economic models. In the aggregate models, the parameter under dispute was the rate of improvement of the Autonomous Energy Efficiency Index. We considered a trend of 1.0 per cent a year plausible, a small increase above the 0.9 per cent number in the Energy Information Agency’s Annual Energy Outlook. We did not consider it wise to assume that such initiatives as the $6.3 billion five-year package of tax cuts and R&D that President Clinton proposed in the 1999 fiscal year budget would over the short span of ten to fifteen years have a payoff greater than this. There was only one way we could see to reconcile the models with the claim that the quantitative targets of Kyoto need not imply large economic costs.

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This was to give full sway to the flexibility mechanisms: the treaty had to specify the environmental goals in an aggregate way and let the market decide how to achieve them most efficiently. We identified provisions falling under three kinds of flexibility: ‘when flexibility,’ ‘what flexibility’, and ‘where flexibility’, all of which were in the end accepted by the other parties at Kyoto. (1) ‘When flexibility’ loosened up the constraint whereby a given country might otherwise have had to hit a given target precisely in a given year. That would have been very difficult, given the imprecision of measurement and in particular, the unpredictabilities of the weather and the business cycle. Rather, countries are allowed to average over the five years of the budget window, 2008–12, and to ‘bank’ any reductions beyond the target for future budget periods. (2) ‘What flexibility’ loosened up the constraint whereby a country might otherwise have had to hit individual numerical targets for carbon dioxide, methane and four other greenhouse gases. The other gases were considered important enough sources of global warming to include, as scientists have a relatively good idea of their contribution to the greenhouse effect. But we will not know which gases firms will find it easiest to cut back on until we try. Thus a linear combination of the six was specified, rather than separate targets for each. The protocol also specified a role for sinks – sequestration of carbon, particularly into growing forests – though how exactly countries would receive credits for sinks was to some extent left for future negotiation. (3) ‘Where flexibility’, the most contentious set of issues, loosened the constraint regarding within whose borders physical reductions in emissions occurred. It is far easier for some countries to cut emissions relative to the BAU path than for others. It is far cheaper for China to refrain from building a coal-fired power plant that it would otherwise have built, using natural gas in its place, than for the United States to tear down an existing coalfired plant. The latter can pay the former for the trade, and both come out ahead. At the insistence of the United States – and allies within the ‘umbrella group’, which included Japan, Canada, Australia and New Zealand – the text agreed at Kyoto allowed international trading of emission permits. The United States was careful to allow that trading could be undertaken by individual entities within a country and need not go through the government; it wanted to be able to respond to charges that US taxpayers were being asked to pay other sometimes-corrupt countries for the right to use energy, by arguing that trading would only take place if private individuals voluntarily wished it. The language specified that countries pay others for emission reductions ‘supplemental’ to those achieved domestically. Left for future negotiations was the definition of ‘supplemental’ – Europeans insisting on

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a cap on trading such as 50 per cent of targeted reductions, and Americans thinking anything up to 99 per cent was fair game. Other details of the trading scheme were also left to be worked out in the future, such as whether buyers or sellers would face legal liability, and whether there would be penalties for abuse. (In my view, if a country sells several years’ worth of emission permits in the first year of the budget period, it should then have to make good with accounted-for domestic cuts before it can sell any more. This was called an ‘empty-tank provision’.) Besides international trading, the other key geographical flexibility provision was the inclusion of developing countries. As already noted, the Kyoto Protocol followed the Berlin Mandate in specifying targets only for the so-called Annex I countries – the industrialized countries and some of the formerly industrialized countries of the former Soviet bloc. In practice, this meant that the United States and other rich countries would compete to buy permits from Russia and the Ukraine. (The latter two would find it easy to reduce emissions relative to 1990 levels, for two reasons. First, they consume six times as much energy per dollar of output as does even the United States. Second, their economies had collapsed in the intervening decade. Thus some, but certainly not all, of the reductions they would be paid for would be ‘paper tons’ or ‘hot air’, that is, reductions that would have occurred even in the absence of an agreement.) President Clinton signed the Kyoto Protocol one year later, November 1998, at the time of the Fourth Conference of Parties in Buenos Aires. But, at the same time, the Administration adopted the position that it would not submit the treaty to the US Senate for ratification – knowing that it would face certain and overwhelming rejection – unless and until negotiations achieved ‘meaningful participation’ by developing countries. That meant not necessarily that all developing countries need participate fully (the Byrd–Hagel position), but that at least a majority of the key large countries – China, India, Korea, Brazil, Mexico, Argentina – must participate. ‘Participation’, in turn, meant adoption of targets, and participation in the voluntary permit trading system. The Kyoto Protocol included a version of the already existing Joint Implementation, dressed up under the name ‘Clean Development Mechanism’ (CDM) to sound like a resource-transfer proposal that came from Brazil. These provisions looked much like emissions trading, except that, divorced from the benchmarks provided by targets, countries were in essence selling permits without the existence of property rights. The idea was to pay Costa Rica to preserve forests or to pay China to switch to clean energy sources. The difficulty was knowing what the benchmark was, what these countries would have done otherwise. Proponents agreed that every effort should be made to ensure ‘additionality’, but in my view gave few real

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grounds for hope that additionality would in practice be much greater than zero. A caricature version of the proposal would have each of a billion Chinese citizens stepping forward, in turn, to explain that he or she had been thinking of building a dirty power plant or chopping down a forest, but that if paid a modest sum he would agree not to do so. My personal view was that the CDM would do more harm than good, by bringing the valuable principle of international permit trading into disrepute. Others thought that it was better than nothing. In any case, the Clinton Administration position was that it would not submit the treaty to the Senate until major developing countries agreed to targets of the same nature as the countries that had signed Kyoto. Even assuming that these countries could be persuaded – and most were adamantly opposed even to discussing the issue – this would require either side agreements with individual countries or negotiating some new parallel agreement. CEA Estimates of the Economic Costs of the Policy In response to insistent demands from the US Congress, the White House produced a set of CEA estimates regarding the economic effects of achieving the Kyoto targets.16 These estimates relied on the Second Generation Model (SGM), of Battelle Labs, with the help of Jae Edmonds.17 The key findings were as follows: (i) international trading, even if just among the Annex I countries, reduced costs by an estimated 50 per cent. If the EU countries chose to forego trading, then the opportunity to buy and sell emission rights within the umbrella group alone (including Russia and some other transition economies) would reduce costs by 60–75 per cent; (ii) inclusion of major developing countries in the target and trade system reduced costs further, to a total saving of 80–87 per cent; and (iii) with these flexibility mechanisms, costs became quite modest, approximately $7–12 billion a year, or only 0.1 per cent of GDP. While predicted economic costs (lost real income) is the relevant statistic for an economist, the public instinctively considers those numbers less real than predictions of the increase in the price of energy; (iv) our prediction was that energy prices would rise modestly: $14 to $23 per ton of carbon equivalent. This translated into increases of 5–9 per cent in fuel oil prices, 3–4 per cent in the price of electricity, and 3–4 per cent in gasoline prices (around 4–6 cents per gallon). For the typical household, it would mean an increase of 3–5 per cent in overall energy prices, or an increased energy bill of $70–$110.18

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It followed from the second point, above, that without international trading, the costs of Kyoto would be five to eight times higher, and thus in excess of $100 per ton of carbon avoided. But we did not include this statistic explicitly in the report, because it would have given hostile opponents a sentence to quote. Some reacted to our report by suspecting that we must have used a model biased to give low estimates. But in fact the SGM model is roughly in the middle of the pack of economic models (and a fortiori more conservative than the techno-optimist models). Subsequently, ten leading models that participate in the Energy Modeling Forum of Stanford’s John Weyant (EMF-16) showed a median prediction of costs in terms of permit prices of Kyoto quite close to ours, both in the case of no international trading and in the case of Annex I trading. With full global trading, the SGM results were a bit below the median, but far from the lowest of the models. The others predicted gains of 70 to 91 per cent from full global trading, consistent with our estimates.19 There was one respect in which our estimates were very optimistic. That was the assumption that there would be effective and unlimited international trading and participation by developing countries, when the EU had not yet agreed to the former and the developing countries were adamantly opposed to the latter. But we were completely explicit about this, and did not offer any estimation that attaining the necessary conditions was politically likely. Better yet, by repeating these estimates and the necessary conditions endlessly in testimony and other public fora, the Administration in effect became completely locked in to the position that it would not submit the treaty for ratification unless or until these conditions were met. There were also respects in which our estimates were pessimistic. First, as noted, we did not rely on the possibility of immediate technological breakthroughs. Second, we made no allowance for the potentially very important global role of sinks in removing carbon from the atmosphere at relatively low cost, in part to be conservative and in part because the specifics were not available. Third, we did not explicitly include auxiliary benefits: the relative price shifts necessary to reduce emissions should produce non-climate benefits in three areas – traffic congestion, highway accidents and air pollution – that we estimated could offset approximately a quarter of the resource cost of climate change policy. And the most important factor that we left out of the assessment was the long-term benefit of beginning to mitigate climate change itself. On the other hand, as the date gets later, as 2008 approaches and no real action has been taken, it gets harder and harder to attain the Kyoto targets. Already by 1998, US emissions of CO2 were something like 12 per cent

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above 1990 levels (and emissions of all greenhouse gases 22 per cent above). By now they have risen substantially more. Thus the cuts envisioned at Kyoto were very large relative to the current path that we were – and still are – on. I have not seen any recent estimates, but as of 2002, I would guess that by now, for the United States, attaining the targets would be so economically ruinous as to be almost out of the question, unless perhaps one were able to make generous interpretation of the sinks provision.

TREATY DESIGN Why did the Kyoto Protocol set quantitative targets, instead of the price mechanism favored by many economists? 20 A global carbon tax, while meritorious in theory, would be an instance of ‘common policies and measures’, which was rejected by the parties. The main explanation, again, is that it is not feasible politically. To dictate to each country the instruments to be used to achieve a shared environmental goal is too large an invasion of national sovereignty. Also a uniform tax would require a far higher sacrifice by the United States, relative to the status quo, than Europe or Japan, because the latter already have high taxes on some forms of energy, so it is not sensible to expect the US government to support such a thing. To address the latter problem, the version proposed by Richard Cooper is a uniform incremental carbon tax. But then Europe and Japan would have a strong incentive to substitute the additional carbon tax for existing energy taxes. Skeptics will say that monitoring and enforcement problems are sufficiently great that quantitative targets are meaningless. They are correct that monitoring and enforcement problems are large, but not that the targets are of no use for this reason. The precedent of the successful Montreal Protocol on stratospheric ozone depletion is somewhat encouraging. Compliance problems would inevitably be greater with global climate change than with ozone, because the number of emitters and range of activities is so much greater. The enforcement clause was left blank at Kyoto, to be filled in later, given a lack of good ideas. In practice, countries would miss targets sometimes – some explicitly, pointing to factors beyond their control such as natural disasters, civil wars, economic hardship, and so forth, and others hiding behind a mask of shameless accounting. But the more egregious cheaters would feel strong moral suasion from others, and when all was said and done, some progress would be accomplished. Unfortunately, the power of moral suasion diminishes sharply if the countries participating know that they are heavily outnumbered by the countries not participating. An excellent idea that might have helped persuade cost-conscious countries was the safety valve: supplementing quantitative targets with a

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provision that if the shadow price of carbon (the price of tradable permits) goes above a pre-arranged level, then it is capped by an arrangement that some authority will sell an unlimited number of additional permits at that price.21 The selling authority could be national governments in one version, or a multilateral authority in another version, with proceeds earmarked for agreed-upon uses. One attractive feature of this idea is that it ‘calls the bluff’ of the techno-optimist environmentalists. If they are right that there are lots of opportunities for reducing emissions cheaply, then they should have no objection to a safety valve that would kick in only at a relatively high price. The proposal is also called an escape clause or, in trade-policy language, a tariff-rate quota. Even after the Kyoto Protocol was written, there was still scope for incorporating such a provision under the compliance section, as a monetary penalty for non-compliance. The safety valve idea had more potential support than most ideas that we economists come up with. If the economic team in the Clinton Administration had been even better prepared, we might have been able to get a safety valve accepted as part of the Administration position. Still, it would have been a difficult ‘sell’. As soon as one names a specific number for the mechanism to be triggered, the number is too high – in that you are admitting to industry the possibility that costs might go that high – and simultaneously too low – in that the environmentalists worry that you are abandoning the objective of putting a ceiling on emissions. Many regard the absence of the developing countries as the most serious and most intractable shortcoming of the Kyoto Protocol. This is right in the sense that we need these countries in the system. We need meaningful participation by developing countries for three reasons: (1) although the industrialized countries created the climate problem, the developing countries are nevertheless the source of the big increases in emissions in coming years under the BAU scenario. (2) If an international regime is implemented without the developing countries, their emissions are likely to rise even faster than BAU, due to the problem of ‘leakage’. And (3), as is apparent in the model results, the opportunity for the United States and other industrialized countries to buy emission reductions from developing countries is crucial to keep the economic cost low. It is also correct that the obstacles to bringing the developing countries in are very large. This was the third of the political gaps identified above. I would disagree with people like my friend and colleague Dick Cooper who claim that the approach of setting quantitative targets does not lend itself to bringing in the developing countries. Before Kyoto, one would reasonably have thought that it would be impossible for countries to agree on differentiated quantitative targets. But the Annex I countries did precisely that. But how, you will ask, could the developing countries now be brought in?

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In the first budget period, the developing countries should be asked to commit to quantitative targets closely related to their BAU paths. These would not be cuts in absolute terms, which it would be completely unreasonable to ask of developing countries, but would rather constitute ‘growth targets’. I have explained elsewhere ideas for how specifically to determine these targets.22 To address problems of both equity and uncertainty, targets could be set by a formula based on countries’ past emissions, income levels and population. Persuading the developing countries to participate should not be quite as difficult as many assume, because they stand to gain from the system, not only environmentally but economically as well, that is, from the opportunity to sell emission credits. As a measure that can offer gains to all parties, both rich and poor, the proposal to add the developing countries to Kyoto by granting them BAU-related paths surely is more likely to be adopted than measures that ask them to make sacrifices. Here I will add a few words on how I propose setting the targets in subsequent budget periods, after the developing countries are in the system and targets for the first budget have been agreed. For the second budget period, participants should again negotiate targets, according to one formula for Annex I countries and another for developing countries. The formula for the Annex I country targets should incorporate small additional cuts in per capita emissions by taking a step in the direction of the worldwide average of per capita emissions. Meanwhile, the formula for developing countries should incorporate small additional cuts (again, relative to existing growth paths) by taking a step in the direction of their 1990 per capita levels. In the third budget period, the formula for Annex I countries would again place a bit less weight on the Kyoto targets and a bit more weight on the global per capita average; and the formula for developing countries would place a bit less weight on the BAU path and a bit more weight on 1990 levels. In the long run, all countries could converge on a common formula for per capita emissions, as a function of each country’s 1990 emission levels and per capita income levels. With a long-term framework of this nature, Kyoto would truly turn out to have been the first step on the path toward seriously addressing global climate change.

NOTES 1. 2. 3.

Working Group I of the IPCC (2001), p. 13–16. A few will try, which is commendable. But absent a commonly agreed set of rules or incentives, voluntary individual efforts are unlikely to add up to much, and rather to remain a matter of ‘private virtue’ (a phrase of Vice President Dick Cheney’s). Nordhaus (1994).

You’re getting warmer 4. 5. 6. 7.

8.

9. 10. 11.

12. 13.

14. 15. 16. 17. 18.

19.

20. 21. 22.

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For example, William Cline (1992). For an introduction to the discount rate issue, see Goulder and Stavins (2002). For a more recent and general review of the timing issues, see Aldy et al. (2001). Manne and Richels (1997). Subsequently, Hammett (1999) estimated that the least-cost emissions path for stabilizing at 550 ppm lies below the fully optimizing path of costbenefit analysis, until 2024, and then crosses above it. Wigley et al. (1996) had earlier proposed a path to this goal (which Manne–Richels found to be almost as cost-efficient as theirs), showing Annex I emissions peaking in 2010, developing countries peaking in 2050 and the global average peaking in 2030. I want to be clear that it still makes sense for most academic models to work in terms of long-term paths. But it is also important to realize that no given policy maker gets to choose a long-term path. The job of each, at most, is to choose the size of one link in the chain. The economic adviser who insists on talking about 100-year paths is making the common mistake of refusing to answer the question that the policy maker has hired him to answer. On several occasions, I would try to explain an intermediate value theorem to my colleagues: Before emissions returned to 1990 levels, their rate of growth would have to turn negative, and before that, their first derivative would have to fall to zero. But nobody wanted to discuss the leveling off date. Awareness is also increasing over time (Kull, 1998, pp. 3–6). The source is a survey conducted by the National Opinion Research Center, for the US Council for Energy Awareness, in 1993. Only 48 per cent favor increasing the tax on gasoline by 10 cents a gallon, according to a Mellman Group poll in August 1997, although a majority is willing to pay more for gasoline in an unspecified way, if it will significantly reduce global warming (73 per cent will pay 5 cents a gallon, and 60 per cent will pay 25 cents), according to a Pew Poll in November 1997 (Kull, 1998, p. 12). Some others share this feeling as well, for example, Sandel (1997). Forty-four per cent said the US should refuse to sign the Kyoto Treaty until all the lessdeveloped countries committed to limits, while 53 per cent said the industrialized countries should proceed with as many countries as would commit to limits (Kull, 1998, p. 10). US Department of Energy (1997). Al Gore’s book on climate change repeats the old joke about a man not wanting to pick up a $20 bill on the sidewalk, under the theory that it couldn’t be real because somebody else would have already picked it up (Gore, 1993, p. 186). The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis, White House, July 1998. Summaries included Yellen (1998); and Frankel (1998). Edmonds et al. (1992, 1997). We made adjustments for the effect of the six-gas objective, as the existing economic models focused on carbon dioxide alone. Joe Aldy was the CEA staff economist who worked with the model. A majority of 52 per cent of Americans say they would oppose signing the treaty at a presumed cost level of $50 a month for an average household (Kull, 1998, p.11). Although the White House did not use or have polling data at the time the policy was formulated, the politically minded aides had a notion of what the public would support that turned out to be about right, judged by subsequent data. Three models were (substantially) more optimistic than SGM: FUND, G-Cubed (McKibbin–Wilcoxen) and RICE. In the case of global trading, six models were more pessimistic than SGM: MIT, AIM, MRT, CETA, MERGE3 and Oxford (the latter few models were substantially more pessimistic). For example, Nordhaus (2001); Cooper (1998), and Chapter 2, this volume. For example, Pizer (1997); Kopp et al. (1999). The Brookings Institution (1999). The targets could be set slightly below the BAU estimates, comparable – controlling for income levels – to the pattern of reductions implicit in the targets agreed by the industrialized countries at Kyoto.

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REFERENCES Aldy, Joseph, Peter Orszag and Joseph Stiglitz (2001), ‘Climate Change: An Agenda for Global Collective Action’, conference on The Timing of Climate Change Policies, Pew Center on Global Climate Change. Cline, William (1992), The Economics of Global Warming, Washington, DC: Institute for International Economics. Cooper, Richard N. (1998), ‘Toward a Real Global Warming Treaty’, Foreign Affairs, March/April, 66–79. Edmonds, J.A., S.H. Kim, C.N. McCracken, R.D. Sands and M.A. Wise (1997), ‘Return to 1990: The Cost of Mitigating United States Carbon Emission in the Post-2000 Period’, Pacific Northwest National Laboratory, Operated by Battelle Memorial Institute. Edmonds, J.A., H.M. Pitcher, D. Barns, R. Baron, and M.A. Wise (1992), ‘Modeling Future Greenhouse Gas Emissions: The Second Generation Model’, in Lawrence Klein and Fu-chen Lo (eds), Modeling Global Climate Change, Tokyo: United Nations University Press, pp. 295–340. Frankel, Jeffrey (1998), ‘Economic Analysis of the Kyoto Protocol’, After Kyoto: Are there Rational Pathways to a Sustainable Global Energy System?, Aspen Energy Forum, Aspen, 6 July, Colorado: White House. Gore, Al (1993), Earth in the Balance: Ecology and the Human Spirit, New York: Plume, Penguin Books. Goulder, Lawrence, and Robert Stavins (2002), ‘How and Why Economists Discount the Future’, Nature, 419, 17 October, 673–4. Hammett, James (1999), ‘Evaluation Endpoints and Climate Policy: Atmospheric Stabilization, Benefit–Cost Analysis, and Near-Term Greenhouse Gas Emissions’, Climatic Change, 41, 447–68. Kopp, Raymond, Richard Morgenstern, William Pizer and Michael Toman (1999), ‘Domestic Trading: A Credible Early Action’, Washington, DC: Resources for the Future. Kull, Steven (1998), ‘Americans on Global Warming: A Study of US Public Attitudes’, Program on International Policy Attitudes, University of Maryland, pp. 3–6, 10–12. Manne Alan S. and Richard G. Richels (1997), ‘On Stabilizing CO2 Concentrations – Cost-Effective Emission Reduction Strategies’, Stanford University and Electric Power Research Institute. National Opinion Research Center (1993), Survey for the US Council for Energy Awareness. Nordhaus, William (1994), Managing the Global Commons: The Economics of Climate Change, Cambridge, MA: MIT Press. Nordhaus, William (2001), ‘After Kyoto: Alternative Mechanisms to Control Global Warming’, American Economic Association, Atlanta, GA, 4 January. Pizer, William (1997), ‘Prices vs. Quantities Revisited: The Case of Climate Change’, Resources for the Future Discussion Paper 98–02, October. Sandel, Michael (1997), ‘It’s Immoral to Buy the Right to Pollute’, New York Times, 15 December, p. A29; reprinted in Robert Stavins (2000), Economics of the Environment: Selected Readings, 4th edition New York: Norton, pp. 449–52. The Brookings Institution (1999), ‘Greenhouse Gas Emissions’, Policy Brief No. 52, June, Washington, DC: The Brookings Institution.

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US Department of Energy (1997), ‘Scenarios of US Carbon Reductions: Potential Impacts of Energy-Efficient and Low-Carbon Technologies by 2020 and Beyond’. Wigley, Thomas, Richard Richels and Jae Edmonds (1996), ‘Economic and Environmental Choices in the Stabilization of Atmospheric CO2 Concentrations’, Nature, 379. Working Group I of the Intergovernmental Panel on Climate Change (2001), Climate Change 2001: The Scientific Basis, Summary for Policymakers Report, United Nations Framework Convention on Climate Change, United Nations, New York, pp.13–16. Yellen, Janet (1998), ‘Testimony before the US House of Representatives Committee on International Relations’, The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis, 13 May, Washington, DC: White House.

PART II

Trade and Environment Policies

4.

Trade, the harmonization of environmental policy and the subsidiarity principle Charles Perrings

INTRODUCTION Enlargement of the European Union implies increasing heterogeneity amongst member states. This raises important questions about the connections between trade and environmental policy in the enlarged EU and in particular, about the role of harmonization in environmental policy. The question posed is the following: what should be the nature of the linkages between common trade and environmental policies, and to what extent should a common environmental policy imply the harmonization of environmental standards? Although the chapter is concerned with the European Union, and with the differences between current and accession states, these turn out to be essentially the same questions being raised at the global level in connection with an environmental analogue to the World Trade Organization (WTO). The institutional implications are somewhat different, but the principles at issue are the same. Given this, the chapter begins with a discussion of the global debate about the linkages between trade and the environment, and the importance of differences between countries for those linkages. This debate is normally considered in terms of North–South differences, but enlargement faces the European Union with qualitatively similar problems. For example, the current concerns of the South about the role of environmental standards as trade protection devices have echoes in the concerns of accession countries over harmonized environmental standards. Globally, the failure of trade liberalization to yield promised development benefits has hardened attitudes in the South against environmental cooperation. The fact that the South’s share of world exports has been steadily declining in the years since the conclusion of the Uruguay Round has made the countries of the South more suspicious than ever of the hidden agendas in environmental negotiations. Within Europe, similar concerns have affected attitudes both to 59

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regional commitments under multilateral environmental agreements (MEAs) and to environmental directives that enforce common standards. The points at issue in the debate are then illustrated through a particular problem – the problem of alien invasive species (IAS). This is not a problem that has yet become a general source of concern, although specific cases of invasive pests and pathogens, such as the current foot and mouth (FMD) epidemic or the AIDS epidemic attract both attention and resources. Indeed, FMD is taken as an exemplar for purposes of discussion. It is a problem that nicely reveals the trade-offs at issue in the linkage between trade and environmental policy, and the case for harmonization.

TRADE–ENVIRONMENT LINKAGES The issue is not whether trade and environment are linked, but how they are linked. To be sure the issue has been blurred by the heated debate over the inclusion of environmental considerations in the WTO.1 But the frequently repeated assertion that trade measures are blunt instruments to deal with environmental problems that are better addressed through dedicated environmental measures does not mean there is or should be no linkage between trade and the environment. The environmental effects of economic activity are frequently not reflected in national or international market transactions – they are external to the market. But environmental externalities exist precisely because there are physical linkages between non-marketed environmental processes and marketed goods and services. Internalization of environmental externalities implies recognition of the physical linkages between economic and environmental processes. The way we choose to do this varies with the nature of those linkages – whether they involve public or private goods, whether the effects are unidirectional or reciprocal, whether they consist of stock or flow pollutants, and whether they cross national boundaries. The specific options open at the international level may be different from those at the national level, but the generic features of those options are the same. There are examples of the internalization of externalities through the assignment or negotiation of property rights at both national and international levels. Safe minimum standards exist for transboundary effects just as they do for domestic effects. Taxes, subsidies or penalties have both national and international analogues, and in both cases efficiency requires that the scale of the intervention is proportionate to the failure of the market concerned. It is related to the marginal damage cost of the external effect. It is certainly possible to pose the question as to whether negotiated changes in the trade regime generate sufficient gains that the new regime is

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superior to the old regime by the compensation principle, irrespective of the welfare costs of environmental externalities. Even if one uses this rather limited test of efficiency, however, the compensation mechanisms for distributing the gains from changes in the trade regime are natural elements of trade negotiations. Indeed, the idea that those who stand to carry increasing environmental costs from a change in the trade regime should negotiate rules without reference to compensation mechanisms is fanciful. The more important question is whether trade agreements exacerbate environmental externalities, and if so how they should be addressed. There has been a long and not particularly helpful debate as to whether trade liberalization is ‘good’ or ‘bad’ for the environment. A common argument is that liberalization of global markets is likely to be environmentimproving as a result of the composition effect. This is, for example, because removal of explicit or implicit agricultural and energy subsidies is thought to reduce the incentive to over-exploit marginal lands and to encourage the adoption of energy-saving technologies, both of which reduce pressure on the environment (cf. Munasinghe and Cruz, 1995). In the same vein, it has been argued that trade liberalization would both lower the cost of environmental protection, and facilitate the diffusion of environmental protection technologies (Anderson and Blackhurst, 1992). Against arguments such as these is the fact that the reallocation of effort on the basis of comparative advantage can lead to greater concentration of activities in particular locations, increasing the environmental impact in those locations. The change in developing country share in world production and trade in the smoke-stack industries, for example, is partially due to changes negotiated in earlier rounds of the General Agreement on Tariffs and Trade (GATT). To the extent that specialization in polluting activities is driven by a set of prices that exclude environmental costs, liberalization has been argued to be ‘bad’ for the environment (Daly and Goodland, 1994; Young, 1994). There are similarly conflicting stories told about the environmental implications of the scale effect. On the positive side, the literature stimulated by Grossman and Krueger’s (1993) study of the environmental implications of NAFTA – the Environmental Kuznets Curve literature – has supported the view that the growth induced by trade liberalization may improve certain measures of environmental quality. This is partly because of the composition effect. The point has already been made, for example, that high income countries have tended to shift out of the most polluting industries such as pulp and paper, iron, steel and non-ferrous metals, petroleum refining and chemical products (Panayotou, 1997; de Bruyn, 1997). But it has also been argued to follow from the fact that growth in incomes induces a proportionately greater growth in environmental expenditures.

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That is, one reason to expect a positive relation between the scale effect and environmental quality is that environmental quality is in the nature of a luxury good (McConnell, 1997). Environmental expenditures are income-elastic. On the other side of the coin, if liberalization stimulates demand for the products of environmentally damaging activities, then it follows that it will increase environmental damage, other things being the same (Anderson, 1992; Barrett, 2000). Of course other things will not necessarily be the same. Feedback mechanisms such as the price system will induce changes in technology and demand. But if there exist no feedback mechanisms, or if the existing feedback mechanisms are blind to environmental effects, then as Daly (1973) has long observed, economic growth will indeed be environmentally harmful. Economic growth is likely to push economies closer to the assimilative or carrying capacity of their environment. As activity levels rise, the environmental constraints to growth may become more and more binding. In extreme cases, environmental impacts may threaten the resilience of the ecological systems on which economic activities depend (Arrow et al., 1995). The main point here, as Barrett (2000) remarks, is that whether liberalization is good or bad for particular environments is an empirical question. At the international level it depends on people’s willingness to trade off environmental quality in different locations, and this involves complex decisions. It may, for example, be possible to relieve an environmental constraint to the growth of industrial output by relocating industry from areas where the assimilative capacity of the environment is fully stretched to those where it is barely tested. This will involve both benefits and costs for people in both areas, and the balance struck will reflect their preferences between environmental quality and the consumption possibilities associated with industrial decline or expansion. It may also be possible to relieve an environmental constraint to industrial growth by enhancing the assimilative or carrying capacity of the environment. Growth in carbon emissions in one location may, for example, be balanced by increasing carbon sequestration in other locations. In this case, the costs of enhancing the assimilative capacity of the environment include the foregone development options of committing land to carbon sequestration. The pertinent questions at the national or international level are: (i) whether the externalities induced by the composition and scale effects of changes in the trade regime outweigh the gains from that change, (ii) whether there exist interventions to internalize the externalities resulting from the change, and (iii) if the change yields potential net benefits excluding externalities, whether there exist compensation mechanisms to ensure that it is welfare improving for all.

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At the international level, the answers to these questions depend on both the physical and institutional linkages between economic and environmental processes. The environmental externalities associated with trade expansion are a function of the physical interactions between economic and environmental processes, given the set of property rights that underpin market transactions, and given the measures taken to deal with problems posed by the incompleteness of markets. That is, externalities exist because of the failure of institutions to match the physical linkages. Environmentalists’ concerns with the WTO stem from the perception that it limits the extent to which transboundary externalities (spillovers) may be internalized. The exceptions allowable under Article XX of the GATT, along with the Sanitary and Phytosanitary Agreement (SPS Agreement), do authorize countries to impose restrictions on trade in order to protect human, animal and plant life. Moreover, it is recognized that tariffs may substitute for Pigouvian taxes in the internalization of international environmental externalities, albeit imperfectly (Markusen, 1975; Brander and Taylor, 1998). But there is a (well-grounded) perception that the exceptions allowable under Article XX and the SPS measures are narrowly interpreted, and that the WTO’s predisposition to see environmental measures as protectionist measures limits their effectiveness. The WTO has in fact been very cautious in granting exceptions to individual countries under Article XX. Aside from Article XX and SPS exceptions, trade sanctions have been successfully included as mechanisms for encouraging participation in and discouraging non-compliance with multilateral environmental agreements (MEAs), the best example being the Montreal Protocol on Substances that Deplete the Ozone Layer (Barrett, 1999). In some cases these have been recognized by the WTO, although in others like the Cartagena Protocol on Biosafety and Genetically Modified Organisms, it is more sceptical (Runge, 2001). The consensus is now that the WTO may not be the place to negotiate cooperative environmental measures (Bhagwati, 2000; Barrett, 2000). Indeed, the WTO itself makes the same point, arguing that international economic integration reinforces the need for international environmental cooperation (Nordstrom and Vaughan, 1999). This had led to growing pressure for the establishment of an environmental analogue to the WTO – either a World Environment Organization (WEO) (Whalley and Zissimos, 2000) or a Global Environment Organization (GEO) (Runge, 2001). The case for either a WEO or GEO has several elements. The first is that the WTO as presently constituted is not the place to address transboundary environmental externalities. The alternative to date has been to negotiate specific MEAs, each covering a particular transboundary issue. This has led to a plethora of agreements – more than 200 so far. In some instances

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these have been linked in the sense that agreement on one issue has been associated with agreement on other issues. The reasons for this are now well understood. Issue linkage turns out to be one of the main mechanisms for assuring the viability and stability of environmental coalitions (Carraro, 1999; Xepapadeus, 2000). There is, however, no mechanism for the general coordination of MEAs. The Global Environment Facility (GEF) may be interpreted as a compensation mechanism for a select number of MEAs, especially the Convention on Climate Change and the Convention on Biological Diversity. But most agreements are both negotiated and then implemented in isolation. Given the physical interdependence of the issues covered by different agreements, this is an important lacuna. Moreover, while not all agreements involve trade sanctions, enough do so for coordination with the WTO to be a problem. Runge (2001) argues that the primary role of a GEO would be coordination of the MEAs, and liaison between MEAs and the WTO. In particular, he regards a GEO as taking responsibility for negotiating Article XX exceptions. A secondary role would be to offer the same sort of dispute resolution function as the WTO. Whalley and Zissimos (2000), by contrast, see the role of a WEO as being explicitly to internalize global environmental externalities. Arguing that the cause of global environmental externalities lies in the lack of well-defined property rights at the global scale, they claim that a primary function of a WEO would be to establish markets for global environmental goods and services. Very few existing MEAs involve markets or compensation mechanisms, so this vision goes well beyond coordination. A key point here is that global environmental externalities are evidence of global market failure, and their internalization implies a mechanism that can operate at the global scale. It does not follow that a WEO or GEO should operate only at the global scale. Most MEAs do not have a global reach, and most transboundary environmental disputes involve a relatively small number of countries. In a similar vein, most disputes brought to the WTO disputes panel – and all of the disputes brought under Article XX – involve a small number of countries. Nonetheless, there is a link between the scale of an environmental externality and the scale of the institutional framework suggested for its internalization. Regional trade agreements typically involve parallel environmental agreements. The form of these differs from one case to another. NAFTA includes an environmental side agreement, the North American Agreement on Environmental Cooperation (NAAEC), which is implemented by the North American Commission for Environmental Cooperation (CEC). The EU includes a much broader array of region-wide environmental policies administered partly through the Environment Directorate and partly

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through other Directorates. But in both cases there are environmental institutions with the same potential reach as the trade pact.

THE IMPORTANCE OF COUNTRY DIFFERENCES The point made at the outset is that enlargement of the EU involves the accession of countries that are different in a number of respects from current member states. The differences may not be as dramatic as North–South differences involved in the enlargement of NAFTA, but they are qualitatively similar and are important. The accession countries are characterized by different economic structures, income levels, labour market conditions, technological development and environmental resource endowments. At the global level, North–South differences have been well enough studied that we can draw some general conclusions about the implications of enlargement for institutional linkages. The most frequently made argument is that agreements which facilitate capital mobility tend to induce a ‘race to the bottom’ as firms in high income countries seek to remain competitive by relocating to countries where labour and environmental conditions are more relaxed (Wheeler, 2000). The race to the bottom implies that a locally relaxed environmental protection regime is maintained in order to induce inward investment. If trade agreements make it impossible to protect domestic agriculture or industry through trade policy, countries may be encouraged to use other policies to the same effect. By this argument, enlargement would be accompanied by increasing levels of activity in accession countries as firms relocate to take advantage of local labour market and environmental regulatory conditions, with resulting impacts on both the local and regional environment. The corollary is that other countries would use environmental regulation as protectionist measures against the accession states. Furthermore, because trade agreements can create both winners and losers, they create the conditions in which side payments or issue linkages can be invoked to improve the stability of the coalition. Differences between current member states and the accession states create an incentive to negotiate linkage between institutions. At the root of the race to the bottom argument is the proposition that competition within a trade pact will drive firms to locate where costs – including the costs of compliance with environmental regulations – are minimized. The empirical evidence for this is mixed. The relocation of polluting industries from high-income to low-income countries is an important part of the explanation for changes in environmental indicators observed in the EKC literature (Barbier, 1997; Cole et al., 1997). However,

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studies of the incentive effects of environmental regulation have concluded that the costs of compliance with environmental regulations are a sufficiently small proportion of total costs and that they do not generally turn location decisions in high-income countries (Jaffe et al., 1995; Levinson, 1996). Labour costs, raw material costs and taxes tend to be more important than the costs of compliance with environmental regulation in firms’ location decisions. Moreover, where firms do relocate they do not necessarily adopt more polluting technology than in their original location (Wheeler, 2000; Jha et al., 1999). Against this, studies using more disaggregated data show that location decisions within a state may indeed be influenced by environmental policy (Copeland, 2000). Wheeler (2000) concludes that the effects of income growth on environmental protection in low-income countries along with the progressive empowerment of local communities affected by relocation will be enough to avert a race to the bottom. What is involved here? The race to the bottom implies that environmental policy is used as an adjunct to trade policy, either to induce inward investment or to protect domestic industry. There is also an implication that countries will accept lower environmental standards than they would in the absence of the ‘race’. Copeland (2000) discusses the theoretical problem in the context of a North–South model that shows how income-related differences in policies can generate trade with environmental consequences. He argues that if a change in some trade agreement is not linked to any environmental agreement, the trade agreement will induce a non-cooperative game in environmental policy. Because the trade agreement does not eliminate a government’s interest in the protection of domestic industries, it will encourage them to seek alternative instruments. Environmental policies may then be adopted in place of trade policies that are excluded by agreement. But note that the incentive to use environmental policy as a surrogate trade policy can work in either direction. Environmental standards below those of the trading partner may be used in place of subsidies, standards above those of the trading partner in place of tariffs. In both cases efficiency requires commitment to binding agreements on both environmental and trade policy. Moreover, linkage is likely to be more important, the more comprehensive the trade pact. This is because the more comprehensive the trade pact, the fewer are the loopholes within the pact, and the stronger the incentive to use non-trade policies as trade-policy surrogates (Copeland, 2000). The evidence on the use of the SPS Agreement provides support both for the race to the bottom hypothesis and the notion that environmental measures are used as surrogate trade measures by high-income countries. As has already been noted, Article XX of the GATT and the SPS Agreement authorize countries to impose restrictions on trade in order to protect human,

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animal and plant life. In principle, the SPS Agreement allows signatories to invoke a precautionary approach to environmental risks. Article 5.7 authorizes the adoption of border restrictions on the basis of existing information, even if there is no firm proof that the importation of a particular species is harmful. In practice, however, Article 5.7 may be interpreted quite narrowly. For example, the Appellate Body decision on the EU–USA growth hormone dispute found in favour of the USA because there was insufficient scientific evidence to justify a precautionary approach. Similarly, a number of rulings of the WTO disputes panels on cases brought under Article XX of the GATT have concluded that restrictions on trade in agricultural, forestry and fisheries products have been directed more at the protection of domestic industries than the protection either of consumers or the environment. Both Article XX and the SPS measures have nevertheless been successfully invoked in many circumstances. What is particularly interesting about the pattern of such measures is their distribution between high-income and low-income countries. In 1995–97 there were 724 measures notified under the SPS Agreement. Of these 55 per cent were notified by high-income countries, 42 per cent by middle-income countries, and only 2 per cent by low-income countries (UNEP, 1999).

COORDINATION, HARMONIZATION AND SUBSIDARITY I now want to consider the characteristics of SPS and Article XX measures associated with trade pacts amongst high-income countries, and especially by the EU. Environmental policy in the EU increasingly emphasizes harmonization in the sense of the adoption of uniform standards for products, processes and environmental quality. Copeland (2000) makes the point that harmonization is to be expected in closely integrated trade agreements such as the EU (though not in looser agreements such as NAFTA and WTO). We need to ask why. It is conventional to distinguish between harmonization of product, process and environmental quality standards. It is also helpful to distinguish between mandatory and voluntary harmonization. Mandatory harmonization involves the imposition of common standards and its enforcement through the regulatory system. Voluntary harmonization refers both to the de facto harmonization that comes from industrial arbitrage between technologies (frequently leading to ‘lock-in’ to particular technologies such as catalytic converters), from arbitrage by consumers among products, and from the adoption of voluntary industrial standards. Voluntary (marketdriven) harmonization is not generally an issue in international trade.

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Mandatory harmonization is admissible under the WTO only if it does not discriminate between domestic and international suppliers, or if it is an authorized exception under Article XX or the SPS Agreement. Theoretically, it is very hard to find a convincing case for mandatory harmonization. Bhagwati and Hudec (1996) and Bhagwati (2000) claim that there should be a mandatory code compelling multinational corporations to adopt home country standards when they invest abroad. Implicitly, it is assumed that the environmental standards of the home country are higher than the foreign country. But it is not at all clear that there are credible efficiency or equity arguments for the claim. Bhagwati’s justification is that harmonization would secure the approval of environmentalists (a political point) at relatively low cost (Bhagwati, 2000). He assumes that many corporations currently apply home standards in their foreign investments, which is why the cost of harmonization is low. But all the same it is a weak argument. If environmental conditions and environmental preferences are different in the two locations, both marginal damage and marginal abatement costs will also be different, and the adoption of a common standard will be inefficient. Indeed, harmonization creates the same problems at the international level as does the use of uniform standards in the environmental regulation of firms at the national level. It is hard to avoid the conclusion that the proponents of harmonization are themselves looking for protectionist devices that are admissible under the terms of the relevant trade pact and the WTO. There is a rather different case for harmonization, which is that it may inhibit free-riding in the provision of environmental public goods (Barrett, 2000). If all users are required to comply with the same process standards, none will be able to free-ride on the efforts of others. The strength of this case depends on the nature of the public goods, and the technology of supply. Free-riding reduces the value of the public good where the benefits to all depend on the sum of the contributions of each (as is the case in carbon emissions/sequestration). It potentially reduces the value of the public good where the benefits to all depend on the least effective contribution (as in the case of the control of communicable or infectious diseases). In both cases mandatory harmonization might compel would-be free-riders to maintain a socially acceptable level of supply. But once again, there is no reason to believe that the resulting allocation would be either efficient or equitable. In other words, even where there is a strong case for coordination of international environmental policy, there seems to be no efficiency-based case for harmonization. In Europe, there is a very uneasy link between harmonization and the principle of subsidarity. By the principle of subsidiarity, individual member states are responsible for determining the appropriate local balance between

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environmental quality, employment, consumption and so on. The notion of subsidiarity implies that decisions should be made at the lowest level consistent with the protection of the interests of the union. If local activities generate only local effects, then subsidiarity implies that the regulation of those effects should be a local matter. If local activities generate transboundary effects, then subsidiarity implies that the regulation of those effects should be a matter for the EU. In practice, the extent of mandatory harmonization of products, processes and environmental quality within the EU is difficult to square with the subsidiarity principle. There is certainly some flexibility for local authorities to set ambient standards, and to choose policies to meet those standards. But the authority given to the EC to harmonize policies under the Treaty of Rome is being used to generate an increasing number of environmental directives that are inconsistent with the subsidiarity principle. These directives require member states to harmonize products, processes and environmental quality without regard to local preferences, and without reference to the geographical impact of local activities. Take an example that with some notable exceptions involves no transboundary externalities. Standards for the quality of emissions from sewage treatment works under the EU’s Urban Waste Water Treatment (UWWT) Directive oblige all water utilities to achieve common emissions standards by 2005. There are significant differences not just in marginal abatement costs, but also in marginal damage costs across current member and accession states. Differences in marginal damage costs are due to the fact that there is very wide variation in the capacity of Europe’s waterways to assimilate the biochemical oxygen demand from sewage treatment works emissions. Sewage treatment works emissions at several times the current volume and the admissible BOD concentration would have no measurable impact on water quality in some rivers. Yet emissions at the current volume and the admissible BOD concentration would cause dissolved oxygen to fall below the level at which other rivers could support aquatic life. The UWWT directive would appear to be incompatible with the subsidiarity principle in that it does not allow local communities the discretion to regulate a local problem. It is also inefficient. This is partly due to the fact that uniform standards are generically inefficient if marginal abatement and damage costs differ. It is also due to the fact that the directive deals with emission standards, not standards for minimum dissolved oxygen levels (or other measures of environmental health). Unless environmental quality standards are defined in terms of the stress imposed by emissions/extraction of environmental resources relative to the assimilative/carrying capacity of the environment, they will be a source of inefficiency. Increasingly, the subsidiarity principle is being interpreted to mean that member states

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can exercise discretion as to how they meet harmonized environmental standards. For transboundary externality problems involving public goods, the case for harmonization seems to be stronger, at least at first sight. The Long Range Transboundary Air Pollution (LRTAP) Convention (ratified 1983) covers a number of the pollutants affecting the problem of acid rain, a regional impure public bad that stems from both fixed and non-fixed sources. The signatories include both current member and accession states. What is interesting about LRTAP is that an initially harmonized approach to sulphur abatement was abandoned in favour of a discriminating approach (Sandler, 1997). The first sulphur protocol, the Helsinki Protocol, came into force in 1987. It adopted a harmonized approach, committing signatories to a reduction in sulphur emissions of 30 per cent of 1980 levels by 1993. Country differences in marginal abatement and damage costs were ignored. The inefficiency in such an approach was subsequently shown to be quite severe (Hutton and Halkos, 1995). The signatories to LRTAP have since negotiated a second sulphur protocol, the Oslo Protocol, which came into force in 1998. Unlike the first, this was based on the minimization of control costs needed to reduce sulphur emissions within the limits of different carrying capacities of the countries concerned (Sandler, 1997). EU environmental policy on transboundary environmental externalities is characterized by a much greater and more persistent commitment to harmonization than this. The Large Plant Combustion Directive, to take just one example, looks exactly like the Helsinki Protocol. It mandates member states to reduce SO2 emissions from thermal power stations and industrial plants by 60 per cent of 1980 levels by 2003. Given the inefficiency of such an approach – Ulph (2000) shows that there are almost no credible cases where harmonization is warranted on efficiency grounds – it is worth considering what potential benefits it has to offer. Barrett (2000) argues that the motive for harmonization may be to reduce the incentive to use local environmental policy in place of trade policy. This is clearly what Copeland (2000) has in mind when he argues that more tightly integrated trade agreements lead to harmonization. Harmonization prevents countries whose socially optimal standard may be less than the harmonized standard from exploiting that fact. The important point here is that harmonization of environmental policy is driven by a trade policy agenda.

THE PROBLEM OF INVASIVE ALIEN SPECIES To make these general comments concrete, let me consider a particular environmental problem – the problem of invasive alien species (IAS).

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This is pertinent given the recent epidemic of foot and mouth disease (FMD) in the UK, and outbreaks elsewhere in Europe and the rest of the world. It is also pertinent given that the problem of IAS is closely related to the growth of trade and the increasing integration of economies linked through trade agreements. It is therefore a risk that would be expected to increase as a result of enlargement. These comments reflect the results of a recent SCOPE/GEF research project: the Global Invasive Species project (GISP) (Perrings et al., 2000; McNeeley, 2001; Mooney and Hobbs, 2000). Invasive species comprise any introduced species that establish, naturalize and spread in a location outside their home range (Williamson, 1996). Examples of invasive species that currently impose significant costs in different sectors of the global economy include the following: the screw worm fly, Chrysomya bezziana, in Australia (Anaman et al., 1994; Watkinson et al., 2000); knapweed and leafy spurge in several US states (Bangsund et al., 1999), the green crab, Carcinus maenas, in the North Pacific Ocean (Cohen et al., 1995); the zebra mussel in the great lakes (Khalanski, 1997); and the comb-jelly, Mnemiopsis leidyi in the Black Sea (Knowler and Barbier, 2000). Invasive species also include a range of pathogens such as the AIDS and Ebola viruses. The FMD virus is a good example. IAS impose non-trivial costs on human societies. Pimental et al. (2000) suggest that the annual cost of IAS in the US is of the order of £137 billion. It is hard to calculate the true cost of the AIDS virus in regions like Eastern, Central and Southern Africa, but it is surely greater still. The costs include direct damage or control costs, plus the impacts of IAS on host ecosystems, and on the human populations dependent on them. These reflect the nature of interspecific interactions, and the way that different species affect or are affected by economic activities. Amongst the ecological consequences of IAS, for example, is the loss of native species. IAS are recognized to be the second most important proximate cause of extinctions worldwide (Wilcove et al., 1998). Most ecosystem types have been affected to a greater or lesser extent by IAS (Williamson, 1998; Parker et al., 1999). It is quite intuitive that the introduction of IAS should be an increasing function of the openness of an economy (its integration with the rest of the world) and the composition of its trade flows (Dalmazzone, 2000). This follows from the fact that invasive species are generally introduced via the movement of goods and people, and that the probability of invasions increases with the volume and complexity of such movements. This in turn depends on trade policies. The increase in the volume of trade due, in part, to the liberalization of trade rules under the GATT, has increased the risk of IAS introductions (Perrings et al., 2000; Enserink, 1999). It is slightly less intuitive that the establishment and spread of IAS should be a function of trade policy, but there is also a connection here.

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Agricultural policies developed to support export-oriented agricultural production have increased the susceptibility of agro-ecosystems to invasion. Policies designed to support export crops, for example, have reduced plant genetic diversity and encouraged pesticide regimes that lay arable systems open to invasion by alien pathogens. Similarly, policies designed to support intensification have increased the density of plant and livestock populations, so increasing the ease with which invasive pathogens may establish and spread. More importantly, agricultural markets fail to reflect IAS risks. The market prices of potentially invasive species do not signal the cost they may impose on society. The liberalization of agricultural markets without attention to IAS externalities encourages farmers to ignore such risks (Perrings et al., 2000). This said, the problem of IAS is one of the few environmental problems recognized under Article XX of the GATT and the Sanitary and Phytosanitary Agreement. The latter allows countries to protect themselves from damage due to the introduction, establishment and spread of pests and pathogens by adopting measures that restrict trade at the border. These include the use of both quarantine and exclusion. Exclusion policies vary, but tend to reject either a named set of potentially invasive species (a ‘black list’) or all species other than those on an approved list (a ‘white list’) (Williamson, 1996). The overt role of trade restrictions of this sort is always to protect plant or animal health. In many cases, however, the restrictions may have a more traditional protectionist function. FMD restrictions, for example, effectively protect a sub-set of meat and meat product markets by excluding competitors who do not have ‘disease-free’ status. The FMD restrictions insulate ‘disease-free’ countries from external competition. Because the standard is applied to both domestic and international users it is perfectly consistent with the GATT, but it is nonetheless a protectionist measure. Taking FMD as an example, let us reconsider the issues of coordination, harmonization and subsidiarity within the EU. In general, responses to the introduction of potentially invasive species include actions designed both to reduce the likelihood that the introduced species will establish or spread (eradication or containment) and to reduce the impact if it does establish itself (adaptation). The relative net benefits of mitigation and adaptation jointly determine the response to IAS and hence the risks of IAS (Shogren, 2000; Shogren and Crocker, 1999). In FMD the alternative strategies are eradication by culling infected and potentially infected animals, vaccination as an adjunct to an eradication strategy, or vaccination as an adaptive strategy. The direct payoffs to eradication relative to adaptation relate to the internationally negotiated rules governing the protected market. Eradication allows a country to return to that market. Adaptation does not.

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Eradication with vaccination allows a country to return to the protected market, but after a longer period than eradication without vaccination. In an integrated livestock market, FMD clearly has transboundary effects. The European outbreaks have all stemmed from livestock movements from the UK. Moreover, the loss of disease-free status by one country compromises the benefits of access to the protected market by others. This fact drives the choice of the control strategy in the EU towards eradication.2 Implementation of the strategy is devolved to the member states, but the strategy itself is determined at the level of the Union. This implies a harmonized measure of environmental quality – that each member state should be ‘disease free’. It reflects the fact that the control of the disease is an international public good, the good being an artefact of the international trade regime. That is, the benefits of control are enjoyed by all those who have access to the protected market. Such benefits are neither rival nor exclusive. But the control of the disease is also a public good of a very particular kind. The benefits of eradication to all those having access to the protected market depend on the effectiveness of the eradication programme in the least ‘competent state’. This implies a utility or welfare function of the general form Ui ⫽ Ui (x, Min( y1, y2, . . ., yi, . . . yn )) in which x is a bundle of private goods, and yi is the ith individual’s contribution to the public good. That is, disease control is a ‘weakest link’ public good (Sandler, 1997). For this reason, country differences matter. The effectiveness of control strategies, the costs of those strategies and the alternative methods for their implementation are all a function of local conditions. The outbreak of FMD in the UK in December 2000 or January 2001 (detected in February 2001) was the first since 1967. In the intervening period, conditions in the UK livestock sector had changed quite substantially. Livestock (and wildlife) densities had both increased, and the pattern of livestock management and movement had changed. Both things altered the dynamics of FMD transmission. At the same time, the Ministry of Agriculture Fisheries and Food and, in particular, the veterinary services had lost some capacity to deal with FMD. The system had thus become more vulnerable to the introduction, establishment and spread of FMD, and the effectiveness of all control measures was accordingly reduced. It should be said that the UK is not alone in this. The OIE/FAO International Scientific Conference on Foot and Mouth Disease, Paris, 17–18 April 2001, noted the widespread emergence of new and/or increasing risks due, inter alia, to changes in the livestock industry, and increased movement of people, products and livestock.3 From a global perspective, since FMD is endemic in many parts of the world, maintaining disease-free status in certain areas without vaccination implies the complete separation of markets. But the increasing integration

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of economies with and without disease-free status means that the separation of markets is more and more difficult to maintain. Markets for tourism link ‘disease-free’ and ‘non-disease-free’ countries more and more tightly. Such markets are more valuable than the protected markets in meat and related products, and continue to grow relative to the protected markets. Moreover, they are increasingly linked to those markets through the rural economies of both sets of countries. The harmonized standard of disease-free status without vaccination accordingly involves a growing risk of FMD introductions, and a heightened vulnerability to the establishment and spread of the disease. More importantly, precisely because of the integration of livestock markets in the EU, the standard implies that risks to individual member states are highly correlated, so reducing the capacity of the Community to insure against the effects of outbreaks. The general point made in the third section of this chapter is that the physical interdependence between economic activities operating in a common environment requires coordination of policy. It does not require harmonization. Because FMD involves transboundary effects, the subsidiarity principle implies that it should be addressed at the international level. But differences between member states mean that the marginal benefits and costs of alternative strategies vary widely. In this case, as in others, harmonization is inefficient. More worrying still is the fact that harmonization in this case, again as in others, is driven by a public good that is itself an artefact of trade policy. The public good is the benefits offered by the protected markets, not the welfare of susceptible animals. By agreement, the membership fee is disease-free status.

HARMONIZATION, ENVIRONMENTAL RISK AND ECONOMIC INCENTIVES Harmonized standards are inefficient because they do not provide resources users with appropriate incentives. In the particular case of FMD, this is both because harmonized standards fail to reflect differences in marginal damage, mitigation or adaptation costs, and because they reduce the private incentive to invest in the provision of disease control. In fact they may increase the risks of FMD. The risks associated with IAS generally have a number of features. They are imperfectly understood, frequently correlated, often irreversible, and potentially catastrophic. There are very limited options for the management of such risks. Arrow–Debreu state-contingent commodity markets are unappealing because of their information requirements and transactions costs. Insurance by risk pooling is indicated where the population is large, risks are small, similar and uncorrelated. Intermediaries can

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then pool statistically independent risks so as to neutralize the risks faced by individual agents. However, insurance tends to fail when risks are highly correlated or when the relative frequencies of the states of nature are unknown. Moreover, both approaches tend to fail when the risks are in the nature of public goods. The main alternative is collective agreement over mitigation and avoidance measures. This is the approach taken in the EU. But so far, little attention has been paid to the role of economic incentives in mitigation and avoidance. It is generally accepted that IAS may be dealt with most costeffectively by preventing their introduction in the first place. This suggests that environmental policy should focus on transmission pathways (Perrault and Muffett, 2001). There is some scope for developing codes of conduct for the main international pathways of IAS. Indeed, these already exist for biocontrol agents (UNFAO, 1995). But codes of conduct do not directly affect the incentives to those responsible for moving organisms along the major pathways. Alternative instruments suggested include pathway user fees (Perrault and Muffett, 2001), insurance premia or environmental bonds (Perrings et al., 2001). Both mechanisms require those responsible for shipment along the major pathways to pay a fee proportional to the risk involved that would operate like a third-party insurance premium. So, for example, importers of potentially invasive species might be required to take out insurance against the risks or to post environmental bonds when commercial insurance is unavailable. To avoid problems of moral hazard, the mechanisms should contain incentives to reduce the risks involved. It is accordingly suggested that the value of the fee, premium or bond be adjusted to reflect activities that reduce the risks associated with the pathway. For example, a pathway fee might be reduced if compliance with relevant codes of conduct could be demonstrated (Perrault and Muffett, 2001). Similarly, a bond might be reduced if the importer could show that actual risks were less than those built into the value of the bond (Perrings et al., 2000). Mechanisms of this sort are designed to generate an insurance fund with which to meet the costs of invasions, and to build capacity in prevention efforts. But their primary aim is to provide those whose activities are a source of risk with appropriate incentives. For species that are already established the options are different. To return to the incentive effects of harmonization of the FMD standard, it might be argued that by precluding the option of vaccination the harmonized standard weakens the incentive both to member states and to individual producers within member states to undertake defensive expenditures against the disease. Vaccination for any communicable disease is in the nature of an impure public good. It implies a utility or welfare function of the form Ui ⫽ Ui (x, yi, Y ) in which

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yi is the ith individual’s contribution to the public good Y. That is, the ith individual benefits twice from investment in yi. Their motivation may be the protection they themselves obtain from the investment, but by protecting themselves, people who invest in vaccination also provide protection to others. The harmonized standard does not allow for inclusion of such an incentive.

CONCLUDING REMARKS Since closer integration and increasing trade are both associated with transboundary environmental externalities there is a case for linking agreements on trade and environmental policy. It follows that enlargement of the European Union should be accompanied by agreement on environmental issues. The trade–environment literature indicates that environmental policy tends to be driven by a trade agenda and not by an environmental agenda. That is, environmental policy tends to be used as surrogate trade policy wherever trade agreements limit the options for countries to protect domestic industry legitimately. Moreover, the greater the fundamental differences between trading partners, the greater the incentive to use trade policy in this way. Since differences between the accession countries and current member states are much greater than differences among current member states, enlargement of the EU is likely to create the same tensions. So far, the EU solution to this problem has been to eliminate the scope for using lax environmental policy to attract investment. The harmonization of environmental measures requires all member states to impose the same standards on industry. This chapter makes three points about the approach. The first is that harmonization of environmental standards is as much a surrogate trade policy as are the implicit subsidies in ecological dumping. The only difference is that harmonization protects the industries of a different set of countries. The second point is that harmonization induces an inefficient and environmentally inappropriate use of local resources in that it ignores local conditions and local preferences. As Ulph (2000) shows, the welfare costs of harmonization rises exponentially with the variance in local damage costs, and can negate the benefits of coordination. The third is that harmonization tends to be incompatible with the subsidiarity principle. Considered only from the perspective of the environment, harmonization violates the principle wherever it imposes a European standard on activities that have only local effects. But it is precisely where there are differences in local conditions that confer a potential trading advantage that harmonization offers

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the highest payoff to its proponents. The implications of these points may be stated quite simply. Just as it is inappropriate for trade policy to be driven by environmental policy, so it is inappropriate for environmental policy to be driven by trade policy. The accession of countries to the EU with very different socio-economic and environmental conditions to current member states will tempt the latter to insist on the application of harmonized environmental standards across the enlarged union. That would be a mistake both for the enlarged economy and its environment.

NOTES 1. The various arguments over linkage via the WTO are summarized in a policy forum in Environment and Development Economics 5(4) organized around a paper by Jagdish Bhagwati (Bhagwati, 2000). See also Cooper, Chapter 2, this volume. 2. The EU policy on FMD stems from Council Directive 92/119/EEC and Council Directive 85/511/EEC, as amended by Directive 90/423/EEC, on Community measures for the control of foot and mouth disease (FMD). It is summarized as follows: ‘The European Community’s strategy to fight foot and mouth disease is aimed at eradicating this highly contagious disease as quickly as possible, and at keeping economic damage to a minimum. The most effective means of doing so is to slaughter and destroy infected or potentially infected animals. As part of this eradication policy, vaccination can and must be used as an emergency measure to prevent the spread of foot and mouth disease within a radius of 1 to 3 km around an infected herd, but only as a temporary measure on animals awaiting slaughter and destruction, where there is insufficient capacity for their immediate slaughter and destruction. . . . The slaughter and destruction of infected or potentially infected animals is necessary to maintain the FMD-free status of the EU as a whole. . . . At present, 11 of the 15 EU countries are free of FMD, and the origin of all infected herds identified outside the United Kingdom can be traced back directly to animals from the United Kingdom. Should the further development of the situation make it necessary for the EU to decide to introduce large-scale vaccination, the immediate consequence would be that third countries would prohibit the import of all live animals and non-treated products from the EU. This would lead to very severe losses in terms of trade and employment.’ 3. www.oie.int/eng/press/a_010418 htm.

REFERENCES Anaman, K.A., M.G. Atzeni, D.G. Mayer and J.C. Walthall (1994), ‘Economic Assessment of Preparedness Strategies to Prevent the Introduction or the Permanent Establishment of Screwworm Fly in Australia’, Preventive Veterinary Medicine, 20(1–2), 99–111. Anderson, K. (1992), ‘The Standard Welfare Economics of Policies affecting Trade and the Environment’, in K. Anderson and R. Blackhurst, The Greening of World Trade Issues, Hemel Hempstead: Harvester Wheatsheaf, pp. 25–48. Anderson K. and R. Blackhurst (1992), ‘Trade, the Environment and Public Policy’, in K. Anderson and R. Blackhurst, The Greening of World Trade Issues, Hemel Hempstead: Harvester Wheatsheaf, pp. 3–22.

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Arrow, K., B. Bolin, R. Costanza, P. Dasgupta, C. Folke, C.S. Holling, B.-O. Jansson, S. Levin, K.-G. Maler, C. Perrings and D. Pimentel (1995), ‘Economic Growth, Carrying Capacity, and the Environment’, Science, 268, 520–21. Bangsund, D.A, F.L. Leistritz and J.A. Leitch (1999), ‘Assessing Economic Impacts of Biological Control of Weeds: The Case of Leafy Spurge in the Northern Great Plains of the United States’, Journal of Environmental Management, 56, 35–43. Barbier, E.B. (1997), ‘Introduction to the Environmental Kuznets Curve Special Issue’, Environment and Development Economics, 2(4), 357–67. Barrett, S. (1999), ‘Montreal versus Kyoto: International Cooperation and the Global Environment’, in I. Kaul, I. Grunberg and M.A. Stern (eds), Global Public Goods: International Cooperation in the 21st Century, New York: Oxford University Press, pp. 192–219. Barrett, S. (2000), ‘Trade and the Environment: Local versus Multilateral Reforms’, Environment and Development Economics, 5(4), 349–60. Bhagwati, J.N. (2000), ‘On Thinking Clearly about the Linkage between Trade and the Environment’, Environment and Development Economics, 5(4), 485–96. Bhagwati, J.N. and R.E. Hudec (1996), Fair Trade and Harmonization Prerequisites for Free Trade, Cambridge, MA: MIT Press. Brander, J.A., and M.S. Taylor (1998), ‘Open Access Renewable Resources: Trade and Trade Policy in a Two Country Model’, Journal of International Economics, 44, 181–209. Carraro, C. (1999), ‘The Structure of International Agreements’, in C. Carraro (ed.), International Agreements on Climate Change, Dordrecht: Kluwer. Cohen, A.N., J.T. Carlton and M.C. Fountain (1995), Introduction, Dispersal and Potential Impacts of the Green Crab Carcinus Maenas in San Francisco Bay, California, Marine Biology, 122(2), 225–37. Cole, M.A., A.J. Rayner and J.M. Bates (1997), ‘The Environmental Kuznets Curve: An Empirical Analysis’, Environment and Development Economics, 2(4), 401–16. Copeland, B.R. (2000), ‘Trade and Environment: Policy Linkages’, Environment and Development Economics, 5(4), 405–32. Dalmazzone, S. (2000), ‘Economic Factors Affecting the Vulnerability to Biological Invasions’, in C. Perrings, M. Williamson and S. Dalmazzone (eds), The Economics of Biological Invasions, Cheltenham: Elgar, pp. 17–30. Daly, H.E. (1973), ‘The Steady State Economy: Toward a Political Economy of Biophysical Equilibrium and Moral Growth’, in H.E. Daly (ed.), Toward a Steady State Economy, San Francisco: W.H. Freeman, pp. 149–74. Daly, H.E., and R. Goodland (1994), ‘An Ecological-economic Assessment of Deregulation of International Commerce under GATT’, Ecological Economics, 9(1), 73–92. de Bruyn, S.M. (1997), ‘Explaining the Environmental Kuznets Curve: Structural Change and International Agreements in Reducing Sulphur Emissions’, Environment and Development Economics, 2(4), pp. 485–503. Enserink, M. (1999), ‘Biological Invaders Sweep In.’, Science, 285, 1834–6. Grossman, G.M., and A.B. Krueger (1993), ‘Environmental Impacts of the North American Free Trade Agreement’, in P. Garber (ed.), The US–Mexico Free Trade Agreement, Cambridge, MA: MIT Press. Hutton, J.P., and G. Halkos (1995), ‘Optimal Acid Rain Abatement Policy in Europe: An Analysis for the Year 2000’, Energy Economics, 17(4), 259–75.

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Jaffe, A.B., S.R. Peterson, P.R. Portney and R.N. Stavins (1995), ‘Environmental Regulation and the Competitiveness of US Manufacturing: What does the Evidence Tell us?’, Journal of Economic Literature, 33, 132–63. Jha, V., A. Markandya and R. Vossenaar (1999), Reconciling Trade and the Environment. Lessons from Case Studies in Developing Countries, Cheltenham: Edward Elgar. Khalanski, M. (1997), ‘Industrial and Ecological Consequences of the Introduction of New Species in Continental Aquatic Ecosystems: The Zebra Mussel and other Invasive Species,’ Bulletin Français de la Pêche et de la Pisciculture, 344–5, 385–404. Knowler D., and E. Barbier (2000), ‘The Economics of an Invading Species: A Theoretical Model and Case Study Application’, in C. Perrings, M. Williamson and S. Dalmazzone (eds), The Economics of Biological Invasions, Cheltenham: Elgar, pp. 70–93. Levinson, A. (1996), ‘Environmental Regulations and Industry Location: International and Domestic Evidence’, in J. Bhagwati and R. Hudec (eds), Fair Trade and Harmonization: Prerequisites for Free Trade?, Vol. 1, Cambridge MA, MIT Press. Markusen, J.R. (1975), ‘International Externalities and Optimal Tax Structures’, Journal of International Economics, 5, 15–29. McConnell, K.E. (1997), ‘Income and the Demand for Environmental Quality’, Environment and Development Economics, 2(4), 383–99. McNeely, J. (ed.) (2001), The Greta Reshuffling: Human Dimensions of Invasive Alien Species, Cambridge: IUCN. Mooney, H.A., and R.J. Hobbs (2000), Invasive Species in a Changing World, Washington, DC: Island Press. Munasinghe, M. and W. Cruz (1995), ‘Economywide Policies and the Environment’, World Bank Environment Paper 10, Washington, DC: World Bank. Nordstrom, H. and S. Vaughan (1999), Trade and Environment, Special Studies 4, Geneva: World Trade Organization. Panayotou, T. (1997), ‘Demystifying the Environmental Kuznets Curve: Turning a Black Box into a Policy Tool’, Environment and Development Economics, 2(4), 465–84. Parker, I.M., D. Simberloff, W.M. Lonsdale, K. Goodell, M. Wonham, M.H. Williamson, B. Von Holle, P.B. Moyle, J.E. Byers and L. Goldwasser (1999), ‘Impact: Toward a Framework for Understanding the Ecological Effects of Invaders’, Biological Invasions, 1, 3–19. Perrault, A., and W.C. Muffett (2001), Encouraging Prevention, Developing Capacity and Providing Accountability: A Strategy for Addressing International Invasive Alien Species Issues, Washington, DC: Center for International Environmental Law. Perrings, C., M. Williamson and S. Dalmazzone (eds) (2001), The Economics of Biological Invasions, Cheltenham: Elgar. Pimentel, D., L. Lach, R. Zuniga and D. Morrison (2000), ‘Environmental and Economic Costs of Nonindigenous Species in the United States’, BioScience, 50, 53–65. Runge, C.F. (2001), A Global Environment Organization (GEO) and the World Trading System: Prospects and Problems, Working Paper WP01-1, St Paul, MN: Center for International Food and Agricultural Policy, University of Minnesota. Sandler, T. (1997), Global Challenges, Cambridge: Cambridge University Press.

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Shogren, J. (2000), ‘Risk Reduction Strategies against the “Explosive Invader” ’, in C. Perrings, M. Williamson and S. Dalmazzone (eds), The Economics of Biological Invasions, Cheltenham: Elgar, pp. 56–69. Shogren, J., and T. Crocker (1999), ‘Risk and its Consequences’, Journal of Environmental Economics and Management, 37, 44–51. Ulph, A. (2000), ‘Harmonization and Optimal Environmental Policy in a Federal System with Asymmetric Information’, Journal of Environmental Economics and Management, 39, 224–41. United Nations Environment Programme (1999), ‘Preparing for a Millennium Round: Striking a Balance between Trade, Environment and Social Equity’, Nairobi: UNEP, mimeo. United Nations Food and Agriculture Organization (1995), Draft Code of Conduct for the Import and Release of Exotic Biological Control Agents, Rome: FAO. Watkinson A., R.P. Freckleton and P.M. Dowling (2000), ‘Weed Invasions of Australian Farming Systems: From Ecology to Economics’, in C. Perrings, M. Williamson and S. Dalmazzone (eds), The Economics of Biological Invasions, Cheltenham: Elgar, pp. 94–116. Whalley J., and B. Zissimos (2000), ‘Trade and Environment Linkage and a Possible World Environment Organization’, Environment and Development Economics, 5(4), 510–16. Wheeler, D. (2000), Racing to the Bottom? Foreign Investment and Air Quality in Developing Countries, Washington, DC: Development Research Group, World Bank. Wilcove, D.S. et al. (1998), ‘Quantifying Threats to Imperilled Species in the United States’, Bioscience, 48, 607–15. Williamson, M. (1996), Biological Invasions, London: Chapman and Hall. Xepapadeus, A. (2000), ‘International Dimensions of Environmental Policy’, Environment and Development Economics, 5(4), 519–24. Young, M.D. (1994), ‘Ecologically-accelerated Trade Liberalisation: A Set of Disciplines for Environment and Trade Agreements’, Ecological Economics, 9(1), 43–52.

5.

Trade and the environment in the perspective of EU enlargement Alexey Vikhlyaev*

INTRODUCTION This chapter is organized as follows. The following section provides an overview of general issues relating to trade measures for environmental purposes, with special references to the World Trade Organization (WTO) and European Union (EU) regimes. The chapter goes on to deal with domestic, extra-jurisdictional and institutional aspects of trade and the environment in the WTO and EU. Finally, conclusions and policy recommendations are offered.

TRADE MEASURES: GENERAL ISSUES The rationale for using trade measures for environmental purposes is that cost differentials arising from lower environmental standards are unfair and distort the prices in the market place.1 However, to eliminate every cost differential is to eliminate all gains from trade. The issue is whether the cost differentials reflect a legitimate comparative advantage or a market or policy failure. The most radical type of trade measure is a ban on imports of a product that has been produced under standards more lax than those imposed on domestic producers. Article XX – the General Agreement on Tariffs and Trade’s (GATT) general exceptions – allows import bans as well as other deviations from the GATT’s rules in specified circumstances, including some relating to human, animal or plant life, health or safety, and some relating to the conservation of exhaustible natural resources. The Agreement on Sanitary and PhytoSanitary Measures (SPS), concluded as part of the Uruguay Round of agricultural negotiations, covers measures relating to human, animal and plant health and safety in agriculture, including, inter alia, pesticide and fungicide tolerances, and inspection rules for meat. The Agreement on Technical 81

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Barriers to Trade (TBT) is applied multilaterally through the Uruguay Round Final Act and meant to ensure that technical standards and regulations not addressed by the SPS Agreement are not used for protectionist purposes. In the EU context, Article 30 (formerly Article 36) of the EC Treaty provides EU members with a right similar to that of WTO members if they pursue non-economic goals such as the protection of human health or life, animals, or plants. Eco-duties countervailing low environmental standards – ‘implicit subsidies’ – appear to be WTO-illegal. Specifically, the Agreement on Subsidies and Countervailing Measures (SCM) defines – for the first time – what a subsidy is and, therefore, what sorts of subsidies are countervailable.2 The concept of state subsidy contained in the EC Treaty is more flexible, but it does not go as far as to include regulatory subsidies. Legal considerations aside, eco-duties are susceptible to ‘capture’ by protectionist interests whose ultimate goals are not environmental. Moreover, calculating the proper level of an eco-duty introduces a range of practical problems. The use of subsidies to offset pollution control costs borne by one’s own industries appears less offensive and less disruptive than eco-duties, but the effect may be identical. Besides, more often than not, subsidizing polluters violates the polluter pays principle.3 The current situation in the SCM has created a regime that is often described in terms of a ‘traffic-light’. The ‘green-light’ subsidies under the SCM cannot, as a rule, be challenged as long as they meet certain narrowly defined criteria. This category includes certain subsidies for the environment. The ‘green-light’ category, however, expired in 1999 due to a lack of consensus in the Committee on Subsidies to extend the non-actionable subsidies. The EU has instituted strict controls on the type of subsidies that member states can use. Under the current multilateral trade rules, taxes and charges applied to domestic products can also be applied to similar – like in trade parlance – imported products (or exempted on exports) as border tax adjustments (BTAs). In practice, the usefulness of BTAs is limited by the fact that the current WTO rules only allow adjustments for environmental taxes or charges on products (for example, ozone-depleting substances or nonrecyclable packaging) or on physically incorporated inputs (for example, chemicals in plastic products). In contrast, the WTO rules do not allow BTAs for environmental charges imposed on production processes (for example, carbon dioxide and sulphur dioxide emissions, waste disposal and water effluent) or on non-physically incorporated inputs (for example, energy used in the production process).4 Whether the WTO should broaden the scope for BTAs to include process-related taxes is a matter of considerable controversy. Tax harmonization is, in itself, an extremely complex matter, as illustrated by the attempts to adopt common environmental taxes across

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the EU. Moreover, taxation is seen by many nations as a core element of national sovereignty. Switching from fiscal to regulatory measures is fraught with similar difficulties as there are two distinct types of environmental standards or regulations. Product standards deal with the characteristics of goods and may operate as barriers to trade, influencing market access. Production process or methods standards (PPMs) do not regulate the characteristics of products themselves, but the way they are made, and affect the conditions of competition. Standards and technical regulations act like non-tariff barriers, driving a wedge between domestic and border prices and protecting domestic markets, not because they are discriminatory, but simply because they are different. The concept of national treatment (GATT Article III) has been construed in such a way as to permit the application of domestic product standards to imported goods. However, the application of domestic PPMs to imported goods would amount to less favourable treatment and hence derive no protection under GATT Article III. While de jure the principle of national treatment is preserved, because of the manner in which the term ‘like’ is construed, it has de facto been undermined in the case of PPMs. In the EU context, the Community’s enhanced capacity for harmonization of standards, including PPMs, has eased the path from national treatment to mutual recognition. However, the mutual recognition framework in the EU is still partial and increasingly flexible in its scope. An answer to the question of whether a given product is safe or dangerous depends upon intrinsic product quality and not upon the production process. However, the two may be related, with production processes impinging upon product quality (product-related PPMs). There is a growing list of PPMs which are not related to the product but which are nevertheless considered to be important for scientific (for example, climate change, ozone depletion, deforestation) or social (for example, consumer choice, societal preferences, animal welfare) reasons or sometimes both. Indeed, there are several instances where the importance of non-product related PPMs has already been recognized by the international community.5 PPM-based criteria are used in voluntary trade measures such as eco-labelling. Eco-labelling schemes do not link market access to compliance with specific standards and, therefore, are generally WTO-consistent. However, eco-labels do present some problems. First, the last few years have seen the development of a large number of eco-labelling schemes. For instance, in the EU, national schemes are allowed to operate alongside the EC eco-label. Their diversity has created a great deal of confusion and made monitoring by public authorities extremely difficult. Second, there is a perception that eco-labels, especially those based on non-product-related

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PPMs, discriminate against imported products, particularly those originating from developing countries. International trade policy is affected by the interpretation of what constitutes quality. Defined under various legislative instruments, the term quality assurance primarily refers to health and safety, which are the ultimate environmental issues. What may be considered by some as product differentiation on health or safety grounds may be considered by others as a form of trade barrier. It is the function of SPS and TBT agreements to bring order and transparency in this respect. In many instances, however, ‘private’ requirements of importing firms, which generally reflect consumers’ preferences, turn into binding constraints for producers and exporters. As there is no universal approach to ensuring coherence of quality requirements prevailing in national, regional, and international markets, companies are inclined to adopt the ISO 9000 and ISO 14 000 series of standards, or the European Eco-management Scheme (ECOMAS). The internationally accepted Hazard Analysis of Critical Control Points (HACCP) provides guidelines for the implementation of quality systems in the food chain. These can be considered common elements of most quality standards, adopted already in the main importing countries, including the EU. HACCP, based on hazards and risks analysis, is at the core of the SPS and the TBT. While, in general, all trade measures for environmental purposes address risk, lack of certainty and action to be taken in such situations and the levels of risk and uncertainty to trigger an action differ, sometimes significantly. Numerous international instruments incorporate the notion of precaution in situations of uncertainty, and regional integration agreements also leave room for measures based on this notion. Although the term precautionary principle is not explicitly used in any WTO agreement, it is woven through a number of current and future possible disputes. The EU believes that trade measures based on this principle are a priori compatible with the WTO rules. Others, however, feel there is a need to clarify this relationship. Deceptively simple to define (the Maastricht Treaty, the Rio Declaration and the Cartagena Protocol), the precautionary principle becomes problematic when it comes to putting it into practice, which is, in the end, a matter of policy: a matter that may turn into a nightmare for the multilateral trading system – a policy-making process that may seem impossible to bring to rule, containing an unmanageable number of entry points for protectionist influence. An essential issue in the context of trade rules is whether risk assessments need to be carried out prior to the adoption of precautionary trade measures, and which conditions such risk assessments must meet. Another important question is, who has to provide evidence to justify the need for

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precautionary measures. The allocation of the burden of such proof requires striking a careful balance between the different interests at stake. Global versus Regional Two core trade and environment concerns are addressed by the multilateral trading system and regional economic groupings, including the EU. First, a balance has to be struck between market access and environmental protection. This balance is struck differently in different agreements. Second, regulatory tensions between jurisdictions with differing environmental standards must be addressed to the extent that these are applied extra-territorially or do not reflect legitimate comparative advantage. The logic of these concerns is quite clear in the trade and environment issues that have received the most attention in the WTO and EU: (1) maintenance of domestic health, safety and environmental standards, (2) cross-border, or extra-jurisdictional activity, that is, regulatory competition, managing global or regional commons, cross-border pollution; and (3) trade and environment institutions, rule making and implementation. These issues have been addressed in different ways in the GATT/WTO and the EU.

GATT/WTO Maintenance of Domestic Standards Three sets of GATT/WTO rules are most relevant to defining the conditions under which a WTO member can use trade measures to maintain its chosen levels of domestic health, safety and environmental protection: Article XX of GATT, the SPS and the TBT. The general rule under the GATT, the SPS and the TBT is that each country may resort to trade measures to protect life and health, and conserve exhaustible natural resources, and may determine for itself the level of risk it deems appropriate to embody in its product standards. This rule is qualified to ensure that these measures are not misused for protectionist purposes (non-discrimination). At the WTO, the evolution of this general rule has been propelled not by negotiation but by judicial interpretation. The limits of Article XX have been tested in nine cases, four of which are most relevant to trade and the environment: Tuna I and II, Reformulated Gasoline, Shrimp-Turtle and Asbestos.6 The salient points of the conclusions are centred on a number of elements such as the function and scope of the preamble, jurisdictional application and the concept of necessity. Importantly, in none of the cases have the panels questioned the environmental objectives or policies of the

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countries concerned; rather they have only examined the trade measures used to achieve them. In Tuna I it was ruled that it is the inconsistency with the GATT which must be justified not the policy goal itself. The Tuna II Panel considered that the term ‘exhaustible natural resources’ included living creatures (dolphins) and was not limited to mineral resources or oil as originally intended by the drafters. In the Reformulated Gasoline case the Panel agreed that clean air was also an exhaustible natural resource. The Asbestos case was the first time a Panel or the Appellate Body upheld a tradeinconsistent measure for non-trade reasons – protection of human life and health. While under GATT trade measures are considered on the criteria of nondiscrimination, the TBT goes further to apply the test of proportionality, which brings it closer to EU legal practice. There have hardly been any cases on TBT, but in 33 instances formal consultations have been held on the basis of the Agreement. Allusions to the TBT can be found in the Gasoline case. In the Shrimp-turtle case, when Article XI was invoked, it had to do with the TBT. There were also links to the TBT in the Thai cigarettes and US automobile tax cases. In the Asbestos case, it was certainly the Canadian position that the TBT applied to the French ban.7 Some observers maintain that, by refusing to adjudicate the Asbestos case on the TBT grounds, the Appellate Body provided an ‘implicit interpretation’ of the TBT Agreement as irrelevant. There is still a bit of a void in terms of having a detailed interpretation of the TBT from the Appellate Body. Some argue that it may be to the advantage of the developing countries if there is a shift in WTO jurisprudence from the GATT to the TBT. This would open the door to more product differentiation and more precise rules. However, the jury is out on whether this change would actually make market access for developing countries easier. An interesting aspect in the relationship of the TBT Agreement to GATT is Most Favoured Nation (MFN) status. Article 6.3 of the TBT gives members absolute freedom to enter into bilateral mutual recognition agreements. This is one area where discrimination can be done without any regard to MFN obligations. In this context, an interesting question arises as to whether a linkage could be made with Article VII.2. of GATT, which has a conditional MFN clause and gives some negotiating rights to join a special agreement. This link is still missing in the ‘judicial geometry’ of the WTO and potentially could be a point to put on the books in future negotiations.8 Implementation concerns have certainly been front and centre stage on the agenda of the TBT Committee for some time now, driven in part by

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the triennial reviews that the Committee has to do of the Agreement as well as by larger discussions on the implementation of the WTO Agreements. Useful work is being done by the Director General of the WTO with the various international standardizing bodies and through the TBT technical assistance programme. Proposals have been made to introduce binding commitments with respect to technical assistance and capacity building. However, without coordination at the national level among standardizing bodies, trade and environment ministries, it is difficult to see such technical assistance really paying off. One of the most drastic proposals is to introduce in the TBT the notion of precautionary principle. If implemented, this proposal would have profound implications. On balance, there is a feeling that the TBT is a complex and relatively untested agreement that has been serving the WTO membership well so far. The preference would be to leave it alone in the context of a possible set of negotiations. The SPS marks an important step in the evolution of WTO rules for trade measures. It takes WTO members beyond ‘non-discrimination’, and to a restrictive interpretation of the GATT general exceptions by elaborating the applicability of the GATT, Article XX(b). This interpretation is rather ‘closed’ in its tendency to privilege scientific rationality. So far, the SPS has been tested in three cases. Each of the three pillars under the SPS has now been addressed: human health in EC – Hormones; animal health in Australia Salmon; and plant health in Japan – Varietals.9 In EC Hormones, the alleged food-borne risk for human life and health related to contaminants (hormone residues) in foods (meat and meat products); in Australia – Salmon, Australia claimed to protect its animals (fish) against the introduction of some 24 salmon diseases; in Japan – Varietals, Japan wanted to avoid the introduction of the codling moth, considered to be a pest, and thereby protect its plants, by banning certain fruit imports from the United States. No further SPS dispute settlement reports are expected in the near future, although the number of SPS-related trade concerns and potential disputes remains substantial. Two crucial decisions have been taken in respect of the question of when the SPS disciplines apply to trade measures. First, the SPS Agreement was found to apply to all SPS measures affecting international trade, notwithstanding the GATT.10 Second, it has been established that the SPS Agreement applies retroactively.11 This latter decision means, of course, that many WTO members will have to re-examine their existing SPS measures, particularly in light of the obligation to base SPS measures on a risk assessment.12 A crucial distinction was found between the risk assessment required for ‘food-borne’ risks and that for disease or pest risks.13 It is unclear whether

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it was the intention of the drafters to make this rather important distinction between two types of risk assessment, and it may be a matter for reconsideration in a future review of the SPS Agreement. For both categories, the following principles were developed through case law: risk assessment can either be quantitative or qualitative; an acceptable level of risk could even be set at ‘zero’; the existence of unknown and uncertain elements does not justify a departure from the risk assessment requirement; risk assessment has to be specific enough;14 the WTO member imposing an SPS measure does not necessarily have to conduct risk assessment itself and can make use of assessments carried out by other members or international organizations; a member has an autonomous right to establish a higher level of sanitary protection than would be achieved by a measure based on an international standard. In EC – Hormones the panel referred to the process of determining and applying the acceptable level of risk as part of ‘risk management’, an exercise in which social value judgements – risk perceptions and tolerance of consumers, social acceptability of certain types of risk and so on – are crucial. Members also have to base the SPS measure they finally select on that risk assessment. The exception to this rule, that is, the possibility of enacting provisional measures, including on the basis of a precautionary principle, is qualified by four requirements.15 The Appellate Body in Japan – Varietals – the only dispute so far where the defendant argued that its measure was a provisional one – found that these four requirements are cumulative in nature. The Appellate Body also defined the possibility of taking provisional measures as ‘a qualified exemption’ from the obligation to maintain SPS measures with sufficient scientific evidence, which means that the party imposing a provisional SPS measure has the burden to prove that it meets all four requirements. In EC – Hormones, the EC did not claim that its import ban was a provisional measure. It invoked the precautionary principle, which is a ‘code word’ for Article 5.1 of the SPS. The Appellate Body ruled that the precautionary principle, other than that expressed in SPS Article 5.7 on provisional measures, does not override the obligation to base SPS measures on a risk assessment. The Appellate Body’s note on the status of the precautionary principle in international law is of special interest: ‘it is regarded by some as having crystallized into a general principle of customary international environmental law. Whether it has been widely accepted by Members as a principle of general or customary international law appears less than clear . . . We note that . . . the precautionary principle, at least outside the field of international environmental law, still awaits authoritative formulation’.16

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Extra-jurisdictional Activity Determining the scope of trade measures for environmental purposes requires finding an answer to the following question: to what extent may states restrict free movement on the basis of a threat which does not find physical expression in the territory of the state adopting the measure? This question arises both in the context of measures with an extra-territorial effect, and also as a result of the ‘scientization’ of the dispute settlement under the WTO, as evidenced by the SPS. The extra-territorial issue concerns the legal capacity of member states to restrict trade with a view to protecting environmental resources situated outside of their territory. Almost invariably this issue arises in a context of the application of domestic PPMs – as distinguished from product standards. The reason PPM-related issues are often framed in the language of extra-territoriality is simple. Trade measures based on PPMs are usually motivated by concerns over environmental impact, not in the state imposing the restriction, but in the state from which the goods originate or, in the case of exports, for which they are bound. The GATT rules do not allow its members to take extra-territorial trade actions, that is, to use trade measures to enforce a member’s own domestic laws in another member state – even to protect animal health or exhaustible natural resources. For instance, WTO members cannot impose any trade restriction or duty surcharge on goods produced in countries with less stringent PPMs. There is no agreement in the WTO to harmonize PPMs at a high level of environmental protection. Since Tuna II, the product–process distinction has been a fairly brightline bulwark against sliding down a slippery slope of blocking products at the border for activities related to production, including environmental measures. It has been consistently held that GATT Article III (national treatment) requires a comparison between products, and not a comparison between the policies or practices of the importing state and the state of origin. Products that are intrinsically comparable will be considered as like, regardless of differences in the manner in which they have been produced or harvested. However, the Shrimp-turtle case seems to signal an evolution of the WTO towards dealing with the issues of PPMs. This evolution is not without a legal precedent. The Agreement on Trade-Related Intellectual Property Rights (TRIPs) is essentially an agreement on PPMs; it allows countries to discriminate at the border between goods that are identical in every way but that have been produced using different processes, one legal and the other illegal. By redefining like goods in its particular context, TRIPs manages to function without eroding the basic principles of national treatment and MFN.

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Part of the jurisprudence carried forward from the GATT has been to look at the notion like product in Article III.4 of GATT (national treatment of like products). The resort to GATT Article III.4 in the Shrimp-Turtle and Asbestos cases promoted apprehensions that the concept of a like product has been reopened to accommodate non-trade concerns, including environment, labour and other human rights. Significantly, the ‘construction’ of like for the purposes of comparing domestic and imported products, and an answer to the question of whether a given trade measure is discriminatory or not is complicated by the fact that, in the WTO, it is considered as an issue of policy rather than an issue of fact. ‘Likeness’ is conceived as, in part, contingent upon the aim and effect of the measure and whether it is such as to afford protection to domestic product against a backdrop of consideration of the overall legitimacy of the measure in terms of its regulatory purpose or protectionist aim or effect. This may account for the fact that when it comes to PPMs in trade–environment cases, there is consistency in terms of result though not in terms of reasoning. Arguably, a more targeted option would be to revisit the definition of (product) related and make it more ‘elastic’ by including the notion of related but not detectable PPMs. In other words, a question could be posed as to whether the fact that any given PPM cannot be detected in the final good also means that it is not related to this product. There are those who argue that certain PPMs are not only related to the product but are a quintessential part of it even though they cannot be detected. Scientific progress, particularly biotechnology, as well as ‘scientization’ of trade measures are pushing the limits and relevance of decades-old terms such as like product. Yet tweaking the definitions relating to the fundamentals of the multilateral trading system is a dangerous path. At some point the international community will probably have to square the circle either through a negotiated solution or by an imposed settlement. Little progress has been made in dealing with the PPM issue in the context of eco-labelling. The views vary widely. Some think that the TBT covers eco-labelling, others think it does not, while yet others think the TBT covers eco-labelling by exclusion. Discussions in the WTO have focused on multi-criteria eco-labelling schemes, especially those that are based on non-product-related PPMs. Proposals have been made to extend the coverage of the TBT to include eco-labelling schemes based on non-product-related PPMs. The effects of ‘type-1’ eco-labelling on international trade, particularly imports from developing countries, have so far been limited.17 However, developing WTO members fear that, without strict international disciplines, eco-labelling schemes, especially those based on the life-cycle

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approach,18 may spin out of control. While the EU is very much in favour of developing eco-labelling schemes, the position of the US, especially after the bio-safety negotiations, is no longer very clear. It would appear that the interest in eco-labelling is, at least in part, attributable to the fact that from a trade-policy point of view, it involves many complex issues, such as PPMs, the definition of international standards and the concept of equivalency. Currently, the debates in the WTO on these issues have not advanced too far. In the International Organization for Standardization (ISO), progress has been made in developing guidelines on transparency, conformity assessment and mutual recognition. One thing is clear though: for a standard to be truly international, developing countries must have effective participation in standard setting. The Tuna II decision, to permit import restrictions for the protection of health or exhaustible natural resources only within the jurisdiction of the importing party, has significant implications for Multilateral Environmental Agreements (MEAs). Under certain circumstances, it may be WTO-inconsistent for a WTO member to comply with trade restrictions required by certain MEAs. Logically, the mere fact that the trade measures MEAs may contain were negotiated and agreed upon by consensus in a multilateral context should serve as a guarantee against discriminatory action and abuse for protectionist purposes. However, the relationship between WTO rules and MEAs in general is far from clear. It is estimated that there are more than 500 international treaties and other agreements related to the environment, of which 323 are regional. By far the largest cluster of MEAs is related to the marine environment, accounting for over 40 per cent of the total, and is distinguished by the United Nations Convention on the Law of the Sea (UNCLOS) (1982), new marine pollution conventions and protocols, the Global Programme of Action for the Protection of the Marine Environment from Land-based Activities (1995), as well as the regional seas MEAs and regional fisheries conventions and protocols. Biodiversity-related conventions form a second important but smaller cluster, including most of the key global conventions: the Convention concerning the Protection of the World Cultural and Natural Heritage (1972), CITES (1973), CMS (1979) and CBD (1992). The cluster of nuclear-related MEAs remains important with the addition of nine global conventions and protocols and several regional agreements. Two important new clusters of MEAs emerge: the chemicals and hazardous waste-related conventions that are primarily of a global nature, and the atmosphere/energy-related conventions. Among the former, the Rotterdam Convention (1998) figures prominently, and the new POPs19 convention was adopted in Stockholm in May 2001. At the forefront of the atmosphere/energy-related conventions are the Vienna Convention for the

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Protection of the Ozone Layer (1985) and its Montreal Protocol (1987) and the United Framework Convention on Climate Change (UNFCCC) (1992).20 Trade measures included in the MEAs can include bans, product standards, notification or labelling requirements attached to the import or export of goods. In some cases, the MEA itself defines ‘specific’ trade measures to be taken, as for example in CITES, the Basel Convention or Montreal Protocol.21 In other cases, the MEA obliges signatories to fulfil certain objectives, and the signatories may do so by resorting to ‘non-specific’ trade measures, which may have trade implications and therefore interact with trade rules. The distinction between the two types of measures is important. Whereas the first type can claim to be based on some degree of international consensus, the second has no such prima-facie claim to legitimacy. The other important distinction from a trade perspective is whether the measures are applied against parties to the agreement or non-parties who have not voluntarily agreed to be restricted by the terms of the MEA. For instance, 30 members of the WTO are not party to the Basel Convention, 15 to CITES, seven to the Convention on Biological Diversity, eight to the Montreal Protocol (Vienna Convention), and 128 to the Kyoto Protocol of the UNFCCC.22 So far, no trade measure taken pursuant to an MEA has been challenged in the WTO by a non-party. It is certain whether this may happen in the future but the legal ambiguity surrounding the possibilities of such a challenge causes uncertainty and doubt over the effectiveness and legal status of such measures and thus weakens MEAs.23 Proposals addressing this problem can be grouped into three categories: status quo, ex post or waivers, and ex ante or environmental window. The proponents of the status quo proposals believe that there are already adequate provisions in the WTO rules for addressing trade measures in MEAs. Interestingly, these countries include those who believe that the WTO rules are clear in sanctioning many such measures (for example, the United States) as well as those who believe the rules are clear in prohibiting them (for example, India). The proponents of the waiver proposals suggest that the WTO might grant waivers to its rules for trade measures in MEAs that meet certain criteria, either on a case-by-case basis or automatically. Such waivers normally require a three-quarters majority to be approved and are time-limited but renewable. The criteria proposed for trade measures to support environmental objectives include such notions as necessity, proportionality, least-trade restrictiveness, effectiveness, broad multilateral support, and adequate scientific evidence. The proponents of the ex ante or environmental window approach argue that greater certainty is needed for negotiators of MEAs and that the

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waiver approach fails to provide this certainty. They propose a modification of WTO rules, such as an expansion of the general exceptions under Article XX of GATT, or the drafting of an understanding, or a nonbinding set of interpretative guidelines, that would spell out under what conditions the WTO would accept the use of trade measures taken pursuant to MEAs. A stronger version of this proposal includes the reversal of the burden of proof as a possibility to provide greater security without altering the rights and obligations of WTO members.24 Institutions, Rule Making and Implementation As far as institutions are concerned, the WTO has a very limited mandate. Trade and environment matters are discussed primarily in three fora: the Committee on SPS, the Committee on TBTs, and the Committee on Trade and Environment (CTE). Discussions are centred on domestic health, safety and environmental protection, and the relationship between the provisions of the multilateral trading system and trade measures for environmental purposes, including those pursuant to MEAs, which is one dimension of the extra-jurisdictional activity. At the insistence of developing countries, the CTE has also been tasked with considering the environmental benefits of removing trade restrictions and distortions and the need to promote sustainable development. The WTO’s Dispute Settlement Mechanism (DSM) is a quasi-judicial system that, strictly speaking, does not operate on precedent: panels and the Appellate Body are not bound by previous rulings so the pendulum can, at least in theory, easily swing the other way. However, there is a perception that, while the Appellate Body and Panels do not legally bind members of the WTO, their precedent-setting value is significant. For some, this perception is aggravated by the fact that, although dispute settlement bodies arrive at acceptable decisions, the way that they do so is questionable. There is little ‘judicial economy’ in the work of panels.25 On the positive side, this approach ensures that the Appellate Body disposes of the necessary factual assessments by the panel to complete a possible appeal in the event the Appellate Body reverses the panel’s first finding of violation.26 Dealing with more claims may also facilitate the process of implementing the reports, in that both parties are informed more extensively about their rights and obligations. On the negative side, this practice opens the door to ‘judicial activism’. The WTO dispute settlement rules are contained in the Dispute Settlement Understanding (DSU, Annex 2 to the WTO Agreement), which includes some comments on the philosophy, the direction and the purposes of the dispute settlement procedure. Article 3.2 of the DSU contains an

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interesting statement which, roughly paraphrased, says that none of the reports of the dispute settlement procedure should result in a change in (addition to, or subtraction from) the rights and obligations of the WTO members. This statement is generally understood as a warning against ‘judicial activism’. However, at least since the Shrimp-Turtle case, the judicial process at the WTO has taken the so-called ‘evolutionary approach’ to interpreting treaty language. The evolutionary development of case law has prompted serious concerns as legal decisions arrived at in the WTO do not necessarily take into account discussions in the CTE or reflect the positions of all member states. The question then is whether an Appellate Body function or a negotiating function is needed to address extra-jurisdictional problems such as PPMs or MEAs. In the Shrimp-Turtle case, the Appellate Body ignored that question, while at the same time suggesting it could uphold border measures that were really targeted at process rather than product. This issue remains open, and it will be interesting to see where it leads. Thus far, efforts to have a decision-making process or a negotiating process solve some of the environmental clashes with trade have failed. There is a very strong impetus to push those issues in the direction of resolution, and the dispute settlement process is a logical target. However, there is apprehension that, Article 3.2 of the DSU notwithstanding, rulings on disputes brought under the GATT/WTO add to the obligations and detract from the rights of members, and this is how countries win or lose their cases. Those, mainly developing, countries that do not agree with ‘judicial activism’ argue that it is for the members themselves to examine whether there is a need to modify trade rules, and, if deemed necessary, proceed on the basis of consensus. This approach would add legitimacy to the multilateral trading system and reduce pressure on the dispute settlement mechanism. The boldest scenario is for the WTO to address environmental concerns as it has addressed a number of other areas of specialized application of trade law: by creating an agreement on trade-related environmental measures (TREMs). One article in TREMs would address PPMs and similarly establish the ways in which PPM-based discrimination may or may not be used, according to the types of instruments, the circumstances, and the prerequisite and supplementary measures that accompany them. Another article would spell out what constitutes an MEA, what constitutes a trade measure, how different types of trade measures should be treated, and what types of complementary measures must be applied under which circumstances. The article would also set up a mechanism for dispute settlement. In essence, this would curb unilateral measures by bringing them under multilateral discipline.

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In the WTO rule-making process, the EU and the US have been the main demandeurs. Japan has generally refused to act as a demandeur of much of anything in the GATT/WTO, and trade–environment issues are no exception. Developing countries have consistently resisted environment-friendly trade–environment provisions in the GATT/WTO, but at the conclusion of the Uruguay Round were induced to accept those through the single undertaking, which included the SPS, TBT as well as other WTO Agreements.27 Discussions on trade–environment rule-making have been bogged down in a North–South conflict, which can be termed as ‘mainstreaming versus implementation’. The proponents of ‘mainstreaming’ – mainly developed countries – argue that transferring specific issues to negotiating bodies may facilitate progress, while a wider coverage of issues in trade negotiations will create a larger ‘opportunity space’ for trade-offs. The developing countries feel that, an open-ended agenda on trade and the environment would compromise the principle of consensus, upset existing checks and balances, and diffuse the work conducted by WTO, making it more difficult for developing countries to participate effectively in policy making. They argue that ‘mainstreaming’ makes sense only in supportive measures (particularly technology transfer) technical and financial assistance through effective binding provisions in WTO Agreements.28 Developed countries, led by the EU (and the US), have sought to establish or clarify WTO provisions, allowing the maintenance of trade measures that protect the domestic environment and address some extra-jurisdictional activity deemed inappropriate by MEAs. More recently, proposals to this effect have been made by Canada (for criteria for the use of trade measures), Switzerland (MEAs and WTO to be restricted to own competencies) and New Zealand (on a consultative mechanism on trade measures). Many developing countries, led by India, Egypt and Brazil, have shown little or no interest in such provisions and instead champion rules that would further limit or raise the costs of maintaining trade measures aimed at protecting the environment, which these countries often consider discriminatory and trade restricting. Developing countries have instead pushed their own agenda set around the following issues: market access; greater transparency of environmental regulations, with reporting requirements going beyond those already required in the SPS and TBT Agreements; modifying the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS);29 concluding an agreement on exports of domestically prohibited goods; and developing an understanding that restricts the use of eco-labelling. While views on these proposals are many, the points of convergence are few and concern mainly ‘win–win’ situations, in particular with respect to agriculture, fisheries and environmental services.

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EUROPEAN UNION Maintenance of Domestic Standards Article 28 (formerly Article 30) of the EC Treaty provides that all quantitative restrictions and measures having equivalent effect shall be prohibited. In the Dassonville case, the European Court of Justice (ECJ) interpreted the concept of ‘measures having equivalent effect’ as ‘all trading rules enacted by member states which are capable of hindering, directly or indirectly, actually or potentially, intra-Community trade’.30 As defined in Dassonville, Article 28 appears to prevent discriminatory and nondiscriminatory environmental measures affecting trade. The Dassonville formula has been criticized as being too broad, and a number of authors have advised the Court to reduce the scope of application of Article 28.31 Two exceptions, however, temper this sweeping free trade principle. Article 30 (formerly Article 36) allows member states to adopt measures that are prima facie incompatible with Article 28 if they pursue noneconomic goals, such as the protection of human health or life, animals, or plants. In addition, the rule of reason, which originated in the Cassis de Dijon case,32 allows member states to adopt non-discriminatory trade-restrictive measures to protect a series of essential requirements, including the protection of health and the environment. It appears that the EU provides member states with a right similar to that of WTO members to restrict imports from other member states that do not comply with domestic levels of health, safety and environmental protection. As in the GATT/WTO, these rules are circumscribed by a set of tests that consider environmental as well as trade concerns: the import restriction must be maintained in a manner that provides for national treatment, the MFN treatment, and scientific risk assessment. Unlike the GATT/WTO, the EU also provides for upward harmonization or approximation of member states’ standards at a high level of protection. This dual approach has led to more extensive convergence on domestic environmental protection than in the GATT/WTO. The trade-restrictive effects of product standards, including environmental product standards, have been a major source of concern in the EU. The harmonization of environmental product standards has been used as a prime instrument to ensure the free movement of products, relying more heavily on uniform standards than any other approach. For example, total harmonization regimes have been adopted for vehicle emission standards, chemical substances, pesticides and batteries. In a number of circumstances, however, the EC has opted for less all-encompassing strategies of harmonization. Thus, in regulating noise-generating equipment, the EC

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has adopted a strategy of optional harmonization that bars member states from requiring companies to meet national standards that are more stringent than the EC norm. The EC has also undertaken to harmonize certain forms of ‘pre-standards’. For example, harmonized risk assessment procedures have been set up for manufacturers and importers of all new chemical substances. In recent years, the EC harmonization strategy has increasingly relied on essential requirements necessary to ensure the free movement of a product. The task of drawing up detailed regulations based on those essential requirements is left to European standardization organizations, such as Comité Européen de Normalisation. Extra-jurisdictional Activity The EU also goes further than the GATT/WTO in addressing extraterritorial activities.33 Thus EU rules specifically permit some import bans directed at poor environmental protection that take place outside a member state’s territory. Perhaps even more significantly, to limit distortions of competition that may be created by inconsistent environmental standards, the EC has increasingly moved to a regime of minimum PPM standards and has adopted a large number of directives dealing with air, water, waste and chemicals. This approach recognizes that some variation in PPMs is legitimate and should be expected given the varying circumstances of the member states. It also protects against the possibility that low PPMs reflect regulatory failure, rather than careful matching of environmental requirements to local circumstances. Minimum standards, moreover, reduce the pollution control cost disparities across the member states, narrowing the environmentalcost-based competitive advantage available to producers in low-standard jurisdictions. The adoption of minimum process standards, while helping to maintain fair conditions for competition, does not prevent any member state from adopting stricter national standards. In certain circumstances, the EU has opted for more flexible strategies of PPM harmonization. For example, the EU adopted a multi-tier harmonization strategy for controlling air pollution from large combustion plants. Considerable controversy has emerged over whether standards should also be differentiated on the basis of differences in ecosystem assimilative capacity.34 The EU members eventually settled on a strategy of harmonized options, whereby effluent standards or emissions limits would be the general rule but a member state could, under strict conditions, opt for an alternative system of ambient quality standards. The controversy over which regulatory technique should be used to harmonize industrial processes has never been totally resolved. Members

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disagreed over how to set emissions limits. Certain member states argued that these limits should be fixed at the EC level on the basis of the best available techniques, that is, technology-based effluent standards. Other member states argued that effluent limits should be adopted at the national level pursuant to more flexible environmental quality standards. These member states suggested that ambient standards would permit them to take into account their environmental circumstances and to exploit their natural locational advantages. The common position reached by the Council (1995),35 which has been formally adopted and become binding law, attempted to reconcile these competing positions. Member state authorities would grant emissions limits to the controlled installations based on the best-available techniques, without prescribing the use of any technique or specific technology, but taking into account the technical characteristics of the installation concerned, its geographical location and the local environmental conditions. In general, minimum harmonization measures, set out in Community directives, establish a ‘floor’ of obligations below which member states may not go. The ‘ceiling’, circumscribing the legitimate scope of more stringent measures introduced by member states, is constituted by the EC Treaty and in particular (in the context of goods) by Articles 28–30 thereof. Somewhat paradoxically, it appears that, in the view of the ECJ, minimum harmonization may sometimes be exhaustive in nature. It certainly seems to be a preference on the part of the ECJ to interpret environmental directives laying down minimum standards as exhaustive in nature whenever the trade measure is meant to promote environmental protection outside of the territory of the regulating state, even if the directive does not expressly establish the territorial limits to stricter national measures. For instance, in the Veal Calves in Crate case,36 the ECJ, while recognizing the ‘minimum’ nature of the obligations laid down in the 1991 directive,37 insists that this directive is such as to lay down ‘exhaustively common minimum standards’. In other words, the directive was interpreted in such a way as to represent both the ‘floor’ and the ‘ceiling’ in terms of member state obligations, thus precluding the member state from recourse to Article 30. This case is distinctly different from, for instance, the Aher-Waggon case,38 where the ECJ’s approach was consistent with traditional conceptions of minimum harmonization. There are nuances, of course.39 Whereas some directives (for example, Protection of Calves of 1991) delimit the territorial scope of application of stricter national measures, others (for example, Wild Birds) do not.40 Consequently, there is, in respect of the latter, considerable room for manoeuvre. It is therefore significant that the ECJ found that the Danish ban on the marketing of ‘dead red grouse’, a bird species not native to the Netherlands and hunted in the United Kingdom in accordance with the

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minimum standards laid down in Wild Birds was not compatible with the Directive.41 The decision implies that the ECJ is sceptical about the legitimacy of trade restrictions adopted with a view to protecting ‘foreign’ environmental goods, at least in so far as these are not conceived as ‘shared’. In this way, just as the protection of consumers in other member states is not, as such, a matter for the national authorities, so too environmental interests may be conceived as territorially bounded, except in the case of those defined as concerning common or shared resources. This ambiguity ‘mirrors’ the WTO approach to PPMs and MEAs. The ECJ approach appears to be distinctly different when it comes to trade measures predicated upon the physical impact of the imported goods on the health of consumers in the importing states. In such cases considerations of what is ‘right’ and ‘wrong’ in terms of PPMs give way to considerations of what is ‘good’ or ‘bad’ in terms of physical impact. The Hormones in Beef case is very telling in this regard.42 The first hormones case was brought before the ECJ almost a decade before the EU hormones regime came to form the subject matter of WTO dispute settlement proceedings. While scientific arguments figured prominently in the ECJ and the WTO when it came to evaluating justifications for trade measures, the qualitative threshold for establishing the existence of risk was lower in the EU context. It should, however, be stressed that the reluctance of the ECJ to second-guess legislative policy choices occurred in the context of trade measures conceived as facilitating rather than impeding market integration. Indeed, had the measures not been enacted, the different approaches adopted by the member states to the administration of hormones in farming might have resulted in market fragmentation as a result of member state recourse to the Article 30 (formerly Article 36) EC exception. In other words, when a particular trade measure is such as to impede free movement of goods, the ECJ is more inclined to assess the credibility of claims made, and to do so on the basis of scientific rationality. The uncertainty that continues to characterize the EU approach to the issue of extra-territorial environmental protection is indicative of the fact that the ECJ has not clarified the territorial scope of the EC Treaty environmental exceptions. It is obvious that the reticence of the ECJ on this point is not matched by a similar degree of restraint on the part of various GATT/WTO panels as evidenced by two (Tuna I and II and Shrimp-Turtle) cases. Institutions, Rule Making and Implementation The EU institutions dealing with trade–environment are better developed, perform more functions, and provide more avenues for participation by

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Non-Governmental Organizations (NGOs) than those in the GATT/WTO. Most EU environmental legislation is adopted by population-weighted voting by member states in the Council, subject to parliamentary action, a process known as qualified majority voting. The absence of a unanimity requirement makes environmental and standards harmonization in the EU technically easier to undertake than under the GATT/WTO, which requires consensus, while safeguards ensure that national environmental measures will not be replaced by less stringent EU standards. The EU law enjoys unqualified supremacy in all member states. Moreover, some EU laws may have direct effect in all member states. The status of EU law creates the possibility of legislating environmental regulations or creating other environmental laws in Brussels that must be enforced by the national courts of all member states despite inaction by a national legislature or the existence of prior inconsistent national law.43 Such a possibility does not exist in the WTO. The Single European Act (SEA) added several provisions to the EC Treaty designed to address the complexity of the decision-making process and the existence of competing interests among member states. First, the SEA replaced the traditional unanimity voting system by a system of qualified majority voting; Article 100a(1) has considerably simplified the decision-making process, thus facilitating the adoption of strict emission standards over the objections of laggards. Second, Article 100a(3) requires the Commission to ‘take as a base a high level of protection’ in its proposals concerning health, safety, environmental and consumer protection. Third, Article 100a(4) authorizes, in certain circumstances, member states to apply more strict national standards rather than EU-harmonized standards if they deem it necessary to protect the environment. Selective judicial invalidation of trade measures, sometimes referred to as ‘judicial bounding’, is the mainstay of the EU’s measures to ensure that product standards do not unduly restrict market access. While the GATT/WTO and the EU each have a rule suggesting that the trade measure in question must be the least trade-restrictive means necessary to achieve the measure’s legitimate purpose, the ECJ has interpreted the rule potentially more broadly as requiring proportionality – a balancing test between the trade restrictiveness of the measure and the purpose of the measure.44 This test invites a determination by the ECJ as to the importance of the measure’s purpose, effectively substituting the Court’s judgment about risk aversion for that of national authorities.45 Not unlike in the WTO, there is a North–South split within the EU in trade and environment rule making. Germany, the Netherlands and Denmark traditionally support stringent standards and other environment friendly measures, whereas Greece, Italy, Portugal and Spain tend to favour

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weaker standards and measures; and France and Britain usually fall somewhere in between. However, the relatively concentrated EU distribution of power in the hands of demandeur countries has facilitated environmental convergence. The EC remains heavily dependent on national environmental efforts. Its only recourse is to initiate legal proceedings against a particular member or members before the ECJ. This procedure is extremely slow and to date has proved a rather weak deterrent against slack environmental performance. There are proposals for the Commission to play a more central role in implementation and enforcement. Yet, because the current political context is dominated by the principle of subsidiarity, it is unlikely that the powers of the Commission will be increased. The implementation record of the EU is more impressive than that of the WTO. A very large proportion of environmental directives have been implemented by all the member states. At the same time, there are wide disparities in the levels of implementation and enforcement of these standards among EU members. While Germany, Denmark and the Netherlands have established sophisticated implementation and enforcement mechanisms, others, for example, Greece, Italy and Spain, have failed to develop such mechanisms and generally have weaker implementation and enforcement records. The EU expansion, which could lead to an organization with 30 or so members by 2010 may create an ‘implementation gap’ that will make ‘hollow’ any harmonization or approximation of standards. The fact that for most EU candidates integration overlaps with transition makes this enlargement the most difficult and complex environmental challenge the EU has ever had. The desire to avoid ‘acquis-picking’, where countries choose the easy elements of the integration ‘menu’, or the situation of ‘multi-speed’ Europe, prompted the insistence on the implementation of the acquis in its entirety by the new members. The danger of this approach, however, is that, besides the ‘implementation gap’, there will be an ever increasing gap between the contents of the acquis and the requirements of the various member states. Deepening and widening at the same time appears to be feasible only within a ‘multi-speed’ Europe. It is no surprise that the total output of new environmental rules in the EU has slowed down considerably in recent years, with revised and updated legislation accounting for a much greater share than primary legislation. This trend can reasonably be expected to continue. It took about 30 years to reach agreement on some 100 000 national regulations and standards and even today, in some areas, the internal market is far from being completed. The two instruments to ensure free circulation within EU are either the mutual recognition of legally marketed goods and

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services, or the technical harmonization of legislation. According to the ECJ, any product legally manufactured and sold in one member state should in principle enjoy free access to the other member states’ markets. Some member states, for example, Germany, objected to this approach and invoked grounds for special protection of health and the environment. This left the Commission with no other option but to promulgate legislation on technical harmonization. Fearing that lack of harmonization of standards and specifications could undo 20 years of hard work, the EU wanted the preparation of the acceding countries to the internal market to be at the heart of a pre-accession strategy. In case candidate countries acceded to the EC without their legislation being harmonized, current member states could retaliate. Adjustment strains in both the current and the new member states would again segment the internal market, particularly in sectors where liberalization under the Europe Agreements had been rather limited. In the Europe Agreements, the countries in accession commit themselves to ensuring that their future legislation will be compatible with EC specifications and standards as far as possible. However, the Copenhagen European Council (1993) wanted these countries to harmonize their standards before their accession to the EU, in an attempt to avoid the distortion of competition and industrial relocation. By applying for membership, the countries in accession have made it clear they are ready for harmonization. However, by requiring these countries to adopt the same legal restrictions on economic activity as it has itself, the EU risks undermining many of the advantages of mutual trade.

CONCLUSIONS When markets are integrated, market failures in one marketplace can create market failures in another marketplace, including those relating to natural resource and environmental management. Trade measures can be part of environmental problems or part of the solution to these problems. The multilateral trading system and the international environmental regime have emerged as the two main sources of international rule making. Environmental issues have found their way onto the trade agenda because there are objective linkages between trade policy and environmental policy at the international level. In fact, neither environmental policy nor trade policy can succeed without the other. Importantly, the evolution of rules relating to trade and the environment has to a large extent been propelled not by negotiation but by judicial interpretation. On balance, the multilateral trade rules are friendly to the environment within the jurisdiction of a WTO member with relatively stringent

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environmental standards. However, qualifications of these rules may be – and are – used to attack the WTO legality of national environmental laws. While the free trade provisions of the WTO have an extremely broad scope, the environmental exceptions are narrowly defined. The sense of imbalance is heightened by the fact that the exposure goes one way: either the public health or environmental protection standard is deemed appropriate, or it is not allowed to stand. Given this imbalance, the GATT/WTO approach is not likely to increase environmental protection in countries with relatively low standards. In other words, the ‘net result’ of the WTO rules is the maintenance of, rather than improvement in, the level of global environmental protection. The GATT/WTO dispute settlement and its transmutation into a judicial system is a fascinating example of how international law changes and affects the internal structures of regional economic groupings, including the EU. With the advent of the WTO, additional factors have arisen owing to the new automaticities of the system. They are of practical importance both in terms of defensive and offensive use of the system. Countries are faced with a process of claims and responses. The EU ranges among the main users of, and commands extensive expertise and experience in, dispute settlement under GATT/WTO. The interpretation of GATT Article XX has shown a measured evolution towards a more environmentally friendly stance. The development has not been linear, however, with the conclusions of some panels not being adopted or the Appellate Body not upholding panel conclusions. The precedent-setting value of these conclusions as well as their actual or potential effects on the rights and obligations of WTO members remain open questions. The EU approach to ‘judicial bounding’ reflects more careful balancing of trade and environment goals than does that of the WTO. Contrary to the WTO practice, the EC Treaty also recognizes the importance of the principle of preventive action, the polluter pays principle and the precautionary principle as core policy rules governing EU action. While the GATT/WTO and the EU each require trade measures to be necessary and least trade restrictive, the ECJ balances these requirements in terms of proportionality. The proportionality test effectively substitutes the Court’s judgment about risk aversion for that of national authorities. Trade and the environment rule making is a function of economic integration. Experience with the WTO and the EU goes to show that trade liberalization, at some point, leads to the adoption of flanking policies which can balance its positive and negative effects. As integration deepens among members of an economic organization, previously ‘domestic’ regulations such as environmental rules, product standards and competition policy find their way onto a common agenda. More importantly, trade liberalization

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inherently starts to require, rely upon and develop positive rules, that is, it depends on common and shared standards and perceptions, or at least, on mutual recognition of national or regional standards. Product standards may act as barriers to trade and influence market access; process standards influence the cost structure of production and condition of competition. Market access has been central to the development of GATT/WTO and the EU. Competitiveness concerns are increasingly cited as a reason not to proceed with further trade liberalization. These concerns have so far been dismissed in the WTO as a non-issue, whereas in the EU they have been causing the member states to explore measures to ensure that competition is not distorted by variations in environmental rules. The premises underpinning the GATT/WTO and the EU legal orders have traditionally been distinct in terms of their approaches to standards and their effects on trade. Whereas Community law is predicated upon the concept of mutual recognition of standards, subject to exceptions, the GATT rests upon a foundation of national treatment, again subject to exceptions. Nonetheless, the GATT/WTO effectively departs from this principle of national treatment, in favour of mutual recognition, when it comes to the issue of PPMs. While in certain respects Community law may also treat product standards and PPMs differently, the consequences of this are less pronounced in terms of the premises underlying the system. There are, of course, other reasons as to why the PPMs issue has proved more contentious in the WTO – as opposed to the EU – context. Most obviously, the Community’s enhanced capacity for harmonization of standards, including minimum standards for PPMs, is of crucial practical and conceptual significance in easing the path from national treatment to mutual recognition. In the environmental policy area, mutual recognition of PPMs in the Community operates against a backdrop of a shared regulatory framework constituted at Community level and gradually moves towards establishing minimum PPMs. By contrast, the WTO does not attempt to harmonize environmental product standards. The TBT and SPS Agreements merely urge WTO members to base their regulatory requirements on international standards. The multilateral trading system may be reaching the point where a framework of analysis is beginning to shift from the functionalist paradigm to constitutionalism, that is, a framework which is capable of taking into account – and can reasonably balance – a broader range of issues and legitimate interests in its operation and dispute resolution.46 Such interests are, on one hand, horizontal and related to subject matter. They are, on the other hand, also vertical interests, affecting the balance of power between different levels of governance – national, regional and international. The WTO is getting increasingly involved in non-trade or para-trade issues such

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as international intellectual property protection, sanitary and phytosanitary standards (Codex alimentarius) and the environment. It is increasingly developing into a cornerstone of international economic constitutionbuilding. The essential requirements harmonization strategy used in the EU seems like an especially useful precedent for the WTO as it moves into the area of positive rule making. The central characteristic of this approach is that harmonization is limited to the adoption of core standards, and that the task of developing the detailed product specifications is left to European standardization organizations. As far as international standards are concerned, two lessons can be drawn from the eco-labelling debate: there is a need to define what an ‘international standard’ is, and to ensure effective and representative participation of WTO member states at all levels of development in international standard setting. The development of environment friendly trade rules depends on the relative power and interests of demandeur states in a particular organization. At the same time, the pace and completeness of national implementation of trade–environment rules appear to parallel roughly each country’s position in the process of trade–environment rule making. These two trends suggest that further development of trade and environment rules will take place along regional paths. The EU maintains the most well-developed trade–environment rules, because it is the organization with the deepest integration and power, which is relatively concentrated in favour of demandeurs’ countries. The comparative analysis of trade and environment issues within the GATT/WTO and the EU also suggests a regionalization of trade and environment rule making, with the EU (and some other regional groupings) moving along its distinctive policy-making path, and the GATT/WTO barely moving at all. The biggest drag in the WTO has to do with the so-called ‘implementation issues’ such as finance, access to environmentally sound technologies and, perhaps to a lesser extent, capacity-building. Progress is likely to continue to be slow, and may actually become even more difficult with the accession of China and, potentially, Russia. Similar concerns exist with respect to the EU enlargement, which can provoke gaps in implementation as well as between the contents of the environmental acquis and the requirements of the various member states. In practice, even though the candidate countries sign up to the acquis communautaire in principle, there must be a rather lengthy transition period before the whole package can conceivably be in place. Normally, harmonization does not precede free trade, it follows it. Tariff removal is bound to leave new members more vulnerable because the standards and technical regulations in these countries are not sophisticated

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enough. This vulnerability will be compounded by the fact that in the year 2001, free trade is supposed to cover 96 per cent of EU exports to countries in accession, but only about 70–80 per cent of these countries’ exports to the EU, since agricultural products are excluded. It would seem more reasonable for the EU to take a relatively hard line in relation to aspects of the acquis communautaire that directly affect competitiveness and market access, for example, industrial pollution controls, while being less concerned about more general aspects, for example, EU drinking water standards. The language of science is spoken both in the WTO and the EU. However, when it comes to evaluating justifications for restricting trade, the qualitative threshold for establishing the existence of risk appears to be lower in a EU context, at least in so far as substances which are generally accepted as dangerous are concerned. This reflects not merely the uncertainty which characterizes costs and benefits in a context of unknown (unknowable) risk, but also the modern conceptions of science – and economics – as capable of delivering merely a version of the ‘truth’, which has its roots in the premises, methodologies and values of the system within which it is articulated. Whatever the differences in legal orders are, the basic fact remains that different (groups of) nations have different levels of tolerance for environmental – and health – risks.47 Scientific progress and the ‘scientization’ of trade measures make the use of trade measures for environmental purposes an increasingly difficult balancing act in the multitude of ‘truths’ produced by social science, societal preferences, cultural values and traditions – on top of differing levels of economic development. The concept of ‘science diplomacy’ is becoming more and more relevant to the trade and the environment agenda. Much international disagreement on trade and environmental issues has to do with the relative weights assigned to science and societal preferences. While science is an essential element in assessing potential health and environmental risks, the management of such risks is in fine the responsibility of policy makers. Decisions to avert potential risks are called for also in cases where science does not provide a full answer, or when it provides several alternatives. Promotion of ‘science diplomacy’ may prove instrumental in handling the implications of the precautionary principle in the context of trade rules. The issue of ‘product versus process’ has emerged as the major stumbling block in advancing the trade and environment agenda. There are two facets to this issue though. One is process standards and their influence on market conditions. The other, arguably much more important aspect, is the (quality of) political process. While discussions of trade measures for environmental purposes tend to be couched in the language of economics and competition law, the underlying problems do not reflect exclusively either economic or competitiveness concerns. Rather, they bear testimony to the moral

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dimension of nations’ relationship with nature. So far as trade measures for non-trade purposes reflect the diversity of national values and of the norms giving expression to these values, they pose a formidable challenge to international trade. Central to this challenge is the well-known fact that the capacity of states to regulate in areas such as the environment is contingent, in practice, upon their capacity to demand compliance with these standards on the part of their trading partners. Dealing with this challenge though judicial or quasijudicial means has its limitations. For instance, application of the proportionality principle is a matter of judgement. It is becoming increasingly clear that not only are courts structurally ill-equipped for dealing with trade measures for non-trade purposes, but this gives rise to profound issues of legitimacy, which, ultimately, have consequences for the acceptance of their decisions and their authority. It is thus the quality of the political process, in terms of interest representation and participation, which is largely viewed as providing the basis for the evaluation of national measures, rather than the substantive merits of the decision from the perspective of the actor enjoying the power of review. A widespread procedural turn in European Community law is indicative in this respect: approaching legitimacy through the lens of process rather than outcome and insisting not only upon an expanded participatory basis in (national and international) decision-making, but also upon civic deliberations. In the WTO, increasing emphasis is being placed on the duty to negotiate and the procedural mechanisms underpinning the certification process. The rights to be heard, to appeal, seek review of a certification decisions and to receive reasoned notification of outcome, are increasingly cited as a factor in invalidating the trade measure in question. These are, in the broadest terms, the seeds of a process-based – as distinguished from productbased – approach, which both the WTO and the EU should develop. In the future, the legitimacy of trade measures for environmental purposes will be judged not merely on the basis of procedural considerations, including the obligation to negotiate seriously, but in the light of their responsiveness to the particular circumstances prevailing in a given state, and their flexibility in acknowledging the equivalence or comparability of different conservation policies adopted by their trading partners. It may be anticipated that measures premised upon a case by case approach, as distinguished from an overall national policy-based approach, may have a higher chance of success. In the years to come, preference will be given to non-unilateral measures, that is, those based on negotiations, international (regional) standards or MEAs. When all is said and done, the final conclusion of any study on trade measures for environmental purposes is bound to be unremarkable. Trade

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measures are seldom the first best policy tools to achieve environmental objectives, be it in the multilateral or regional context. They may not even be the second best tools. Some argue that the adoption of ‘home country’ standards by TNCs is a superior policy choice. This is not to say that trade measures are not necessary. They certainly are, and the PIC48 Agreement (the Rotterdam Convention), Basel Convention and CITES are very indicative in this regard. However, promoting the first best approach is important because it can address the division between the private and the social cost at the source of the environmental problem. It ensures that global or national environmental concerns are met in a manner that is consistent with global or national trade concerns. It is always the least distortive and most efficient measure that can achieve a particular result. It can guide the consultative process between the parties. In the case of a dispute, for instance, the transfer of technology may achieve the primary objective, that is, protect the environment, avoid a costly (in political and economic terms for all parties) dispute settlement case and thereby reduce the potential for discriminatory or arbitrary measures. There is nothing particularly new about the first best approach, but it can go a long way towards finding solutions to the most intractable trade and environment problem – that of PPMs. Examining incentives and enabling measures to assist all countries to move towards more environmentally friendly PPMs (and comply with provisions of MEAs) may be more useful than pursuing the PPM debate in the context of trade rules.

NOTES *

1. 2.

This chapter derives from a number of drafts developed over time with a view to assessing the scope for and implications of trade measures for non-trade purposes in the multilateral trading system and regional integration arrangements. It draws on the written work and presentations of Thomas Cottier, Professor of European and International Economic Law at the University of Berne, Joanne Scott at Harvard Law School, Daniel Esty, Director of Yale Centre for Environmental Law and Policy, Damien Geradin, Assistant Professor of Law at University of Liège, Joost Pauwelyn at the Legal Affairs Division of the World Trade Organization (WTO) and Mohan Kumar, Counsellor at the Permanent Mission of India to the WTO. Errors and omissions remain my own. The views expressed are those of the author and do not necessarily reflect those of the UNCTAD secretariat. There are special cases, however. For example, trade measures under the Convention on International Trade in Endangered Species (CITES), which have been prompted by non-market imperatives; in the case of CITES, the protection of plants and animals. The Agreement (Article I, 1.1(a)(i)) stipulates that a subsidy must reflect ‘a financial contribution by a government or any public body’. The definition goes on to spell out that subsidies arise only when there is ‘a direct transfer of funds (for example, grants, loans or equity infusion), potential direct transfers of funds or liabilities (for example, loan guarantees’).

Trade and the environment in the perspective of EU enlargement 3. 4. 5.

6. 7.

8. 9. 10.

11. 12. 13.

14. 15.

16. 17. 18. 19. 20. 21. 22. 23.

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In certain cases, the polluter gets paid to improve environmental performance. See Esty and Geradin (1997, 1998). For example, the signatories to the Montreal Protocol on Ozone Depleting Substances (ODS) have agreed to impose trade restrictions on goods made with (but not containing) ODS; and the importance of how a good is made is recognized in GATT Article XX(e) regarding the products of prison labour. GATT/WTO (1998) The Panel considered the ban as a non-TBT issue, but the exception to the ban was considered a TBT issue. The Appellate Body considered the measure as a whole and decided the case on the GATT grounds, citing insufficient information as a reason for not deciding it as a TBT case. The observation was made by Thomas Cottier at the international workshop entitled Negotiating Agenda for Market Access: Cases of SPS and TBT, Geneva, 24–25 April 2001. See Pauwelyn (1999). Before the entry into force of the SPS Agreement, health regulations only had to be justified once a prior violation of one of the GATT principles had been found. Article XX(b) of GATT (human, animal or plant life or health) is, indeed, activated only once a violation of, say, the non-discrimination provisions (in Articles I or III of GATT) has been established. Under the SPS Agreement, all disciplines apply even if no prior discrimination has been found. That is to say, not only to SPS measures enacted subsequent to the entry into force of the SPS Agreement (post 1 January 1995 regulations), but also to SPS measures passed prior thereto and still in force thereafter (pre 1 January 1995 regulations still in place). SPS measures cannot be maintained without sufficient scientific evidence. Japan – Varietals is the first, and so far the only, dispute where this requirement was expressly addressed. While risk assessment for ‘food-borne’ risks requires only the evaluation of the potential for adverse effects on human or animal health, risk assessment for disease or pest risks calls for the evaluation of the likelihood of entry, establishment or spread of a disease, and of the associated potential biological and economic consequences. That is, a separate risk assessment must be conducted for each substance; also, the studies part of a risk assessment needs to be specific enough to address the particular kind of risk at stake. Under Article 5.7 of the SPS Agreement, WTO members can enact a provisional SPS measure if this measure is: (1) imposed in respect of a situation where ‘relevant scientific information is insufficient’; and (2) adopted ‘on the basis of available pertinent information’. However, such a provisional measure may not be maintained unless the member which adopted it: (1) ‘seek[s] to obtain the additional information necessary for a more objective assessment of risk’; and (2) ‘review[s] the . . . measure accordingly within a reasonable period of time’. Cited from Pauwelyn (1999), p. 651. ‘Type-1’ eco-labels, in the terminology of the ISO, may be awarded by a third party to products that meet (multiple) pre-set environmental criteria, generally following a ‘lifecycle’ approach. Eco-labels following the latter approach are frequently based on criteria that relate to only a few aspects of a process of production or of a product. This creates the potential for unwarranted trade restriction, in particular protectionism in disguise. Persistent organic pollutants. For an overview of MEAs, see International Environmental Governance (2001). As far as the Montreal Protocol is concerned, such measures are limited to trade bans with non-parties. For details, see WTO Secretariat (2000). The premature implementation by the EU of the Basel Ban Amendment, which is not yet in effect, is one case in point.

110 24. 25.

26. 27.

28.

29.

30. 31. 32.

33.

34.

35. 36. 37. 38. 39. 40. 41. 42.

Trade and environment policies It is a generally accepted canon of evidence in civil law, common law and, in fact, most jurisdictions, that the burden of proof rests upon the party, whether complaining or defending, who asserts the affirmative of a particular claim or defence. Traditionally, once a GATT panel had found a violation in respect of one legal claim it did not further address the other legal claims. However, under the new WTO dispute settlement system, with a newly created appeals organ, panels have often opted to examine more than one claim, even if they found a violation under the first claim. The Appellate Body itself cannot make findings of fact nor can it remand a case to the original or another panel. Failure by developing countries to sign the Uruguay Round’s single undertaking would have jeopardized MFN treatment of their goods because the United States and the European Union were withdrawing from GATT 1947 and joining GATT 1994, the latter of which constitutes an integral part of the single undertaking. There is always a possibility of de facto ‘mainstreaming’ as environmental issues may be raised in any negotiating group, including under ‘other business’, even if they are not explicitly mentioned in the negotiating mandate. It is all the more important to establish a clear hierarchy between the deliberations of the CTE and those of the negotiating groups in future trade negotiations. The scope for adjustment here is rather broad and is circumscribed by issues such as access to environmentally friendly technology (Article 7); additional protection of geographical indications (Article 23); patentability of technologies that can harm the environment, with special reference to GMOs (Article 27.2); implementation of effective sui generis systems (Article 27.3b); disclosure of origin (Article 29), technology transfer to least developed countries (Article 66.2); and, last but not least, technical and financial assistance to developing countries (Article 67). Case 8/74, Procureur du Roi v. Dassonville et al., 1974 ECR 837. For details see Steiner (1992); White (1989). In its judgment, Case 120/78, Rewe-Zentrale AG v. Bundesmonopolverwaltung fur Branntwein, 1979 ECR 649, the European Court indicated that the principle of mutual recogniton is inapplicable if the standards of the member state of export are insufficient to ensure an adequate level of protection. External relations competence in trade and environment fields remains with the member states unless a matter is explicitly and unanimously extended to the Communities, presumably in the course of internal harmonization. At the same time, the EC is responsible under international law for compliance with the GATT/WTO owing to full membership of the Communities in the WTO. Members of the WTO may therefore bring complaints in such matters against the EC, one or more member states, or both, due to individual membership in the WTO. Harmonized ambient standards, in contrast with emissions limits, preserve the comparative advantage of industries located in regions that are less polluted or better able to absorb pollution. For instance, the use of water quality standards rather than effluent limits would allow a country to exploit a locational advantage. Directive 96/61, supra note 178, at Article 9(4). Case C-1/96 (1998) ECR I-1251. For details see Elworthy (1997). Council Directive 91/629/EEC OJ 1991 L240/28. Case C-389/96, judgement of 14 July 1998. For details see Scott (2000). Council Directive 79/409/EEC OJ 1979 L103/1. The Court held that stricter measures could be enacted only in respect of bird species occurring within the territory of the regulating state, or in respect of species which are endangered or migratory which constitute a common heritage of the Community. Hormones in beef have been the subject matter of a number of cases before the European Court brought by organizations representing business and agricultural interests: Case 160/88 (1988) ECR 6399, Case 160/88R (1988) ECR 4121, Case 34/88 (1988) ECR 6265, Case 376/86 (1988) ECR 0209, Case C-331/88 (1990) ECR I-4023, Case 68/86 (1988) ECR 0855.

Trade and the environment in the perspective of EU enlargement 43.

44. 45. 46. 47. 48.

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Supremacy of Community law is not as firmly enshrined in reality as case law suggests. It depends on legitimacy and persuasion. Rules that are inconsistent with international obligations negotiated by the Community and member states cannot and do not provide such qualities in incidents of protectionist policies. To pass this test, trade restrictions must be (1) pertinent, that is, there must be a causal relationship between the measure adopted and the attainment of the objective pursued, and (2) the least restrictive method of attaining their objective. It is to be noted that the ECJ has been careful about intruding on national judgements in adjudicating disputes over import restrictions adopted for the purposes of domestic health or environmental protection. See Cottier (1998). The absorptive capacity of their natural environment also differs greatly. Prior Informed Consent.

REFERENCES Agreement on Subsidies and Countervailing Measures (SCM), Article I, 1.1(a)(i). Agreement on Trade-Related Aspects of Intellectual Property Rights, Articles 7, 23, 27.2, 27.3b, 29, 66.2, 67. Cassis de Dijon case (1979), Case 120/78, Rewe-Zentrale AG v. Bundesmonopolverwaltung für Branntwein, ECR 649. Cottier, T. (1998), ‘Dispute Settlement in the World Trade Organization: Characteristics and Structural Implications for the European Union’, Common Market Law Review, 35, 325–78. Cottier, Thomas (2001), ‘Negotiating Agenda for Market Access: Cases of SPS and TBT’, international workshop, Geneva, 24–25 April 2001. EC (1995), Directive 96/61, supra note 178, at Article 9(4). ECJ (1974), Case 8/74, Procureur du Roi v. Dassonville et al., ECR 837. ECJ (1979), Council Directive 79/409/EEC OJ L103/1. ECJ (1988), Hormones in beef, Case 160/88 ECR 6399. ECJ (1988), Hormones in beef, Case 34/88 ECR 6265. ECJ (1988), Hormones in beef, Case 160/88R ECR 4121. ECJ (1988), Hormones in beef, Case 376/86 ECR 0209. ECJ (1988), Hormones in beef, Case 68/86 ECR 0855. ECJ (1990), Hormones in beef, Case C-331/88 ECR I-4023. ECJ (1991), Council Directive 91/629/EEC OJ 1991 L240/28. ECJ (1998), Case C-389/96, 14 July. Elworthy, S. (1997), ‘Crated Calves and Crazy Cows: Live Animals and the Free Movement of Goods’, in J. Holder, The Impact of EC Environmental Law in the Unite Kingdom, Chichester: Wiley, 1997. Esty, D. and D. Geradin (1997), ‘Market Access, Competitiveness and Harmonization: Environmental Protection in Regional Trade Agreements’, Harvard Environmental Law Review, 21(2). Esty, D. and D. Geradin (1998), ‘Environmental Protection and International Competitiveness. A Conceptual Framework’, Journal of World Trade, 32(3). GATT Article XX(b), (e). GATT/WTO (1998), ‘Dispute Settlement Practice Relating to Article XX’, Paragraphs (b), (d) and (g) of GATT, WT/CTE/W/53/Rev.1, 26 October 1998; www.wto.org/english/tratop_e/envir_e/edis 00_e.htm.

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International Environmental Governance (2001), ‘Report of Executive Director of UNEP, IGM/1/2, 3 April 2001’, Meeting of the Open-ended Intergovernmental Group of Ministers on International Environmental Governance, New York. Pauwelyn, J. (1999), ‘The WTO Agreement on Sanitary and Phytosanitary (SPS) Measures as Applied in the First Three SPS Disputes’, Journal of International Economic Law, 641–64. Scott, J. (2000), ‘On Kith and Kine (And Crustaceans): Trade and Environment in the EU and WTO’, Harvard Jean Monnet Working Paper 3/99, Seminar and Workshop on Advanced Issues in Law and Policy of the European Union, NAFTA and the WTO, Harvard Law School, Cambridge, MA, USA. Steiner, J. (1992), ‘Drawing the Line: Uses and Abuses of Article 30 EEC’, Common Market Law Review, 29, p. 749. Veal Calves in Crate case (1998), Case C-1/96 ECR I-1251. WTO Secretariat (2000), ‘Matrix on Trade Measures Pursuant to Selected MEAs’, informal note, WT/CTE/W/160, 19 September. White, E. (1989), ‘In Search of the Limits to Article 30 of the EEC Treaty’, Common Market Law Review, 26, p. 235.

6.

Can environmental regulations be compatible with higher international competitiveness? Some new theoretical insights* Savas Alpay

1

INTRODUCTION

As environmental problems on both the national and the global level get more and more serious, public awareness on this issue is rising, and an increasing number of countries are undertaking environmental regulation. Environmental concerns have also attracted the attention of academic circles, and a lot of new research areas are opening. One of the earliest discussion topics was about the types of regulations which include command and control, effluent fees or taxes, tradable emission permits, and so on. Out of this discussion, incentive-based techniques (effluent fees, tradable emission permits) were shown to be superior to non-incentive-based techniques like command and control. There is a somewhat heated debate on the influence of incentive-based environmental regulations on the international competitiveness of regulated firms, and we will explore this debate in this chapter. Conventionally, it has been argued that environmental regulations would lower the competitiveness of the firms being regulated as compared to those subject to lax environmental conditions. This argument was assumed to apply to all cases, regardless of the type of environmental regulation. Recently, this view has been challenged by a revisionist school. This school argues that properly crafted environmental regulations (that is, incentivebased) not only bring social benefits (like increased environmental quality, a decline in health risks associated with pollution, and so on), but can also increase the competitiveness of the firms being regulated as higher environmental standards can trigger innovation that may offset compliance costs. This debate is more explicitly seen in a series of papers published in the Fall 1995 issue of Journal of Economic Perspectives (see Palmer et al.,

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1995, Porter and van der Linde, 1995). We can associate the conventional school with Palmer et al. (1995), and the revisionist school with Porter and van der Linde (1995). The views of these two schools will be explored in the next two sections. There have been at least 100 empirical studies on this debate. The literature has recently been surveyed by Jaffe et al. (1995). They conclude, however, given the lack of evidence on either side: International differences in environmental regulatory stringency pose insufficient threats to US industrial competitiveness to justify substantial cutbacks in domestic environmental regulations. Nor does the evidence recommend enactment of stricter domestic environmental regulations in order to stimulate economic competitiveness.

Theoretical work, relatively limited by comparison to empirical work, tends to support the conventional school; see, for example, Pethig (1976), Siebert (1977), Yohe (1979) and McGuire (1982). Recently, Barrett (1994) has shown that the introduction of a ‘weak’ environmental standard by the domestic government may increase the competitiveness of a monopoly when foreign industry is imperfectly competitive; where the domestic industry consists of more than one firm, there are incentives for ‘strong’ standards.1 However, these studies ignore innovation, which is an important part of the Porter hypothesis. Simpson and Bradford (1996) included innovation in their model, in which environmental regulation takes the form of effluent taxes. They state that the impact of stricter environmental regulation on the performance of the industries being regulated would likely differ across sectors and be impossible to predict with any precision. They also conclude that it is difficult to construct examples in which tougher regulation should be enacted to enhance the long-run competitiveness of domestic industry, and thus, ‘tightening regulation to induce advantage may be extremely dubious as practical policy advice’. In this chapter, we shed new theoretical light on the relationship between environmental regulations and the international competitiveness of firms subject to higher environmental standards. In our model, the environmental agency uses a tradable emission permits regulation system, which has not been studied before in this context. By doing so, we also make it possible to compare an effluent tax system (studied by Simpson and Bradford, 1996) with tradable emission permits with regard to the international competitiveness of regulated firms. We present evidence for the contentions of both schools of thought. Although we take a neutral approach in this chapter, our results show that the Porter hypothesis’ theoretical validity should be given more credence than the previous (theoretical) studies in

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this area concluded. We show that one does not need to deviate from the neoclassical model’s assumptions on the behaviour of the firm (like X-inefficiency and so on, as suggested earlier in this literature) to find theoretical support for the possible positive impact of environmental regulations on the international competitiveness of the firms being regulated. We start with a closed economy, where two Cournot-oligopolists produce a good that causes pollution, to model the interactions among environmental regulations, competitiveness and innovation. In this basic framework, we show that an increase in the stringency of incentive-based regulation, namely tradable emission permits here, will not unambiguously lower the competitiveness of firms. It is shown that, among other things, the frontier between the two contentions on the impact of environmental regulation on competitiveness heavily depends on the features of the permit market’s features, such as the price elasticity of permit demand. With the introduction of stricter environmental policy (achieved by lowering the total amount of available permits), firms consider abatement seriously. There are two reasons for this: (i) they do not want to purchase costly permits that allow them to pollute, and (ii) they want to make use of the permits they already have by selling them to those in need to obtain permit revenues. These revenues will reduce the adverse effect of the regulation on the competitiveness of the firms. If the permit market is sufficiently inelastic, stricter policy may result in increased competitiveness for the regulated firms even if the firms do not innovate. Investment in R&D which results in innovation with some known probability, will make the increase in competitiveness more likely. An important criticism of the revisionist school by the conventional school is the question of why firms do not take all profitable opportunities before regulation; that is, if they can increase their profits by innovation or other means, why do they wait for environmental regulation? We provide an answer to this question by demonstrating that the regulatory policy causes changes in some parameters, like permit prices and price elasticity of demand for the good, which are outside the control of the firm but have an impact on its decision. We show that some non-feasible R&D projects can become profitable after the enactment of stricter regulations because of the associated changes in these parameters. Then, we move to an open economy case where we assume the existence of a second country with, again, two Cournot-oligopolists producing the same good. Our results in the domestic case have their analogues here, and we present the conditions for when regulation worsens international competitiveness (conventional school) and when it improves international competitiveness (revisionist school). These conditions are determined by, among other things, the probability of innovation, the cost of R&D, returns

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to innovation (new technology parameters), and the price elasticity of permit demand. Some recent studies on the Porter hypothesis reinforce the theoretical results we present here. Xepapadeas and de Zeeuw (1998) show that downsizing and modernization of firms subject to environmental policy will increase average productivity, and will have positive effects on the marginal decrease of profits and environmental damage. They conclude, rather neutrally, that a win–win situation as suggested in the Porter hypothesis can generally not be expected, but the trade-off between environment and competitiveness is not so grim as is often suggested. A stronger case for the Porter hypothesis is provided by Albrecht (1998) in an empirical study. Albrecht (1998) considers a model for international CFC regulation and the export performance of CFC-using industries like refrigerators, freezers and air-conditioning machines; he demonstrates that when regulation is linked to specific products, there is clear evidence for the Porter hypothesis. Sequentially, we present the views of the conventional and revisionist school. Our model and formal results follow these two sections. Concluding remarks appear in Section 6.

2

CONVENTIONAL SCHOOL

In their 1994 paper, Oates et al. write: There has been widespread concern that the increasing stringency of domestic environmental regulation will put home-based industries at a competitive disadvantage in the international marketplace (see, for example, The Business Roundtable (1993)). According to this view, the increased costs that accompany more stringent controls will mean that domestic firms must confront their competitors abroad subject to an ‘unfair’ burden. Such concern has even led to some proposed legislation in the form of a bill that would have introduced ‘counterveiling levies’ against foreign nations whose ‘exports’ benefit from the cost advantages associated with lax environmental programs.

By the very notion of profit maximization, the firm must have realized all available profitable opportunities; therefore, environmental regulation, which is a constraint by itself, should not be expected to increase the profits of the firms being regulated.2 If it were otherwise, firms would not have been realizing all their profitable opportunities and thus they would have been operating inside their production possibilities. In brief, there are no $10 bills lying on the ground waiting to be picked up. More specifically, it has been stated that environmental regulation imposes significant new costs

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on domestic firms, and thus, given the lax regulations abroad, they will experience a fall in their international competitiveness. A number of theoretical studies present evidence for this view. See, for example, Pethig (1976), Siebert (1977), Yohe (1979) and McGuire (1982). These studies do not take account of the innovations that may become possible with stricter regulation. Recently, Simpson and Bradford (1996) included innovation in their model. Their results can be interpreted as further support for the conventional school. Palmer et al. (1995) accept the possibility that stricter regulation may result in innovation and that innovation may offset the costs associated with new regulation; however, they say, this is very rare in practice. Moreover, even if regulation fosters innovation, it will harm competitiveness by crowding out funds for other potential (and possibly more productive) projects.

3

REVISIONIST SCHOOL

This view is proposed by Porter (1991). Porter states that the trade-off between environmental stringency and international competitiveness comes from the ‘static’ approach to the problem. In fact, if the analysis is carried out within a ‘dynamic’ framework,3 which mainly encompasses possibilities of innovation in technology, product and processes, then there is room for improvement in international competitiveness as a result of stringent environmental regulation. It is true that environmental regulation increases the number of constraints that firms face; however, this may motivate the firm towards innovation, which may offset the costs associated with stricter regulation. Porter and van der Linde (1995) state: . . . we will argue that properly designed environmental standards can trigger innovation that may partially or more than fully offset the costs of complying with them. Such ‘innovation offsets’ . . . can not only lower the net cost of meeting environmental regulations, but can even lead to absolute advantages over firms in foreign countries not subject to similar regulations. . . . In short, firms can actually benefit from properly crafted environmental regulations that are more stringent (or are imposed earlier) than those faced by their competitors in other countries. By stimulating innovation, strict environmental regulations can actually enhance competitiveness.

More explicitly, the Porter hypothesis asserts that, in general, the efficiency of an industry can be improved by more stringent environmental (or other) regulations, either through sweeping inefficiencies out of the production process or through fostering innovation. As firms struggle to meet new environmental regulations, they reconsider their production processes

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and they may discover new techniques in abatement (and possibly production) technology; thus, it may be the case that, overall, firms experience a fall in their costs of production. Previously, these innovations have not been made because, facing lax environmental conditions, the firms did not have incentives to start the innovation process.4

4

MODEL

Having introduced the views of both schools of thought, we can now present our framework for analysis and demonstrate some new theoretical insights into the impact of environmental regulation on competitiveness. First, we will take the case of a closed economy and see the interactions between environmental stringency, innovation and competitiveness. Then, we will extend this basic set-up to the open economy setting where we can show our results in the context of the regulation and international competitiveness debate. Like Sartzetakis and Constantatos (1995), we assume that two Cournotoligopolists produce a good that generates pollution. To concentrate on the effect of regulation on competitiveness, we will try to make simplifying assumptions where necessary. So, the marginal cost of production, c, is assumed to be the same across firms and constant for analytical simplicity. Each firm maximizes its own profit by taking the other firm’s production decision into account. The inverse demand function is given by p⫽a⫺bQ, a⬎0, b⬎0, where p and Q represent price of and demand for the good; supply of the good is, q1 ⫹q2 which is the sum of the production of two firms, and so, Q ⫽q1 ⫹q2. Since the production process generates pollution, the firms are required to take some abatement actions. The emissions are proportional to the firms’ output levels, and so Ei ⫽rqi, where Ei is the emission demand of firm i and r ⬎0. Firms can reduce their emission levels either by decreasing the output level or by undertaking some abatement. Total abatement is represented by Ai ⫽␣iqi, where ␣ represents the abatement choice variable, with the corresponding convex abatement cost, Ci ⫽ ei A2i , where ei is a positive number. The environmental agency implements a tradable emission permits (TEP hereafter) regulation system to control the aggregate emission level. As we stated above, the claim of the revisionist school is that environmental regulation may increase the competitiveness of the firm if environmental regulation is of the right type; the right type being incentive-based regulation as opposed to standard setting.5 TEP is one example of incentive-based instruments, so it can be used to analyse Porter’s hypothesis.

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In this system, firms must have a pre-specified quantity of permits to discharge a certain amount of pollution; for example, they may need to surrender one permit per unit of emissions. Firms can trade permits among themselves. A thorough analysis of tradable permits can be found in Montgomery (1972). Overall pollution is the result of many polluting industries inside a country. We assume that environmental regulation is applied to all polluting industries. We further assume that the market for tradable permits is perfectly competitive and thus firms take the permit prices, P␧, that causes zero net demand for the permits as given. Each firm is given E amount of tradable permits initially. Firm i’s demand for permits is given by the difference between its desired level of emissions and abatement less the initial permit endowment, that is, Ei ⫺ Ai ⫺ E. Thus, the optimization problem of each firm is as follows:
␲i ⫽ pqi ⫺ cqi ⫺ eiA2i ⫺ P␧(Ei ⫺ Ai ⫺ E ) max q ,␣ i

(6.1)

i

Firms choose the output and abatement levels (through ␣) to maximize their profits. Replacing Ai and Ei in (6.1), we get an open form for the firms’ optimization problem: max
pqi ⫺ cqi ⫺ ei (␣i qi)2 ⫺ P ␧(rqi ⫺ ␣iqi ⫺ E ) qi , ␣i

(6.2)

where ␣i is the choice variable related to the optimal abatement level. As shown in the appendix, the reaction function for firm i is given by: qi ⫽

a ⫺ c ⫺ rP␧ 1 ⫺ qj 2b 2

(6.3)

Solving for optimal output levels, we get, qi ⫽

a ⫺ c ⫺ rP␧ 3b

(6.4)

Firms produce the same level of output, which is not surprising under our symmetry assumptions.6 Similarly the optimal abatement level is: Ai ⫽ ␣iqi ⫽

P␧ 2ei

(6.5)

The good will sell for, p ⫽ a ⫺ b(q1 ⫹ q2) ⫽

a ⫹ 2c ⫹ 2rP␧ 3

(6.6)

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Upon the substitution of optimal values, corresponding profit levels will be: ␲i ⫽

(a ⫺ c ⫺ rP␧)2 (P␧)2 ⫹ ⫹ P␧E 9b 4ei

(6.7)

These values represent the positions of the firms before the stringent regulation program was introduced. It can easily be seen that the firm with lower abatement costs (that is, lower e) will have higher profits than the other firm. A change in P␧, permit price, has ambiguous effects without further specification of the model’s parameters. Before moving on to the impact of a strict environmental policy on the competitiveness of the firms, let us first try to answer the following question: can a regulated firm increase its profits over the non-regulated case when the environmental agency uses the TEP system? Proposition 1 When environmental regulation is done through TEP, it is possible for the regulated firm to have higher profits in the regulated case than in the non-regulated case if it earns enough revenue through the permit market. Following a similar analysis, if there is no regulation then the profits of the firm, which normally will not carry out any abatement activity, will be:7 ␲i ⫽

(a ⫺ c)2 9b

(6.8)

When we compare equation (6.8), showing the profits of a non-regulated Cournot-oligopolist, with equation (6.7), showing the profits of a regulated and abating Cournot-oligopolist, we can easily see that it is possible for a regulated case to result in higher profits than a non-regulated case due to the positive effects arising from sales of emission permits. For a more concrete demonstration of this and the necessary conditions, see the appendix. This proposition shows that it is conceivable that some of the firms will increase their profits after regulation; this may arise from the superiority of the abatement technology that they have at the time of regulation, or it may perhaps be due to the initial permit allocation across firms. Thus, the proposition has implications for the environmental agency, at least, in terms of the initial distribution of permits. Now, let us see the impact of a stricter environmental policy on the competitiveness of the firms. 4.1

Stricter Regulation, Innovation and Competitiveness

The environmental agency limits the number of permits that are available from ET to ET. As environmental regulation becomes more stringent,

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there are two options for firms: the status quo or innovation; that is to say, they may continue with their current production and abatement technology or they may try to obtain a better abatement (and/or production) technology through increased investment in R&D. So, as a result of more stringent regulation, with two firms, there are four possible behaviours: both firms choose to invest in R&D, or both continue without investing in R&D, or one of them decides to invest while the other does not. Note that, so far, we have concentrated on the domestic economy, setting up a framework through which the regulation and innovation process can be studied. Then, once we have this set-up, we can use it to obtain the relationship between international competitiveness and environmental regulation. We assume that if the firm engages in R&D then it has to incur a cost of CR and in return, with probability ␥, it can develop a new (abatement) technology, with parameters e, and r where e ⬍ e, and r ⬍ r. With probability (1 ⫺␥), a firm will not be able to innovate, but it will still incur the cost of R&D.8 We also note that a rise in the stringency of environmental regulation will have an impact on the permit market because a fall in the total supply of permits will increase permit prices. A change in permit prices naturally generates incentives for the firm to change its decisions on output, level of abatement and investment in R&D. As will be shown in more detail below, this kind of change may make some projects feasible that were not so before and the profits of the firm may become higher than in the initial situation. We would like to note that changes in the permit market are outside the control of the firm; thus, the permit price externality associated with environmental regulation may change the value of the projects available to the firm. This is a possible reason why firms might not undertake profitable projects before stringent regulation, a major criticism by the conventional school against the revisionist school. We have therefore provided an explanation of why that criticism may not always be justified. Let us begin to show the mechanics of this. Case I In this case, none of the firms undertakes R&D, so the market share and profit level for each firm will be as follows (assume that P␧ represents new permit prices): qi ⫽

a ⫺ c ⫺ rP␧ 3b

(6.9)

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The corresponding profit levels will be: ␲i ⫽

(a ⫺ c ⫺ rP ␧)2 (P ␧)2 ⫹ ⫹ P␧E 9b 4ei

(6.10)

If the permit demand is very price elastic, so that P␧ can be assumed to be very close to P␧, then, as seen from equations (6.4) and (6.9), market shares remain almost the same; however, the returns to each firm are expected be smaller with more stringent regulation since E ⬍ E. If permit demand is price inelastic, then permit prices do change considerably with stricter regulation. Since the supply of permits has declined, permit prices will increase, P␧ ⬎ P␧, and thus each firm will produce less from equation (6.9); however, the impact on profit levels is not clear. The increase in permit prices has both positive and negative effects on profit levels (the first term in (6.10) represents negative effects and the second and third terms represent positive effects). Thus, it is conceivable that profits may increase with the tightening of environmental regulation even if firms do not innovate. Case II In this case, we assume that firm 2 engages in R&D, and firm 1 continues to use its old technology. Firm 2 is assumed to obtain a new technology with parameters r and e2 at a cost of CR with probability ␥. Also assume that permit demand is not very price-elastic and so P␧ rises to P␧. This will affect the market shares, the abatement level and the profit level as follows (note that firm 2 will now maximize its expected profits): max
␥[pq2 ⫺ cq2 ⫺ e2(␣2q2)2 ⫺ P␧(rq2 ⫺ ␣2q2 ⫺ E) ⫺ CR] q2,␣2

⫹ (1 ⫺ ␥)[pq2 ⫺ cq2 ⫺ e2(␣2q2)2 ⫺ P␧(rq2 ⫺ ␣2q2 ⫺ E) ⫺ CR] (6.11) Firm 1’s problem is as in case I; as shown in the appendix, the solution to the firms’ problems will be: a ⫺ c ⫺ 2rP ␧ ⫹ (␥r ⫹ (1 ⫺ ␥)r)P ␧ 3b a ⫺ c ⫺ 2(␥r ⫹ (1 ⫺ ␥)r)P␧ ⫹ rP␧ q2 ⫽ 3b

q1 ⫽

(6.13)

P␧ 2e1

(6.14)

P␧ 2(␥e 2 ⫹ (1 ⫺ ␥)e2)

(6.15)

A1 ⫽ A2 ⫽

(6.12)

Can environmental regulations be compatible with competitiveness?

␲1 ⫽ ␲2 ⫽

(a ⫺ c ⫺ 2rP␧ ⫹ (␥r ⫹ (1 ⫺ ␥)r)P ␧)2 (P␧)2 ⫹ ⫹ P ␧E 9b 4e1

123

(6.16)

(a ⫺ c ⫺ 2(␥r ⫹ (1 ⫺ ␥)r)P␧ ⫹ rP␧)2 (P␧)2 ⫹ ⫹ P ␧E ⫺ CR 9b 4(␥e2 ⫹ (1 ⫺ ␥)e2) (6.17)

Derivation of profit expressions in equations (6.16) and (6.17) are given in the proof of proposition 2 which we present now. Proposition 2 When the environmental regulation becomes more stringent, the firm that innovates will increase its market share and will undertake a higher abatement as compared to the one which does not innovate. That firm will also have a higher profit than the non-innovating firm, if, for example, the cost of innovation, CR, satisfies (P␧) 2

(e1 ⫺ (␥e2 ⫹ (1 ⫺ ␥)e2)) ⬎ CR 4e1(␥e2 ⫹ (1 ⫺ ␥)e2)

Proof of the above proposition is presented in the appendix. To summarize, the first part, (q2 ⬎q1), follows from equations (6.12) and (6.13) with the reminder that (␥r ⫹ (1 ⫺ ␥)r) ⬍ r, that is, expected return to R&D is better than old technology. The second part requires us to show that the firm which tries to innovate will have higher returns as compared to a status quo firm, that is, ␲2 ⬎␲1. The firm that engages in R&D benefits from the decrease in emission level at each output level (decline in r) and that generates a reduction in the cost of production and causes an increase in its market share as compared to the other firm. Note that the change in permit prices does not affect this result since both firms will be facing the same prices. With a better ‘expected’ abatement technology, the innovative firm produces a higher abatement (equations (6.14) and (6.15)); this is so because of a decline in the expected cost of abatement as represented by (␥e2 ⫹ (1 ⫺ ␥)e2), which is assumed to be smaller than e1. This brings about the possibility of a larger permit revenue for the innovating firm; through this channel, firm’s expected profits tend to increase. Larger abatement imposes new costs on the firm but technological changes through R&D might offset these partially or fully. Also, the cost of R&D needs to be taken into consideration. Under certain conditions, as shown in the appendix in the proof of the above proposition, environmental regulation increases the competitiveness of the firm which undertakes innovation; the status quo firm loses from stringent regulatory conditions. This is a

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variant of the Porter hypothesis. Environmental regulation is not in itself a reason for a loss in competitiveness. Moreover, we also recognize the possibility that stringent regulation may result in a loss in competitiveness of the innovative firm. This would be the case if the cost of the innovation is very high. Related to this case, we can also prove one other interesting result. It is reasonable to assume that innovation opportunities exist both before and after regulation. So, the question is, if innovation increases profits, why doesn’t the firm invest to innovate before the stringent regulation? In fact, this is one of the main criticisms of the conventional school to the view of the revisionist school. We take up this point now. Proposition 3 Due to changes in permit prices with the enactment of stricter environmental policies, it is possible that the projects that were not feasible before may become profitable for the firm. The proof is given in the appendix. The intuition behind this result is as follows. Stricter regulation increases permit prices, and thus, the potential for higher permit revenues rises; however, it is uncertain whether the investment in R&D will bring about a better technology, and the firm’s subjective evaluation of possible innovation (as reflected in the magnitude of ␥) may be such that the firm does not find it in its interest to invest in R&D before the stricter regulation due to lower permit prices and higher innovation costs (this follows from the maximization of expected profits). As permit prices increase with new regulation, given the same prospect for the innovation, it may turn out that expected returns to R&D outweigh the cost of innovation, and thus the firm decides to undertake the projects that it did not pursue before. Thus, regulatory changes in the environment in which the firm operates can generate positive externalities through which previously non-feasible projects become feasible. Thus, in our model, we could answer the question of why the firm does not innovate before, but after, stringent regulation by referring to the features of the permits market and the innovation possibilities. Case III This case is associated with innovation by firm 1 and maintenance of the status quo by firm 2. The analysis will be exactly the same as in case II where the position of the firms are interchanged. Case IV In this last case, both firms are motivated by stringent regulation and both of them invest in R&D. Assuming that the resulting technology parameters

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from innovation are the same across firms with the same probability of innovation, the optimal values will be as follows: q1 ⫽ q2 ⫽

a ⫺ c ⫺ (␥r ⫹ (1 ⫺ ␥)r)P ␧ 3b

Ai ⫽ ␲i ⫽

P␧ 2(␥ei ⫹ (1 ⫺ ␥)ei)

(6.18)

(6.19)

(a ⫺ c ⫺ (␥r ⫹ (1 ⫺ ␥)r)P ␧)2 (P ␧)2 ⫹ ⫹ P ␧E ⫺ CR (6.20) 9b 4(␥ei ⫹ (1 ⫺ ␥)ei)

Then, Proposition 4 More stringent environmental regulation will result in increased profits for both firms if they undertake innovation and if the cost of innovation satisfies (P␧)2 (P␧)2 ⫹ P␧E ⫺ ⫺ P␧E ⬎ CR 4(␥ei ⫹ (1 ⫺ ␥)ei) 4ei Also note that the competitiveness of the firm is more likely to improve when it is the only one that innovates than when both firms innovate. Proof of this proposition easily follows from a comparison of profit expressions in (6.20) and (6.7); note that first term of (6.20) is greater than that of (6.7), since ␥r ⫹ (1 ⫺ ␥)r ⬍ r; under the given condition, other terms in (6.20) also outweigh the terms in (6.7). The second part of the proposition can be shown by comparing (6.20) with the profit of the only innovating firm in case II, given by equation (6.17). Since ⫺2(␥r ⫹ (1 ⫺ ␥)r) ⫹ r ⬎ ⫺(␥r ⫹ (1 ⫺ ␥)r), then ␲2 ⬎␲i ; the profit of the innovating firm will be higher when only one of the firms innovates than when both innovate. The second part of the last proposition is interesting and may seem, at first reading, surprising. This is so because when both of the firms innovate, the market share of the innovating firm will be smaller by comparison to the case when only one of them innovates as can easily be shown from the comparison of equations (6.13) and (6.18). In this section, we have shown the interactions between regulation, innovation and competitiveness in a domestic economy. Our results show that when environmental regulation becomes more stringent, the profits of the regulated firms may move in either direction depending on returns to and the costs of innovation and also on the properties of the permit market. We note that up to this point, regulation is applied to all the firms in the market.

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The more interesting topic is what can be said about competitiveness if the regulation is applied exclusively as in the case of a two-country model in which one country imposes higher environmental standards at a trading equilibrium, and the other does not. This will be studied in the next section. One other important result in this domestic case is our counter-evidence to the earlier view that the Porter hypothesis could not be given credence theoretically unless one drops the rational behaviour assumptions for the firm. (For example, Palmer et al. (1995) refer to X-inefficiency, while Simpson and Bradford (1996) state that the Porter hypothesis calls for specific cost functions.) In a simple model without any extreme assumptions on the behaviour of the firms, we have not only shown that with the stricter regulation, the firm will be better off (in terms of expected profits) if it invests in R&D than if it does not, but also that it is possible that the firm can do better than the non-regulated case through innovation or even without innovation depending on the price elasticity of the permit demand. The key feature of our results is that the profits of the firm depend on permit revenues, and thus, the properties of the permit market are as important as innovation.

5

INTERNATIONAL COMPETITIVENESS AND REGULATION

Given this basic set-up for the interactions between regulation, innovation and competitiveness, we can now extend our results to an open economy. Through this extension, we can present evidence or counter-evidence for the views of the conventional and the revisionist schools, and also see how the interactions between regulation, innovation and competitiveness in a closed economy compare with an open economy. We start by describing a simple open economy. We assume two countries, home (H) and foreign (F). Each country produces the same good. The demand for the product is represented by9 p ⫽ a ⫺ b(QH ⫹ QF )

(6.21)

As in the previous section, each country’s output is produced by two Cournot-oligopolists. Each country applies the TEP regulation policy; however, the regulatory environment is relatively lax initially. We will investigate the effects of an increase in environmental controls in the home country. Let us first determine the initial positions of the firms in each country. To make the analysis more tractable with four different firms, we assume that the firms are symmetric in every aspect inside and across the

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countries; this will help us to isolate the impact of environmental regulation on the competitiveness of firms that are otherwise identical. As shown in the appendix, profit maximization results in the following output, abatement and profit levels: a ⫺ c ⫺ rP␧ 5b

(6.22)

P␧ 2e

(6.23)

(a ⫺ c ⫺ rP␧)2 (P␧)2 ⫹ ⫹ P␧E 25b 4e

(6.24)

F qH i ⫽ qi ⫽

F AH i ⫽ Ai ⫽ F ␲H i ⫽ ␲i ⫽

Initially, each country distributes ET amount of permits among the firms. Since the countries are assumed to be identical, output levels, abatement levels and profits are also identical. At such an initial equilibrium position, the home country puts new environmental regulations into effect and decreases the number of tradable permits from ET to ET. The crucial question is what will happen to the competitiveness of the domestic firms (i) if they both continue with their present technologies, (ii) if both of the firms try to innovate and develop a better technology at some cost, and (iii) if one of the firms tries to innovate while the other keeps its old technology. Let us investigate each case separately: Case I In this case, we assume that none of the domestic firms undertakes R&D. The market shares of the firms will remain the same, if we assume that price elasticity of permit demand is very elastic; otherwise, permit prices, P␧, will increase in the home country, the market share of the domestic firms will fall and the share of foreign firms will rise; an expected result. Note that since environmental policy does not change in the foreign country, permit prices will remain at P␧. If the new permit price level at home is P␧, the new output, abatement and profit levels will be as follows: qH i ⫽

a ⫺ c ⫹ (2P␧ ⫺ 3P␧)r 5b

(6.25)

qFi ⫽

a ⫺ c ⫹ (2P␧ ⫺ 3P␧)r 5b

(6.26)

AH i ⫽

P␧ 2e

(6.27)

AFi ⫽

P␧ 2e

(6.28)

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␲H i ⫽

(a ⫺ c ⫹ (2P ␧ ⫺ 3P ␧)r)2 (P ␧)2 ⫹ ⫹ P␧E 25b 4e

(6.29)

␲Fi ⫽

(a ⫺ c ⫹ (2P ␧ ⫺ 3P ␧)r)2 (P ␧)2 ⫹ ⫹ P ␧E 25b 4e

(6.30)

The market share of the foreign firms will exceed that of the domestic firms; this follows from equations (6.25) and (6.26); since P␧ ⬎ P␧, then F (2P␧ ⫺ 3P␧) ⬍ (2P␧ ⫺ 3P␧), and so qH i ⬍ qi . Comparison of profit levels (and so competitiveness) is not as straightforward. If permit demand is very price elastic so that P␧ ⬇ P␧ and since E ⬎ E, then we will have ␲Fi ⬎ ␲H i , which supports the view of the conventional school. In general, P␧ ⬎ P␧, and a comparison of profits becomes more difficult. Depending on the price elasticity of permit demand, and the amount of available permits, there will be evidence for the conventional school or the revisionist school. Note that, in this case, regulated firms are assumed not to under take any R&D investment; the possibility of innovation will be considered in the next two cases. The inter-firm comparison can also be coupled with a comparison of the profits of the firm across regulation stringencies. This is very clear in the foreign firms’ case; since P␧ ⬍ P␧, then (2P␧ ⫺ 3P␧) ⬎ ⫺P␧, and so the profits of the foreign firms after stringent regulation (equation (6.30)) is greater than their profits before regulation (equation (6.24)). We can state this more formally: Proposition 5 Stricter regulation in the home country will make foreign firms better off unconditionally; however, there may be cases in which their improvement will be less than that of the domestic firms, depending on the properties of the permit market. The last part of the proposition above follows from a comparison of equaF tions (6.29) and (6.30); it is conceivable that ␲H i ⱖ ␲i . The first part is already shown in the last paragraph above. Now, let us continue with the more important case where regulated domestic firms, now subject to stricter standards, take steps to innovate. Case II In this case, domestic firms engage in R&D, and they succeed in innovation with a probability of ␥. As above, new technology variables will be e and r. Also, permit prices in the home country rise to P␧ with stricter regulation. The resulting values of output, abatement and profit levels for both domestic and foreign firms are as follows: qH i ⫽

a ⫺ c ⫹ 2rP ␧ ⫺ 3REP ␧ 5b

(6.31)

Can environmental regulations be compatible with competitiveness?

a ⫺ c ⫹ 2REP␧ ⫺ 3rP␧ 5b P␧ AH i ⫽ 2(␥e ⫹ (1 ⫺ ␥)e)

qFi ⫽

AFi ⫽ ␲H i ⫽

P␧ 2e

129

(6.32) (6.33) (6.34)

(a ⫺ c ⫹ 2rP ␧ ⫺ 3REP ␧)2 (P ␧)2 ⫹ ⫹ P ␧E ⫺ CR (6.35) 25b 4(␥e ⫹ (1 ⫺ ␥)e) ␲Fi ⫽

(a ⫺ c ⫹ 2REP␧ ⫺ 3rP␧)2 (P␧)2 ⫹ ⫹ P␧E 25b 4e

(6.36)

where RE ⫽ ␥r ⫹ (1 ⫺ ␥)r. Then, Proposition 6 When environmental regulation becomes more stringent at home, and domestic firms innovate after environmental regulatory change, the market share of domestic firms will increase if rP␧ ⬎ REP␧; firms in the home country will undertake a higher level of abatement as compared to firms in the foreign country. Finally, domestic firms will be more competitive if the following condition also holds (P ␧)2 (P ␧)2 ⫹ P ␧E ⫺ ⫺ P ␧E ⬎ CR 4(␥e ⫹ (1 ⫺ ␥)e) 4e The proof is presented in the appendix. Depending on the values of the new technology parameters (e and r ), the cost of R&D, CR, the price elasticity of permit demand, and the probability of innovation, ␥, our model presents evidence for the view of the revisionist school or that of the conventional school. Under the conditions of the proposition, we have pro-revisionist results: the domestic firms not only increase their profits over the profits of the foreign firms but also over their pre-regulation profits (shown in the appendix). Moreover, the postregulation profits of foreign firms after the introduction of stricter regulation in the home country will be less than their pre-regulation profits,10 which follows from a comparison of profit expressions in (6.24) and (6.36). One should emphasize the role of the price elasticity of permit demand on these conclusions. If we assume rP␧ ⬍ REP␧, that is, the opposite case, then we will get pro-conventional results. Relative magnitudes of r and RE ⫽ ␥r ⫹ (1 ⫺ ␥)r show the partial impact of innovation on this debate. How does this case compare to the one in which only one of the domestic firms innovates? Will the competitiveness of the innovating firm be higher than in this case? We take up these questions now.

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Case III This case is associated with R&D by firm 1 and status quo by firm 2 in the home country. The resulting output, abatement and profit levels are as follows: qH 1 ⫽

a ⫺ c ⫹ 2rP␧ ⫺ 4REP␧ ⫹ rP␧ 5b

(6.37)

qH 2 ⫽

a ⫺ c ⫹ 2rP ␧ ⫹ REP ␧ ⫺ 4rP ␧ 5b

(6.38)

a ⫺ c ⫺ 3rP ␧ ⫹ REP ␧ ⫹ rP␧ 5b ␧ P AH 1 ⫽ 2(␥e ⫹ (1 ⫺ ␥)e)

q1F ⫽ q2F ⫽

(6.39) (6.40)

P␧ (6.41) 2e P␧ (6.42) AFi ⫽ 2e (a ⫺ c ⫹ 2rP␧ ⫺ 4REP␧ ⫹ rP␧)2 (P␧)2 ␲H ⫹ ⫹ P␧E ⫺ CR (6.43) 1 ⫽ 25b 4(␥e ⫹ (1 ⫺ ␥)e) AH 2 ⫽

(a ⫺ c ⫹ 2rP␧ ⫹ REP␧ ⫺ 4rP␧)2 (P␧)2 ⫹ ⫹ P␧E 25b 4e (a ⫺ c ⫺ 3rP ␧ ⫹ REP ␧ ⫹ rP ␧)2 (P ␧)2 ␲F1 ⫽ ␲2F ⫽ ⫹ ⫹ P ␧E 25b 4e ␲H 2 ⫽

(6.44) (6.45)

where RE ⫽ ␥r ⫹ (1 ⫺ ␥)r as above. Proposition 7 When environmental regulation becomes more stringent at home, and only one of the domestic firms innovates, market share of the noninnovating domestic firm will be less than the shares of the other firms. Market share of the innovating domestic firm will be larger than those of the two foreign firms if rP␧ ⬎ REP␧. The innovating domestic firm will abate more than the other firms. Its competitiveness will rise relative to all other firms if the cost of R&D satisfies (P ␧)2 (P ␧)2 ⫹ P ␧E ⫺ ⫺ P ␧E ⬎ CR. 4(␥e ⫹ (1 ⫺ ␥)e) 4e Finally, the returns to innovation will be higher when only one firm innovates than when both firms innovate.

Can environmental regulations be compatible with competitiveness?

131

This result is very much in accordance with the Porter hypothesis. The revisionist school claims that stricter environmental regulation should motivate firms to invest in R&D to innovate, and innovation will generate a positive impact on the competitiveness of the firms by lowering the costs of the production. They suggest that innovation motivated by environmental concerns can also bring about a fall in the non-abatement cost of production which will improve competitiveness further. In this chapter, we have shown that even if innovation does not bring about a fall in the non-abatement costs of the firm, the changes in abatement technology through innovation and the changes in the permit market arising from environmental regulation may be enough to offset the burden associated with new environmental regulation. Since our results are conditional, we again need to stress that they may be used as evidence for both schools of thought; nevertheless, our results provide stronger pro-revisionist theoretical evidence than previous studies in the literature.

6

CONCLUSION

We present some new theoretical results in the debate about the impact of stricter environmental policies on the international competitiveness of regulated firms. Our study incorporates TEP as an environmental regulation system, and this turns out to be an important factor in this debate. The possibility of trade in emission permits opens up new opportunities, and thus abatement and innovation become more attractive for the regulated firms. Our results present evidence in favour of both the conventional school and the revisionist school depending on the parameters of the model; however, the most interesting result is that the Porter hypothesis is not a theoretical impossibility, and moreover, it does not require extreme assumptions in order to be valid as suggested by earlier papers in the literature. The frontier that separates the two schools of thought on the regulation– competitiveness issue depends not only on the properties of the innovation process but also on the features of the permit market. An important criticism levelled against the revisionist school by the conventional school concerns why firms do not undertake all profitable opportunities before regulation; that is, if they can increase their profits by innovation or other means, why do they wait for environmental regulations? We provide an answer to this question by demonstrating that the regulatory policy causes changes in some parameters, like permit prices, which are outside the control of the firm but have an impact on its decision. We show that some non-feasible R&D projects can become profitable after the enactment of stricter regulations because of the associated changes in these parameters.

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It would be a mistake to see the Porter hypothesis as indicating an automatic increase in the competitiveness of regulated firms under stricter regulations. On the contrary, this view clearly suggests that it is the active involvement of the regulated firms in innovation activities that will improve their competitiveness. Furthermore, one of the important competition strategies today is differentiation. Both the innovation process and compliance with higher environmental standards contribute to differentiation. In developed countries, it is not uncommon to see the voluntary adoption of environmental management systems and environmentally friendly production certificates. For example, ISO 14 000 (the environmental management system of ISO) is being applied by many firms (Boudoropoulos and Arvanitoyannis, 2000). In 1999, there were 10 439 firms with ISO 14 000 certification in the world. The top five countries with respect to the number of firms with ISO 14 000 certification were Japan (2124), Germany (1400), England (947), Sweden (645) and Taiwan (492); all these countries are very highly competitive. In our future work, we are planning to extend the current model. In the current setting, we have assumed that permit prices are given exogenously; we will relax this assumption by introducing a permit market explicitly. In addition to our analysis on the production side, we will also incorporate some demand-side changes into our model. As in the case of eco-labelling or green-labelling, consumers may prefer the good that is produced in a cleaner way; thus, the price elasticity of demand for the good that is produced under stricter regulation may be higher (in absolute value) than for a good that is produced under relatively lax environmental conditions. At first glance, it seems that incorporation of this idea into our model will provide support for the revisionist school since higher environmental standards at home increases the demand for domestic production, and opens up a new channel towards increased competitiveness. The details have yet to be shown in a general setting.

NOTES * 1. 2. 3.

An earlier version of this chapter has appeared in Trade and the Environment by the same author, published by Kluwer Academic Publishers, 2002. Strong (weak) standards mean that the marginal damage from pollution is less (higher) than the marginal cost of abatement. They state that ‘The model essentially formalizes the basic point that the addition (or tightening) of constraints on a firm’s set of choices can not be expected to result in an increased level of profits’. The terms static and dynamic should not be considered in terms of a model that has an explicit time dimension, but rather in terms of the possibilities of innovation and other possible changes.

Can environmental regulations be compatible with competitiveness? 4. 5.

6. 7. 8. 9.

10.

133

As we will show below, when environmental regulation is done through tradable emission permits, changes in permit prices with stricter regulation can make non-feasible projects profitable due to increases in permit revenues. For example, in the case of Barrett (1994), the government imposes environmental standards (command and control), and there is no room for innovation. These two do not conform to the requirements of the revisionist school. Therefore, that study should not be referred to for a comparison of the above schools of thought. If we had assumed a different average emission rate, r, across firms, then the firm with the smaller emission rate would have produced more. The related maximization problem is maxqi ␲i ⫽pqi ⫺ cqi. We assume away the positive spillover effects of innovation across firms as it is not a major component of this debate. For ease of exposition, here we assume that home and foreign production are perfect substitutes for each other; however, our results are independent of this assumption. We will also present a case in which stricter regulation changes the demand for the good, benefiting those producing the good in a more environment-friendly manner; this has not been studied before. This is a result of the assumption that rP␧ ⬎ REP␧. If we reverse this assumption, the profits of the foreign firms will increase with stricter regulation as in proposition 5.

REFERENCES Albrecht, J.A. (1998), ‘Environmental Costs and Competitiveness. A ProductSpecific Test of the Porter Hypothesis’, manuscript, www.ssrn.com. Barrett, S. (1994), ‘Strategic Environmental Policy and International Trade’, Journal of Public Economics, 54, 325–38. Boudoropoulos, I.D., and I.S. Arvanitoyannis (2000), ‘Potential and Perspectives for Application of Environmental Management System (EMS) and ISO 14 000 to Food Industries’, Food Review International, 16(2), 177–237. Jaffe, A.B., S.R. Peterson, P.R. Portney, and R.N. Stavins (1995) ‘Environmental Regulation and the Competitiveness of US Manufacturing: What Does Evidence Tell Us’, Journal of Economic Literature, 33, 132–63. McGuire, M.C. (1982), ‘Regulation, Factor Rewards, and International Trade’, Journal of Public Economics, 17(3), 335–54. Montgomery, W.D. (1972), ‘Markets in Licenses and Efficient Pollution Control’, Journal of Economic Theory, 5(3), 395–418. Oates, W.E., K.P. Palmer and P.R. Portney (1994), ‘Environmental Regulation and International Competitiveness: Thinking about the Porter Hypothesis’, Resources for the Future Discussion Paper 94–02. Palmer, K.P., W.E. Oates, and P.R. Portney (1995), ‘Tightening Environmental Standards: The Benefit–Cost or No-Cost Paradigm’, Journal of Economic Perspectives, 9(4), 119–32. Pethig, R. (1976), ‘Pollution, Welfare and Environmental Policy in the Theory of Comparative Advantage’, Journal of Environmental Economics and Management, 2, 160–69. Porter, M.A. (1991), ‘America’s Green Strategy’, Scientific American, 168. Porter, M.A., and C. van der Linde (1995), ‘Towards a New Conception of the Environment–Competitiveness Relationship’, Journal of Economics Perspectives, 9(4), 97–118.

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Sartzetakis, E.S., and C. Constantatos (1995), ‘Environmental Regulation and International Trade’, Journal of Regulatory Economics, 8(1), 61–72. Siebert, H. (1977), ‘Environmental Quality and Gains from Trade’, Kyklos, 30(4), 657–73. Simpson, R.D., and R.L. Bradford (1996), ‘Taxing Variable Cost: Environmental Regulation as Industrial Policy’, Journal of Environmental Economics and Management, 30, 282–300. Xepapadeas, A., and A. De Zeeuw (1998), ‘Environmental Policy and Competitiveness: The Porter Hypothesis and the Composition of Capital’, manuscript, www.ssrn.com. Yohe, G.W. (1979), ‘The Backward Incidence of Pollution Control – Some Comparative Statics in General Equilibrium’, Journal of Environmental Economics and Management, 6(3), 187–98.

Can environmental regulations be compatible with competitiveness?

135

APPENDIX Let us begin with the problem facing each firm. Firms maximize their profits by choosing levels of output and abatement; substituting p in (6.2) by a⫺b(qi ⫹qj): max (a ⫺ bqi ⫺ bqj)qi ⫺ cqi ⫺ ei (␣iqi)2 ⫺ P ␧ (rqi ⫺ ␣iqi ⫺ E) q ,␣ i

(6A.1)

i

Differentiate (6A.1) with respect to qi: a ⫺ 2bqi ⫺ bqj ⫺ c ⫺ 2ei(␣i)2qi ⫺ P␧(r ⫺ ␣i) ⫽ 0

(6A.2)

and with respect to ␣i: qi(⫺2ei␣iqi ⫹ P␧) ⫽ 0

(6A.3)

From equation (6A.3), Ai ⫽ ␣iqi ⫽

P␧ 2ei

(6A.4)

which is equation (6.5). Using equation (6A.4) in equation (6A.2), we obtain qi ⫽

a ⫺ c ⫺ rP␧ 1 ⫺ qj 2b 2

which is the reaction function in (6.3). Similarly, qj ⫽

a ⫺ c ⫺ rP␧ 1 ⫺ qi 2b 2

Substituting this in the previous equation, we get the optimal output level in (6.4). Proof of Proposition 1 This requires us to show that the profit of the regulated firm in equation (6.7) is greater than that of the non-regulated firm in (6.8), that is, (a ⫺ c ⫺ rP␧)2 (P␧)2 (a ⫺ c)2 ⫹ ⫹ P␧E ⱖ 9b 4ei 9b

(6A.5)

The first term on the left-hand side (LHS) can be written in an open form, (a ⫺ c)2 2(a ⫺ c)rP␧ (rP ␧)2 (P ␧)2 (a ⫺ c)2 ⫺ ⫹ ⫹ ⫹ P ␧E ⱖ 9b 9b 9b 4ei 9b

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Trade and environment policies

which implies r2P␧ P␧ 2(a ⫺ c)r ⫹ ⫹E ⱖ 9b 4ei 9b

(6A.6)

So if the condition in (6A.6) holds then the firm’s profits in the regulated case will be higher than its profit in the non-regulated case. Proof of Proposition 2 Differentiating (6.11) with respect to q2, after replacing p with a⫺b(q1 ⫹q2): a ⫺ 2bq2 ⫺ bq1 ⫺ c ⫺ 2(␥e2 ⫹ (1 ⫺ ␥)e2)(␣2)2q2 ⫺ P␧((␥r ⫹ (1 ⫺ ␥)r) ⫺ ␣2) ⫽ 0

(6A.7)

and with respect to ␣2: q2( ⫺ 2(␥e2 ⫹ (1 ⫺ ␥)e2)␣2q2 ⫹ P ␧) ⫽ 0

(6A.8)

To get the output and abatement levels, we also need to solve for the optimization problem of firm 1; but, this has already been shown above, in the first part of the appendix, as firm 1 does not engage in R&D. Solving equations (6A.2), (6A.3), (6A.7) and (6A.8) together, we get optimal output and abatement levels in equations (6.12)–(6.15). Using these values one can obtain the corresponding profit levels. Since r ⬍ r, ␥r ⫹ (1 ⫺ ␥)r ⬍ r (note that ␥ is between 0 and 1 since it measures the probability of innovation), and so, ⫺2(␥r ⫹ (1 ⫺ ␥)r) ⫹ r ⬎ ⫺2r ⫹ (␥r ⫹ (1 ⫺ ␥)r), hence, q2 ⬎q1. Also, since ␥e2 ⫹ (1 ⫺ ␥)e2 ⬍ e2, then A2 ⬎A1. Using these comparisons in the profit expressions (6.16) and (6.17), if we assume that (P ␧)2 (P ␧)2 (e ⫺ (␥e2 ⫹ (1 ⫺ ␥)e2)) ⫺ CR ⬎ → (P␧)2 1 ⬎ CR 4(␥e2 ⫹ (1 ⫺ ␥)e2) 4e1 4e1(␥e2 ⫹ (1 ⫺ ␥)e2) then ␲2 ⬎␲1. This condition is a sufficient condition, and not a necessary one. It clearly shows that the effect of regulation on the competitiveness of firms depends not only on the parameters of innovation but also on the features of the permit market, as reflected in permit prices. Proof of Proposition 3 Here, we will show the possibility of projects that become feasible and increase the profits of the firm under stricter environmental regulation

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Can environmental regulations be compatible with competitiveness?

(and not before the regulation). Assume that, before stricter regulation, investment in R&D is not feasible when permit prices are P␧, so, (P ␧)2 (a ⫺ c ⫺ 2(␥r ⫹ (1 ⫺ ␥)r)P␧ ⫹ rP␧)2 ⫹ ⫹ P ␧E ⫺ CR 9b 4(␥e2 ⫹ (1 ⫺ ␥)e2) ⱕ

(a ⫺ c ⫺ rP␧)2 (P␧)2 ⫹ ⫹ P␧E 9b 4e2

(6A.9)

After the introduction of stricter environmental regulation, permit prices will increase to P␧, and the expected returns to innovation may change such that the above inequality is reversed: (a ⫺ c ⫺ 2(␥r ⫹ (1 ⫺ ␥)r)P ␧ ⫹ rP ␧)2 (P ␧)2 ⫹ ⫹ P ␧E ⫺ CR 9b 4(␥e2 ⫹ (1 ⫺ ␥)e2) ⱖ

(a ⫺ c ⫺ rP␧)2 (P ␧)2 ⫹ ⫹ P ␧E 9b 4ei

(6A.10)

Since P␧ ⬎ P␧, one can check how the LHS and right-hand side (RHS) of the expression in (6A.9) would change following an increase in permit prices. Let ⌬ be the difference between LHS and RHS. It can be shown that (d⌬ ⲐdP␧) ⱖ 0 if (a ⫺ c ⫺ 2REP␧) ⱖ 0. Equations (6A.9) and (6A.10) demonstrate that the returns to new projects depend on, among other things, the permits’ prices, which will change with changes in the stringency of environmental regulation. Thus, projects that were not feasible before may become feasible with outside changes that are not under the control of the firm. International Competitiveness First, let us try to obtain optimal output and abatement levels when there are foreign firms competing in the same market as domestic firms. Firm i in the home country solves the following optimization problem: H H H 2 ␧ H H H max
pqH i ⫺ cqi ⫺ ei(␣i qi ) ⫺ P (rqi ⫺ ␣i qi ⫺ E) H qH i ,␣ i

(6A.11)

where p ⫽ a ⫺ b(QH ⫹ QF), and Qk ⫽ q k1 ⫹ q k2, k ⫽ H, F. First-order conditions result in the following reaction functions: qH i ⫽

a ⫺ c ⫺ rP␧ 1 H 1 ⫺ qj ⫺ QF 2b 2 2

(6A.12)

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The same reaction functions apply in the case of foreign firms, and so, qiF ⫽

a ⫺ c ⫺ rP␧ 1 F 1 ⫺ qj ⫺ QH 2b 2 2

(6A.13)

H Using equations (6A.12), (6A.13) and noting that QH ⫽ qH 1 ⫹ q2 and F F QF ⫽ q1 ⫹ q2 , we get F qH i ⫽ qi ⫽

(a ⫺ c ⫺ rP␧) 5b

(6A.14)

which is the same as equation (6.22). Abatement levels will be the same as in the closed economy case. Using these results, one can easily obtain the profit levels in equation (6.24). Proof of Proposition 6 Both of the domestic firms maximize their expected profits: H H H 2 ␧ H H H max
␥[ pqH i ⫺ cqi ⫺ e(␣i qi ) ⫺ P (rqi ⫺ ␣i qi ⫺ E) ⫺ CR] ⫹ H qH i ,␣ i

H H H 2 ␧ H H H (1 ⫺ ␥)[ pqH i ⫺ cqi ⫺ e (␣i qi ) ⫺ P (rqi ⫺ ␣i qi ⫺ E) ⫺ CR]

(6A.15)

The optimization problem of foreign firms is the same as in equation (6A.11) above. Solving these two optimization problems together we get the optimal output, batement and profit levels given in (6.31)–(6.36). Market shares of the innovating domestic firms and foreign firms are given by equations (6.31) and (6.32). Since REP␧ ⬍ rP␧, then F (2rP␧ ⫺ 3REP␧) ⬎(2REP␧ ⫺ 3rP␧), and so qH i ⬎ qi . Higher abatement in the home country follows from the fact that ␥e ⫹ (1 ⫺ ␥)e ⬍ e; see equations (6.33) and (6.34). Competitiveness will be measured by the changes in profit levels which we now show. The first term in the profit expression of the domestic firm in (6.35) is greater than the corresponding term in the profit expression of foreign firms in (6.36) since they are the same as market shares (to the second power). If the cost of R&D satisfies the condition in the proposition, then F H F other terms also become larger in ␲H i than in ␲i , and so ␲i ⬎ ␲i . Thus, domestic firms become more competitive after the enactment of stricter environmental regulation. Under the given conditions, the new profits of domestic firms (equation 6.35) will exceed their pre-regulation profits (equation 6.24) since ⫺ rP␧ ⬍ (2rP␧ ⫺ 3REP␧).

Can environmental regulations be compatible with competitiveness?

139

Proof of Proposition 7 The optimization problem of the innovating domestic firm (firm 1) is: H H H 2 ␧ H H H max
␥[pqH 1 ⫺ cq1 ⫺ e(␣1 q1 ) ⫺ P (rq1 ⫺ ␣1 q1 ⫺ E) ⫺ CR] ⫹ (1 ⫺ ␥) H qH 1,␣ 1

H H H 2 ␧ H H H [ pqH 1 ⫺ cq1 ⫺ e(␣1 q1 ) ⫺ P (rq1 ⫺ ␣1 q1 ⫺ E) ⫺ CR]

(6A.16)

The optimization problem of the non-innovating domestic firm (firm 2) is: H H H 2 ␧ H H H max pq
H 2 ⫺ cq2 ⫺ e(␣2 q2 ) ⫺ P (rq2 ⫺ ␣2 q2 ⫺ E)

(6A.17)

q H2, ␣ H 2

The optimization problem of the foreign firms is the same as before (equation 6A.1). The following reaction functions can easily be derived from the associated first-order conditions: qH 1 ⫽

a ⫺ c ⫺ REP ␧ 1 H 1 F ⫺ q2 ⫺ Q 2b 2 2

a ⫺ c ⫺ rP␧ 1 H 1 F ⫺ q1 ⫺ Q 2b 2 2 ␧ a ⫺ c ⫺ rP 1 F 1 H qiF ⫽ ⫺ qj ⫺ Q 2b 2 2

qH 2 ⫽

where RE ⫽ ␥r ⫹ (1 ⫺ ␥)r. Solving these equations together we obtain the output, abatement and profit levels in (6.37)–(6.45). The output level of the non-innovating domestic firm (firm 2) after stricter regulation will be smaller than the output levels of other firms. H Since r ⬎ RE, (rP␧ ⫺ 4REP␧) ⬎ (REP␧ ⫺ 4rP␧), and so qH 1 ⬎ q2 . Similarly, F. since P␧ ⬍ P␧, (2rP ␧ ⫺ 4rP␧) ⬍ (rP␧ ⫺ 3rP␧), and so qH ⬍ q 2 i Since REP␧ ⬍ rP␧ is assumed, then (2rP␧ ⫺ 4REP␧) ⬎ (REP␧ ⫺ 3rP␧), and F so qH 1 ⬎ qi . Higher abatement by the innovating firm in the home country follows from the fact that ␥e ⫹ (1 ⫺ ␥)e ⬍ e and P␧ ⬎ P␧; see equations (6.40)–(6.42). Also note that due to higher permit prices at home, the non-innovating domestic firm will also abate more than foreign firms (equations 6.41 and 6.42). The first term in the profit expression of the innovating firm in (6.43) is greater than the corresponding term in the profit expression of the noninnovating domestic firm and the foreign firms (equations (6.44) and (6.45),

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respectively), as shown in the comparison of output levels. If the cost of R&D satisfies the condition in the proposition, then the other terms also H F H H H F become larger in ␲H 1 than in ␲2 , and ␲i ; so, ␲1 ⬎ ␲2 , and ␲1 ⬎ ␲i . Thus, as suggested by Porter, firms subject to stricter environmental regulations can become more competitive by investing to innovate. Finally, let us compare the returns to innovation when only one firm innovates to the situation where both firms innovate. This requires us to compare the profits of the innovating domestic firm in (6.43) with (6.45), the profits of the domestic firms when they both innovate. Since these expressions differ only in those terms, we just need to compare the first terms. Again since REP␧ ⬍ rP␧, then (2rP␧ ⫺ 4REP␧ ⫹ rP␧) ⬎ (2rP␧ ⫺ 3REP␧), and so ␲H 1 in (6.43), which represents the profits of the innovating firm when only one firm innovates, is greater than ␲H i in (6.35), which represents the profits of the innovating firm when both firms innovate.

PART III

Environmental Policy Concerns in the Context of EU Enlargement

7.

Environmental implications of EU enlargement: lessons from the southern member states and preliminary evidence from Poland Onno J. Kuik and Frans H. Oosterhuis

INTRODUCTION The accession of countries from Central and Eastern Europe to the EU will lead to institutional and economic changes in these countries that may affect their natural environments in various ways. One way of trying to understand these changes and their effects on the environment is to study past accessions to the EU. The southern enlargement of the EU in the 1980s offers an interesting comparison. At the time of their accession, certain economic and environmental characteristics of Greece, Spain and Portugal were comparable to those of present-day Central and Eastern European countries. This chapter analyses the environmental changes that accompanied the southern enlargement with a view to drawing some lessons for the eastern enlargement. As a check on the validity of these lessons, the preliminary evidence on the impact of Poland’s process towards accession will be discussed as well. In analysing the environmental dimensions of the southern enlargement we have used the analytical framework commonly used to study the impact of trade liberalisation on the environment: the decomposition of environmental effects into scale, composition and technique effects. The following section introduces this framework and explains how it is used in the present study. The next section looks at similarities between the southern accession countries in the mid-1970s and Central and Eastern European countries in the 1990s and argues that these similarities might justify a comparison. We then briefly describe the accession experience of the southern accession countries and identify the main similarities and differences in economic and environmental trends and tendencies between those countries. A further section presents preliminary evidence on trends and tendencies for Poland. The final section concludes. 143

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TRADE LIBERALIZATION AND THE ENVIRONMENT The environmental impact of trade liberalization has been the subject of many heated debates and scholarly treatises. In theory, in the (hypothetical) case that all environmental costs have been adequately internalized in prices and costs of production, trade liberalization would benefit the environment by a more efficient allocation of resources (including environmental resources) within and between countries. However, without perfect internalization of environmental costs in all trading countries, the impact of trade liberalization on the environment is more difficult to predict. Trade liberalization can influence environmental quality in five ways (Kuik and Oosterhuis, 1999): ●

●

● ● ●

by encouraging imports of products which may be environmentally inferior or superior to their domestic substitutes; by changing production patterns and production technologies in the trading countries; by enhancing transport between the trading countries; by enhancing economic growth in the trading countries; and by affecting the possibilities of and the incentives for national governments to implement and enforce domestic environmental policies.

Whether the net effect of these impacts is positive or negative for the environment depends on the economic, technological, environmental and legislative circumstances prevailing in the countries that engage in trade liberalization. Since Grossman and Krueger’s influential paper on the environmental impacts of the North American Free Trade Agreement (NAFTA) (Grossman and Krueger, 1991), the environmental impact of trade liberalization is often decomposed into scale effects, composition effects and technique effects. Scale effects The opening-up of trade often raises the level of economic activity in trading countries. Trade (especially exports) is often viewed as a motor of economic growth. All things being equal, this growth in economic activity raises demand for raw materials, energy and transportation services, resulting in increased levels of pollution and natural resource depletion. Composition effects Trade liberalization may affect the relative prices of final and intermediate goods in different sectors to such an extent that capital

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145

and labour may be induced to shift between sectors, thereby affecting the structure or composition of industry within a country. The composition of the package of consumption goods purchased may also change, as a result both of relative price changes and of an increase in disposable income. Whether this is good or bad for the environment depends on the direction of the shift: whether it is to relatively clean or dirty industries and products. Technique effects The last factor is the effect of trade liberalization on changes in production methods. Production methods or techniques may change in a more environmentally friendly manner if, for example, income growth after trade liberalization leads to more demand for higher environmental quality and more stringent environmental policies and enforcement, or if increased foreign direct investment results in faster depreciation and replacement of obsolete, environment-intensive capital equipment. It could also lead to more environment-intensive techniques if the relative prices of inputs change in such a way that firms chose a more polluting input mix or if governments try to gain trade advantages by lowering environmental standards or by lowering their efforts to enforce existing standards. It is impossible to predict a priori the combined impact of the scale, composition and technique effects on environmental quality. The Task Force on the Environment and the Internal Market (1992), which advised the European Council on the environmental dimensions of the completion of the internal market of the EU in 1992, stressed the environmental implications of the expected acceleration in economic growth due to the completion of the internal market. The Task Force concluded that without adequate policy responses, the completion of the internal market could lead to negative environmental impacts due to an accelerated growth in energy demand, international transport and waste generation. It also identified potential spatial problems and specific problems for the peripheral EU member states. Besides these ‘dynamic effects’, the Task Force also warned of the environmental risks that could arise (for example, transport of hazardous waste) if all border controls (including environmental inspections) were to be removed without putting in place alternative policy measures (Task Force, 1992).

WHY STUDY THE SOUTHERN ENLARGEMENT? A potentially interesting case for the eastern enlargement of the EU, is the southern enlargement of the EU that took place in the 1980s. What were

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the economic and environmental effects of the accessions of Greece (1981), Spain (1986) and Portugal (1986) to the EU? Parallels between the southern and the eastern enlargement have previously been noticed, for example by Hardes and Stupp (1996). The accession of Greece, Spain and Portugal was characterized by a long transition period. Greece had an association treaty with the EU as early as 1961. Spain and Portugal followed in 1970 and 1972, respectively. However, it was not until the mid1970s that political changes in the three countries paved the way for further integration with the EU. The formal accession dates did not mark the full liberalization between the southern accession countries and the EU; for many products a further transition period was negotiated. It was not until 1992 that full liberalization was complete. Hardes and Stupp therefore consider the full period from 1975 to 1992 to analyse the economic effects of accession on the southern accession countries. For a comparison between the initial economic and environmental situation in the southern accession countries and the four Accession Countries (ACs) in Central and Eastern Europe (the so-called Viségrad countries), see Table 7.1. This compares macroeconomic and environmental indicators in 1975 and 1990, respectively. Table 7.1 shows that the sizes of the economies of the Viségrad countries can be compared with the southern accession countries – in terms of employment. Poland’s economy can be compared to Spain, those of Hungary and the Czech Republic can be compared to those of Greece and Portugal. The economy of the Slovak Republic is smaller. The relative income measures for the Viségrad countries are significantly smaller than those of the southern accession countries.1 On the environmental side, the sulphur dioxide (SO2) emissions of Poland and the Slovak Republic (in 1990) can be compared with those of Spain (in 1975). However, the carbon dioxide (CO2) emissions in the Viségrad countries are much larger than those in Spain and Portugal. The relative pollution measures of the Viségrad countries are much larger than those of Spain and Portugal. Comparable is the low level of ‘openness’ towards the EU of the economies of the southern accession countries and the Viségrad countries in 1975 and 1990, respectively.2 The rate with which the openness changed in the first years after 1975, through 1990, differed significantly (with a much faster rate of change in the Viségrad countries). Given these similarities (while acknowledging the differences), it is interesting to study the history of the southern enlargement, to look for common trends and patterns that might also be applicable to the eastern enlargement. Therefore, we will now give a brief account of the economic and environmental aspects of the southern enlargement.3

147 –

–

16.8 1.5 1875 42.3 3.4 3.1 – 86.7 7.7 2443 55.7 13.7 12.5 3003 15.0 625 6.4 48 18.0

Spain

Source: Hardes and Stupp (1996) and OECD (1991, 1997b).

GDP (billion ECU) EC-9/EU-12 ⫽ 100 GDP/capita (ECU) EC-9/EU-12 ⫽ 100 Employment (millions) EC-9/EU-12 ⫽ 100 SO2 emissions (kton) EC-9/EU-12 ⫽ 100 NOx emissions (kton) EC-9/EU-12 ⫽ 100 CO2 emissions (ml.ton) EC-9/EU-12 ⫽ 100

1975 Greece 12 1.1 1373 31.3 4.0 3.7 178 0.9 104 1.1 7 0.8

Portugal 49.0 1.2 1283 9.8 16.5 11.3 3210 27.6 1280 11.0 350 12.7

1990 Poland 24.8 0.6 2409 18.4 5.4 3.7 1876 16.2 742 6.4 157 5.7

Czech

11.3 0.3 2128 16.3 2.5 1.7 3757 32.4 227 1.9 – –

Slovak

26.1 0.6 2508 19.2 4.7 3.2 1010 8.7 238 2.0 68 2.5

Hungary

Table 7.1 Macroeconomic and environmental indicators for southern accession countries in 1975 and ACs in 1990, in relation to the EC-9 and EU-12, respectively

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Environmental policy concerns and EU enlargement

THE ACCESSION EXPERIENCE OF GREECE, PORTUGAL AND SPAIN Greece became a member of the European Community in 1981. Spain and Portugal followed in 1986. In all three countries the prospect of future membership led to an anticipation process that induced patterns of convergence towards EU economic, social, institutional and environmental standards in advance of the accession dates. Nevertheless, considerable differences between the acceding countries and the EU remained. Therefore, transition periods were negotiated during which complete mutual market access was restricted for some product categories, unharmonized external tariffs were allowed, and/or full application of the Common Agricultural Policy (CAP) was postponed. All three countries also managed to obtain transition periods allowing them temporary exemptions from the full application of the obligations imposed by the environmental acquis communautaire. Economy For all three countries, some general economic tendencies following trade liberalization with and accession to the EU can be observed: 1. A substantial increase in the volume of foreign trade, accompanied by a significant shift of foreign trade towards the EU at the expense of traditional trading partners, and a growing trade deficit, due to massive imports of consumer and capital goods. In the years prior to accession, Greece had developed an intricate system of protection for its industries through external protection walls and through wide state intervention (Kazakos and Ioakimidis, 1994). A major consequence of accession was the gradual removal of this external protection (both tariff and non-tariff) and state aid, including export subsidies to industrial firms. Greek firms were ill prepared for this more competitive environment. As a consequence of the loss of protection, they saw their market shares (both at home and abroad) quickly deteriorate. Import penetration, especially from EC countries, rose fast, in particular for traditional consumer goods, intermediate products and capital goods (Giannitsis, 1994). The ratio of imports to apparent domestic consumption increased from 25.8 per cent (1978–80) to 43.1 per cent (1989). The increase in imports was much higher than the increase in exports. The uneven rates of growth of imports and exports led to alarming trade deficits from US$ 7 billion in 1976–80 to US$ 20 billion in 1991. Greece experienced an acute balance-ofpayment crises in 1985 and 1990/91. In Portugal both imports and exports

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rose substantially. The trade share of the EC increased for both imports and exports. This was primarily due to the removal of trade barriers with Spain (Glejser and Moro, 1996). Third-party countries saw their export shares decreasing, especially the USA. The rise in imports was mainly due to increased imports of cars, machines, textiles and footwear. In fact, in the period 1985–92 the share of consumer goods in total imports rose from less than 9 per cent to more than 28 per cent. Exports also increased but the export structure changed very little. Exports remained concentrated in textiles, clothing, footwear, products of the automobile sector and machines. Actually, trade effects reinforced the Portuguese traditional pattern of specialization (Marques-Mendez, 1993). The trade effects of Spain’s accession were quite significant. After 1986, Spanish agricultural exports to the EC-10 show a strong and significant breakthrough. The same holds true, to a lesser extent, for industrial exports (Glejser and Moro, 1996). The share of the EC in Spanish imports (both agricultural and industrial) also rose very fast. In contrast, the shares of Latin America and Africa in Spanish imports (especially for agriculture) sharply declined. The accession of Spain thus caused some substantial trade diversion. The EC-10’s share of agricultural imports from Latin America also shows a breakpoint around 1986: from rising to falling. Glejser and Moro (1996) attribute one-third of Latin America’s loss in agricultural exports to the EC-10 to the accession of Spain and Portugal. 2.

Considerable changes in the composition of agricultural production.

In Greece, accession influenced the relative prices of agricultural products, to the advantage of products that faced least competition from the EC (especially industrial crops such as cotton and tobacco, and citrus fruits), and to the disadvantage of products where competition with the EC was fierce (cereals, beef). Table 7.2 shows developments in Greek agriculture, prior and post accession. In Portugal the area of arable land slightly decreased in the period 1980–1990 (⫺2 per cent), while the area planted with permanent crops rose (⫹11 per cent). In Spain, the area of crops fell while the area of permanent grassland saw a relatively large increase. Within the crops sector, the area shares of industrial crops, cereals, permanent crops (including olives) grew, while the area shares of root crops (potatoes, sugar beet), pulses, vegetables and temporary grassland remained relatively stable. The share of other crops fell to zero. Crop yields per hectare increased for root crops (with about 10–15 per cent), but cereal yields stayed low and show a large annual variation. Livestock numbers increased, especially the number of sheep, goats and pigs, which saw the most significant increase.

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Table 7.2 Growth of Greek agricultural activity by enterprise prior and post accession Crop area/livestock units (%) Enterprises

1965

1980

1984

Crops Cereals Vegetables Industrial crops Fodder crops Fruit trees Citrus trees Olive trees Vineyards

100.0 43.6 4.6 9.7

100.0 33.3 5.3 8.4

100.0 28.1 5.9 12.2

⫺23.6 ⫹15.2 ⫺13.4

⫺15.6 ⫹11.3 ⫹45.2

15.7

22.9

23.1

⫹45.9

⫹0.9

1.2 1.4 15.8 8.0

2.0 1.5 20.4 6.2

2.2 1.9 21.1 5.5

⫹66.7 ⫹7.1 ⫹29.1 ⫺22.5

⫹10.0 ⫹26.7 ⫹3.4 ⫺11.3

Livestock Bovines Sheep Goats Pigs Poultry

100.0 34.0 32.1 15.9 9.1 8.9

100.0 26.3 30.1 17.8 14.8 11.0

100.0 22.6 30.6 17.9 15.8 13.1

⫺22.6 ⫺6.2 ⫹11.9 ⫹62.6 ⫹23.6

⫺14.1 ⫹1.7 ⫹0.6 ⫹6.8 ⫹19.1

2442.8 2678.0 2679.0

⫹9.6

Total (lu)

Pre-entry 1966/80 %

change

Post-entry change 1981/94 %

⫹0.04

Source: Zioganas (1998).

3. A decrease in the share of agriculture in GDP and employment. In Spain, for example, the share of agriculture in total employment dropped from 18.7 per cent to 10.1 per cent, while its share in GDP fell from 5.6 to 4.6 per cent in the decade after accession (OECD, 1997a). 4. Large inflows of subsidies and credits from the EU and international financial institutions. In Greece, transfers and loans from the EC increased substantially during the 1980s, and probably prevented a major economic crisis in Greece. In 1990 alone, Greece received almost 3 billion ECU in direct grants, totalling about 4 per cent of its annual GDP. Greece also borrowed heavily after its two balance-of-payments crises. In Portugal and Spain the inflow of Structural Funds from the EC totalled about 2.7 per cent and 0.7 per cent of GDP, respectively (1989–93: European Commission, 1999a).

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Table 7.3 Annual GDP growth (%) in Greece, Portugal, Spain and the EC in constant 1990 prices

Greece Portugal Spain EC-112

1961–70

1971–80

1981–85

1986–90

1991–95

1996–991

7.6 6.5 7.3 5.3

4.7 4.7 3.5 3.3

1.4 0.9 1.5 1.4

1.9 5.5 4.5 3.4

1.1 1.7 1.3 1.5

3.2 3.6 3.3 2.4

Notes: 11998–99: projections. 2Before 1991, excluding new German Länder. Source: European Commission (1998).

There are also differences: 1.

2.

3.

4.

Economic growth in Greece slowed down after accession, whereas in Portugal and Spain the introduction of trade liberalization with the EU was accompanied by a rapid growth of GDP (Table 7.3). Industrial specialization in Greece and Portugal remained much the same after accession, while Spain managed to diversify its industrial structure. Table 7.4 presents an overview of revealed comparative advantages by sector. The revealed comparative advantages of Greece and Portugal are still very much in agriculture, minerals and basic manufactures, while Spain has diversified to more advanced industrial sectors such as metal products and transport equipment. The volume of total agricultural production and exports increased in Spain much more than in the other countries. In the period 1986–97, the value added earned in agriculture in Spain increased by 50 per cent in real terms. About half of this increase was due to a rise in the value of output; the other half was due to a rise in direct subsidies. In Portugal, by contrast, accession and transition measures lowered the real prices of many agricultural products in the period 1985–89 by 20 per cent (wheat) to 30 per cent (pork and poultry). Although intermediates also became cheaper, agricultural incomes fell sharply. Real farm family incomes dropped by 16 per cent (Avillez, 1993). In Greece, agricultural production remained stagnant in the 1980s, with investments (both public and private) falling in real terms (Maraveyas, 1994). Farmers’ incomes increased because of the support of the CAP, but there was no modernization and no structural improvement. Foreign direct investment (FDI) increased substantially in Portugal and Spain, but not in Greece. The inflow of FDI in Portugal increased

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Table 7.4

Revealed comparative advantages by sector, 19971 Greece

Spain

Portugal

EU-15

Agriculture Mining and quarrying Petrol and gas extraction and refinement Electricity, gas and water supply Basic metal products Mineral products Chemicals and pharmaceuticals Fabricated metal products Machinery and equipment Office machinery and computers Electrical and telecom equipment Transport equipment Aviation and space Instruments Food, beverages and tobacco Clothing and textiles Wood Paper and printing Rubber and plastics Various

0.19 ⫺0.88 ⫺0.30

0.10 ⫺0.81 ⫺0.54

⫺0.67 ⫺0.95 ⫺0.65

⫺0.20 ⫺0.53 ⫺0.38

⫺0.52

⫺0.87

⫺0.82

⫺0.36

⫺0.23 0.04 ⫺0.67

⫺0.09 0.36 ⫺0.24

⫺0.57 0.26 ⫺0.52

⫺0.06 0.12 0.04

⫺0.57

0.02

⫺0.10

0.11

⫺0.76

⫺0.19

⫺0.53

0.23

⫺0.85

⫺0.46

⫺0.81

⫺0.11

⫺0.59

⫺0.18

⫺0.12

0.05

⫺0.91 ⫺0.65 ⫺0.91 ⫺0.34

0.15 ⫺0.15 ⫺0.49 ⫺0.01

⫺0.15 ⫺0.41 ⫺0.55 ⫺0.29

0.09 0.05 ⫺0.02 0.07

⫺0.09 ⫺0.74 ⫺0.32 ⫺0.54 ⫺0.09

0.05 0.02 ⫺0.08 ⫺0.01 0.15

0.34 0.51 0.10 ⫺0.43 ⫺0.48

⫺0.05 0.02 0.09 0.07 0.13

Total

⫺0.40

⫺0.06

⫺0.18

0.03

Notes:

1(X⫺M)/(X⫹M),

where X ⫽ exports, M ⫽ imports.

Source: European Commission (1999a), table 12.

substantially, especially from other EC member states but also from third-party countries. FDI rose throughout the 1980s, reaching a peak of 2 billion ECU in 1990. Major investors were Spain, the UK, France and Germany. Most of the investments went into services, particularly banking, property and business services. Within a number of years there was also substantial investment in electricity, gas, water and

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Table 7.5

Foreign direct investment in Cohesion countries, 1987–96

Member state

Intra-EC ECU million

Extra-EC ECU million

Intra-EC % of GDP

Extra-EC % of GDP

Greece Portugal Spain EU-15

2 623 8 567 46 143 332 892

804 2 756 18 521 246 538

0.4 1.4 1.2 0.6

0.1 0.4 0.5 0.4

Source: European Commission (1999a).

construction. In the period 1989–93, FDI was about 2.8 per cent of GDP. The inflow of FDI into Spain increased rapidly after accession, reaching a peak of almost 10 billion ECU in 1990. Half of the FDI went into manufacturing, especially into the food, chemical and motor vehicle industries. In the services industry they went into banking and business services, including computing (European Commission, 1999a). Over the period 1987–96 the total inflow of FDI into Spain totalled 64 billion ECU, or 1.7 per cent of GDP. FDI in Greece remained limited, far below the EU-15 average. Greece is the only country among the four Cohesion countries (Ireland, Spain, Portugal and Greece) where FDI in the period 1989–93 was less than the contribution of the EC’s Structural Funds. Table 7.5 presents an overview. These differences can to a large extent be explained by the unequal starting points, the prevailing economic climate during the years of liberalization, the domestic macroeconomic policies, labour market features, and geographical factors such as proximity of markets, infrastructure and so forth. Environment Scale While economic growth in the three countries following EU accession differed widely, the environmental impact of growth also differed. Regional differences can also be observed as a result of the unequal geographical distribution of growth. For example, air pollution in Greece increased mainly in the Athens area. In all countries, growth in transport (both of goods and persons) has been particularly high, with substantial consequences for environment, nature and landscape. In Greece the length of motorways increased more than 14 times in the period 1980–97, and the number

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of motor vehicles increased almost threefold in the period 1980–97. In Portugal the economic growth in urban areas led to an increase in the amount of household and industrial waste. The infrastructure for waste collection and disposal lagged behind, resulting in a significant growth in unregulated waste dumps and a particularly troubling situation in the case of industrial, hazardous wastes. In the early 1990s, 75 per cent of these hazardous wastes were simply dumped without treatment (OECD, 1993). The integration of Spain into Europe has accelerated economic growth and influenced consumption patterns that, at least in certain regions, are rapidly converging towards those patterns found in north European member states. Economic growth in Spain has generated significant pressure on the environment (OECD, 1997a). Between 1985 and 1993, the increase in environmental pressure often exceeded the growth in industrial production, energy production and growth of GDP. Fast-growing environmental pressures include water extraction, nitrous oxide (NOx) emissions, municipal waste and road traffic volumes. Table 7.6 also shows that the growth in energy demand equals GDP growth. Composition Production The environmental impact of changes in the composition of production activities has been mixed. In agriculture, some specialization in relatively polluting products and sectors can be observed (for example, cotton in Greece; livestock farming in Spain), but in the case of Portugal the reduction of cereals production can be considered beneficial to the environment. Portuguese agricultural policy since the 1930s had heavily subsidized cereal growing, expanding the area where annual crops are cultivated towards marginal and unsuitable (erosion-prone) land. After accession, the real price of wheat and maize dropped by 23 per cent and 30 per cent respectively in the period 1985–89 (Avillez, 1993). The resulting reduction in arable land in favour of permanent crops reduced (the risks of) erosion substantially. Consumption Rising incomes and the availability of a wide choice of consumption goods from the EU have greatly affected the spending patterns of households in all three countries. From an environmental point of view, the spectacular growth of private car ownership and use is the most obvious trend. Technique Two major factors determine the EU-induced developments in the environmentally relevant ‘technique’ aspects of production and consumption: the application of EU policies and standards, and the more autonomous

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Environmental implications of EU enlargement

Table 7.6 Growth of the economy and environmental pressures in Spain, 1985–93 Selected driving forces Population GDP Industrial production Agricultural production Total primary energy supply Total final energy consumption Energy intensity per GDP Vehicle ownership Road traffic (veh. km) Selected environmental pressures SO2 emissions NOx emissions CO2 emissions from energy use Water withdrawal Municipal waste generation Nitrogenous fertilizer use Phosphate fertilizer use Pesticide use

1985–93 (% change) 1.5 26.8 11.1 2.8 26.5 25.7 ⫺0.3 49.6 38.4 5.2 49.8 16.6 ⫺33.51 42.42 ⫺2.5 7.5 ⫺33.33

Notes: 1this decrease is due to unavailability of water as a result of drought. 21985–92. 31987–93. Source: OECD (1997a).

‘modernization’ of products and technologies. Furthermore, R&D can be an important factor stimulating environmentally compatible technology. The EU environmental acquis All three countries have introduced several policy measures targeted towards less polluting processes and products. To a large extent these measures were taken in response to the need to implement EU policies. However, there are large differences between sectors and full implementation has yet to be accomplished. Air and water pollution has been reduced by means of ‘end-of-pipe’ abatement as well as modernization of production equipment. Nevertheless, many emissions are above average EU levels, especially when measured on a per unit of GDP basis. Modernization of processes, production methods and products Apart from the direct influence of EU policies, the environmental impact of processes

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Environmental policy concerns and EU enlargement

and products has been influenced by a variety of changes in technologies, management practices and lifestyle among others. For the most part, these were not adopted because of EU environmental policy considerations, but because of economic attractiveness or personal preferences. The overall outcome of these factors is mixed. In all three countries the lifetime of many products has tended to become shorter, leading to growing volumes of waste and low recycling rates. Environmental Indicators The overall result of the scale, composition and technique factors is reflected in the final impact on emissions and the environment. The net outcome differs between environmental items. Emissions of the main traditional air pollutants (SO2, NOx, Volatile Organic Compounds (VOCs), CO2) have increased, as has the amount of municipal waste generated. On the other hand, the percentage of households connected to public wastewater treatment has also grown in all three countries. Regional Disparities In the process of their integration with the EU, Greece and Spain experienced an increase in regional disparities, whereas Portugal did not. Generally, economic growth induced by liberalization seems to be concentrated in the main urban areas and in the regions that are located relatively close to, or have good connections with, other EU countries. Despite support from CAP and the Structural Funds, regions where agriculture dominates and/or which are situated on the periphery tend to fare less well. Nevertheless, the example of Portugal suggests that increases in regional disparities are not Table 7.7 GDP per capita and regional disparities, purchasing power standards (EU-15 ⫽ 100) Member state

Greece Portugal Spain EU-15

GDP per capita

Regional disparity (standard deviation)

1986

1996

1986

1996

59.2 55.1 69.8 100.0

67.5 70.5 78.7 100.0

6.0 16.2 13.7 27.1

8.6 13.1 16.8 26.9

Source: European Commission (1999a).

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157

an inevitable by-product of EU accession. It is perfectly conceivable that in time economic growth will ‘trickle down’ to poorer regions. This process could be supported by sensible regional policies and financing.

PRELIMINARY EVIDENCE FROM EASTERN ENLARGEMENT: THE CASE OF POLAND Although the accession countries in Central and Eastern Europe (CEE) are still in the process of negotiating their EU membership, their economies and policies have already been deeply influenced by the EU during the past decade. Take for example, Poland, the country that was the first to start reforms. We can examine whether the findings on the impact of EU accession, as described in the preceding section on three southern member states, might be valid for CEE countries as well. Economy Poland’s economy shows considerable differences with the present EU-15, both in size and structure. GDP per capita (in purchasing power standard) amounted in 1998 to 7800 ECU or 39 per cent of the EU average. After a period of decreasing economic activity during the early years of transition, Poland’s GDP started to grow again in 1992. Since 1994, Poland has shown real GDP growth of about 6 per cent per year. Domestic demand (consumption and investments) has been the largest component of GDP growth in the 1990s. With the exception of the year 1995, exports increased at a slower rate than imports, continuously widening Poland’s trade deficit. The EU is Poland’s main trading partner: it accounts for 66 per cent of Poland’s imports and 68 per cent of Poland’s exports. More than half of Poland’s exports to the EU go to Germany. For the EU, Poland is the fourth biggest export market (Allen, 1999). The growth in trade relations with EU countries has been accompanied by a decrease in trade with Poland’s traditional trading partners, especially the former Soviet Union. Since 1996, Poland has had the highest inflow of foreign direct investment (FDI) among the transition countries. In 1998, FDI in Poland amounted to US$6.3 billion (United Nations – Economic Commission on Europe (UN-ECE), 1999). Grants and credits from the EU (for example, Phare and European Investment Bank (EIB)) and other international institutions (such as the European Bank for Reconstruction and Development (EBRD)) have been an important source of funding for Poland’s economic restructuring in the 1990s, but private capital flows are currently much larger.

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Environmental policy concerns and EU enlargement

Table 7.8 Share of main sectors in value added and employment in Poland and the EU-15 % of gross value added

% of employment

PL-1995 PL-1998 EU-1996 PL-1995 PL-1998 EU-1998 Agriculture Industry (excl. construction) Construction Services

7.0 31.9

4.8 27.9

2.3 25.4

22.6 25.9

19.1 25.0

7.3 53.8

8.6 58.7

5.3 67.0

6.1 45.4

7.0 48.9

4.8

  29.5  65.7

Source: European Commission (1999b, c), Eurostat (1998).

In terms of Poland’s economic structure, the position of the agricultural sector is remarkable. Agriculture (including forestry) accounts for about 20 per cent of employment, and contributes some 5 per cent to GDP. These figures are more than four times and twice as high as the EU-15 average, respectively. Industry (including construction) in Poland is also relatively more important than in the EU (although the relative difference is much smaller here), whereas the services sector accounts for lower shares in employment and GDP. Table 7.8 shows the structural composition of the Polish economy in terms of value added and employment. In recent years, growth of value added has been particularly strong in the manufacturing industry. Since 1992, the value of exports of manufactured articles (expressed in US$) more than doubled, whereas food exports almost doubled, fuel exports hardly increased and raw materials exports decreased. Within agriculture, a pattern of specialization is emerging in a limited number of products, especially pork, poultry and sugar. Cereals are clearly on the decline, whereas the picture for other products (such as beef, dairy products, fruit and vegetables) is less clear. Trends in agriculture may change again once Poland becomes an EU member: currently it only benefits from market access, but in the future Polish agriculture will also be eligible for price and income support under the CAP. However, as the CAP itself is likely to change considerably before accession, the outcome of the process is quite uncertain. In manufacturing, a specialization in the direction of ‘light’ industry is becoming apparent. Product groups where Poland’s production and exports have been increasing include wood manufactures, clothing, footwear, passenger cars and some household appliances. Chemicals,

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Table 7.9

Selected environmental indicators for Poland and the EU-15 Poland

SOx emissions per capita (kg) NOx emissions per capita (kg) VOC emissions per capita (kg) CO2 emissions per capita (tonnes) Energy supply per unit of GDP (Tonne of Energy (TOE)/US$) Freshwater abstraction per capita (m3) % of population connected to sewage treatment plant Intensity of forest use (harvest/annual growth) Amount of municipal waste per capita (kg) Traffic volume by passenger car (veh. km/capita) Fertiliser use (total of N, P and K; kg per ha)

EU-15

1989–90

1996–97

1995–97

102.6 38.8 26.7 11.2 0.54

61.3 29.9 19.8 9.4 0.45

25.1 29.9 33.2 8.7 0.23

374 35.4

310 46.6

522 69.8

0.50 290 761 174

0.60 320 2196 86

0.62 461 5955 121

Source: OECD (1999a) and own calculations.

machinery, building materials and vehicles (other than passenger cars) have been declining. Environment As with the economy, Poland’s environment has experienced considerable changes during the 1990s, although the pace of change differs widely between the various environmental issues. Table 7.9 shows the changes that have occurred since 1989–90 in some selected parameters influencing the quality of the environment and compares them with recent values for the EU-15. Most of the chosen indicators point at convergence: in areas where Poland’s environmental record was worse than that of the EU (such as air and water pollution and energy use), it is improving; on the other hand, it is deteriorating in areas where Poland’s record used to be ‘greener’ than that of the EU (such as waste and transport). The reductions in emissions have led to substantial improvements in environmental quality in Poland. Since 1990, national average SO2 concentrations in the ambient air have been reduced by more than 50 per cent and average lead concentrations by more than 70 per cent. Concentrations of heavy metals in inland waters have decreased, in many cases by 80 or 90 per cent (OECD, 1999a).

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Analysis of Environmental Impacts The changes that are taking place in emissions and environmental quality in Poland can be related to the three factors that were distinguished above: scale, composition and technique. Scale In the early years of transition, environmental improvements in Poland were to a large extent due to the decline in economic activity. Emissions decreased at about the same rate as GDP and industrial production. However, since 1992, pollution has not followed the upward trend of the economy (see Figure 7.1). Whereas industrial production in 1997 was 160 140 120 100 80 60 40 20 0 1989

1990

1991

1992

1993

GDP (constant prices) Industrial production CO2 emissions SO2 emissions NOx emissions

1994

1995

1996

NH3 emissions NMVOC emissions CO emissions CH4 emissions lead emissions

Source: EMEP (2000); OECD (1999a).

Figure 7.1 Indices of economic activity and emissions in Poland (1990 ⫽ 100)

1997

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almost 50 per cent higher than in 1990, emissions to air were still below their 1990 levels. Thus, the increases in production volume have apparently been more than offset by changes in the composition of production and in technologies. The scale of consumption has also grown very fast. From 1991 to 1998, private final consumption expenditure increased by 42 per cent in real terms. Ireland was the only OECD country with a higher growth figure (44 per cent) over the same period (OECD, 1999a). Although technical improvements may have reduced the adverse environmental impact of this growth, it is obvious that the ‘decoupling’ is less impressive than on the production side. For example, while there has been a small decrease in VOC emissions from road traffic since 1991, NOx emissions from traffic have increased. The amount of municipal waste per capita has also grown (OECD, 1999a). Composition As we have seen in Table 7.8, the share of agriculture and industry in GDP is decreasing, whereas that of services is increasing. This development towards a ‘service economy’ contributes to a lower level of emissions per unit of GDP. Within industry, the tendency towards lighter industries is likely to contribute to decreases in pollution (cf. Vukina et al., 1999). The environmental impacts of agricultural specialization, on the other hand, may be less favourable: the growth in pork and poultry, for instance, could imply the development of an intensive livestock breeding sector with its associated high levels of nitrate and ammonia pollution. The composition of private consumption in Poland differs from that of the EU-15 in some respects (see Table 7.10). Polish consumers spend a relatively large part of their income on food (only Portuguese and Greek households spend Table 7.10 Composition of household consumption by major spending categories (as % of total household expenditure), 1997 Category

EU-15

Poland

Food Clothing and footwear Fuel and power Health Education Transport and communication Other

10–28 3–7 2–6 7–21 6–16 8–17 35–52

20 3 5 12 19 6 34

Source: World Bank (1999).

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relatively more) and on education (in which they exceed all EU countries). On transport and communication, Polish households spend less than those in the EU. Thus, in terms of composition, expenditure patterns in Poland seem to be somewhat less environmentally harmful than those in the EU, although there is a trend towards convergence (illustrated by the recent strong growth in car sales). Technique Improvements in production technology (both through modernization of production technology and through ‘end-of-pipe’ pollution control technology) have been important factors behind the reduction in emissions in specific sectors. For example, while steel production in Poland increased by 13 per cent in the period 1992–96, SOx and particulates emissions from the Polish steel industry decreased over the same period by 38 per cent and 53 per cent, respectively (OECD, 1999a). The ‘technique’ aspect of consumption shows a mixed picture from an environmental point of view. For instance, the emission characteristics of passenger cars have improved considerably. By 1997, unleaded gasoline had reached a 50 per cent market share in Poland (OECD, 1999c). On the other hand, recycling rates of paper and cardboard had dropped from 48 per cent in 1991 to 13 per cent in 1996 (OECD, 1999a). Regional Disparities There are large regional disparities in Poland. The European Commission’s 1999 Progress Report on Poland (European Commission, 1999c) noted, ‘people living in rural areas have not benefited greatly from economic growth’. The regional GDP per capita ranged between 25 per cent of the EU average in the region of Lubelskie and 55 per cent in the region of Mazowieckie (Warsaw). These regional disparities are largely related to the unfavourable position of agriculture, although the collapse of particular industries has also played a role. The regions with the lowest incomes (mainly in the north-eastern and south-eastern parts of the country) are the same as those where small farms prevail. Unemployment in these regions can be expected to increase as a result of rationalization and modernization in agriculture. Until now, unemployment has been concentrated in the north and west, where there has been large-scale industrial decline. Foreign direct investment in the CEE countries is mainly directed towards capital cities, large urban centres and western regions bordering the EU. However, in Poland FDI inflows are more evenly spread out than in other CEECs (European Commission, 1999c).

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CONCLUSIONS The present chapter has shown that the process of trade liberalization and EU accession can cause considerable changes in a country’s economy, the environment and the regional distribution of wealth and employment. In addition, EU enlargement also has consequences for existing EU members and for their existing trade partners throughout the world. The developments in the four countries considered in this chapter were by no means uniform. There were differences in: initial conditions, the prevailing economic climate during the years of liberalization, domestic macroeconomic policies, labour market features, and geographical factors such as proximity of markets, infrastructure and so forth. However, some common general tendencies can be observed that lead to the following: ●

●

●

●

●

A substantial increase in foreign trade with the EU, partly at the expense of traditional trading partners. In the case of the accession of Spain and Portugal it was mainly Latin America that lost a market for its food exports. In the case of Poland, trade has been diverted from the Former Soviet Union. A growing trade deficit. Imports tend to rise faster than exports. Whether this causes a balance of payments problem depends on the capital account. All countries except Greece experienced large increases in the inflow of foreign capital, both from EC and other financial institutions and from private sources. This is also the case for Poland. Changes in the composition of agricultural production (and to some extent also in industrial production). Agriculture in the southern accession countries shifted towards the cultivation of Mediterranean products. That is of course not possible for Polish agriculture. At the moment a pattern of specialization is emerging in a limited number of products, especially pork, poultry and sugar. Cereals are clearly on the decline. However, it is difficult to predict what will happen when Polish agriculture joins the CAP, or what will happen to the CAP itself. The composition of industry has changed more in Poland than in the southern accession countries. This can be explained by the different initial economic structures of the two regions, of the Polish economic structure having been extremely capital-intensive. Massive growth in private consumption, especially in car ownership and use and an increase in the generation of household wastes. This is a common feature of all four countries. Growing regional disparities can be observed almost everywhere, with, possibly, the exception of Portugal. Regional disparities can

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already be observed in Poland and the disparities may accelerate after accession. The environmental impact of these developments is mixed. The relative importance of the scale, composition and technique factors varies and often these factors have opposite effects. Generally speaking, the composition effect is relatively unimportant except in some specific cases. In Poland, there is a compositional shift towards light industry, which is, by and large, favourable for the environment. The scale factor (exercising a negative effect on the environment) is particularly strong in terms of growth in transport (both of goods and people) and waste. The technique effect is generally positive for the environment in industry and transport. But the technique effect may be less beneficial in agriculture if it destroys existing small-scale, low-input farming practices with their associated nature values. The future of the structure of agriculture and farming practices in Poland is highly uncertain, but may have a large impact on the environment and natural values. Past experience with the CAP in the southern member states gives cause for concern.

NOTES 1. Hardes and Stupp remark that the GDP measures of the Viségrad countries may have been somewhat underestimated because of the ‘shock’ of the transformation and the undervaluation of the national currencies with respect to the ECU (Hardes and Stupp, 1996, pp. 357). 2. The openness ratio is defined as 0.5 x (EXeu ⫹ IMeu)/GDP. In 1975 Spain, Greece and Portugal had openness ratios of 3 per cent, 7 per cent, and 8 per cent, respectively. In 1989, Poland, Czechoslovakia and Hungary had openness ratios of 5 per cent, 5 per cent, and 10 per cent, respectively (Hardes and Stupp, 1996, p. 358). 3. Kuik and Oosterhuis (2000) give a detailed account of the southern enlargement history.

REFERENCES Allen, T. (1999), ‘Expanding EU Trade with Poland’, Statistics in Focus – External Trade, 3/1999, Luxembourg: Eurostat. Avillez, F. (1993), ‘Portuguese Agriculture and the Common Agricultural Policy’, in J. da Silva Lopes (ed.), Portugal and EC Membership Evaluated, London: Pinter Publishers Ltd., pp. 30–50. EMEP (2000), ‘Tables of Anthropogenic Emissions in the ECE Region’, http:// www.emep.int. European Commission (1998), European Economy: Broad Economic Policy Guidelines, No. 66, Brussels: Directorate-General for Economic and Financial Affairs.

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European Commission (1999a), Sixth Periodic Report on the Socio-economic Situation and Developments in the Regions, Brussels: Directorate-General Regional Policy and Cohesion, http://inforegio.cec.eu.int/6pr. European Commission (1999b), ‘Regular Report from the Commission on Progress toward Accession. Poland – October 13, 1999’, http://europa.eu.int/comm/ enlargement/poland/rep_10_99/x.htm. European Commission (1999c), Employment in Europe 1999, Brussels. European Environment Agency (1998), Europe’s Environment: The Second Assessment, Copenhagen: EEA. Eurostat (1998), Key figures. Bulletin of Economic Trends in Europe, Luxembourg. Giannitsis, T. (1994), ‘Trade Effects, the Balance of Payments and Implications for the Productive System’, in P. Kazakos and P.C. Ioakimidis (eds), Greece and EC Membership Evaluated, London: Pinter Publishers Ltd., pp. 36–55. Glejser, H. and S. Moro (1996), ‘Estimates of Trade Effects of Portugal’s and Spain’s Entry to the European Union’, De Economist, 144, 285–304. Grossman, G. and A. Krueger (1991), Environmental Impacts of a North American Free Trade Agreement, Cambridge, MA: National Bureau of Economic Research, Working Paper No. 3914. Hardes, H.-D. and S. Stupp (1996), ‘Die Integrationserfahrungen Südeuropas: Wirtschaftlicher Wegweiser für eine Ostweiterung der Europäischen Union?’, Osteuropa-Wirtschaft, 41(4), 354–63. Kazakos, P. and P.C. Ioakimidis (eds) (1994), Greece and EC Membership Evaluated, London: Pinter Publishers Ltd. Kuik, O.J. and F.H. Oosterhuis (1999), ‘Eastward Expansion of Free Trade: A Green Prospect? Environmental Implications of Trade Liberalisation between the European Union and Countries of Central and Eastern Europe’, Report prepared for the European Environment Agency, Copenhagen. Kuik, O.J. and F.H. Oosterhuis (2000), Free Trade and the Environment in the Euro-Mediterranean Context: Lessons learned from Spain, Portugal, Greece and Poland, Report prepared for the Mediterranean Commission for Sustainable Development, W-00/04, Amsterdam: Institute for Environmental Studies, Vrije Universiteit. Maraveyas, N. (1994), ‘The Common Agricultural Policy and Greek Agriculture’, in P. Kazakos and P.C. Ioakimidis (eds), Greece and EC Membership Evaluated, London: Pinter Publishers Ltd. pp. 56–73. Marques-Mendez, A.J. (1993), ‘The Development of the Portuguese Economy in the Context of the EC’, In J. da Silva Lopes (ed.), Portugal and EC Membership Evaluated, London: Pinter Publishers Ltd. pp. 7–29. OECD (1991), Environmental Data, Compendium, 1991, Paris: Organisation for Economic Co-operation and Development. OECD (1993), OECD Environmental Performance Reviews: Portugal, Paris: Organisation for Economic Co-operation and Development. OECD (1995), Economic Accounts for Agriculture, Paris: Organisation for Economic Co-operation and Development. OECD (1997a), OECD Environmental Performance Reviews: Spain, Paris: Organisation for Economic Co-operation and Development. OECD (1997b), Environmental Data, Compendium 1997, Paris: Organisation for Economic Co-operation and Development. OECD (1998), OECD Economic Surveys 1997–98: Poland, Paris: Organisation for Economic Co-operation and Development.

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OECD (1999a), OECD Environmental Data 1999, Paris: Organisation for Economic Co-operation and Development. OECD (1999b), Environment in the Transition to a Market Economy. Progress in Central and Eastern Europe and the New Independent States, Paris: Organisation for Economic Co-operation and Development. OECD (1999c), Environment in the Transition to a Market Economy. Progress in Central and Eastern Europe and the New Independent States, Paris: Organisation for Economic Co-operation and Development. OECD (1999d), The Agri-environmental Situation and Policies in the Czech Republic, Hungary and Poland, COM/AGR/ENV(99)60/FINAL, Paris: Organisation for Economic Co-operation and Development. Task Force on the Environment and the Internal Market (1992), The Environment and the Internal Market: Challenges and Opportunities, Report, Brussels. United Nations – Economic Commission on Europe (UN-ECE) (1999), Economic Survey of Europe, New York. Vukina, T., J.C. Beghin and E.G. Solakoglu (1999), ‘Transition to Markets and the Environment: Effects of the Change in the Composition of Manufacturing Output’, Environment and Development Economics, 4, 582–98. World Bank (1999), World Development Indicators, Washington, DC: The World Bank. Zioganas, C.M. (1998), ‘The Organization of Primary Agricultural Production in Greece: Evolution and New Challenges for Re-orientation’, in J.N. Lekakis (ed.), Freer Trade, Sustainability, and the Primary Production Sector in the Southern EU: Unraveling the Evidence from Greece, Dordrecht: Kluwer Academic Publishers, pp. 19–32.

8.

Strategic environmental policies with foreign direct investment: implications of European enlargement* M. Özgür Kayalica and Sajal Lahiri

1

INTRODUCTION

The European Union (EU) is one of the most successful economic unions. It has, however, changed substantially both in terms of its scope and membership. It started as an economic community after the Treaty of Rome in 1957 with six founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands. It has undergone four successive enlargements with Denmark, Ireland and the United Kingdom joining in 1973, Greece in 1981, Portugal and Spain in 1986, and Austria, Finland and Sweden in 1995. Currently, negotiations are under way with thirteen other countries – most of them from Central and Eastern Europe – for possible accession in the near future. The EU is no longer just a free trade area; it is involved in coordinating policies among its members on a wide range of issues. Environmental policies are one of these issues. The enlargement of the EU, at the current stage of its development, poses a particular challenge as the new members are likely to be significantly more heterogeneous than the existing ones. The environment may be one of the most challenging areas in the new round of enlargement. The differences between environmental standards in Austria, Finland and Sweden, on one hand, and the 12 existing members at the time of accession of the former three, on the other, are much narrower than between the existing 15 member countries and the new potential entrant countries from the Central and Eastern European countries. Furthermore, substantial crossborder pollution from some of the candidates for membership in the next round of enlargement to a number of existing members of the EU also makes the challenge of enlargement particularly interesting. The EU is aware of these difficulties and has environmental accession strategies. One

167

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of these strategies is to help the new entrants bring their environmental policies closer to those of the EU members and, at the same time, give them easier access to the markets in the EU. The purpose of this chapter is to examine if easier access to EU markets actually helps bring environmental policies closer to each other. The environment is, of course, a very broad concept which encompasses, inter alia, waste management, noise pollution, water pollution, air pollution and nature conservation. The list of instruments that can potentially be used to protect the environment is also long, and the suitability or effectiveness of any particular instrument obviously depends on the nature of environmental degradation that is being targeted.1 In recent years the EU has been very keen on widening the set of instruments that it uses. The instruments that are widely used, though not necessarily within the EU, can broadly be classified within three categories: quantitative instruments (such as emission quotas and emission standards), fiscal instruments (such as pollution taxes) and technical instruments (such as eco-labeling and the community system of environmental management and auditing). A popular instrument, particularly in the USA, is marketable emission permits, which combines both quantitative and fiscal dimensions. In this chapter, it will be helpful to think of environmental degradation as simply air pollution generated by production. As for the instrument, our analysis will be restricted to the use of a quantitative restriction in the form of a stipulated maximum amount of pollution that a firm is allowed to emit per unit of output. We shall call this instrument simply ‘emission standards’.2 We develop a Cournot oligopoly model where a number of foreign firms located in a host country compete for the market of a homogeneous commodity in a country with a domestic firm. The host country, a candidate for membership in an enlarged EU, is the country where the goods are consumed. Production by every firm causes pollution as a by-product and there is cross-border pollution from the host country of foreign direct investment (FDI) to the EU. We assume the existence of unemployment in the host country. Both countries control pollution emissions by applying emission standards. However, because of the nature of imperfect competition in our model, emission standards in the consuming country also have strategic roles for profit shifting in the model.3 The EU has tariffs on imports from the host country, and a reduction of the tariffs is taken as part of EU enlargement or of a pre-accession strategy. Given the importance of FDI in the world economy today and the concern for the environment throughout the globe, it is surprising that there is only limited literature on the interface between FDI and the environment. Markusen et al. (1993) analyse the location decisions of two firms in a two-region model where the government in one region is passive in the

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169

face of investment flows. In Markusen et al. (1995), the second government is brought into play and they then analyse the outcome of competition between the two countries to encourage the entry of a foreign firm (or to discourage the entry of a foreign firm, if the disutility from pollution is sufficiently high). Gokturk (1979), Rauscher (1995) and Levinson, (1997) also examine the effect of environmental policies on an exogenous number of firms’ location decisions. Lahiri and Ono (2000) develop a one-country model, in which they analyse the different effects of tax and quantity restrictions on pollution controls in the presence of an endogenous number of foreign firms.4 The benchmark model, where the number of foreign firms in the host country is exogenous, is developed in the following section. We also characterize the Nash optimal values of emission standards. In Section 3, we examine the effects of changes in the size of the market and in the tariff rate on the optimal emission standards. We also examine the effects on welfare in both countries of a small uniform reduction in emission standards, starting from the Nash optimal levels. Section 4 examines the equilibrium in the presence of free entry and exit for foreign firms in the host country and examine if free entry and exit change the results obtained in Section 3. Finally, some concluding remarks are made in Section 5.

2

THE BENCHMARK MODEL

We develop a model of Cournot oligopoly in which there are two countries: A (EU) and B (Central and Eastern Europe). There is one domestic firm which operates in Country A and n identical foreign firms in Country B. In Section 4, we shall consider the case of free entry and exit of foreign firms. Each firm produces a homogeneous good to be consumed in Country A.5,6 Country A imposes tariffs on imports at the rate t. We assume the existence of unemployment in Country B. The inverse demand function for the oligopolistic good is given by p⫽␣⫺␤D,

(8.1)

where p is price and D is the total demand for the good, which is equal to the sum of output produced by the country A firm, x1, and output produced by the foreign firms in Country B. That is, D⫽x1 ⫹nx2, where x2 is the output by each foreign firm in Country B.7

(8.2)

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Profits of the firm in Country A and that of a representative firm in B are respectively given by ␲1 ⫽[ p⫺c1 ⫺␮1(␪1 ⫺z1)]x1,

(8.3)

␲2 ⫽[ p⫺c2 ⫺␮2(␪2 ⫺z2) ⫺t]x2,

(8.4)

where c1 and c2 are the constant average (marginal) costs of production in the two countries, the ␪i’s are the gross pollution (pollution before abatement) per unit of output, the ␮i’s are the constant unit cost of abatement, and zi 僆 (0, ␪) is the maximum amount of pollution per unit of output that the firms are allowed to emit into the atmosphere (i⫽1, 2).8 In our terminology, z1 and z2 are the emission standards stipulated by the two governments respectively. Under the Cournot–Nash assumptions the optimal outputs of the firms are as follows:

x1 ⫽

␣ ⫺ ␥1(1 ⫹ n) ⫹ n(␥2 ⫹ t) , ␤(2 ⫹ n)

(8.5)

␣ ⫹ ␥1 ⫺ 2(␥2 ⫹ t) , ␤(2 ⫹ n)

(8.6)

x2 ⫽ where

␥i ⫽ci ⫹␮i (␪i ⫺zi), i ⫽1, 2.

(8.7)

As stated before, we assume that there is unemployment in Country B. Following Brander and Spencer (1987), factor input costs are taken to be the income of the factors which would remain unemployed in the absence of the production of the oligopolistic good. Hence, the welfare levels in Country A and Country B are given by W1 and W2 below. W1 ⫽␲1 ⫹x2nt ⫹CS1 ⫺␾1 (x1z1 ⫹k nx2z2),

(8.8)

W2 ⫽nx2c2 ⫺␾2x2nz2,

(8.9)

where ␾1 and ␾2 are the marginal disutilities of pollution in the two countries, and k is the degree of cross-border pollution or the pollution spillover parameter. The four terms in (8.8) are respectively the profit income, tariff revenue, consumer surplus, and pollution disutility in Country A. We assume that the profits of FDI are repatriated to the source country. Hence, country 2 benefits from FDI only through the employment generated by

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foreign firms (the first term in (8.9)), but suffers from some disutility from its own pollution (the second term in (8.9)). Throughout the chapter we shall assume that the marginal disutility from pollution in Country A is higher than the marginal cost of abatement in that country. That is, ␾1 ⬎␮1.

(8.10)

Differentiating equations (8.5) and (8.6) we obtain (1 ⫹ n)␮1 n␮2 dz ⫺ dz , ␤(2 ⫹ n) 1 ␤(2 ⫹ n) 2

(8.11)

␮1 2␮2 dx2 ⫽ ⫺ dz1 ⫹ dz . ␤(2 ⫹ n) ␤(2 ⫹ n) 2

(8.12)

dx1 ⫽

The above equations state that each firm will increase (decrease) production if it is allowed to emit more (less) pollution or if the amount of pollution that the rival firm is allowed to emit is reduced (raised). This is because a stricter emission standard (a lower z) in a country implies higher costs of production for the firms operating in that country and, therefore, gives the firms operating in the other country a competitive advantage. Turning to welfare, totally differentiating the welfare functions we get ␤(2 ⫹n) dW1 ⫽A1dz1 ⫹A2dz2,

(8.13)

␤(2 ⫹n) dW2 ⫽A3dz1 ⫹A4dz2,

(8.14)

where A1 ⫽␾1␮1[knz2 ⫺(1 ⫹n)z1]⫺␤x1[␾1(2 ⫹n) ⫺␮1(2n⫹3)]⫹␮1n(␤x2 ⫺t), A2 ⫽␾1␮2[z1n⫺2kz2(2 ⫹n)]⫺␤x2n[k␾1(2 ⫹n) ⫺␮2(4 ⫹n)], ⫹␮2[2t(n⫹2) ⫹␤x1(4 ⫺n)], A3 ⫽␮1n(␾2z2 ⫺c2), A4 ⫽(2 ⫹n) [2␮2(c2 ⫺␾2z2) ⫺␾2␤x2n]. The effects of a change in one of the z’s has a number of opposing effects via changes in relative costs, levels of profit, pollution emission, employment, consumers’ surplus and tariff revenue. Also note that because of oligopolistic interdependence and cross-border pollution, there are policy externalities, that is, policy intervention in one country affects welfare in the other.

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Setting A1 and A4 in (8.13) and (8.14) equal to zero, we find the noncooperative Nash equilibrium values of the instruments as follows:9 zN 1 ⫽

␤x1[␮1(2n ⫹ 3) ⫺ ␾1(n ⫹ 2)] n(␤x2 ⫺ t) nk(2␮2c2 ⫺ ␾2␤x2n) ⫹ ⫹ (8.15) ␾1␮1(1 ⫹ n) ␾1(1 ⫹ n) 2␾2␮2(1 ⫹ n) zN 2 ⫽

(2␮2c2 ⫺ ␾2␤x2n) 2␾2␮2

(8.16)

There are two opposing terms in (8.16). The first term is due to the employment effect and relaxes (increases) the optimal value of z2. The second term is due to the disutility of pollution and this has the opposite effect vis-à-vis the employment effect. In contrast, the expression for the optimal value of z1 is more complex. Although the employment effect is absent, there are a number of other effects here which are absent in the case of Country B. These are the profit-shifting effect, the effect on consumers’ surplus, the effect on their own pollution, the effect on cross-border pollution from Country B and the effect on tariff revenue. The last term in (8.15) is the one that occurs via changes in cross-border pollution from Country B.

3

COMPARATIVE STATICS

In this section we shall examine the effect of changes in two of the parameters of the model on the Nash optimal levels of emission standards. The parameters we focus on are the demand parameter ␣, representing the size of the market and the tariff rate t; a reduction in the latter representing a larger degree of integration between the two countries. Finally, we also examine the effects on welfare in both countries of a multilateral reduction in emission standards, starting from their Nash optimal levels. These exercises are carried out in turn in the following sub-sections. 3.1

Emission Standards and Market Size

Differentiating the equilibrium levels of emission standards in the two countries (that is, equations (8.15) and (8.16)) with respect to the parameter ␣ we get ⭸zN 1 1 ⫽⫺ [␮ [␾ (4 ⫹ 4n ⫹ n2) ⫺ ␮1(6 ⫹ 9n ⫹ 2n2)] ⫹ ␾1␮1kn2] ⭸␣ ␮1H1 2 1 ⭸zN n 2 ⫽ ⫺ (3 ⫹ 2n)(␾1 ⫺ ␮1), ⭸␣ H1 where H1 (⬎0) is defined in endnote 9.

(8.17) (8.18)

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It follows from (8.10) and (8.18) that an increase in ␣ reduces zN 2 . That is, a larger market in the consuming country implies that a stricter emission standard will be imposed by the government of the host country. This is because a higher ␣ implies a higher output by all the firms and therefore, ceteris paribus, a larger emission of pollution in the two countries. Since the government of the host country does not need to use emission standards as a strategic instrument, it imposes a higher emission standard in response to higher production by the firms operating from its soil. The negative effect on employment of such a policy is dominated by the positive effect of pollution reduction since these effects are evaluated at the Nash equilibrium. However, since z1, as mentioned before, has many strategic roles apart from the role of reducing pollution, the effect of an increase in ␣ on zN 1 is ambiguous. However, if ␾1 is significantly higher than ␮1, the pollution-control role of z1 will dominate and the consuming country will also apply a stricter emission standard if ␣ is increased. These results are stated formally as a proposition below. Proposition 1 A larger market implies a stricter emission standard in the host country for that industry. The same is true in the consuming country if the marginal disutility from pollution is significantly larger than the unit abatement cost in that country. 3.2

Emission Standards and Tariffs

Differentiating equations (8.15) and (8.16) with respect to the tariff rate t, we find: ⭸zN 2n 1 ⫽ [␾ n(␮1k ⫺ ␮2) ⫺ ␮2(2␾1 ⫹ ␮1)], ⭸t ␮1H1 1

(8.19)

⭸zN n 2 ⫽ [␾1 ⫹ 3(n ⫹ 1)(␾1 ⫺ ␮1)]. ⭸t H1

(8.20)

It follows from (8.10) and (8.20) that a reduction in t reduces zN 2 . The intuition is similar to that in the previous case. A reduction in t increases production by the firms located in the host country and the government there responds by imposing a stricter emission standard. Once again the effect on zN 1 is ambiguous. However, if the degree of cross-border pollution k is sufficiently high, a reduction in t will reduce zN 1 as well. Formally, Proposition 2 Economic integration leads to stricter emission standards in the host country. The same is true in the consuming country if the degree of cross-border pollution is sufficiently high.

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3.3

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A Multilateral Reform of Emission Standards

In this section we examine the effects on welfare in both countries of a small uniform reduction in the emission standards in the two countries, starting from their Nash equilibrium levels. This can be viewed as a multilateral effort to coordinate pollution policies. Specifically, the reform is defined by dz1 ⫽dz2 ⫽⫺␦,

(8.21)

where ␦ is a positive parameter. Substituting (8.15) in (8.13), (8.16) in (8.14), and using (8.21) we get:10 2␤␮1␾2(1 ⫹ n)(2 ⫹ n) dW1 ⫽ [␾2␮1␤x2n[␾1n2k ⫺ 2␮2(4 ⫹ n2 ⫹ 6n)] ⫹ 2␮1␮2(4 ⫹ n2 ⫹ 6n)(␾1kc2 ⫺ ␾2t) ⫹ 2␾2␮2␤x1[␾1n(2 ⫹ n) ⫺ ␮1(4 ⫹ n2 ⫹ 6n)]]␦, (8.22) 2␮2(2 ⫹n) dW2 ⫽␮1␾2x2n2␦ ⬎0.

(8.23)

It is clear from equation (8.23), that, starting from the non-cooperative equilibrium, a small uniform reduction in the emission standards would make Country B unambiguously better off. This is because a stricter emission standard in Country A increases the cost of production of the firm located there and gives competitive advantage to the foreign firms located in Country B. This increases employment and pollution in Country B. However, at the Nash equilibrium, the employment effect dominates the pollution effect. A stricter emission standard in Country B also gives competitive advantage to the firm in Country A, increasing its profit income. Such a policy change also reduces cross-border pollution, but increases domestically generated pollution in Country A. Furthermore, a stricter emission standard in Country B increases the price of the commodity and therefore reduces consumers’ surplus in Country A. As result of these conflicting effects, the net effect on the welfare in Country A is ambiguous. However, if the marginal disutility of pollution is sufficiently high in Country A, the effect of the reform on welfare there is also positive. These results are stated formally in the following proposition: Proposition 3 Starting from the non-cooperative equilibrium, a small uniform reduction in emission standards in the two countries makes country 2 unambiguously better off. The same is true for country 1 if the marginal disutility of pollution there is sufficiently high.

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4

FREE ENTRY AND EXIT OF FDI

So far it has been assumed that the number of foreign firms located in the host country n is exogenous. Now we extend the model developed in the previous sections by allowing the number of foreign firms to be endogenous. Following Lahiri and Ono (1998), it is assumed that Country B plays a small role in the market for FDI. Hence, foreign firms will move into (out of) Country B if the profits they make in Country B are larger (smaller) than the reservation profit, p, that they can make in the rest of the world. Therefore, in the FDI equilibrium we must have (8.24)

␲1 ⫽ p.

The rest are as before. With this extra equation, some of the key variables can be solved as:

ˆ

ˆ

n⫽

ˆ

␣ ⫺ 2(␥2 ⫹ t) ⫹ ␥1 ⫺ 2, √p√␤

(8.25)

ˆ

√p √␤ ⫹ ␥2 ⫺ ␥1 ⫹ t , ␤

(8.26)

x2 ⫽

␣ ⫺ 2(␥2 ⫹ t) ⫹ ␥1 √p ⫽ . ␤(2 ⫹ n) √␤

(8.27)

x1 ⫽

ˆ

ˆ ˆ

ˆ

ˆ

ˆ

From the above we obtain ␮1 2␮2 dz ⫹ dz , √p √␤ 1 √p √␤ 2 ␮ ␮ dx1 ⫽ 1 dz1 ⫺ 2 dz2, ␤ ␤

dn ⫽ ⫺

dx2 ⫽0.

(8.28) (8.29) (8.30)

The important difference here, as compared to the case where n is exogenous, is that changes in the policy instruments have no effect on the output by each foreign firm, and the effects on the oligopolistic industry in the host country are borne exclusively by changes in the number of foreign firms. A less (more) profitable situation for the foreign firms implies that some of them leave (enter) the host country, but output per firm does not change. Completely differentiating the welfare functions we get ␤ dW1 ⫽B1dz1 ⫹B2dz2,

(8.31)

␤ dW2 ⫽B3dz1 ⫹B4dz2,

(8.32)

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where

ˆ

B1 ⫽ [␤x1(2␮1 ⫺ ␾1) ⫹ ␾1␮1(kz2 ⫺ z1) ⫺ t␮1],

ˆˆ

ˆ

B2 ⫽ [␤x2n(␮2 ⫺ ␾1k) ⫹ ␾1␮2(z1 ⫺ 2kz2) ⫺ ␮2(␤x1 ⫺ 2t)], B3 ⫽ ␮1(␾2z2 ⫺ c2),

ˆˆ

B4 ⫽ [2␮2(c2 ⫺ ␾2z2) ⫺ ␾2␤x2n]. Setting B1 and B4 in (8.31) and (8.32) equal to zero, we find the Nash equilibrium values of the instruments as follows.11

ˆ

zN 1 ⫽

ˆ

ˆˆ

␤x1(2␮1 ⫺ ␾1) t k(2␮2c2 ⫺ ␾2␤x2n) ⫺ ⫹ , ␾1␮1 ␾1 2␾2␮2

ˆ

zN 2 ⫽

ˆˆ

(2␮2c2 ⫺ ␾2␤x2n) . 2␾2␮2

(8.33) (8.34)

Having obtained the Nash equilibrium values of the emission standards, we shall now carry out similar exercises to those in Section 3, and compare the two sets of results. 4.1

Emission Standards and Market Size

Differentiating (8.33) and (8.34), we get:

ˆ

⭸zN ␾ (␮ k ⫹ ␮2) ⫺ 2␮1␮2 1 ⫽⫺ 1 1 , ⭸␣ ␮1H2

ˆ

⭸zN 2 2 ⫽ ⫺ (␾1 ⫺ ␮1) ⬍ 0, ⭸␣ H2

(8.35) (8.36)

where H2 (⬎ 0) is defined in endnote 11. The results are similar qualitatively to the case where n is exogenous. That N is, an increase in ␣ reduces zN 2 . It also reduces z1 if ␾1 is sufficiently high. There is one difference in the present case. It can be shown that the numerator of (8.35) is negative (positive) if the reaction function derived from Country A’s first-order condition (B1 ⫽0) is negatively (positively) sloped. In other words, an increase in ␣ will reduce (increase) zN 1 if the two instruments are strategic complements (substitutes) (see Bulow et al., 1985). Formally,

ˆ

ˆ

ˆ

Proposition 4 In the presence of free entry and exit of foreign firms, a larger market implies stricter emission standards in the host country for that

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industry. The same is true in the consuming country if emission standards in the two countries are strategic complements. 4.2

Emission Standards and Tariffs

Differentiating (8.33) and (8.34) with respect to tariff rate t we find:

ˆ

(8.37)

ˆ

(8.38)

⭸ zN 2␾1 1 ⫽ (k␮1 ⫺ ␮2), ⭸t ␮1H2 ⭸zN 1 2 ⫽ 3(␾1 ⫺ ␮1) ⬎ 0. ⭸t H2

ˆ

ˆ

N As before, a reduction in t reduces zN 2 and the effect of a change in t on z1 is ambiguous. However, from (8.37) we can draw some interesting conclusions. Suppose that the unit abatement costs are the same in the two countries, that is ␮1 ⫽␮2. Then from (8.37) it follows that a reduction in t will reduce zN 1 if and only if k⬎1. Noting that k is the spillover parameter, it should be evident that k⬎1 when emissions in Country B create more pollution in Country A than in Country B. This can be quite realistic in many situations. If the polluting industries are located in the region bordering the two countries, it is quite possible that emissions in one country create more pollution in the neighbouring country than in the country of origin.12 Stating the results formally,

ˆ

Proposition 5 In the presence of free entry and exit of foreign firms, economic integration leads to stricter emission standards in the host country. The same is true in the consuming country if the degree of cross-border pollution is sufficiently high. 4.3

A Multilateral Reform of Emission Standards

Finally, we study the welfare effects of a multilateral reform on emission standards of the type given by (8.21) in the presence of free entry and exit of foreign firms. Substituting (8.33) in (8.31), (8.34) in (8.32), and using (8.21) we get

ˆˆ

2␤␮1␾2 dW1 ⫽ ␾2␮1␤x2n(␾1k ⫺ 2␮2) ⫹ 2␮1␮2(␾1kc2 ⫺ ␾2t)

(8.39)

ˆ

⫹ 2␾2␮2␤x1(␾1 ⫺ ␮1),

ˆˆ

2␮2 dW2 ⫽ ␮1␾2x2n ⬎ 0.

(8.40)

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The results are similar to the previous case with a fixed number of foreign firms. That is, the reform unambiguously improves the welfare of the host country, but also increases the welfare of the consuming country if the marginal disutility of pollution there is sufficiently high. Formally, Proposition 6 In the presence of free entry and exit of foreign firms, starting from the non-cooperative equilibrium, a small uniform reduction in the emission standards makes country 2 unambiguously better off. The reform is Pareto-improving if the marginal disutility from pollution in country 1 (␾1) is sufficiently large.

5

CONCLUSION

The interdependence between foreign direct investment (FDI) and pollution control is well known. As environmental policies in some countries are strengthened, some firms in those countries decide to relocate to countries where environmental restrictions are laxer, creating possible ‘pollutionhavens’. In fact, in recent years many foreign firms have relocated to many of the countries in Eastern and Central Europe for easier access to European Union (EU) markets. These countries are also candidates for membership in an enlarged EU. In this chapter we have developed a stylized model of FDI, pollution and economic integration in order to examine the effect of economic integration on optimal environmental policies in the countries concerned. In our model there are two countries. The oligopolistic market of a homogeneous commodity is located exclusively in one of the countries (which we call the consuming country). This country also has one firm which competes with a number of foreign firms located in the other country (which we call the host country). The consuming country is viewed as the EU and the host country as a candidate for membership of the EU. The host country has unemployment. Pollution is created as a by-product of production in both countries. Pollution from the host country is also transmitted across the border to the consuming country. The two countries use emission standards – maximum allowable emissions per unit of output for each firm – in order to maximize their respective welfare. We have characterized the Nash optimal levels of emission standards in the two countries and have examined the effects of an increase in the market size and a decrease in tariffs on imports in the consuming country on the equilibrium levels of emission standards. We find that such changes unambiguously make emission standards stricter in the host country. The same is true in the consuming country if the marginal disutility of pollution (and/or

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the degree of cross-border pollution) is sufficiently high. We also find that a multilateral strengthening of emission standards in the two countries, starting from the Nash equilibrium levels, unambiguously improves the welfare of the host country and also improves the welfare of the consuming country if the marginal disutility of pollution is sufficiently high there. These results hold whether the number of foreign firms is exogenously given or it is endogenous via free entry and exit of foreign firms.

NOTES *

1. 2.

3. 4.

5. 6.

7. 8. 9.

An earlier version of paper was presented at the FEEM Workshop on Trade and the Environment in Milan, in 2001. The authors are extremely grateful to Charles Perrings, Carlo Pettinato and Rafael Reuveny, to the participants at the conference for their valuable comments, and to the FEEM for financial assistance. See Cropper and Oates (1992) for a survey of the literature. See also Baumol and Oates (1988). As Helfand (1991) points out, an emission standard itself can take a variety of forms such as an emission quantity restriction per unit of output, an emission restriction per unit of certain inputs, restrictions on the use of a particular input, or mandated use of a particular pollution-control technology. In this chapter, we shall use a quantity restriction on emission in the form of a restriction on emission per unit of output, and for expositional simplicity call it simply an emission standard. An emission standard is typically not marketable, that is, it is imposed by environmental authorities as a command. See Brander and Spencer (1985, 1987) for strategic trade polices, and Copeland (1996) for strategic environmental policies. There is also a large literature on environmental policies in models with imperfect competition. The bulk of this literature tends to focus on international trade in goods rather than on FDI. For example, Conrad (1993) considers strategic rent-shifting use of emission taxes where consumers’ surplus has no role. Kennedy (1994) extends this analysis to allow for domestic consumption. Barrett (1994) considers strategic use of emission standards. Ulph (1992, 1996) compares different environmental policies under different types of oligopolistic competitions. We shall refer to country A as the consuming country and country B as the host country. Implicitly, there is a numeraire good in the background and this good is produced using labour and a sector-specific factor inelastically supplied. Labour is freely mobile between the two sectors (within a country) and the wage rate in terms of the numeraire good is rigid. Labour is the only factor of production in the oligopolistic sectors. Production technologies are of the constant returns to scale type everywhere. Given this framework, for our welfare analysis, we can ignore the numeraire good sector. All the variables for Country A (B) will be subscripted by 1 (2). Both ␪i’s and zi’s are implicitly assumed to be above the level which the World Health Organization considers to be harmless. The second-order conditions are: ⭸2W1 ⬍0 ⭸z21 if [␮1(2n(2 ⫹n) ⫹3)] ⬍2␾1[n(3 ⫹n)⫹2], and this holds because of (8.10), and ␤(2 ⫹ n)

⭸2W2 ⫽ ⫺4␾2␮2(1 ⫹ n) ⬍ 0. ⭸z22

180

Environmental policy concerns and EU enlargement It can also be shown that the equilibrium is stable (see Seade, 1980 and Bulow et al., 1985) if H1 ⫽␾1␮2(8 ⫹16n⫹7n2) ⫺{6␮1␮2(1 ⫹n2) ⫹␮1n(11␮2 ⫹␾1 kn)}⬎0.

10.

11.

Since we take the Nash equilibrium as the starting point, the effects of a policy change in any one of the countries would not have any effect on the same country (because of the envelope property); it is only the international externalities of emission standards that would play a role here. The second order conditions are: (␤Ⲑ2␮1)

⭸2W1 ⫽ ⫺(␾1 ⫺ ␮1) ⬍ 0 ⭸z21

(because of (10)) and ␤

⭸2W2 ⫽ ⫺4␾2␮2 ⬍ 0. ⭸z22

Finally, the stability of the Nash equilibrium requires that H2 ⫽7␾1␮2 ⫺␮1(6␮2 ⫹␾1k) ⬎0. 12.

In the context of the EU and enlargement, this issue is not far from being very pertinent. For example, many of the highly polluting industries in Poland are located near its border with Germany. There are numerous such examples.

REFERENCES Baumol, W.J., and W.E. Oates (1988), The Theory of Environmental Policy, 2nd edition, Cambridge: Cambridge University Press. Barrett, S. (1994), ‘Strategic Environmental Policy and International Trade’, Journal of Public Economics, 54, 325–38. Brander, J.A., and B.J. Spencer (1985), ‘Export Subsidies and International Market Share Rivalry’, Journal of International Economics, 18, 83–100. Brander, James A., and Barbara J. Spencer (1987), ‘Foreign Direct Investment with Unemployment and Endogenous Taxes and Tariffs’, Journal of International Economics, 22, 257–79. Bulow, J.I., J.D. Geanakoplos and P.D. Klemperer (1985), ‘Multimarket Oligopoly: Strategic Substitutes and Complements’, Journal of Political Economy, 93, 488–511. Conrad, K. (1993), ‘Taxes and Subsidies for Pollution-intensive Industries as Trade Policy’, Journal of Environment Economics and Management, 25, 121–35. Copeland, B.R. (1996), ‘Pollution Content Tariffs, Environmental Rent Shifting, and the Control of Cross-border Pollution’, Journal of International Economics, 40, 459–76. Cropper, M.L., and W.E. Oates (1992), ‘Environmental Economics: A Survey’, Journal of Economic Literature, 30, 675–740. Gokturk, S.S. (1979), ‘A Theory of Pollution Control, Location Choice, and Abatement Decisions’, Journal of Regional Science, 19, 461–7.

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Helfand, G. (1991), ‘Standards versus Standards: The Effect of Different Pollution Restrictions’, American Economic Review, 81, 622–34. Kennedy, P.W. (1994), ‘Equilibrium Pollution Taxes in Open Economies with Imperfect Competition’, Journal of Environment Economics and Management, 27, 49–63. Lahiri, S., and Y. Ono (1998), ‘Foreign Direct Investment, Local Content Requirement, and Profit Taxation’, Economic Journal, 108, 444–57. Lahiri, S., and Y. Ono (2000), ‘Protecting Environment in the Presence of Foreign Direct Investment: Tax versus Quantity Restriction’, Discussion Paper, Department of Economics, University of Essex. Levinson, A. (1997), ‘A Note on Environmental Federalism: Interpreting some Contradictory Results’, Journal of Environmental Economics and Management, 33, 359–66. Markusen, J.R., E.R. Morey and N. Olewiler (1993), ‘Environmental Policy when Market Structure and Plant Locations are Endogenous’, Journal of Environmental Economics and Management, 24, 69–86. Markusen, J.R., E.R. Morey and N. Olewiler (1995), ‘Competition in Regional Environmental Policies when Plant Locations are Endogenous’, Journal of Public Economics, 56, 55–7. Rauscher, M. (1995), ‘Environmental Regulation and the Location of Polluting Industries’, International Tax and Public Finance, 2, 229–44. Seade, J. (1980), ‘On the Effects of Entry’, Econometrica, 48, 479–89. Ulph, A. (1992), ‘The Choice of Environmental Instruments and Strategic International Trade’, in R. Pethig (ed.), Conflicts and Cooperation in Managing Environmental Resources, Berlin: Springer, 111–32. Ulph, A. (1996), ‘Environmental Policy Instruments and Imperfectly Competitive International Trade’, Environmental and Resource Economics, 7, 333–55.

9.

External actors and their prospective roles in environmental cleanup in Central and Eastern Europe Matthew R. Auer and Rafael Reuveny

INTRODUCTION For nearly 15 years, countries in Central and Eastern Europe (CEE) have struggled to clean up communist-era sources of industrial pollution. Auer et al. (2001) report on how CEE countries dealt with this problem during the 1990s.1 Communist-era governments perpetrated environmental crises in CEE that are well-known to scientists, scholars and ordinary people alike. Many contaminated sites and pollution-prone industries remain in CEE; a large fraction of these sites are located in economically troubled subregions of CEE. Authorities in the region have endeavored to clean up and revitalize these polluted and economically distressed areas. The record of accomplishment is mixed. Foreign investors are key, prospective actors in the cleanup and restoration of old, contaminated sites and in the rehabilitation of pollutionprone industries in CEE. Paradoxically, in the early 1990s, many observers warned that foreign direct investment (FDI) to CEE would be stymied by investors’ fears of liability for past environmental damages, and more broadly, investors’ ambivalence about the lack of clear rules governing environmental liability. Reacting to alleviate these fears, during the 1990s, CEE governments clarified rules and procedures governing environmental liability. In many cases, governments also granted investors partial or total immunity from liability for past damages. Auer et al. (2001) found that the aggregate level of FDI in CEE was not gravely affected by environmental liability problems. However, during the 1990s, foreign firms did steer investments away from pollution-prone and contaminated industries, investing in greenfield projects and in cleaner industry sectors. One explanation for this trend is that despite efforts to

182

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clarify environmental liability rules, foreign investors were skeptical about the profitability of contaminated and pollution-prone industry sectors. Another possibility is that investors worried that rules were impermanent or would be enforced in an arbitrary manner. Also, non-environmental factors may explain sluggish FDI flows to these industries, including their overcapacity; intense regional competition; barriers to entry; and structural problems, including labor–management conflict. The causes of underinvestment in pollution-prone industries and in cleanup of contaminated industries are numerous; but the fact remains: many old, industrial sites and environmentally compromised primary industry sectors remain in state hands. Additionally, FDI to these sectors, including mining, non-ferrous metals, and steel, has declined over time as a percentage of overall FDI to the region (Auer et al., 2001). Cleaning up, restoring, and transferring contaminated properties in CEE requires more than simply clarifying environmental liability rules. To manage these problems effectively, CEE governments at both the national and local levels must explore more comprehensive reforms, including brownfields revitalization. CEE governments should consider whether other, wealthier countries’ brownfields revitalization experiences are adaptable to the CEE context. Auer et al. (2001) argue that CEE countries are capable of adopting regulatory reforms required for Western-style brownfields revitalization. However, currently, most domestic public resources for environmental protection in CEE are channeled to prevent future pollution. The resources for cleanup of past pollution are scarce. Moreover, as noted above, foreign firms are reluctant to invest in contaminated sites and in pollution-prone industries. Many of these properties are concentrated in poor locales of CEE – including in the industrial corridors and ‘black triangle’ subregions – areas that tend to be more polluted and more economically distressed than neighboring areas. This chapter contends that donors, including bilateral and multilateral donors, should re-examine the special needs of these subregions since these external actors are the most plausible source of financing for brownfields cleanup in the near future. This chapter focuses in particular on the prospective roles that multilateral financial institutions and intergovernmental organizations can play in the cleanup of past pollution in CEE. More broadly, this chapter suggests that simplistic market-oriented and institutional approaches are not sufficient to realize sustainable development in CEE or in any other region. Conventionally, it is argued that free markets and well-functioning legal and macroeconomic institutions are sufficient for remedying environmental problems and nurturing sustainable economic development. The experience of CEE demonstrates that making

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legal assurances to investors and appealing to investors’ profit motives are not adequate to the task at hand.

PATTERNS OF INWARD INVESTMENT TO CENTRAL AND EASTERN EUROPE FDI involves partial or total ownership of a firm in one country by a firm in another country. In addition to a transfer of capital and managerial resources, FDI implies control over production. In 2000, advanced industrialized countries took in more than three-quarters of the world’s FDI inflows. In contrast only 19 per cent of FDI flowed to lesser developed countries (LDCs), declining from a peak of 41 per cent in 1994. In 2000, CEE countries maintained their 2 per cent share of total FDI inflows vis-à-vis 1999 (UNCTAD, 2001, pp. 294–5). Inward investment to CEE grew considerably during the transition period. Between 1987 and 1992, the average annual FDI inflow to CEE was $1.58 billion (UNCTAD, 1999, p. 480); it was $21.9 billion in 2000. The stock of FDI in CEE grew from $2.96 billion in 1990 to $99.94 billion in 2000 (UNCTAD, 1999, p. 492; UNCTAD, 2001, p. 305). As noted by Lucas (1997) and Sinn and Weichenrieder (1997), many LDCs are more successful than are CEE countries in attracting FDI in per capita terms. UNCTAD’s World Investment Report (1998b) attributes this weak performance to CEE’s relatively undeveloped legal/regulatory systems and to CEE countries’ relatively cumbersome privatization rules and procedures. The Czech Republic, Hungary and Poland account for more than 75 per cent of the stock of FDI in CEE. In 2000 FDI stocks in the Czech Republic, Hungary and Poland were $21.10 billion, $19.86 billion and $36.48 billion, respectively (UNCTAD, 2001, p. 305). These countries are relatively more attractive to FDI because they have made more progress in the transition toward a market economy and have more developed legal and regulatory institutions (UNCTAD, 1998b). Moving to the origin of FDI, in 2000, France was the largest source of FDI to CEE2 (17 per cent), followed by the United States (15.3 per cent) and the Netherlands (14.6 per cent). The European Union (EU) accounted for more than two-thirds of FDI in CEE. Germany and the Netherlands were the largest sources of inward investment to both the Czech Republic and Hungary, while the largest flows to Poland came from France and the United States (UNCTAD, 2001, pp. 249–50). The importance of FDI to CEE can be measured by the size of FDI relative to the size of CEE economies. In 1995–97, the average ratios of

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FDI inflow to gross fixed capital formation were 40 per cent in Latvia, 30 per cent in Hungary and 15 per cent in Estonia, Poland and Bulgaria (UNCTAD, 1999, p. 71) respectively. In 1997, the ratios of FDI stock to GDP were 35 per cent in Hungary, and about 23 per cent in Estonia, Latvia and the Czech Republic respectively. (The average of this ratio for the CEE region as a whole is 9 per cent.) We identified inward investment flows to pollution-intensive industries in CEE. These industries are deemed pollution-intensive or ‘pollution-prone’ to the extent that a relatively large fraction of their annual total costs are environment-related expenditures (see, for example, Leonard, 1988; Low and Yeats, 1992). Pollution-intensive industries, according to the United Nations Conference on Trade and Development (1999, p. 294) include: (1) chemicals; (2) paper and pulp; (3) cement, glass and ceramics; (4) minerals and mining; (5) iron and steel; (6) non-ferrous metals; (7) coal mining and production; (8) refineries and petroleum products; and (9) leather and tanning. In our analysis, rubber and plastic products are added to the list of pollution-prone industries.3 Table 9.1 exhibits data on the shares of FDI inflows directed to each sector in the Czech Republic, Hungary, Latvia, Poland, Slovakia and Slovenia. The data are aggregated from the primary, secondary and tertiary sectors (UNCTAD, 1999, p. 435). The primary sector includes ‘less polluting’ subsectors (for example, hunting, forestry and fishing) and pollution-prone subsectors (for example, mining, quarrying and petroleum). The secondary sector also includes less polluting subsectors (for example, machinery and equipment, electrical machinery, automotive, food, beverages, and tobacco) as well as pollution-prone industries (for example, leather, wood, paper and pulp, coke, petroleum products, metal and metal products, and chemicals). All of the industries in the tertiary sector are relatively less polluting (this includes water distribution, wholesale and distribution trade, hotels and restaurants, telecommunication, insurance and banking, and real estate). Table 9.1 clusters the data into polluting and less polluting subsectors; however, this is imperfect for precise analytical purposes. For example, the paper industry is grouped together with the cleaner activities of publishing and printing. Also, the pollution-intensive leather industry is grouped with the less polluting textiles and clothing industries. A more accurate data classification of investment flows to polluting and less polluting industries requires refined FDI data that are unavailable from most CEE countries (to the best of our knowledge) nor are they available from UNCTAD or other international sources. That said, Table 9.1 suggests that most FDI inflows to CEE are directed to relatively clean industries. In the Czech Republic, 14 per cent of FDI goes to pollution-prone subsectors, in Hungary 17 per cent, in Latvia

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Table 9.1 Environmental characterization of FDI inflows to CEE in 1997 and 1998 (%) Czech Hungary, Latvia, Poland, Slovakia, Slovenia, Republic, 1997 1998 1997 1998 1997 1997 Primary sector Pollution-prone Less polluting

1 0

1 1

0 1

0 1

1 0

0 0

Secondary sector Pollution-prone Less polluting

13 32

16 23

10 8

20 25

0 47

19 19

Tertiary sector

43

59

79

44

51

53

Unspecified

11

0

2

10

0

8

Notes: Pollution-prone industries from the primary sectors are mining, quarrying and petroleum. Pollution-prone industries in the secondary sector are textiles, leather and clothing; wood, paper, publishing, and printing; coke and petroleum products; chemical and chemical products; rubber and plastic products; and basic metals and metal products. The tertiary sector includes only less polluting industries. Source:

UNCTAD (1999, pp. 294–5, 435).

10 per cent, in Poland 20 per cent, in Slovakia 1 per cent and in Slovenia 19 per cent. The share of inward investment to pollution-prone subsectors in CEE is relatively small compared to pollution-prone FDI inflows to newly industrialized countries, especially Asian countries. UNCTAD (1999, p. 297) measured such flows to Brazil, Hong Kong, India, Indonesia, the Philippines, South Korea, Singapore and Thailand in 1990 and 1996. In those two years, the share of pollution-intensive inward investment to the manufacturing sector varied from a low of 15.7 per cent in Hong Kong (1990) to 68 per cent in Indonesia (1996). For most countries, the share was well above 30 per cent. The data in Table 9.1 is corroborated by national sources. Auer et al. (2001) report comparable data for Poland, based on indicators from the Polish Agency for Foreign Investment (PAIZ). The share of FDI inflows to pollution-prone industries as a percentage of overall FDI inflows to Poland declined from 24 per cent in 1993 to slightly more than 10 per cent in 1999. The discrepancy between the data reported here and that reported for pollution-intensive FDI inflows to Poland in the previous paragraph is likely due to the more refined data set used by PAIZ, that is, data disaggregated to the level of industry subsectors and sub-subsectors. In contrast, national level data cited by UNCTAD are compiled at a higher level of

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sector aggregation, leading to an overestimation of the amount of FDI flowing to pollution-prone industries in Poland and other CEE countries. To summarize, FDI inflows to CEE grew in the 1990s and most investments came from advanced industrialized countries. The EU supplied around two-thirds of FDI in CEE. FDI is important to CEE countries, in particular for capital formation, transferred technology and know how (Lansbury et al., 1996). Poland, the Czech Republic and Hungary absorb most of the FDI in CEE. The share of FDI inflows destined for pollutionprone subsectors in CEE was around 15 per cent during the 1990s, with considerable variation from country to country. However, pollutionintensive FDI inflows as a portion of overall inward FDI is greater in large industrializing Asian nations than in CEE countries.

THE COSTS AND BENEFITS OF FDI The costs and benefits of FDI to host countries are intensely debated. Much of the debate revolves around the interests and activities of multinational corporations (MNCs); MNCs account for the majority of world FDI. Here, we summarize the different positions.4 On the positive side, it is argued that MNCs promote technological progress and managerial efficiency, increase labor productivity and promote economic growth in the host country. Given the international scope of their business, MNCs have relatively great access to world markets, which indirectly benefits the host country by promoting local production and employment (Butler, 2000). Others argue that MNCs, the overwhelming majority of which are incorporated in industrialized countries, use cleaner production techniques since they must abide by stricter environmental codes in their home countries (Goldenman, 1999, p. 75). On the negative side, some authors argue that MNCs repatriate profits away from host countries hence depriving emerging economies of scarce income. Others argue that MNCs take advantage of market imperfections and legal gaps in developing countries and that they tend to focus on profits and market share to the exclusion of other concerns (D’Mello, 2002). It is also argued that MNCs absorb local talent and savings that could otherwise promote more lasting, local economic growth.5 Some have suggested that inward investment can exacerbate monopoly problems in host countries by concentrating wealth and facilitating collusion (Butts, 1997; Drahos and Joseph, 1995). Another view is that MNCs promote bad environmental practices because they are prone to shift their production activities to low-cost countries, including countries with low environmental standards (Daly, 1993).

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In the context of CEE, as summarized by Lucas (1997), it is argued that selling state-owned property to foreign investors distracts policy makers from the more complex task of macroeconomic reform and that it distorts CEE development. Another complaint is that CEE state-owned assets are sold below their ‘true’ value to attract foreign firms. These firms fail to invest adequately in R&D in newly bought firms and they tend to neglect local suppliers in favor of foreign counterparts. Others argue that MNCs do not attend to social needs in Central and Eastern Europe, instead, unfairly exploiting that region’s relatively cheap and abundant human, capital and natural resources (Henderson, 1995). Evidence of a strong positive relationship between FDI and economic growth in CEE is scarce (Smolik, 1997). However, some commentators (for example, SadowskaCieslak and Pac-Pomarnacki, 1991; Pac-Pomarnacki, 1998; Lucas, 1997; EBRD, 2001) detect a positive effect of FDI on CEE economic growth and expect stronger effects in the future, as MNCs provide management skills, replace equipment and participate in the privatization of state-owned enterprises. Notwithstanding this debate about the alleged pluses and minuses of FDI, CEE governments and CEE private sector actors generally welcome FDI. Some observers argue that FDI in CEE promotes environmental quality (Goldenman, 1999; OECD, 1999c). However, there is evidence that FDI has not been as ameliorative to the environment as originally hoped. Private investors’ decisions about where to invest in CEE are multidimensional, involving political, economic and environmental calculations and concerns (Meyer, 1998; Estrin et al., 1997; Smolik, 1997; Klavens and Zamparutti, 1995). However, anecdotal evidence suggests that a large fraction of FDI in CEE goes to greenfield investments. Some observers believe that this trend is associated with investors’ concerns about liability for past pollution (UNCTAD, 1998a; Linn, 1998; Bluffstone and Panayotou, 2000). Ensuing paragraphs consider these latter concerns, in detail.

MANAGING ENVIRONMENTAL LIABILITY RISKS Beginning in the early days of the post-communist era in CEE, donor countries and international financial institutions (IFIs) worried that poorly defined rules governing liability for past pollution in CEE would chase away prospective investors (see, for example, US General Accounting Office, 1994). However, there is considerable evidence that CEE governments made genuine progress in clarifying and instituting environmental liability rules beginning relatively early in the transition period. Some governments, including the government of Poland, quickly realized: (a) that

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liability rules governing past pollution had to be developed and deployed to reassure foreign investors; and (b) that the new liability regimes must provide an exemption or comparable incentives to investors, otherwise investors would steer away from contaminated properties, leaving the state with environmentally damaged assets and most or all of the cleanup costs. By the early 1990s, the Polish, Czech and Hungarian governments were using combinations of incentives to reassure investors, including, for example, allowing investors to subtract part or all costs for cleanup of past pollution from the purchase price of the property. Another popular inducement was to offer new owners limited liability against pollution cleanup and third-party damage claims, and/or escrow accounts whereby investors placed part of the property’s purchase in escrow to use for approved cleanup purposes, with the unused account balance reverting to the government after a specified time. In all three of these countries, problems cropped up with these various remedies. For example, in at least one instance, the Hungarian government’s reimbursement of cleanup costs to a new owner of a state-owned factory exceeded the purchase price of that factory (Heti Vilaggazdaság, 1994). Fearing a similar outcome, the Czech parliament slowed down the approval process for a deal between privatization authorities and Germany’s Volkswagen. The latter hoped to purchase the Czech automobile company, Skoda. Lawmakers worried that the Czech state was offering overly generous terms to Volkswagen for future environmental cleanup claims at Skoda (Wassersug, 1994). In Poland, escrow accounts were phased out in the mid-1990s after a court forbade future deals with this type of instrument. The court questioned the government’s claim on unused and expired escrow monies (S´leszynski, ´ 1999). CEE governments also made changes to environmental liability rules and procedures over the course of the 1990s that unsettled some investors. For example, the Czech government announced in the early 1990s that investors in the ‘first wave’ of privatization would not receive exemptions against pollution-related damage claims, whether or not these exemptions were issued at the time of the original property sale (Lawson, 1994). This policy was changed after confused and angry investors protested. Despite these problems, it is clear that CEE governments made reasonable efforts to assuage investors’ concerns about environmental liability by immunizing investors against damage claims and helping to pay cleanup costs, among other incentives. Moreover, some governments, including Poland, have been credited with streamlining environmental liability rules and procedures and with creating offices dedicated to negotiating these matters between the state and prospective investors. Certainly, improvements could be made to current liability schemes in these countries, including, for example, a system for more thorough and accurate inventorying of

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environmental damages at properties and increased availability of insurance to investors seeking protection against potential pollution cleanup and damage claims. But overall, legal assurances to foreigners who considered investing in contaminated properties were much more explicit and clear at the end of the 1990s than at the beginning of that decade. These reforms notwithstanding, it appears that clarification of environmental liability rules and relatively generous terms for indemnification and cleanup compensation have not accelerated private investment inflows to pollution-prone industries and contaminated properties in CEE. For example, in Poland, over the course of the 1990s, foreign investments in pollution-prone heavy and extractive industries fell as a percentage of total FDI to the Polish economy (Auer et al., 2001, pp. 18–19). A variety of factors – some having nothing to do with environmental liability – could explain this trend. But at a minimum, we can state that environmental liability reforms were not sufficient to move significant sums of foreign private investment into industries such as steel, metallurgy, mining and chemicals in Poland. Moreover, anecdotal evidence suggests that during the 1990s, in several CEE countries, many private investors built factories on greenfield sites rather than paying to cleanup and rebuild on old industrial sites.

PAST CONTAMINATION IN CEE: NOT JUST A LIABILITY PROBLEM More than merely an environmental dilemma, contaminated, moribund industrial sites in CEE are symptomatic of more complicated and entrenched problems. Areas harboring large numbers of polluted industrial properties are indicative of a broader kind of deprivation characterized by a lack of economic opportunity, high unemployment, lasting economic recession, poor public infrastructure, impaired public health and other socio-economic ills. In the United States, otherwise wealthy cities harbor pockets of economic backwardness and persistent poverty. High unemployment, broken families and de facto racial segregation are endemic to many of these neighborhoods. Frequently, these areas are blighted by shuttered factories, condemned warehouses and obsolete infrastructure, such as old, idle railway yards and empty, trash-strewn building lots. Auer et al. (2001) suggested that certain sub-national regions in Central and Eastern Europe evince similar combinations of social and environmental ills. We substantiate that argument here. Namely, we contend that: (1) enduring economic problems and persistent environmental ills occur in concert in parts of Central and Eastern Europe; and (2) economically and environmentally poisoned areas of CEE are distinctly disadvantaged and

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are deserving of renewed attention by European and American governmental and transnational actors such as the European Union, the European Bank for Reconstruction and Development, the World Bank Group and bilateral aid agencies. Economic and environmental trends from various CEE countries substantiate these arguments. Czech Republic Public health problems and ecological stress caused by pollution in the Northern Bohemia district of the Czech Republic is infamous in its scope, and many commentators describe this region as the country’s most environmentally damaged (see, for example, Environmental Resources Limited, 1990: 27). The Czech Republic is among Central Europe’s largest emitters of sulfur dioxide both in absolute and per capita terms, and Northern Bohemia, rich in sulfur-rich brown coal and lignite, is the origin of much of this pollution. At the end of the 1990s, Northern Bohemia was home to an inordinately large number of major emitters of dust and sulfur dioxide (Cˇesky´ Ekologicky´ Ústav, 2002). In addition, the majority of the republic’s largest emitters of arsenic – a known human carcinogen – resided in that region (Figure 9.1). Not coincidentally, mortality from malignant tumors

Source: Cˇesky´ Ekologicky´ Ústav (2002).

Figure 9.1 Twenty largest point sources of arsenic pollution in the Czech Republic, 1993–97

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Standardized mortality index (Czech Republic = 100) 0–90.9 91.0–96.9 97.0–102.9 103.0–108.9 109.0–114.9 115.0 and above

Maximum: Chomutov =129.0 Minimum: Pardubice = 81.4

Source: Czech Statistical Office (2001a).

Figure 9.2 Standardized mortality due to malignant neoplasm in the Czech Republic, 1996–99 average is more common in districts of Northern Bohemia than anywhere else in the country (Czech Statistical Office, 2001a). High pollution levels and elevated environment-related mortality rates also correlate with high, longterm unemployment rates (Czech Statistical Office, 2001b). In 1999, in Prague, the unemployment rate fluctuated between 3.6 and 4.2 per cent. It was three times higher in Northern Bohemia (Czech Statistical Office, 2000). Slovak Republic During the socialist period, central planners in Slovakia concentrated particular economic activities in particular regions, with some of the most highly pollution-prone industries located in the eastern city of Kosice. Unusually high mortality rates and medical pathologies in this region are blamed on the hangover from heavy industrial pollution. In Kosice, neonatal mortality (that is, death of newborns between zero to 28 days after birth) is nearly twice the rate of that in the capital, Bratislava (CommonHealth, 1997). Infant mortality (up to one year of age) is 14 for every 1000 live births in Kosice compared to 5.9 per 1000 live births in Bratislava. As concerned physicians note, Kosice is a relatively large city

Environmental cleanup in Central and Eastern Europe

Czech Republic = 38.4 Maximum:Most = 53.8 Minimum:Benesov = 12.8 ˆ

0–29.9 30.0–34.9 35.0–39.9 40.0–44.9 45.0 and above

193

Source: Czech Statistical Office (2001b).

Figure 9.3 Long-term unemployment as a percentage of total unemployment in the Czech Republic (31 December 2000) and some one-third of all births occur in the eastern half of Slovakia. Significantly lowering infant mortality in this region would substantially reduce the country’s infant mortality overall (CommonHealth, 1997). In the central town of Ziar nad Hronom, male workers in the local aluminum plant suffer from high rates of bladder cancer, and a high incidence of fluorosis has been documented in residents living near the smelter (Pavlínek and Pickles, 2000, p. 149). Poor health in Kosice and Ziar nad Hronom are exacerbated by a poor health care system, unhealthy lifestyles and chronically faltering local economies. Since the fall of communism in Slovakia, unemployment in central Slovakia and eastern Slovakia has been consistently higher than in all other regions in the country. In Kosice, the unemployment rate was 18.3 per cent in 1998, more than doubling over the course of the 1990s (OECD, 1999a). Hungary The Borsod-Abauj-Zemplen industrial zone in Hungary ails from the same combination of economic recession and environmental malaise as does Northern Bohemia in the Czech Republic and Kosice and Ziar nad Hronom in Slovakia. Among the more grim indicators of morbidity, people

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living in Borsod County, home to metal smelters and other pollution-prone factories, have higher stomach cancer rates, chronic bronchitis, emphysema and asthma than do ‘control’ towns with little or no industry (Hertzman, 1995, p. 34–5). High incidence of stomach cancers in Borsod County may also be a consequence of high nitrate levels in drinking water. Compared to a standardized national average of 100 for various indicators of public health, data from Borsod are disturbing: families in Borsod use physicians more frequently (112) than do average Hungarian families (100), but there are far fewer doctors per capita in Borsod than in the nation as a whole (74 doctors per 1000 persons in Borsod versus 100 doctors per 1000 persons as the standardized national average) (OECD, 1999b, p. 112). Correlated with high rates of illness in the Hungarian industrial heartland are high unemployment rates. In 2000, as in most years since the end of the communist era, Borsod-Abauj-Zemplen led all other Hungarian regions with more than 11 per cent of the labor force unemployed (Hungarian Central Statistics Office, 2002). Estonia Estonia’s most industrialized area resides in the northeast in the county of Ida-Viru. There, oil shale extraction, refining and combustion industries are prominent. So are the byproducts of these industries, including a landscape cratered and subsiding due to mining, ash fields contaminated with hazardous waste and poor air quality caused by two power plants that burn oil shale. By far, Ida-Viru leads all other counties in the production of sulfur dioxide and dust – due largely to the activities of the power stations (Ministry of Environment of Estonia, 1997, pp. 49–50). During the 1980s, respiratory illnesses were 1.5 times higher among children living in northeastern towns than in the population as a whole. Hypertension and sensitivity to allergies in adults were 2.7 and 2.5 times as high, respectively, in the northeast versus the rest of Estonia (Silla, 1996, p. 164). Estonian physicians believe these and other elevated morbidity rates are linked to relatively high concentrations of air pollution in the northeast, including in Kohtla-Jarve, Kivioli and Narva. But lower access to health care and relatively depressed economic conditions in this region contribute to the public health crisis. In the late 1990s, average gross wages for Estonian workers in the northeast rose less steeply than did wages in the country as a whole (Figure 9.4). Moreover, GDP per capita in the northeast was between 60.0 and 67.3 per cent of the national average during the late 1990s (Statistical Office of Estonia, 2001). An important and troubling aspect of this situation is that a majority of the population in the northeast is ethnic Russian.

Average monthly gross wages (kroons)

Environmental cleanup in Central and Eastern Europe 4500 4000 3500 3000 2500 2000 1500 1000 500 0

195

Ida-Viru county Estonia (all counties)

1995

1996

1997

1998

Year Source: Data adapted from Ida-Viru County (2001).

Figure 9.4 Average monthly gross wages (kroons) in Ida-Viru County versus all Estonian counties Russian-speaking residents occasionally query whether the national government in Tallinn pays enough attention to the economic and environmental problems of the northeast. Poland The heavily industrialized Upper Silesian region is Poland’s most polluted territory. Katowice Voivod in Silesia is among the most notoriously damaged, with serious environmental problems across various environmental media. To illustrate, its agricultural crops contain high concentrations of heavy metals: a thorough inventory and environmental assessment of farm land in Katowice found less than 40 per cent of plots fit for unrestricted cultivation (Hertzman, 1995, p. 21). Cadmium and lead concentrations in potatoes from parts of Katowice greatly exceed World Health Organization maximum acceptable limits. As Hertzman notes, because heavy metals persist in soils, reducing emissions from new pollution sources will not alleviate this problem. Blood lead levels in children in Katowice Voivod are higher than in children living in less contaminated subregions of the country. Consequently, Katowice’s children suffer from elevated rates of anemia, diseases of the digestive tract, chromosome abnormalities and epilepsy (Hertzman, 1995, p. 22). As is true of the other contaminated subregions of Central and Eastern Europe mentioned above, Upper Silesia’s environmental and public health problems are correlated with severe economic deprivation. In 2000,

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Table 9.2 Rate of increase in unemployment in fourth quarter 2000 versus November 1997 across Polish Voivodships Voivodship (subregion)

Increase of 4th quarter 2000 unemployment rate over Nov. 1997 unemployment rate (%)

Dolnoslaa˛skie Kujawsko-Pomorskie Lubelskie Lubuskie L ⁄ òdzkie Ma l⁄opolskie Mazowieckie Opolskie Podkarpackie Podlaskie Pomorskie S´la˛skie S´wie˛tokrzyskie Warminsko-Mazurskie Wielkopolskie Zachodniopomorskie

64.5 41.1 72.7 86.5 51.3 25.0 52.4 43.8 51.7 44.3 62.5 104.5 47.1 29.7 88.6 25.0

Source: Adapted from Polish Statistics Office (2001).

unemployment in Upper Silesia hovered around 17 per cent. This is high by any reasonable standard, though not the highest rate of any Polish subregion. However, there is some evidence that as the Polish economy experiences a nationwide slowdown, economic hardship in Upper Silesia is especially severe (Table 9.2). Slaskie, which encompasses Upper Silesia, was the only subregion in Poland where the unemployment rate more than doubled between November 1997 (the earliest date when such data were recorded in the newly designed Voivod system in Poland) and the fourth quarter of 2000.

BROWNFIELDS REVITALIZATION Since economic and environmental problems go hand in hand in these subregions of Central and Eastern Europe, it is sensible for CEE governments at various levels – from local to national – to devise multi-faceted strategies to resuscitate these local economies. As the CEE experience reveals,

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clarification and incentivization of environmental liability schemes, alone, will not solve the problem, and in particular, are not sufficient to move large private resources into contaminated industries in CEE. This outcome is unsurprising since environmental liability is only one of the problems that encumber these industries and the locales where they reside. Environmentally contaminated industrial lands and the communities that surround them need economic stimuli that include, but are not confined to, liability-related incentives. Western-style brownfields revitalization programs offer more versatile remedies. In the United States, Germany, the Netherlands, Austria and England, governments have experimented with combinations of legal and economic reforms to encourage private cleanup of contaminated publicly and privately owned land. In the United States, for example, the federal government has entered into ‘covenant not to sue’ arrangements with purchasers of old, contaminated lands. These covenants protect investors against the more onerous clauses of the ‘Superfund’ law governing cleanup of sites with serious hazardous waste contamination. Superfund imposes strict, retroactive, joint and several liability: owners are liable for past pollution on properties they purchase, whether or not they generated the pollution in question. Brownfields revitalization programs often partly or fully exempt purchasers from this liability assignment. Even more generous amnesty provisions have been offered to purchasers of contaminated properties in eastern Germany, in the Netherlands and in Austria. The rationale for granting immunity is to lure investors to make what are otherwise legally and financially precarious investments. CEE governments are certainly capable of instituting similar limited and non-retroactive liability arrangements. Indeed, and as discussed above, the Czech, Hungarian and Polish governments have, at times, adopted similar schemes. But it is not the legal requirements for brownfields revitalization that are impractical for CEE governments. The key obstacle is that brownfields revitalization is costly. Moreover, cleanup costs are seldom the sole responsibility of private actors. In Western Europe and the United States, governments have played major roles in paying for cleanup. Most CEE governments are precluded from doing likewise. In Germany, taxpayer money covered most of the cleanup of the Ruhrgebiet in Nordrhein-Westfalen – a region where more than two-thirds of Germany’s old, derelict factories and contaminated industrial lands reside (Meyer et al., 1995). Similarly in Austria, the Netherlands and the UK, governments are prominent actors in the cleanup of old, contaminated lands. This is the case even in instances where governments have identified private sector culprits of past contamination (see, for example, Kasamas, 1995).

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This level of domestic, public sector largesse is impractical for CEE governments to copy, and not simply because CEE governments and taxpayers lack ‘deep pockets’ to pay for cleanup of communist-era pollution. No less important is that, in CEE, there is a bias toward abating future pollution rather than cleaning up past pollution. CEE governments that aspire to EU membership are obliged to reduce emissions to levels approximating those of member states. Moreover, the primacy of pollution abatement is reinforced by donor governments and international financial institutions (IFIs) who have declared, formally, a preference for pollution prevention over pollution cleanup. The OECD reports that, in CEE, most private sector environmental investments are channeled to pollution prevention. Hence, neither CEE governments, bilateral donors nor IFIs are focusing primarily on cleaning up CEE’s past pollution. This situation condemns old, contaminated lands, the factories on them and the neighborhoods around them, to a dismal economic and environmental future.

CLEANING UP PAST POLLUTION IN CEE In light of the financial constraints faced by CEE countries, in the near future, external public actors are the most promising sources of financing for brownfields revitalization. These actors include private investors, bilateral aid agencies and international financial institutions who offer credit at concessionary rates of interest. The last element deserves elaboration. CEE countries are not low-income countries, but neither they are rich. These countries face the formidable challenge of transforming their economies, efforts that will continue for years to come. In light of the likely accession of several CEE countries into the EU, it is in the EU’s interest and in the interest of supporters of EU enlargement (including the US) to promote sustainable development in CEE. Part of the process of environmental restoration is cleaning up beleaguered subregions that are at once environmentally and economically distressed. These regions should qualify for aid, much as American inner cities in the Great Lakes region and the Northeast, with their combinations of persistent high unemployment, high crime rates and boarded-up businesses and brownfields are recipients of federal assistance. In a prospective plan to revitalize depressed subregions of CEE, loans from external public sector actors could be managed by CEE governments, and the cleanup of past pollution administered by joint ventures between governments and foreign and domestic private investors. Restored sites could be transferred to private hands and some portion of revenues from the operation of the transferred properties returned to the lending

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institution(s). CEE governments are capable of supervising the cleanup and adopting the appropriate regulatory environment to facilitate this aid regime. Since many of the properties in question are state-owned or formerly state-owned, CEE governments are knowledgeable about the particular problems at each site. It is true that many CEE governments, especially in the southern tier of the region, have been slow, and in many cases, reluctant to transfer public properties to private hands. Nevertheless, for the foreseeable future, it is appropriate that CEE governments play a significant role in brownfields cleanup and revitalization schemes since many of the properties in question are publicly owned. To facilitate the process, CEE governments must grant foreign investors and IFIs fairly generous immunity to liability from past environmental damages. Some, and in certain cases, all cleanup costs and third-party damage claims would be borne by CEE governments themselves. This otherwise unbearable burden is lightened in the scheme proposed here because cash-strapped CEE governments would receive short-term financing from IFIs, the European Union’s pre- and post-accession facilities, from bilateral donors and from private investors who take equity stakes in revitalized brownfield projects. Moreover, private insurers would play a much larger role in the region than they currently do. In ensuing paragraphs, we consider the prospective roles played by a variety of external actors, with special attention to IFIs and the EU.

EXTERNAL PUBLIC FINANCIAL SOURCES Four actors/instruments that can help expedite cleanup of past pollution in CEE are the International Finance Corporation (IFC) of the World Bank Group, the European Bank for Reconstruction and Development (EBRD), the Instrument for Structural Policies for Pre-accession (IPSA) and the EU’s Objective 1 funds. International Finance Corporation The IFC is the largest multilateral source of funds for development projects in LDCs that involve foreign and local private capital and/or public–private joint ventures.6 A member of the World Bank Group, the IFC was established in 1956 to promote private sector development in low-income countries. This mission is advanced through project financing, helping companies raise money in international financial markets, and providing technical assistance and advice to governments and businesses. The financial products offered include long-term loans and currency hedging, various

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equity-based instruments, and loan guarantees and standby financing instruments. Currently, there are 174 member countries in the IFC, all of whom are members of the World Bank Group’s International Bank for Reconstruction and Development (IBRD). Member countries are either donors or nondonors. Donors are typically advanced industrialized countries whereas CEE countries who joined in the late 1980s and early 1990s are non-donors. The latter are eligible for IFC loans. Most IFC project operations are financed through institutional borrowing in international markets. Around 20 per cent of the IFC’s funds are borrowed from the IBRD. The IFC’s lending policies are appropriate to the challenges of brownfields cleanup and revitalization in CEE. The IFC requires that financed projects produce profits for investors and are beneficial to the economy as a whole. These are reasonable requirements for economies in transition. Second, IFC projects must comply with strict environmental standards. In practice, brownfields cleanup will not restore the environment to pristine conditions. Nevertheless, cleanup of brownfields to a level that is appropriate for industrial and commercial uses – a practice condoned in Western Europe and the United States – is a model worth striving for in CEE and is consistent with the spirit, if not the letter, of IFC lending rules. Third, the IFC finances projects that are private–public partnerships, provided that the project is managed on a commercial basis. Owners may include combinations of foreign and host country actors. These management and ownership schemes are appropriate for the cleanup of past pollution in CEE; the record already shows that successful cleanup of old contamination in CEE tends to involve multiple actors – public and private, foreign and domestic – and that the best experiences involve enterprises that operate on a commercial basis. Consider, for example, the cleanup and revitalization of Kunda Cement in Estonia – a large, pollution-prone enterprise bought by an Asian investor from the Estonian government in the mid-1990s. The retrofitting and modernization of that facility were greatly assisted by a $44 million loan from the IFC. By the mid-1990s, Kunda Cement had reduced its emissions of dust from a high of more than 160 kg per ton cement to less than 1 kg per ton (Auer and Raukas, 2002). European Financial Institutions Given their quest to join the EU, CEE countries could approach Europeanbased sources of capital to fund cleanup of past pollution. Two possible sources of financing are the EBRD and ISPA.7 The EBRD was established in 1991 to foster economic transition in CEE and the former Soviet Union through private–public co-financing of

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projects. The financing instruments of the EBRD include guarantees, equity investments and loans. The EBRD is organized into three country groups (Central Europe; Russia and Central Asia; Southern and Eastern Europe and the Caucasus) and three sector groups (financial institutions; infrastructure; and industry and commerce). The EBRD emphasizes sustainable development and environmentally sound practices as criteria for project financing. To date, most of the environment-related projects financed by the Bank deal with prospective pollution. But cleanup of past pollution could be an elevated priority of at least two Bank groups. The industry and commerce group promotes private sector participation and investments in oil, gas, petroleum and mining industries.8 The infrastructure group focuses on, inter alia, drinking water and sewage treatment infrastructure projects. Brownfields cleanup – though not a major area of lending in these groups – could and should be a higher priority, particularly for projects with promising commercial prospects. The European Union’s Instrument for Structural Policies for Preaccession (ISPA) maintains a different approach to aid. The ISPA was established in 1999 by the European Council. The Council authorized more than a billion euro (over the period 2000–2006) for CEE countries preparing to join the EU, namely, Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. Most ISPA assistance is in the form of grants, focusing on environmental infrastructure and transportation. Environmental projects help enable eligible countries to comply with EU environmental directives and standards. The ISPA charter embraces assistance to remedy severe environmental problems in CEE, making it a plausible source for the cleanup of past pollution in the region. ISPA funds are apportioned on the basis on recipient countries’ GDP per capita, population size and land area. The countries receiving the largest shares of ISPA funds are Poland (30–37 per cent) and Romania (20–26 per cent). Other recipients are Bulgaria (8–12 per cent), the Czech Republic (5.5–8.0 per cent), Lithuania (4.0–6.0 per cent), Slovakia and Latvia (3.5–5.5 per cent, each) and Estonia and Slovenia (2.0–3.5 per cent and 1.0–2.0 per cent, respectively). ISPA projects may finance up to 85 per cent of total project costs, depending on the availability of matching funds and the potential revenue generated by the project. Upon accession to the EU, CEE countries lose their entitlement to ISPA funds. However, with accession, new member countries may become eligible for the EUs so-called ‘Objective 1’ funds. These resources may be used for brownfields revitalization. Other recent admittees to the EU have received access to these funds, so it is plausible that CEE members will be accorded similar privileges. Compared with the IFC and the EBRD, the ISPA and Objective 1 funds

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offer cheaper, more flexible and more attractive sources of financing for CEE countries seeking to remediate past pollution. But to date, and with the exception of Objective 1, anecdotal evidence suggests that most of these institutions and instruments tend to favor remediation of prospective pollution over cleanup of past pollution.

REVITALIZING EXTERNAL PARTICIPATION IN THE CLEANUP OF POLLUTION IN CEE In this chapter, we propose that the donor community re-examine the basis for making – or not making – loans and concessionary grants available to regions that are at once environmentally challenged and economically depressed. Referring not to CEE countries but to lesser developed countries, a recent article by Ricardo Hausmann (2001) calls for a similar reassessment of ‘business as usual’ by the donors. Hausmann notes that physical geographical explanations for persistent poverty in lesser developed countries are coming back into vogue. The resurgence of geography for understanding underdevelopment is inspired, in part, by waning confidence in the World Bank’s and other IFIs’ conventional explanations for persistent poverty in LDCs. Hausmann provides an alternative explanation, urging that ‘bad latitude’ condemns countries between the Tropics of Capricorn and Cancer to poverty. Regions with bad latitude are often landlocked, tend to face much steeper travel costs to get their products to market, have trouble coordinating infrastructure expenditures with neighboring regions, have less incentive to spend on R&D, and have a host of other problems (Hausmann, 2001, pp. 47–9). We contend that another problem, born of geography, affects polluted and economically depressed regions of Central and Eastern Europe. Not so much a function of ‘bad latitude’, ailing subregions of CEE are victims of ‘dirty factor endowments’. They suffer from natural, geographical disadvantages vis-à-vis neighboring regions. True, in earlier decades, other regions envied the great veins of brown coal and lignite in Upper Silesia and Northern Bohemia and the vast oil shale deposits in northeast Estonia. Moreover, these resources were the backbone of local industry. But as factors of production, these resources are of comparably poor monetary and energy value and are environmentally pernicious. The combination of dirty factors endowments and economic planners who ordered the indiscriminate and careless exploitation of these resources led to enduring environmental problems that are not ameliorated by pollution abatement. So far, the crisis of past pollution in many subregions of CEE has lasted longer because resources for pollution management – whether from public

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or private sources or from foreign or domestic actors – are directed primarily at pollution prevention or pollution control projects rather than cleanup of past pollution. The emphasis on pollution abatement rather than pollution cleanup is consistent with norms enunciated at the Aarhus Conference (Linn, 1998) and is justifiable on cost and environmental grounds. However, this policy has negative consequences in that past pollution is neglected, leaving potentially productive capital and land assets idle, and rendering some regions economically depressed and environmentally poisoned. Since domestic public and private investment in these countries is channeled preferentially to pollution prevention and control, financing for cleanup of past pollution must come from external sources. Foreign private investors are potential participants in this endeavor, but precisely because foreign investors are wary about liability for past pollution and are naturally inclined to greenfield projects, these actors will not cleanup brownfields in the absence of external public investment. It is time for external public sector actors, including the IFIs (such as the IFC and the EBRD, both of whom work closely with private sector actors) and the European Union, to elevate their participation in cleanup of past pollution, since these entities are the most promising actors to jumpstart the process. Bilateral aid agencies like the United States Agency for International Development should return to the table too, especially since, as argued above, various subregions of CEE qualify for concessionary aid in the de facto sense that these areas are chronically economically and environmentally distressed.

NOTES 1. CEE countries include Poland, Hungary, Czech Republic, Slovakia, Romania, Bulgaria, Albania, the successor countries of communist-era Yugoslavia, and the Baltic States. 2. For this indicator (largest national sources of inward investment to CEE), CEE includes Russia and Ukraine. 3. UNCTAD (1999, p. 297, notes to table x.3) define production of rubber and plastics as pollution-intensive in developing countries though not in industrialized countries. We adopt a conservative approach and assume that manufacturing of these products in CEE is relatively pollution-intensive. 4. For a recent review, see Moran (1999). 5. A recent article contends that not only developing countries but also wealthy countries can be hurt by FDI: McVicar (2002) found that FDI and imports have powerful marketstealing effects on domestic manufacturers in Great Britain. 6. Regarding the structures and functions of the IFC, see: www.ifc.org. 7. See www.ebrd.org for more information on the EBRD. See EU (2001) for more information on the EU’s Instrument for Structural Policies for Pre-Accession. 8. By the end of 2000, EBRD had signed 32 projects in the natural resources sector, with a total investment of around 1.4 billion euro (around US$ 1.4 billion).

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REFERENCES Auer Matthew, and Anto Raukas (2002), ‘Determinants of Environmental clean-up in Estonia’, Environment and Planning C: Government and Policy, 20(5), 679–98. Auer, M., R. Reuveny and L. Adler (2001), ‘Environmental Liability and Foreign Direct Investment in Central and Eastern Europe’, Journal of Environment and Development, 10, 5–34. Bluffstone, Randall A., and Theodore Panayotou (2000), ‘Environmental Liability and Privatization in Central and Eastern Europe: Toward Optimal Policy’, Environmental and Resource Economics, 17, 335–52. Butler, N. (2000), ‘Companies in International Relations’, Survival, 42(1), 149–64. Butts, D. (1997), ‘Joblessness, Pain, Power, Pathology and Promise’, Journal of Organizational Change Movement, 10(2), 111–29. CommonHealth (1997), ‘Improving Perinatal Care in Eastern Slovakia’, http:// www.aiha.com/English/pubs/spr 97/slovakar.cfm (accessed 29 May 2002). Cˇ eskyˇ Ekologicky´ Ústav (Czech Ecology Institute) (2002), ‘Mapy registru kontaminovany´ch ploch – GIS’, http://gis.ceu.cz/rkp/ (accessed 4 June 2002). Czech Statistical Office (2000), Employment and Unemployment in the Czech Republic as Measured by the Labour Force Sample Survey (4th Quarter of 1999), www.czso.cz/eng/figures/2/31/09129948/data/tso505cq4.pdf (accessed 2 May 2001). Czech Statistical Office (2001a), Standardized Mortality Due to Malign Neoplasm – 1996–1999 Average (map), http://www.czso/cz/eng/figures/1/12/127201/m12.htm (accessed 26 May 2002). Czech Statistical Office (2001b), Proportion of Long-time Unemployed Persons per All Unemployed (31 December 2000) (map), http://www.czso.cz/eng/figures/ 1/12/127201/m19.htm (accessed 26 May 2002). Daly, H. (1993), ‘The Perils of Free Trade’, Scientific American, November, 50–7. D’Mello, B. (2002), ‘Transnational Pharmaceutical Corporations and Neo-liberal Business Ethics in India’, Journal of Business Ethics, 36(1–2), 165–85. Drahos, P., and R.A. Joseph (1995), ‘Telecommunications and Investment in the Great Supranational Regulatory Game’, Telecommunications Policy, 19(8), 619–35. EBRD (European Bank for Reconstruction and Development) (2001), ‘Recent Developments in the Transition Process’, http://www.ebrd.com/new/index.htm (accessed 29 May 2002). Environmental Resources Limited (1990), Eastern Europe: Environmental Briefing, January 1990, London: Environmental Resources Ltd. Estrin, Saul, Kirsty Hughes, and Sarah Todd (1997), Foreign Direct Investment in Central and Eastern Europe: Multinationals in Transition, London: Pinter. European Union (2001), ‘ISPA Manual: Working Document (July 2001)’, http:// europa.eu.int/comm/regional_policy/funds/download/mnu_en.pdf (accessed 29 May 2002). Goldenman, G. (1999), ‘The Environmental Implications of Foreign Direct Investment: Policy and Institutional Issues’, Foreign Direct Investment and the Environment, Paris: OECD, pp. 75–91. Hausmann, R. (2001), ‘Prisoners of Geography’, Foreign Policy, January/February, 45–53. Henderson, A. (1995), ‘The Politics of Foreign Investment in Eastern Europe’, Problems of Post-Communism, 42(3), 51–6.

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Hertzman, Clyde (1995), Environment and Health in Central and Eastern Europe: A Report for the Environmental Action Programme for Central and Eastern Europe, Washington, DC: The World Bank. Heti Vilaggazdaság, (1994), ‘Hungary: LEHEL Environmental Programme Nears Completion’, 22 October (On-line). Available: Nexis, Europe Library. Hungarian Central Statistics Office (2002), Number of Full-Time Employees, Earnings, Unemployment, http://www.ksh.hu/pls/ksh/docs/index_efontosabb_ adatok.html (accessed 29 May 2002). Ida-Viru County (2001), Average Monthly Gross Wages, http://www.ida-virumaa. ee/ivarvudes/keskminepalk.html (visited 30 April 2001). Kasamas, H. (1995), ‘The Contaminated Land Programme in Austria’, Chemistry and Industry, 13, 512–13. Klavens, J., and A. Zamparutti (1995), Foreign Direct Investment in Central and Eastern Europe: A Survey, Washington, DC: World Bank. Lansbury, M., N. Pain, and K. Smidkova (1996), ‘Foreign Direct Investment in Central Europe since 1990: An Econometric Study’, National Institute Economic Review, 156, 104–13. Lawson, M.L. (1994), ‘New Owners Bear Brunt of their Property’s Old Ecological Problems’, Prague Post, 20 April, 1. Leonard, H.J. (1988). Pollution and the Struggle for the World Product: Multinational Corporations, Environment and International Comparative Advantage, Cambridge: Cambridge University Press. Linn, Johannes (1998), ‘Keynote Speech on Environmental Financing’, Environment for Europe: Aarhus, Denmark, 23–25 June 1998 (http://www. mem.dk/aarhus-conference/statements/worldbank.htm) (accessed 29 May 2002). Low, P., and A. Yeats (1992), ‘Do “Dirty” Industries Migrate?’, in P. Low (ed.), International Trade and the Environment, World Bank Discussion Paper No. 159 Washington, DC: The World Bank, pp. 89–103. Lucas, Edward (1997), ‘Business in Eastern Europe: The Next Revolution’, The Economist, 22 November, Survey 4–22. McVicar, D. (2002), ‘Spillovers and Foreign Direct Investment in UK Manufacturing’, Applied Economic Letters, 9(5), 297–300. Meyer, Klaus (1998), Direct Investment in Economies of Transition, Cheltenham: Edward Elgar. Meyer, P.B., R.H. Williams, and K.R. Yount (1995), Contaminated Land: Reclamation, Redevelopment and Reuse in the United States and the European Union, Aldershot: Edward Elgar. Ministry of Environment of Estonia (1997), Keskkond 1996 (Estonian Environment 1996), Tallinn: Ministry of the Environment of Estonia. Moran, Theodore H. (1999), Foreign Direct Investment in Development: The New Policy Agenda for Developing Countries and Economies in Transition, Washington, DC: Institute for International Economics. OECD (Organization for Economic Cooperation and Development) (1999a), OECD Economic Surveys 1998–1999: Slovak Republic, Paris: OECD. OECD (Organization for Economic Cooperation and Development) (1999b), OECD Economic Surveys 1998–1999: Hungary, Paris: OECD. OECD (Organization for Economic Cooperation and Development) (1999c), Environment in the Transition to a Market Economy: Progress in Central and Eastern Europe and the New Independent States, Paris: OECD.

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Pac-Pomarnacki, R. (1998), ‘Foreign Direct Investment in Poland’, Polish Agency for Foreign Investment, www.pnsnmarket.com (accessed 03 May 2001). Pavlínek, P., and J. Pickles (2000), Environmental Transitions: Transformation and Ecological Defence in Central and Eastern Europe, London: Routledge. Polish Statistics Office (2001), Unemployment Rate, http://www.stat.gov.pl/english/ index.htm (accessed 2 May 2001). Sadowska-Cieslak, E., and R. Pac-Pomarnacki (1991), Foreign Investments in Poland: Experience and Prospects, Warsaw: Foreign Trade Research Institute. Silla, R. (1996), ‘The Impact of Pollution on Human Health’, in Estonian Environment: Past, Present and Future, Tallinn: Ministry of Environment of Estonia, pp. 164–71. Sinn, H-W., and A.J. Weichenrieder (1997), ‘Foreign Direct Investment, Political Resentment and the Privatization Process in Eastern Europe’, Economic Policy, 24, 179–210. S´leszy´nski, J. (1999), Privatization and Environmental Policy: Environmental Liability in Transition Period. The Experience of Poland and Former GDR, Warsaw: University of Warsaw, Faculty of Economic Sciences. Smolik, Joe (1997), An Overview of the Integration Tendencies of the Transition Economies, Geneva: United Nations Economic Commission for Europe. Statistical Office of Estonia, Regional Gross Domestic Product at Current Prices, 1996, http://www.stat.vil.ee/pks/index1i.html (accessed 2 May 2001). United Nations Conference on Trade and Development (1998a), United Nations Conference on Trade and Development, Press Release, 2 November, Press Unit, Geneva: UNCTAD. United Nations Conference on Trade and Development (1998b), World Investment Report 1998, New York: United Nations. United Nations Conference on Trade and Development (1999), World Investment Report 1999, New York: United Nations. United Nations Conference on Trade and Development (2001), World Investment Report 2001, New York: United Nations. US General Accounting Office (1994), Environmental Issues in Central and Eastern Europe: U.S. Efforts to help Resolve Institutional and Financial Problems (Document GAO/RCED-94-41), Washington, DC: US General Accounting Office. Wassersug, S.R. (1994), ‘Limiting Environmental Liabilities in Privatization in Central and Eastern Europe’, Environmental Claims Journal, 6(3), 391–418.

10.

How can economies in transition pursue emissions trading or joint implementation?* Fanny Missfeldt and Arturo Villavicenco

INTRODUCTION Although the adoption of the Kyoto Protocol (KP) dates back to 1997, it was only in November 2001 that essential guiding rules for the Kyoto Mechanisms were adopted as part of the Marrakesh Accords. The Kyoto Mechanisms comprise emissions trading (Article 17 KP), joint implementation (JI, Article 6 KP) and the Clean Development Mechanism (CDM, Article 12 KP). Sometimes the provision for several countries to commit to a joint emissions target (Article 4 KP) is also referred to as one of the mechanisms (Missfeldt, 1998).1 The Marrakesh Accords (UNFCCC, 2001b) present framework rules for those issues that were put forward for further elaboration through the Buenos Aires Plan of Action (1998). Among the Kyoto Mechanisms, emissions trading and JI apply to the countries with economies in transition (EITs). In principle, EITs could also invest in CDM projects in developing countries. However, none of the countries in the region has shown any interest in doing so. Many have maintained that the economies in transition may stand to gain substantially from the Mechanisms, especially from emissions trading (Korppoo et al., 2001; Missfeldt and Villavicenco, 2000). According to the United Nations Framework Convention on Climate Change (adopted in 1992) most economies in transition have adopted an emission reduction target under Annex B of the Kyoto Protocol, and are therefore considered as ‘Annex B’ Parties. ‘Non-Annex B’ Parties are those countries without legally binding emissions reduction targets, which are mostly developing countries. Nevertheless countries such as Kazakhstan, Kyrgyzstan, Uzbekistan, Turkmenistan, Tajikistan, Georgia and Azerbaijan are economies in transition without a legally binding target. In the following discussion we will focus on those countries that are member of Annex B.

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Among the economies in transition, both Russia and the Ukraine have been allocated particularly lenient targets of stabilization of their emissions at their 1990 levels by 2012. Because of the dramatic slump of economic output in both countries, greenhouse gas emissions have dropped. This leaves both countries a substantial amount of tradable units in an international emission trading market. In March 2001, President Bush stated that the USA did not intend to ratify the Kyoto Protocol (Korppoo et al., 2001). In order to ratify the Kyoto Protocol without the USA, the EITs, Japan and the European Union are necessary. This follows from Article 25, which sets out that a minimum 55 Parties have to ratify the Kyoto Protocol, representing a minimum of at least 55 per cent of total carbon dioxide (CO2) emissions in 1990 (UNFCCC, 1997). Both the European Union and Japan have ratified the Kyoto Protocol. The withdrawal of the USA also casts a question mark over the future of the Kyoto Mechanisms. Estimates by Hagem and Holtsmark (2001) indicate that the drop in demand per ton of carbon equivalent (tC) as induced by the withdrawal of the USA would result in a drop of greenhouse gas market prices from US$10–12 to around US$5. If credits from the forestry and agricultural sector for the uptake of CO2 emissions are included, this number is likely to be lower. In the following sections we discuss the potential benefits from emissions trading and JI. We consider factors necessary for successful implementation of emissions trading and JI. The institutional structure for the implementation of JI through public administration is pivotal for the sustained success of the implementation of the Mechanisms. At the international level, revenue can be maximized by limiting sales from the region.

THE KYOTO MECHANISMS POST-MARRAKESH JI is generally thought of as a project-based mechanism where emission reductions are measured on a credit against baseline method. Emissions trading is considered a cap and trade mechanism. Actual boundaries between both mechanisms in physical terms may be blurred. In terms of the Kyoto Protocol, the major difference between emissions trading and JI is the requirement that JI has to be ‘additional to what would have happened otherwise’. This means that the potential burden for JI would be higher, as it would involve proof of such additionality. This has led some observers to suggest that they would undertake JI as a project-based mechanism, but register it as an emissions trade in order to avoid the burden of proof of additionality (EBRD, 1998).

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However, in September 2000 in a negotiating session of the UN Framework Convention on Climate Change (UNFCCC) the European Union and the USA-led ‘umbrella group’ had agreed in principle to a facilitating deal called the ‘two-track approach’. The Marrakesh Accords specify the terms and conditions under which this approach will operate in the future. The two-track approach implies that a CDM-like approach for JI projects remains possible even if a country does not fulfil all eligibility requirements. The first track implies that as long as countries are able to fulfil all eligibility criteria up to the standards required under the UNFCCC/Kyoto Protocol, JI and emissions trading can go ahead without any further thirdparty review. The host country will be responsible for verifying the additionality of a project and for issuing the emission reduction units (ERUs) (UNFCCC, 2001b, Guidelines for the Implementation of Article 6 under the Kyoto Protocol, Annex, paragraph 23). These eligibility requirements are: ● ● ●

● ● ●

ratification of the Kyoto Protocol; calculation and recording of the ‘assigned amount’; a national system for the estimation of greenhouse gas emissions and sources is in place; a national registry is established; submission of the most recent required inventory; additional information about the ‘assigned amount’.

The ‘assigned amount’ is the amount of greenhouse gas emissions that a Party may spend in terms of greenhouse gas emissions and that a Party may increase through the purchase of credits from the Kyoto Mechanisms. Excess ‘assigned amount’ can be sold through emissions trading. If the eligibility requirements for this first JI track are only partially fulfilled, a clean development mechanism (CDM)-like process for accreditation of JI projects would be required.2 This would mean that emissions reductions are to be verified by an ‘independent entity’ who has been accredited through the ‘Article 5 supervisory committee’. The independent entity will verify the project following the verification procedure set out for Article 6 activities. It will thereby take into account the criteria for baseline setting and monitoring developed in the Marrakesh Accord (UNFCCC, 2001b, Guidelines for the Implementation of Article 6 under the Kyoto Protocol, Annex, Section E and Appendix B). Any country that is eligible for the simple track of JI may still resort to using the track two approach. The minimum requirements for participation in track two of JI are: ratification of the Kyoto Protocol; calculation and recording of the assigned

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Table 10.1 Fulfilment of eligibility requirements for the Kyoto Mechanisms Annex B Countries

Kyoto Kyoto Use of Total number Target for Protocol Protocol Common of National completion ratification target1 Reporting Communications of the Format submitted registry in 2001 (three required) design (year)

Bulgaria Croatia Czech Rep. Estonia Hungary Latvia Lithuania Poland Romania Russian Federation Slovakia Slovenia Ukraine

In process In process Yes

⫺8 % ⫺5 % ⫺8 %

Yes

In process In process In process In process Yes Yes In process

⫺8 % ⫺6 % ⫺8 % ⫺8 % ⫺6 % ⫺8 % 0%

Yes Yes Yes

Yes In process In process

⫺8 % ⫺8 % 0%

Yes

Yes

Yes

2 1 3 3 2 3 1 3 2 2 3 0 1

2004 2004

2003 2003

2003 2002

Note: 1Specified in terms of percentage reduction as compared with the country’s base year. Sources: UNFCCC (2001c); UNFCCC (2002).

amount, and establishment of a national registry (UNFCCC, 2001b, Guidelines for the Implementation of Article 6 under the Kyoto Protocol, Annex, paragraphs 21 and 24). The simplification compared to the first track of JI is not as extensive as it may appear. In order to establish the assigned amount, Parties have to submit a complete set of inventories from the base year through the last year and describe their national system. Six Parties in the region are currently actively pursuing the establishment of a registry. This does not include Russia and the Ukraine, among the largest potential sellers. Table 10.1 illustrates which reporting requirements are currently being met by countries in the region. Four countries have ratified the Kyoto Protocol, and a ratification process is under way in all countries in the region. Seven of 12 countries reported, in 2002, their annual inventories in

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accordance with the common reporting format (CRF), and five of 12 countries have submitted all three required national communications on greenhouse gas emissions, which illustrate policies and measures in the area of climate and report on emission trends in a country. This is only slightly worse than the performance of the European member states, where only eight of 15 countries submitted all required national communications. The countries that will have the biggest problems fulfilling the eligibility criteria are Croatia, Lithuania, Romania, Russia, Slovenia and the Ukraine. Noteworthy is the case of Slovenia, which has neither submitted a national communication nor presented any common reporting format. For the purposes of the second track JI, the Marrakesh Accords establish a JI Authority, which will have ten members. Three members will be from Parties included in Annex B that are economies in transition, three members will come from Annex B and not be from an economy in transition, three members will be non-Annex B countries, and one member will be from the small island development states. The JI authority will meet for the first time at the first meeting to the Parties of the Kyoto Protocol, that is, after the ratification of the Kyoto Protocol. Another important development at the international level is the 2001 EU Draft Directive on Greenhouse Gas Trading (European Commission, 2001). The Draft envisages the stepwise introduction of greenhouse gas trading for power plants of a size exceeding 20 MW(e). The European Council of Ministers adopted the Directive on 25 October 2003. A voluntary trading regime would subsequently be established from 2005 to 2007. During this period it would only be possible to trade CO2 emissions. From 2008 a legally binding regime is to follow, which would then also allow for the trading of greenhouse gases other than CO2. Although the Draft Directive envisages voluntary participation in EU emissions trading, accession countries to the European Union will have to consider the implication of the Directive in their own policies and measures on climate change. This is particularly important for those countries that are considering the implementation of a domestic trading regime. This applies especially to the Slovak Republic, which has passed legislation for a CO2 trading regime beginning in 2005 (Bodnar et al., 2002). The Czech Republic is also in the process of developing its own trading regime.

BENEFITS OF THE KYOTO MECHANISMS While the underlying goal of the Kyoto Protocol as part of the climate regime is to prevent dangerous levels of climate change from occurring,

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the Kyoto Mechanisms could provide additional benefits to EITs. These benefits are: ● ● ● ●

additional revenue; project finance; knowledge and technology transfer; synergies with existing policies (for example, sustainable development).

As mentioned above, substantial revenue could be generated through participation in emissions trading because it allows for the sale of ‘hot air’. Such benefits would be substantially improved if the USA could re-join the regime. The countries that stand to gain most are the Ukraine and Russia. Poland, Bulgaria and Romania may also expect significant inflows of revenue for the sale of emissions. These potential windfall profits for economies in transition have been termed ‘hot air’. Revenues at current market prices of 5USD/tC range from 188.8 million USD for the Ukraine to 0.3 million USD for Slovakia. These estimates are substantially lower than earlier estimates, which assumed higher market prices. In the case of the Ukraine, for example, potential revenue is estimated at 3.7 billion USD (Missfeldt and Villavicenco, 2000). As Table 10.2 indicates, a number of countries in the region will have to engage in additional emissions reductions or purchase additional emissions quota abroad if they want to meet the Kyoto target. Whether and to what extent sizeable revenues will be realized depends on a number of factors that need to be assessed for each country. They are: the price development of tradable units and the actual and potential amount of credits for sale. The revenue also depends on the amount of credit for sale, which can be calculated as the difference between the emission target and the emissions trends of a country. While the target is fixed, the absolute trend in emissions can change both through active measures and unexpected external changes. A comprehensive package of policies and measures, for example, can achieve real additional emissions reductions that may in turn be sold. Structural change is still ongoing in economies in transition, even more than ten years after the transition process began. The importance of heavy industry is declining, while the service sector is growing. While this leads to a further stabilization of emissions at their current low levels, the increase in private transportation has to be balanced against these trends. While the CO2 intensity in these countries has decreased compared with pre-transition levels, the figures are still several times higher for most countries than the average values for the EU and the OECD countries as Figure 10.1 illustrates.

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Table 10.2 Annex B countries

Quantifying ‘hot air’ ‘Hot air’ (all GHGs, thousand tons of CO2)1

Bulgaria 8 581.60 Croatia ⫺5 844.09 Czech Rep. 17 216.20 Estonia ⫺14 578.98 Hungary ⫺10 221.40 Latvia ⫺12 676.48 Lithuania 3 253.84 Poland ⫺18 250.40 Romania ⫺58 437.68 Russian ⫺128 532.00 Federation Slovakia ⫺180.40 Slovenia 1 758.29 Ukraine ⫺138 338.00

% of base year

Standard deviation 1990–97 (all GHGs)

Hot air at 2002 market price (5 USD/tC) in million USD2

AIJ/JI projects (no.)

6.07 18.29 8.96 35.80 9.82 35.54 6.31 3.19 20.48 4.23

16 595.44 3 348.29 14 732.31 5 013.86 8 383.46 6 607.43 4 058.31 46 609.76 33 537.53 337 990.70

⫺11.71 7.98 ⫺23.50 19.90 13.95 17.30 ⫺4.44 24.91 79.77 175.45

2 – 5 21 3 25 9 8 9 11

0.25 9.15 15.27

6 820.59 27.11 46 287.52

0.25 ⫺2.40 188.83

4 – –

Notes: 1 Negative numbers imply that a country can sell emissions quota. 2 Positive numbers indicate a likely income, negative numbers indicate an expenditure for purchasing quota. Sources: UNFCCC (2001c); own extrapolation of emissions.

Only Slovenia has levels of CO2 intensity that come close to OECD and EU levels. A benefit occurring in JI projects is that additional project finance can be generated for projects that would not have happened in the absence of potential income from emission reduction units. In particular, for small projects such as small energy efficiency projects and small renewable energy projects, the added value from such income can increase the internal rate of return of such projects substantially. As the host countries are entitled to issue emission reduction units nationally as long as the country is eligible for track one JI, establishing rules that allow for ex ante or early crediting of emission reduction units could increase the value of these credits further: it is usually at the beginning of the project when up-front capital is needed.

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CO2/GDP (kg CO2/1995 USD)

9 8 7 6 5 4 3 2 1

R

ch ze C

La tv ia Li th ua ni a Po la nd R om an Fe R ia u de ss ra ia Sl tio n ov n ak R e Sl p. ov en ia U kr EU ain e av O EC erag e D av er ag e

ia ep ub lic Es to ni a H un ga ry

ro at

C

Bu lg a

ria

0

Source: IEA (2000).

Figure 10.1

Carbon intensities in EITs in 1999

In conducting a JI project jointly in the host country, training and technology transfer from the investing partner to the host country will take place. The Swedish AIJ biomass boiler projects in the Baltic States are a good example of how capacity can effectively be built in this area. Finally, if JI projects are selected carefully, they can assist and generate synergies with existing policies in the host countries. Such synergies could be in the areas of sustainable development and other environmental policies, employment policies and EU accession policies. Of the potential benefits, emissions trading is likely to generate the highest level of revenues, while JI will lead to more project finance, knowledge and technology transfer, and could entail higher synergies with existing policy goals. Thus, JI will generate more diverse benefits. On the other hand, it would be possible to earmark the revenue from emissions trades for projects so that similar benefits as in JI could be generated. As a result, more diverse benefits could be generated through emissions trading.

SUCCESSFUL DOMESTIC IMPLEMENTATION A framework for successful implementation of the Kyoto Mechanisms in the EITs requires a clear and stable institutional environment in accordance with the Kyoto policy framework; accurate data management and emissions projection; and accurate monitoring of implementation, especially in

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the context of JI projects. Beyond this, EITs can maximize the quantity of their sales by adopting suitable policies and measures. The minimum requirement for participation in the Mechanisms is the implementation of the Marrakesh Accords. Generally, the institutional environment for implementation of climate policies is more secure the more stable the general macroeconomic environment of a country, based on factors such as macroeconomic growth, inflation, income distribution and the stability of governments. Accurate data management (in accordance with Articles 5.1 and 5.2 of the Kyoto Protocol) and annual reporting is at the core of meeting this requirement. In the language of the Marrakesh Accords, this is referred to as the country’s national system. It is key for those countries interested in participating in any form of trading to ensure consistent reporting from a fixed institutional base. Accurate reporting is also in the self-interest of any country involved, as any inaccurate projections of emissions and subsequent overselling of emissions quota will be penalized in accordance with the compliance agreement under the Kyoto Protocol. Parties will also have to set up registries in order to track emission transfers at the international level. However, such registries would also be capable of handling trades at the national level. In addition to registering trades, the registries will keep the commitment period reserve of that country set aside in a separate account. This reserve prevents overselling of the emissions quota. Only countries that have their own registry established will be able to participate in both JI and in emissions trading. Smaller countries that may find it too costly to keep a registry can still participate in JI through the second track. There is no provision for establishing joint registries for a group of countries such as the Baltic States. However, several countries have indicated that they are considering cooperation or even consolidation of registries with other countries. Among these are Bulgaria, Croatia, Estonia, Latvia, Poland and Slovakia (UNFCCC, 2002). If a country wants to pursue track one JI it needs to develop its own baseline and monitoring methodology, even if this methodology largely draws from existing international regulations such as for track two JI and the CDM. The accuracy of this methodology is important, as the EITs will have to comply with their Kyoto targets. National JI authorities also need to ensure that projects are in agreement with the existing policy priorities of a country (Petkova and Baumert, 2000). On the other hand, synergies may exist with other policies such as in the transportation sector, which, in addition to climate change, also has serious local environmental impacts. The streamlining of activities can help to reduce transaction costs and render projects more attractive to potential investors.

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One of the initial problems during the precursor phase to JI, the activities implemented jointly (AIJ) pilot phase, has been the lack of clarity regarding the responsibility of signing the memorandum of understanding (MOUs) of an AIJ project. Complex situations may arise when foreign investors who are especially keen on getting engaged in JI obtain promises for emissions reduction units at the local or regional level without informing the central government. But national governments that have undertaken an emission reduction commitment under the Kyoto Protocol need to balance such sales in order to meet the target. Attributing responsibility for the signing of MOUs to a unique (public) body on a permanent basis would be crucial in creating a stable investment environment for JI. As is the case at the international level, the entity endorsing the credit and issuing it (which possibly is identical with the registry) should not be institutionally related to those entities that are earning the credit. A key criterion of whether countries should undertake emissions trading is the comparison of projections of emissions until 2012 with the target under the Kyoto Protocol. A country has to be certain that its emissions in 2012 will be below those required under the Kyoto target. These projections should capture all policies implemented and planned with certainty at the time at which projections are made. Only if there is a sufficiently wide gap between the projections and the target should the country (or entities in the country entitled to engage in trading) undertake emissions trading. In order to arrive at a valid projection of greenhouse gas (GHG) emission, trends for the most important sectors in the economy need to be analysed. The quality of input data is crucial in achieving reliable estimates. Being able to account for GHG emissions on the basis of UNFCCC reporting guidelines is thus essential. There are significant uncertainties as to whether there are excess emissions. An indication of the certainty with which a certain amount may be for sale can be given when those values are compared with the standard deviation of the data of greenhouse gas emissions between 1990 and 1997. In a number of cases the standard deviation of the data exceeds by approximately double the amount of emission quota that can be predicted on the basis of existing data and projections. This is the case for Russia, Poland and Bulgaria (see Table 10.2). This could imply that selling off emissions quota on the basis of current projections for those countries would not be safe, as the size of their ‘hot air’ lies well within the standard deviation of the data. For JI, the investment climate and the emissions reductions potential of a specific project are more important. The country’s investment climate is reflected in the general and projected performance of the economy as well as in how well business legislation is implemented and enforced (that is,

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property laws, anti-trust and anti-corruption laws). Another crucial question in relation to JI is who would be investing in such a project. The AIJ pilot phase could not attract private investors above and beyond demonstration cases (Evans et al., 2000). Circumstances are, however, different for JI, because, in contrast to AIJ, emission credits may be sold. The attractiveness of projects to investors will depend on the economic returns a project can provide, including the returns from emission credits. A key component is the rate at which credit can be financed in a country. An example of how discount rates and time patterns may affect the decision process in a market-oriented environment can be found in IDEE/FB (1999). The case study identified the development of hydro power as one of the promising options to limit CO2 emissions in Argentina. According to existing regulations in the country, private investments on hydro-power plants are bound by the following rules: ●

●

●

30-year term of licence to operate the plant (period shorter than the useful life of the plant, estimated at 50 years); the payment of royalties to local governments for use of the resource; and a 15-year payback period for investments in the expansion of the transmission network.

Figure 10.2 shows the effects of discount rates on CO2 reduction costs under three perspectives: ●

●

●

the social perspective, where taxes are excluded and the payback period of the investments, including transmission facilities, spans the lifetime of the project (50 years); the ‘private before taxes’ case corresponds to bringing forward payback periods to 30 years for the hydro-power plant and 15 years for transmission lines; and the ‘private after taxes’ case with the same payback periods as above but where taxes and royalties are included.

Figure 10.2 shows that even at a 5 per cent discount rate the hydro-power option is unattractive for private investors, while at the same rate and given longer payback periods the option becomes profitable from the social viewpoint. At an 11 per cent discount rate (a relatively low rate by private standards in Argentina), private mitigation costs are twice the corresponding costs from a social perspective. The above example raises a number of questions in relation to who would be a suitable co-funder of a project in the host country. It indicates

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Figure 10.2

Public versus private perspectives on CO2 reduction costs

that private co-finance may not be found as easily as public co-finance. Potential co-finance in EITs may come from national environmental funds. These were established in most countries in the region upon transition. They were resourced initially through debt for nature swaps. The private sector remains underdeveloped and subject to continuous changes in its regulatory environment, for some countries not least as a result of the accession process towards membership of the European Union. In donor countries, the same relationship as in Figure 10.2 applies in principle, except that private discount rates are closer to public discount rates, and both discount rates tend to be lower than in developing countries. This gives private investors in potential donor countries an advantage over private investors from economies in transition. JI may then well mean that foreign investors would reap the ‘low hanging fruit’, that is, the very cheap mitigation options. An alternative view would be that such projects would not take place for years if it were not for foreign investors.

NEGOTIATING AT THE INTERNATIONAL LEVEL As the economies in transition stand to gain from the Kyoto Protocol, it appears rational for them to become more active in the international debate. The factors that will influence the revenue from trading most are the price for tradable units, the quantity of potentially tradable emissions and

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the quantity actually traded at any point in time. Influencing the market price of emissions and the actual quantity traded requires that countries act jointly, possibly in terms of a cartel. After the break-up of the Soviet Union and the fall of Communism in the early 1990s, EITs did not form a negotiating group because the new governments no longer wished to identify themselves with other former communist countries. During that time, the influence of countries depended on individual negotiators, who through their skills could push the climate agenda in few areas. Only in the late 1990s did countries in the region begin cooperating in the area of international climate negotiations with other existing negotiating blocs. Following the conclusion of the negotiations surrounding the Kyoto Protocol in 1997, Russia and the Ukraine became part of the ‘umbrella group’.3 In parallel, Central and Eastern European countries with economies in transition that are preparing for European Union (EU) accession began to adopt negotiation stances in line with the EU position. During the late 1990s, there were frequent instances when the EU and a range of accession countries presented a common position. In June 2001 the Central Group of 11 (CG11) was formed during the second part of COP 6 in Bonn. This group consists of those EITs that are EU accession countries.4 One of the first successes of CG11 was to be consulted by the chair of the negotiations as a separate negotiating group along with the umbrella group and the EU when the Bonn deal was struck. The Bonn deal enabled the adoption of the Marrakesh Accords. The activities of the EITs in relation to the Kyoto Mechanisms have until mid-2002 focused mainly on technical and financial issues and on increasing the potential size of tradable emissions available to them. For example, Russia has successfully pushed for a doubling of the size of creditable sinks under Article 3.4 of the Kyoto Protocol from 17.63 to 33.0 MtC/year, and under Article 3.3 of the Kyoto Protocol from 8.2 to 9.0 MtC/year in its greenhouse gas inventory. These were endorsed as part of the Marrakesh Accords (UNFCCC, 2001b). While Russia argued for such sinks on scientific grounds, it also clearly used its bargaining position, which results from the fact that Russia will be needed for the ratification of the Kyoto Protocol. In June 2002 Croatia put forward proposals to adjust its base year and the size of its sinks. These submissions aim at alleviating the task of meeting the Kyoto Protocol target. In its proposal Croatia is being supported by the CG11. On the basis that the anticipated trading price will be far below what was anticipated before the withdrawal of the USA, it can be expected that EITs will form a coalition with the aim of maximizing the revenue from tradable units sold by postponing the sale of a certain amount of quota until the

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second commitment period. Even Russia, as the largest supplier in the market, could drive market prices up during the first commitment period from 2008 to 2012 if it banked units for future periods. Total revenue could be increased through such monopolistic behaviour. Estimates for prices per ton of CO2 in USD after the withdrawal of the USA range from USD 0 (Blanchard et al., 2002; Boehringer, 2001; Boehringer and Loeschel, 2001) to USD 12.50 (Buchner et al., 2001), assuming a competitive market and no further behavioural action by trading partners. If strategic behaviour by Parties with a Kyoto target (but excluding the USA) is considered, prices have been estimated to reach between USD 1.10 (Jotzo and Michaelowa, 2001) to USD 30.20 (Manne and Richels, 2001). These estimates imply that strategic behaviour by EIT countries is well worthwhile.

PARTICIPATION OF ECONOMIES IN TRANSITION IN EMISSIONS TRADING AND JOINT IMPLEMENTATION Although Russia and the Ukraine are the largest potential sellers of emission quotas, they have perhaps made the smallest steps towards implementation of the Kyoto Mechanisms. While the Ukraine does not have any concrete AIJ or JI project examples, Russia has 11 examples. In order to allay the concerns of buyer countries like Japan and the EU, Russia has suggested a Green Investment Scheme (GIS), whereby revenues from emissions trade are reinvested in JI-type projects in order to ensure additionality of emissions reductions. RAO-UES, the biggest electricity utility in Russia and largest emitter of CO2 emissions, has established the ‘Energy Carbon Facility’ (ECF), which could be used as a basis for further trades. Otherwise, the ‘Interagency Commission on Climate Change’ is temporarily in charge of assessing JI projects, but institutional clarity still needs to be established as to who is in charge of signing the MOUs for JI projects on a permanent basis. Following Russia and the Ukraine, Poland is the third largest emitter of GHG emissions among the economies in transition. Despite the steep slump in economic production in the early 1990s, Poland has been able to get back to pre-transition GDP levels. As a result of a shift towards a more service-based economy, and thanks to the implementation of more energyefficient technologies, Poland’s greenhouse gas emissions seem to have de-coupled from economic activity. Poland has a well-established structure for the implementation of the Kyoto Protocol and the Climate Convention. As early as 1994, the Polish

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Ministry of the Environment established a JI secretariat, which became operational in September 1996. In 1999 the Secretariat became a subdepartment of the Climate Convention Executive office. Two other previously existing offices were relocated under this secretariat: the Greenhouse Gas Section and the Climate Convention Secretariat. The executive office is part of the National Environmental Fund. The offices fulfil three functions: a policy function (Climate Convention Secretariat) a reporting function (the GHG Secretariat) and a mechanisms function (the JI Secretariat) (Petkova and Baumert, 2000). Poland has outlined a set of selection criteria for JI projects that takes account of both the requirements of the Kyoto Protocol and the specific needs of Poland. In addition to issues relating to baseline accuracy, coherence with Polish environmental priorities overall, avoidance of environmental damage, and exclusion of dumping of second-rate technology, the guidelines emphasize that Polish partners need to be solvent in the long term.5 While this currently excludes most of the emerging Polish private sector as investors, it guarantees that projects, once begun, will be completed (Petkova and Baumert, 2000; UNFCCC, 1998).6 There is uncertainty as to whether Poland wants to participate in emissions trading. The Baltic States (Estonia, Latvia and Lithuania) have so far shown no interest in engaging in emissions trading. They have, however, good experience in AIJ/JI through their cooperation with the Swedish NUTEK. Around 50 projects have been implemented by NUTEK in the region. Most of them are boiler conversions to biofuels and energy-efficiency measures in distribution networks and residential buildings. For this group of countries it may be most cost-effective to participate in the second track JI. Slovenia, the Slovak and the Czech Republics are considering the implementation of a CO2 trading regime at the domestic level. This is to be understood also as a response to the development of the EU directive on emissions trading. Both countries are hoping for accession to the EU in the near future. Bulgaria, Hungary and Romania have limited experience in the AIJ pilot phase. Croatia has shown no interest in participating in the Kyoto Mechanisms.

CONCLUSION With the departure of the USA from the Kyoto Protocol, the likely revenues from international emissions trading for the economies in transition are likely to be limited, at least during the first commitment period. Therefore, banking excess emissions credits for a second commitment period may be more attractive than selling quota at a comparatively low price. In addition,

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the risk of overselling emissions quota inadvertently is comparatively high given the significant economic changes these countries have gone through since the early 1990s. A key criterion on whether countries should undertake emissions trading is the comparison of projections of emissions through 2012 with the target under the Kyoto Protocol. These projections should capture all policies implemented and planned with certainty at the time at which the projections are made. Only if there is a sufficiently wide gap between the projections and the target should the country (or entities in the country entitled to engage in trading) undertake emissions trading, especially as the uncertainties of such projections in economies in transition are high. For JI, the investment climate and the emissions reductions potential of a specific project are more important. The country’s investment climate is reflected in the projected performance of the economy as well as in implemented legislation for businesses. This discussion indicates that although there are a number of general criteria that can give countries guidance on what may be suitable, countryspecific circumstances may not easily be captured by such indicators. Thus, countries that are bound by the Kyoto Protocol should implement a clear institutional structure, which includes a JI office or a position solely in charge of JI. Any JI deal or suggestion would have to pass through them. Even if the country decides not to engage in JI, such an office would help to guide possible foreign investors.

NOTES *

The authors would like to thank the Danish Energy Agency for the funding of their work, Lasse Ringius for comments on their paper, and Sevdalina Todorova for providing additional information. All eventual errors are of the authors alone. 1. The tradable units in the Kyoto Mechanisms market are: ● ● ●

assigned amount units (AAUs); emission reduction units (ERUs); certified emission reductions (CERs).

AAUs are those units assigned as part of a country’s emission reduction target. If the AAUs are in excess of emissions in the first commitment period, these units may be traded as part of emissions trading. ERUs are generated by conducting JI projects within Annex B countries, and CERs are generated as part of clean development projects within nonAnnex B countries. 2. Note, however, that the procedure under the CDM is somewhat more onerous. In addition to ex post verification of a project, which leads to certification and issuance of certified emissions reduction credits (CERs), the project (project design document and monitoring plan) has to be validated by a separate independent entity. The terminology is also different: an independent entity under the CDM is called an operational entity; the equivalent to the Article 5 supervisory committee is the ‘executive board to the CDM’.

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3. The ‘umbrella group’ acts as a loose negotiating group. Its members are Australia, Japan, the USA, Canada, Iceland, Norway, New Zealand, Russia and the Ukraine. 4. The members of the CG11 are Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. Malta and Cyprus have been admitted as observers to the group. The chair of the group rotates alphabetically. In 2002 Croatia was chair. Substantive issues are divided up between countries. For example, Poland has been in charge of following the Kyoto Mechanisms debate. 5. It is unclear why this rule does not apply to the foreign donor or investor in a JI project. 6. Poland has so far undertaken 3 AIJ projects: ●

●

●

a coal to gas conversion project with the Norwegian government with a total investment of 48 million USD; the modernization of heat supply in the town of Byczyna with the Dutch government with an investment of 632 000 USD; and sustainable heat and power for public networks undertaken with the Dutch government with a total investment of 724 000 USD.

The total mitigation potential of these projects has been estimated at 3 129 807 tons of CO2 equivalent.

REFERENCES Blanchard, O., P. Criqui and A. Kitous (2002), ‘After The Hague, Bonn and Marrakech: The Future International Market for Emissions Permits and the Issue of Hot Air’, Cahier de Recherche no. 27 bis, Grenoble: Institut d’Economie et Politique de l’Energy, January. Bodnar, P., B. Hannes, J. Hauff and G. Lipcsey (2002), ‘CO2 Emissionshandel in Mittel- und Osteuropa – eine Chance für Unternehmen des Energiesektors’, Zeitschrift für Energiewirtschaft (ZfE), 26(1), 73–81. Boehringer, C. (2001), ‘Climate Politics from Kyoto to Bonn: From Little to Nothing?’, The Energy Journal, 23(2), 51–71. Boehringer, C., and A. Loeschel (2001), ‘Market Power in International Emissions Trading: The Impact of US Withdrawal from the Kyoto Protocol’, Discussion Paper No. 01–58, Mannheim: Zentrum für Europaeische Wirtschaftforschung GmbH (ZEW). Buchner, B., C. Carraro and I. Cersosimo (2001), ‘On the Consequences of the US Withdrawal from the Kyoto/Bonn Protocol’, Nota di Lavoro 102.2001, Milan: Fondazione Eni Enrico Mattei, December. European Commission (2001), ‘Proposal for a Directive of the European Parliament and of the Council establishing a framework for greenhouse gas emissions trading within the European Community and amending Council Directive 96/61/EC’, COM(2001)581, Brussels. Evans, M., S. Legro and I. Popov (2000), ‘The Climate for Joint Implementation: Case Studies from Russia, Ukraine and Poland’, Mitigation and Adaptation Strategies for Global Change, 5, 319–36. Hagem, C., and B. Holtsmark (2001), ’From Small to Insignificant: Climate Impact of the Kyoto Protocol with and without US’, CICERO Policy Note, 2001 (1), Oslo. IEA (200), World Energy Outlook 2000, Paris: International Energy Agency (IEA). Instituto de Economía Energética (IDEE/FB) (1999), Argentina, Country Study

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Series, Economics of Greenhouse Gas Limitations, Risø: UNEP Collaborating Centre on Energy and Environment. Jotzo, F., and A. Michaelowa (2001), ‘Estimating the CDM Market under the Bonn Agreement’, Discussion Paper 145, Hamburg: Hamburg Institute of International Economics (HWWA). Korppoo, A., C. Vrolijk and J. Stern (2001), ‘Energy and Climate: RussianEuropean Partnership’, available at http://www.riia.org/index.php?id⫽135. Manne, A., and R. Richels (2001), ‘US Rejection of the Kyoto Protocol: The Impact of Compliance Costs and CO2 Emissions’, Working Paper 01–12, Washington, DC: AEI Brookings Joint Centre for Regulatory Studies, October. Missfeldt, F. (1998), ‘Flexibility Mechanisms: Which Path to Take after Kyoto?’, Review of European Community and Environmental Law (RECIEL), 7(2), 128–39. Missfeldt, F. and A. Villavicenco (2000), ‘The Economies in Transition as Part of the Climate Regime: Recent Developments’, Environment and Planning B: Planning and Design, 27, 379–92. Petkova, E., and K. Baumert (2000), ‘Making Joint Implementation Work: Lessons from Central and Eastern Europe’, World Resources Institute Climate Notes, Washington. UNFCCC (1997). The Kyoto Protocol to the Convention on Climate Change. France. UNFCCC (1998), ‘Activities Implemented Jointly: National Programmes for Activities Implemented Jointly under the Pilot Phase’, The national reporting formats for national programmes submitted by Parties, http://wwww.unfccc.int/ program/aij/aij_np.html. UNFCCC (2001a), ‘Review of the Implementation of the Commitments and of Other Provisions of the Convention’, Preparations for the first session of the Conference of the Parties to the Kyoto Protocol (Decision 8/CP.4), Consolidated negotiating text proposed by the President. Addendum, Decisions concerning Mechanisms pursuant to Articles 6, 12 and 17 of the Kyoto Protocol, FCCC/CP/ 2001/2/Add.2. UNFCCC (2001b), ‘Report of the Conference of the Parties on its Seventh Session, Held at Marrakesh from 29 October to 10 November 2001’, Addendum. Part Two: Action Taken by the Conference of the Parties, volume II, FCCC/CP/2001/ 13/Add.2. UNFCCC (2001c), ‘Emissions Data’, On-line searchable database of greenhouse gas inventory data, available at http://unfccc.int/resource/ghg/tempemis 2.html. UNFCCC (2002), personal communication.

PART IV

Economic and Environmental Policies in Transition Economies

11.

Energy and sustainability in Central Europe: a decade of transition in review* Diana Ürge-Vorsatz, László Paizs and Radmilo Pesic

INTRODUCTION As Frank Carter, a lecturer in Geography at the School of Slavonic and East European Studies at the University of London, stated, the communists had a cynical approach to pollution. ‘They monitored air and water pollution faithfully, but did little to curb it . . . State-run factories, the biggest polluters, found it far cheaper to pay the fines than to introduce control measures’ (Hinrichsen, 1998). This is why, in the 1990s, life expectancies in the so-called ‘Black Triangle’, the areas of heavy industry and coal mining of Poland, then Czechoslovakia and East Germany, were three to six years below the average for Europe (Moldan and Schnoor, 1992), while levels of particulates and sulphur dioxide were more than twice to three times WHO air quality guidelines (Hofmarcher, 1998). The Chernobyl nuclear catastrophe left tens of thousands dead and hundreds of thousands seriously ill in Belarus, the Ukraine and the rest of Europe. Although the official Soviet data about the expected number of deaths is only 31 (Savchenko, 2000), many more estimates predict a far greater number, as high as half a million (Lenssen, 1994). Per capita sulphur emissions in 1989 were two to six times higher than in OECD countries (WRI, 1992), as demonstrated in Figure 11.1. Carbon emissions per unit of economic output also ranked among the highest in the world. There were other serious pollution problems as well, such as freshwater pollution that was reaching crisis levels in some areas. The Volga–Caspian basin, for example, contains 700 times the legal levels of petroleum products and 113 times the permitted levels of surface pollution from synthetic products, according to Professor Vladimir Lukyanenko, a top Russian biologist (Dudley, n.d.). In the months and years following the fall of the Berlin Wall, Western media turned its attention to Central and Eastern Europe (CEE) – but much of 227

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Figure 11.1

Per capita SO2 emissions in selected countries, 1989

this attention was not focused on the grave environmental conditions the centrally planned era left in this region. While almost all aspects of industrial and agricultural production contributed to a highly polluted environment, the single largest polluter in this region was the energy sector: from mining through production and end-use. Beyond the general socialist disregard for the environment and emissions controls, there were other important factors contributing to the energy sector’s giant contribution to poor environmental conditions. While industrial output and living standards were far behind those in OECD countries, the level of energy consumption, and therefore energy-related environmental emissions, were comparable to those in the West. Energy and carbon intensities – the primary energy necessary for and carbon emitted per unit of economic output – were several times higher than those in OECD countries. In fact, energy and carbon intensities of most Central European countries and former Soviet republics were, and for some still are, among the highest in the world.1 This represented a massive economic inefficiency, which also caused unsustainable environmental consequences. This inefficiency represented by world-record energy intensities is at the core of the majority of energy-related environmental problems in the region, including the high carbon emissions. Thus, beyond the general environmental clean-up tasks and increasing the environmental performance of industry (including the energy industry), the most important policy goal for improving the sustainability of energy in the region is to reduce energy intensities. The purpose of this chapter, hence, is to overview how the first decade after the transition from a centrally planned economy has affected energy

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intensities, and therefore the sustainability of the energy sector. First, we describe the major characteristics of the energy sectors in Central Europe at the fall of communism, and compare the key energy and carbon indicators to those of OECD countries. Then, we look behind the statistics and analyse the reasons for these massive rates of inefficiency in the energy sector. After identifying the legacies of the centrally planned economy affecting energy and carbon intensities, we design a policy agenda capable of addressing these legacies. We follow this by a review of the ‘energy history’ of the first decade of economic transition in three selected CEE countries, and analyse how much of the policy agenda described has been implemented. Then we examine the situation today: how much has the sustainability of the CEE energy sectors changed? In particular, how have energy and carbon intensities developed? We conclude by identifying remaining policy agenda items which need to be implemented to complete the transitions in the energy sector. While achieving even these policy targets will not transform CEE energy sectors into fundamentally sustainable ones, at least they will complete the process of transforming energy sectors from a centrally planned mechanism to a market-based one, and to energy sectors which are mature enough for European integration. In addition to discussing the negative legacies of the centrally planned economy, we also attempt to identify opportunities for potential ‘leap-frogging’. And we look for some ‘positive’ legacies of the centrally planned economy, which may need to be preserved instead of simply copying the West and some of its less sustainable models.

ENERGY IN CEE AT THE FALL OF COMMUNISM During the socialist era, energy in Central and Eastern Europe was supplied by some of the most monolithic fuel mixes in Europe. For instance, Poland relied on coal for close to 70 per cent of its primary energy and 97 per cent of its electricity supply in 1998 (IEA, 2000). Lithuania, Bulgaria, Slovakia and Hungary ranked among the top ten in the world in their reliance on nuclear energy for their electricity supply: in 1995 Lithuania produced 85.6 per cent, Bulgaria 46.4 per cent, Slovakia 44.1 per cent and Hungary 42.3 per cent of their electricity from nuclear energy (UI, 2001). Another key characteristic of the energy supply of Central European countries and Soviet republics was that they relied heavily on energy imports from Russia: energy was one of the leashes through which Russia kept its republics and the satellite countries of CEE dependent, in accordance with the provisions of the Yalta Treaty of 1945. Large imports of natural gas, electricity, oil, nuclear fuel and other primary energy carriers comprised the basis of CEE energy supply.

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Kg of CO2 equivalent per 1990 US$

One of the few positive legacies of the Soviet era for the CEE region is the consequence of this policy: the high share of natural gas in the fuel mix, and the relatively well-developed infrastructure for natural gas. Since Russia is endowed with the lion’s share of the world’s natural gas reserves, it relies heavily on natural gas as a primary energy source. Furthermore, Russia has developed an extensive pipeline network to provide Central European economies with natural gas. This has resulted in a relatively high dependence on natural gas in these countries. The share of natural gas use in Hungary presently exceeds 40 per cent, while more than 60 per cent of Hungarian households are supplied with natural gas (MOL, n.d.). Other countries in the region also rely largely on natural gas in their total primary energy supply, such as the Ukraine (42.9 per cent), Romania (37.7 per cent) and Czechoslovakia (19.9 per cent) (data are for the year 1999; IEA, 2001). Since natural gas is the least polluting of all fossil fuels and emits approximately half as much carbon to the atmosphere per unit of energy as coal, this had a positive impact on the overall environmental performance of the energy sectors of these economies. While this high reliance on natural gas was desirable from an environmental perspective in the short term (since it replaced poor quality coal or nuclear fuel), after the fall of the Soviet era, it raised concerns over national sovereignty in several CEE countries and former Soviet republics. Since diversifying the import sources of natural gas is burdensome due to costly and time-consuming pipeline construction, fuel diversification emerged, instead, at the top of the energy policy agenda of several CEE countries as 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0

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Figure 11.2 CO2 emissions per unit of economic output in selected countries and OECD, 1980, 1989 and 1999

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a tool to promote energy security. Natural gas, however, remains an important fuel in the CEE region. Energy, as mentioned above, was the single largest polluter of the CEE region at the end of the socialist era. In the Black Triangle, referred to above, acid rain has turned square miles of forests into a moonscape. Carbon emissions per unit of economic output were among the highest in the world; several times higher than those in OECD countries. One of the reasons for high environmental emissions was the relatively poor quality of the fossil fuels, especially concerning sulphur content. For example, pollution from the combustion of coal is consistently worse in Poland than in OECD nations. Sulphur dioxide emissions in 1989 were estimated at 32 kg per ton of coal in Poland, well ahead of most OECD countries, where typical values range between 2 to 4 kg per toe (Financial Times, 1993). In addition to poor fuels, energy production had little or no environmental pollution control and energy facilities were old by 1990s standards and equipped with obsolete, inefficient technologies. However, at the root of all environmental damage related to the energy sector was one single phenomenon: the wasteful production and use of energy in the CEE region. While quality of life was much behind that in OECD countries, levels of per capita energy consumption were comparable to those in the most developed economies. In 1989 the average Russian citizen ‘consumed’ more energy than the average citizen of any EC country (Figure 11.3), while he enjoyed only a fraction of the wealth of an EU 9 8

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Figure 11.3 Per capita primary energy supply in selected countries and country groups, 1989

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Figure 11.4 Energy intensities in selected countries and country groups, 1989

citizen.2 As a result, per capita and per GDP environmental emissions were also very high, compared to the low living standards. Thus, at the root of the grave energy-related environmental damage was the inefficiency of the energy chain, which is often characterized by the indicator energy intensity (TPES/GDP). While this is an indicator which is subject to discussion in the literature the scale of the differences it points to in CEE definitely reveals real and serious problems. Figure 11.4 compares energy intensities in four CEE countries with the OECD and EU-15 in the year 1989. Figures 11.3 and 11.4 lead us to the key sustainable energy policy goal of the economic transition: the reduction of high-energy intensities. Since per capita energy consumption in the CEE countries and Russia was high enough to support the life-style of the most developed economies, there was no need to increase ultimate supply, but to rationalize the generation and use of the supply. Improving the efficiency of energy consumption and production would not only deliver improved environmental conditions, but would enhance national wealth by increasing economic efficiency and productivity and by cutting waste. A significant increase in energy efficiency would also bring other key benefits, including a reduction in the need for energy imports, thereby increasing national sovereignty; reducing foreign debt (to which energy imports contributed to a large extent); freeing up badly needed capital for other sectors of the economy; and easing the social burden of rising energy bills resulting from tariff hikes.

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But to understand how most effectively to reduce energy waste, we need to understand the reasons for these record high-energy intensities. The following chapter explores the legacies of central planning, which resulted in these wasteful energy practices.

LEGACIES OF THE CENTRALLY PLANNED ECONOMY The reasons for the observed high-energy intensities are embedded in the nature of the socialist economy. Several features of the centrally planned economy contributed to the wasteful practices and energy-intensive structures, leaving behind legacies for the transition economies that need to be addressed. Negative Legacies First of all, a planned economy does not itself reward efficiency. In fact, sometimes it encouraged inefficiency: an enterprise obtained energy resource allocations for the next planning period based on its consumption in the previous five-year plan. This practice not only encouraged waste, but provided an incentive for companies to report higher than actual use to achieve higher allocations. Actually, production processes themselves were also inefficient: for example, Polish cement required twice as much energy per ton as French cement; in the 1980s Soviet steel mills used 1.5 tons of coal to produce a ton of steel, while the Japanese used half as much (Chandler, 2000). On an individual level, the communist paradigm of ‘each to work according to his capabilities, and to be rewarded according to his needs’ entirely decouples consumption from production, therefore again encouraging waste. This paradigm has manifested itself in several features of the economy: highly subsidized energy prices (since obtaining the basic utilities was considered an elementary right), the charging of flat rates independent of actual consumption, and the lack of metering. For industry, the additional rationale for the subsidization of energy prices was that it served as a means of promoting industrial competitiveness in world markets. Furthermore, prices for residential consumers were typically lower than those charged for industrial consumers. With regard to the consumption of natural resources, Marxist economics also detached consumption from resource availability and other features of nature by providing no price signals. In Marx’s labour theory of value, natural resources (or rather ‘raw materials’ as he preferred to call them) had

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no intrinsic value; the value of a commodity was determined only by the amount of labour that went into producing it (Papp, 1977). Thus, the market had no route to signal resource scarcity, market shortages or environmental damage associated with the use of the resource. For instance, oil prices were calculated on the so-called ‘Bucharest formula’, which was based on the rolling average of oil prices in the past five years. This, for instance, isolated the socialist world from the impact of the oil crisis in the 1970s, and, in general, resulted in oil prices detached from world prices and market signals. In addition to resource pricing and the economy not penalizing inefficiency, the oversized scale of economies also discouraged efficiency. Instead of local demands driving production, a socialist system-wide ‘division of labour’ resulted in giant industrial establishments producing not only for one country, but typically for several of them. Some industries were assigned to certain countries, for example, Hungary supplied socialist countries with buses and much of the socialist bloc with canned agricultural products. This division of labour, the purpose of which was also to keep the member countries of the bloc dependent on each other, resulted in large inefficient production structures, and the unnecessary shipping of resources and goods. However, beyond the wasting of energy, high comparative energy intensities resulted also from the economic structure. Heavy industry, being a high-energy-intensive sector, comprised the lion’s share of socialist economies. The deliberate development of heavy industry, even in countries lacking the resource basis for it, such as Hungary, was ideologically founded: communism, after all, was founded by and on the pillars of industrial labour. In addition, the strong militarization during the Cold War also required an extensive heavy industry base. Even when there was an intention to increase energy efficiency, such as in the late 1980s and early 1990s, it was hard to start: there was a lack of information and detailed data about real energy consumption; there was a lack of awareness of energy-wasting practices and how to improve efficiency. Corruption, widespread in the former socialist bloc, is also a factor contributing to economic and energy inefficiency. First, corruption contributes to general economic inefficiency, further increasing energy intensities. Second, corruption related to energy payments eliminates any incentives to conserve energy and/or develop efficient-energy management (Popiashvili, 2000). Corruption in the energy sector in CEE has been present at all levels, from the level of the household to large companies (Lovei and McKechnie, 2000). A milder version of corruption, prevalent even in the three most developed CEE countries examined, is energy theft. Utility officials estimate that as much as 20 per cent of revenue is lost in

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Hungary in some electric utility areas due to non-payment and electricity theft. Interestingly, an important portion of the theft occurs not for the purposes of meeting elementary human needs, but for heating indoor swimming pools or to eliminate the need to shovel snow in the winter by heating driveways. This, consequently, leads to large energy waste or at least highly energy-intensive consumption practices for luxury services ultimately paid for by the taxpayer. Positive Legacies In addition to the negative legacies of the centrally planned economy, usually well known and often blamed for today’s poor economic performance, there were also a number of ‘positive’ legacies left to the transition economies. These positive ‘by-products’ of socialist planning are also important to acknowledge, since they could allow leap-frogging in certain aspects of the economy compared to the most developed countries in the world. One of the few areas where former socialist countries led the world at the fall of communism was the high share of organized modes of transportation, that is, urban public transport, and rail passenger and freight transport. For instance, in Warsaw, 80 per cent of all trips were made on public transport in 1985, and the rate was similarly high in Budapest (Vorsatz, 1996). In 1988, only approximately one-third of the average 6000 km travelled per person were by car in all the countries examined by the IEA (IEA, 1997), including Poland, Estonia and the USSR, while this share was around 80 per cent in European OECD countries.3 In 1989, while over 90 per cent of freight ton-kilometres were shipped by rail in Romania, this figure was less than 20 per cent in the UK and less than 50 per cent in other West European countries (IEA, 1997). This was partly the result of a policy to keep people’s mobility artificially reliant on organized modes of transport; therefore, people’s movements could be controlled by the state. This was achieved by a number of means: citizens had to wait several years for the delivery of their purchased automobile. For instance, in the former East Germany, waiting periods for a Wartburg were as high as 14 years. In addition to the long waiting times, cars and driving were rather unaffordable based on the uniformly low wages, especially when compared to the costs of subsidized public transportation. But in addition to the artificial control of individual mobility, efficient public transportation systems also provided a positive incentive for the use of public transport. Although this was not uniform, in several CEE cities public transport network density was very high, providing easy access to transport lines. Frequent services also made public transport an attractive

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alternative to the automobile. Passenger rail transport possessed similar features: the railway also connected low-population villages to the network. At the same time, buses, trains and other public transport vehicles were often congested and not clean, leaving space for improvement in a market economy to make them more desirable. As a result of the high load factors and the high share of trips made by public transport, specific energy consumption by transport (expressed by energy per passenger-kilometre) was much lower than in OECD countries, even that of Japan (Vorsatz, 1994). For instance, while a Polish citizen travelled only about 40 per cent less in 1988 than West Europeans, he consumed less than a quarter of the energy for travel than a West European would have done (IEA, 1997). This was the exact opposite of the general energyintensity comparisons described above. One of the reasons CEE settlements were easily serviceable by public transport was the concentrated socialist land use planning. High-rise buildings and concentrated settlements provided not only ideal ground and economic rationale for public transport networks, but also for district heating networks. From an energy perspective, the high share of district heating among heating modes also results in a ‘positive’ legacy. Most district heating, though, is in multi-storey apartment buildings in urban areas: for instance, 80 per cent of the apartments in urban areas in Poland were served by district heating in 1995 (IEA, 1997, p. 119). Large-scale heating systems, especially if provided from a ‘waste’ heat source of industrial units or from other cogeneration sources, are more energy-efficient than individual heating systems. As a result of integrated settlement planning, it was often possible to utilize the waste heat of power plants or industrial plants as district heating or for other heating needs. Thus, cogeneration is not a new invention in the former socialist world, but a rather common practice in several CEE countries. This trend, though, was not uniform. For example, cogeneration had a low share in district heating in Poland (Raczka, personal communication). However, district heating is a double-edged sword: while the general concept is desirable, as often in socialism, implementation was poor: today systems are leaky, inefficient and obsolete and have high losses, and are thus often uneconomically sound and expensive. In the winter in CEE cities, lines of melted snow on the ground are a common sight, marking the underground district heating pipes. Another issue to consider is the initial intention to ensure energy efficiency through building multi-family apartments, which should have been more energy saving than single-family houses. The assumption was that as multi-family housing had a smaller external building envelope than individual houses with the same floor space, the energy losses per unit of living space should be smaller (Chandler, 2000). However, this planned

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effect was many times offset by the lack of basic energy-efficiency features in apartments, built of cement blocks or concrete panels – Polish homes still use twice as much energy per given amount of living space as Western European homes do (Chandler, 2000). Another positive legacy of the planned economy, largely disappearing by the turn of the millennium, was the low rate of consumerism. For instance, the rate of packaging was very limited during the socialist era, and reusable packaging was common. This has resulted in a common and efficient bottle deposit system for beverages, and, in some cases, certain goods, such as honey in Kiev (Watt, personal communication), were only purchasable if the buyer brought a container with him or herself. In addition to packaging, reusing materials and components on a household level was common, shown by the relatively low volume of household waste, which could be measured by the small garbage cans and relatively infrequent emptying practices. This high level of reusing and recycling materials was not only the result of the low spending power of salaries, but also of the supply-limited economy of socialism. In most countries long queues were common for even everyday goods such as bread and milk; some countries (for example, Poland) even adopted voucher systems for basic foods, such as meat and sugar, on an individual quota basis. In such a supply-limited environment, residents had an incentive to make the most of all products by reusing packaging and mending faulty products instead of replacing them. Even though imposed by constraints, such behaviour resulted in a decrease in waste and an increase in economic efficiency on a household level.

POLICY AGENDA FOR ENERGY MARKET TRANSITION IN CEE In the sections above we concluded that the single most important policy goal of a sustainable energy policy for the economic transitions in CEE is the reduction of energy intensities, thus improving the energy efficiency of the transition economies. A concrete policy agenda follows from this policy goal and can be elaborated from the discussion above based on the key reasons contributing to high-energy intensities. In this section, we review the policy responses to the legacies from a planned economy identified above. The following sections discuss how much progress has been made during the first decade of transition to implement this policy agenda. First of all, the key energy policy priority of most CEE countries and former Soviet republics is the diversification of energy imports and fuels to increase national sovereignty and energy security. This has been achieved,

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to some extent, over the first decade of transition, for instance by joining the Western electric grid in the case of Hungary, and by strengthening electricity and gas supply infrastructure in the other countries. Beyond diversification, most CEE countries identify increasing energy efficiency and renewable energy sources as a national energy policy priority. However, concrete steps to achieve these goals have been limited. Many of the factors that resulted in high-energy intensities are likely to be addressed in a transition from a planned economy to a market economy. A market economy, ideally, introduces incentives to cut waste, rewards efficiency and penalizes inefficiency. It promotes economic activity on a smaller scale more tailored to local conditions and demand, and provides price signals for excessive use of resources. However, there are some painful aspects of a market-based energy sector that need to be introduced as part of the transition process. One of the most socially problematic aspects of the transition to a market economy in the energy sector is the lifting of energy subsidies, and thus increasing energy prices. The first step in this process is to raise prices to cover costs of production. The following goal is to allow price revenues to cover a certain profit margin for energy producers. The final step to a market-based energy sector is to liberalize energy prices completely under the framework of a general energy market allowing market competition. The mechanism of energy pricing is a cornerstone of energy market structures and sustainable energy consumption, and we discuss in detail below the pathways different countries have taken in lifting energy subsidies and energy price regulation in order to achieve liberalization. Social concerns can be addressed through specific and closely targeted subsidies – cold weather payments for low income consumers, an energy supplement or free minimum fuel allowance for domestic consumers can help the disadvantaged without distorting the effective price (Grubb, 1991). In addition to raising prices, it is important that consumers pay for their real consumption instead of facing flat rates. Thus, metering of energy consumption needs to be introduced for end-users; this was not the practice during socialism. However, consumption-based billing alone is not enough to cut waste: tenants need to be able to control their energy consumption. This often requires system changes, for instance, in district heating, where in many cases thermostats, control valves and bypass pipelines need to be installed so that the users are able to control individual consumption. The dominance of heavy industry was also identified as a key factor contributing to high-energy intensities. With transition to a market economy, it is expected that economically inefficient, obsolete industrial operations will go out of business, and heavy industries will stay in operation only where the availability of resources justifies this, or where demand supports it.

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In general, the economies will probably shift towards more service-oriented structures, thus reducing energy intensities. Table 11.1 below summarises the key legacies from a centrally planned economy that have contributed to high-energy intensities, and the policy responses to address them. With regard to the ‘positive’ legacies identified in the previous section, it is an important question whether any of them should or could be preserved. It is clear that a large number of these positive features cannot be sustained in a market economy, examples being the artificially low rate of individual transport and the very concentrated settlement patterns integrated with industrial areas. However, preserving as much of the more

Table 11.1 Policy agenda to reduce high energy intensities and unsustainable energy practices in CEE Feature of centrally planned economy contributing to high energy intensity and unsustainable energy practices

Policy response to address feature

No competition, no penalty for inefficiency Unrealistic resource valuation Subsidized energy prices

Transition to a market economy Privatization Introduction of market prices Lifting subsidies Liberalization of energy prices Consumption-based billing Introduction of metering Transition to a market economy Restructuring Transition to a market economy Privatization Education, technology transfer Data collection on end-use practices Establishment of energy-related state institutional background Open access to information Public awareness-raising campaigns on efficient energy use practices Harmonizing environmental legislation with EU Improvement of enforcement Privatization

Flat rates Dominance of heavy industry Large-scale economies/oversized enterprises Lack of expertise and awareness Insufficient data and understanding related to energy use

Lack of pollution control

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sustainable positive legacies into the market economy as possible could certainly result in leap-frogging in certain aspects of the economy. For instance, while a transition to a higher share of individual mobility is inevitable, if careful attention is paid to keeping a high proportion of the regular public transport passengers, a more sustainable transport system could certainly be developed in CEE countries than in OECD countries. As shown by the painful attempts in developed countries to increase the share of public transport, if a regular public transport passenger is lost from the system to individual transport (automobile), the trend is extremely hard to reverse because of behavioural changes. Hence, preservation of as many of these positive trends as is realistic in market conditions is key to sustainable energy consumption. These countries should pay careful attention to how to sustain the high usage of public transport, the high utilization of rail for freight shipping, how to improve district heating so that it is an economically attractive heating option, and what aspects of a low consumption culture could be preserved or promoted. Obviously these goals require policy ‘leap-frogging’: there are no examples here (or very limited ones) from the developed market economies to follow in the process of transition.

A DECADE OF TRANSITION: ENERGY IN CEE AT THE TURN OF THE MILLENNIUM In this section we review how much of the policy agenda outlined above has been implemented in CEE countries, and its result: what is the energy landscape at the turn of the millennium in the CEE? Since covering the entire energy sector and the entire CEE and former Soviet Union (FSU) region would be well beyond the scope of this chapter, here we constrain our discussion to one fuel: electricity; and focus on four selected countries. We discuss developments in the three CEE countries most likely to join the EU in the first round of accession: Hungary, Poland and the Czech Republic; and as a contrast, Russia, where developments often went in a very different direction.

A CHRONICLE OF THE FIRST DECADE OF ENERGY TRANSITION Instead of socialist structures during the first decade of transition, all CEE and FSU economies have assumed the basic characteristics of market economies. This, in theory, should have addressed most legacies left behind by the centrally planned economy contributing to the high energy

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intensities. However, the transition to market structures is a gradual one, and the different countries of the region have assumed different pathways for restructuring their economies. This section aims to chart how much the selected countries progressed in the key policy agenda items in their electricity sectors: restructuring, privatization and price reform. Yet, two major impediments related to creating competition in the electricity sectors of the transition economies should be taken into consideration. First, there was a lack of experience with privatization in the region and with competition in the power sector in general. Then, adjusting the power systems in the region implies substantial capital costs, which should come from abroad, thus raising worries about giving strategic sectors to foreigners (Chandler, 2000). Electricity Industry Reform in CEE and Russia Most countries in Central and Eastern Europe and the Commonwealth of Independent States (CIS) now pursue similar policies in order to increase the role of the market in the provision of electricity services. Before 1990, electricity industries in the CEE countries and the FSU were organized in vertically integrated state enterprises that encompassed all stages of production: generation, transmission and distribution of electricity. In the Czech Republic and Hungary, the domestic electricity industry consisted of a single utility, while Poland’s and Russia’s electricity industries were made up of a number of regional utilities (five and 72, respectively). In the socialist economies, electric utilities operated under the close supervision of the central authorities of the state. This meant that electric utilities, similar to other state enterprises, had their investments approved and financed by the state (Stern and Davis, 1997, p. 6). Following 1989, the re-establishment of financial separation between utilities and the state was set as a policy objective in all newly emerged market economies. Corporatisation of electric utilities served as a first step toward making utilities operate on commercial terms. It aimed to create hard budget constraints on electricity enterprises and to abolish the funding of investments from the state budget (Stern and Davis 1997, p. 6). All three CEE countries and also Russia undertook the task of utility corporatization early in the 1990s. Corporatization usually occurred in combination with various measures of restructuring. Russia and the Czech Republic – the only countries pursuing voucher-based privatization schemes in our sample – also carried out partial privatization early in the process of their electricity industry reform. As a first step, in the early 1990s, governments divided their electric utilities into smaller units and corporatized them separately. While

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restructuring in the Czech Republic and Russian electricity industry was limited to the unbundling of the distribution sector of the industry from the transmission and generation sectors, Hungary and Poland also undertook unbundling between generation and transmission. These steps served both to increase the transparency of utilities’ operation and to set the stage for further liberalization measures such as privatization and deregulation. The subsequent histories of electricity industry reform in the four countries show a rather mixed picture. Poland and Hungary have taken significant steps towards liberalizing their electricity industries. Both countries have also established a separate regulatory body responsible for administering regulation. Poland has also introduced a partial liberalization of the retail market, with full liberalization scheduled for 2005. It is interesting, however, that, despite Poland’s strong commitment to deregulation, so far it has proceeded quite slowly with privatization – so far only six or seven energy companies have been privatized. In contrast, Hungary embarked on a largescale privatization program in the mid-1990s, selling all distribution companies and six power companies (out of the country’s eight) to strategic investors, mostly foreigners. In terms of deregulating the electricity market, however, Hungary is lagging far behind Poland. Hungary’s new electricity law, setting the framework conditions for introducing competition, has not yet been passed, and the date of market-opening has been delayed until 2003. Compared to Poland and Hungary, the Czech Republic and Russia have made relatively less progress in restructuring their electricity industries over the last decade. Though both countries privatized parts of their electricity industries quite early, during the first half of the 1990s, their governments continue to retain the control over the great majority of the privatized enterprises. Furthermore, in both countries, generation and transmission activities remain largely integrated, presenting a major impediment to creating competition. Little progress has been made either in establishing an effective and transparent regulatory framework. Despite Russia’s considerable efforts to reform its electricity sector, the industry’s monopolistic structure remains. A major obstacle to introducing competition is that one company controls over half the country’s total generation capacity. Lack of cost-based prices presents another major obstacle to further progress in Russia. Until tariffs are allowed to reflect the relative costs of supplying different groups of consumers, regional utilities will not obey federal rules permitting third-party access (TPA) for industrial consumers. Finally, in Russia, electricity reform has been hampered by general economic conditions as well. Operation of the economy has been paralysed by non-payment and arrears problems throughout the 1990s. In the electricity sector, sizeable parts of the total bills remain unpaid and power theft occurs on a large scale. It is very unlikely that the markets will play a greater

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role in the provision of electricity in Russia until the basic institutional pillars of the market economy have been dismantled. Chronicle of Energy Price Reforms: Electricity Tariffs in the Selected Countries As mentioned above, during the socialist era energy prices were generally kept well below cost in the CEE economies and the Soviet Union, and industrial tariffs cross-subsidized lower residential ones. Following 1989, the newly elected governments in CEE and CIS have all been facing the challenge of both raising absolute prices towards economic cost and rebalancing relative prices between major groups of consumers. Figures 11.5 and 11.6 show that the dynamic of price rebalancing varies significantly from one country to another even in the CEE group. Poland increased relative prices throughout the first half of the 1990s, raised household prices above prices for industrial consumers by 1992, and, by 1995, achieved a price ratio of 1.5, which is comparable to those in OECD countries. Since then, electricity prices have stabilized at the 1995 level. Hungary carried out a significant increase in household prices over the 1994–97 period, and achieved a price ratio of around 1.35 between residential and non-residential consumers by 2000. The Czechs increased 9 8

US cents/kWh

7 6 Czech Republic Hungary Poland Russia OECD

5 4 3 2 1 0 1990

1991

1992

1993

1994

1995 1996 Year

1997

1998

1999

2000

Source: IEA (1998a, 1999a, 2001).

Figure 11.5 The development of electricity prices for industry in selected countries and OECD, 1990–2000 (in current US dollars)

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14 12

Cents/kWh

10 8

Czech Republic Hungary Poland Russia OECD

6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year

Source: IEA (1998a, 1999a, 2001).

Figure 11.6 The development of electricity prices for households in selected countries and OECD, 1990–2000 (in current US dollars) relative prices sharply between 1990 and 1992, but then made almost no progress for several years. It was not until 1999 that household prices became higher than prices for industrial consumers. In 2000, households prices were 15 per cent above those charged for industry. In Russia, energy prices, especially for gas and electricity, remain well below cost. According to recent IEA estimates, Russia’s gas and electricity prices reflect rates of subsidy of 46 per cent and 42 per cent, respectively (IEA, 2000, p. 122).4 Furthermore, these prices are often not the effective price paid for energy resources. Non-payment, late payment and payment by barter have become widespread in the Russian economy since the beginning of the 1990s. Payment and arrears problems have had a harmful effect on the energy sector too. In 1997, the collection rate in the gas sector was around 60 per cent. Moreover, cash payment was estimated at only 17 per cent of total bills paid. Like the gas sector, the electricity and coal industries also had poor collection rates (IEA, 2000, p. 124).5 Prices for Russian industrial consumers increased steadily between 1991 and 1996–97, but household prices remained well below those charged for industry. This shows that industrial consumers were compelled to subsidize household prices throughout the 1990s. Due to low energy prices and a limited payment infrastructure, industrial enterprises have not had any incentive to reduce energy consumption or to invest in more effective technologies.

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In Hungary, electricity price regulation is based on a hybrid method combining elements of both price caps and rate of return regulation. The initial prices of 1 January 1997 were set to cover justifiable costs and 8 per cent return on assets. Individual prices were determined for the generators and the transmission company, whereas an average price was set for distributors. Between 1997 and 2000, prices were adjusted according to formulas set by statute. Prices are allowed to follow inflation, but are reduced by an efficiency factor. Fuel costs are allowed to be passed through to generators, and distribution companies were allowed to pass costs of generation and transmission onto end-users until 2000.6 The Energy Landscape at the Turn of the Millennium GDP trends and the demand for primary energy It is well known that all post-communist economies of Central and East Europe (CEE) and the Commonwealth of Independent States (CIS) experienced deep structural crises after 1989. The Czech Republic, Hungary and Poland experienced an average contraction of around 18–20 per cent in real GDP between 1989 and 1993 (Figure 11.7).7 Since then, the same three countries have had significant GDP growth, and the 1989 level was recovered in the second half of the 1990s. Compared to the CEE economies, the Russian economy has undergone a much deeper 120.00

Per cent of 1989 values

110.00 100.00 Czech Republic Hungary Poland Russia

90.00 80.00 70.00 60.00

19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99

50.00 Year

Source: IEA (1998b, 1999b, 2001).

Figure 11.7 GDP of Hungary, Poland, the Czech Republic and Russia (1989 = 100%)

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110.00 105.00 100.00

Per cent

95.00 90.00 85.00 80.00

Czech Republic Hungary Poland Russia

75.00 70.00 65.00 60.00 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Year

Source: IEA (1998b, 1999b, 2001).

Figure 11.8 The development of primary energy supply in selected CEE countries, 1985–98, as a percentage of 1989 values recession over the last ten years. Real GDP dropped by about 43 per cent between 1989 and 1996. After recovering modestly in 1997, Russian GDP resumed its decline in 1998 due to a financial crisis. The crisis resulted from two main factors: first, lower world-market prices for oil led to a sharp drop in earnings from oil and gas, and second, the Asian crisis undermined confidence among portfolio investors in emerging markets (IEA, 2000). The economic crisis resulted in a significant drop in the demand for energy for the three CEE countries. In 1993, total primary energy supply (TPES) in the three chosen countries in CEE was on average 18 per cent below the 1989 level, and in 1998, 19 per cent below it (Figure 11.8). Thus, despite the economic recovery since 1993, energy consumption in the three CEE economies has stabilized at the 1993 level. This demonstrates a continuous improvement in energy intensity, to be discussed in the following section. As a direct consequence of the continuing economic recession, Russia’s energy demand has declined sharply throughout the 1990s. Between 1989 and 1998, TPES fell by about 34 per cent (Figure 11.8). The evolution of energy consumption in Russia has also resulted in a significant reduction of energy supply per capita to reach the European Union average or the corresponding figure for the Czech Republic. In the case of Hungary and Poland, energy supply per capita is about 30 per cent lower than the EU average (Figure 11.9).

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Toe per capita

5.5

US Russia Germany Czech Republic OECD EU-15 Poland Hungary

5 4.5 4 3.5 3 2.5 2 1989

Source:

1990

1991

1992

1993 1994 Year

1995

1996

1997

1998

IEA (1998b, 1999b, 2001).

Figure 11.9

TPES per capita in selected countries and country groups, 1989–98

110.00 105.00 100.00 Czech Republic Hungary Poland Russia

Per cent

95.00 90.00 85.00 80.00 75.00 70.00 1989

1990

1991

1992

1993

1994 1995 Year

1996

1997

1998

1999

Source: IEA (1998b, 1999c, 1999d, 2001).

Figure 11.10 The development of electricity consumption in selected CEE countries, 1985–99 (1989 = 100%) Electricity demand trends in CEE The evolution of electricity consumption and production has been deeply influenced by the profile of economic activity: decreasing continuously between 1989 and 1993 and increasing continuously between 1993 and 1997 in the Czech Republic, Hungary and Poland (Figure 11.10).8 Stern and Davis

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Index of industrial production (1990 = 100)

140 120 Hungary Czech Republic Poland OECD total

100 80 60 40 20 0 1990

1991

1992

1993

1994

1995

1996

1997

Year

Note: Industrial production refers to the goods produced by establishments engaged in mining (including oil extraction), manufacturing, and production of electricity, gas and water. Source: IEA (1999b).

Figure 11.11 Index of industrial production in selected CEE countries, (1990 = 100%) (1997) suggest that the electricity demand decrease in the early 1990s was largely determined by the substantial reduction in industrial output, particularly output of heavy industry. This can easily be seen if one considers the industrial sector’s large share in total electricity demand and the fact that industrial output shrank even more than real GDP between 1989 and 1993. Figure 11.11 shows the decline in industrial output in the three selected CEE countries in comparison with the trend in the OECD. As can be seen, the fall in industrial production in Hungary and Poland has been more abrupt and steady than the decline in the Czech Republic. In the period 1990–97 industrial production in Hungary decreased by almost 40 per cent and the decrease for Poland was similar. Electricity consumption fell by around 12 per cent over the 1989–93 period in the three CEE economies under study. This shows that electricity consumption reductions were below the GDP falls for these countries.9 An important contributing factor to this situation was the increase in household consumption of electricity, which partly offset the effect of decreasing industrial demand. The increase was 20 per cent for Hungary, while it was 57 per cent for the Czech Republic and Slovakia over the 1988–94 period (Stern and Davis, 1997, p. 20). The underlying trend in total electricity consumption has increased in the CEE economies since domestic production recovered in 1993. Since then, the average rate of growth in

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electricity demand has remained below the average rate of real GDP growth in Poland. Despite the return of GDP to its 1989 level (or above in the case of Poland), electricity consumption is still well below the 1989 level in Hungary and Poland. The Czech electricity demand trend has followed a somewhat different pattern. Subsequent to the economic recovery in 1993, there was a strong upward trend in total consumption, and total demand returned to the 1989 level in 1995–96. After peaking in 1996, electricity demand declined, and has shown a continuous decrease since then. This variation in electricity consumption profiles between the Czech Republic, on the one hand, and Hungary and Poland, on the other, can be partly explained by these countries’ different approaches to price rebalancing. The fact that the Czech Republic slowed down in rebalancing household prices in the mid-1990s can be seen as a major factor in the sharp rise in its total electricity demand, even after controlling for growth in its domestic product over the same period. The growth in total demand was mostly driven by a sharp increase in household electricity consumption, including a 32 per cent increase between 1993 and 1994, and a further 5.8 per cent increase in 1995 (Stern and Davis, 1997, p. 21). Although household consumption increased regularly in all CEE countries between 1993 and 1996, the rate of growth was much larger in the Czech Republic than in Hungary and Poland, where household prices of electricity had already been set at higher levels (Figure 11.6).

WHY POLAND? CHRONICLE OF ENERGY INTENSITY DEVELOPMENTS Revisiting our policy agenda outlined in Table 11.1 above, we can now conclude that the majority of the policy priorities influencing energy intensities in CEE were implemented in the three selected CEE countries. Energy subsidies have been lifted, cross-subsidization has ceased and payments are based on consumption in most cases. A significant share of the economy has been privatized, and the energy industry has either largely been privatized, or privatization and transformation into a market-based system has at least begun (in the case of Poland). Most inefficient, obsolete industrial operations have gone out of business. The new economic enterprises are usually less capital intensive, more energy efficient, and typically represent much less energy-intensive branches of the economy than the heavy industry. Therefore, after addressing the reasons for inefficiency, it can be expected that energy intensities dropped to levels close to those in OECD countries. Let us thus review the developments in energy intensities over the last decade.

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Poland has achieved a total improvement of 32 per cent in its energy intensity over the 1989–98 period. In the Czech Republic and Hungary, the gain has been of the order of 16 per cent (Figure 11.12). As shown in Figure 11.13, despite the recent trend, energy intensities in the CEE economies remain high as compared to those in developed countries. In 1997, Hungary’s energy intensity, measured by using the 1990 exchange rate, was 3.5 times higher than the corresponding figure for the European Union. In Poland and the Czech Republic, the energy intensity was about twice as high as in Hungary. However, these ratios should be interpreted with caution. The figures for energy intensity can vary greatly because of the different approaches to estimating GDP. The above figures, based on exchange rates, lie on the higher boundary of estimates and, hence, indicate a large discrepancy between transition economies and developed economies in terms of energy intensity. Other estimates, based on purchasing power parities (PPP), yield less difference in GDP and, hence, in energy intensity between the two groups of countries and within the group of three CEE economies. For example, in 1999 Hungary’s energy intensity at PPP rates was just 10 per cent above the OECD average and only 20 per cent below the corresponding figures for the Czech Republic and Poland (Figure 11.14). Economic restructuring, combined with the prolonged recession, has so far worsened the situation in Russia and led to an even higher energy intensity of output than in the Soviet era. Energy intensity in Russia increased by about 16 per cent between 1989 and 1998 and only started to decline in

120.00

Per cent

110.00 100.00

Czech Republic Hungary Poland Russia

90.00 80.00 70.00 60.00 1989

1990

1991

1992

1993 1994 Year

1995

1996

1997

1998

Source: IEA (1998b, 1999b, 2001).

Figure 11.12 The development of energy intensities in CEE countries, 1989–98

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Energy and sustainability in Central Europe

TPES/GDP (toe per thousand 1990 US$)

2.5

2 Hungary Czech Republic

1.5

Poland Russia1 1

EU-15 OECD total

0.5

0 1983

1985

1987

1989

1991

1993

1995

1997

Year

Note: Source:

1 Until

1992 the data are for the former USSR.

IEA (1998b, 1999b, 2000).

Figure 11.13 The development of energy intensities in selected countries and other country groups, 1983–97 (in toe per thousand 1990 US$ exchange rate)

TPES/GDP (toe per thousand 90 US$ PPP)

1.0 0.9 0.8 Hungary

0.7 0.6

Czech Republic

0.5

Poland

0.4

Russia1

0.3

OECD total

0.2 0.1 0.0 1983

1985

1987

1989

1991 1993

1995

1997

1999

Year

Note: Source:

1 Until

1992 the data are for the former USSR.

IEA (1998b, 1999b, 2001).

Figure 11.14 The development of energy intensities in selected countries and OECD, 1983–99 (in toe per thousand 1990 US$ PPP)

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Economic and environmental policies in transition economies

1998 (Figures 11.13 and 11.14). There are a number of factors that must have contributed to this development. In the industrial sector, the increase may have happened as many inefficient enterprises did not shut down after 1989, but continued to operate at a lower level of activity. As a result, the ratios of fixed energy demand to variable energy demand have increased for these firms. This led to lower energy efficiencies for some key industries of the economy, and contributed thereby to higher energy intensity for the country as a whole (Directorate General, 1998, p. 122). The lack of pricing incentives has also played a significant role. Energy prices, especially for gas and electricity, remain well below cost, as discussed above. Payment and arrears problems have had a harmful effect on the energy sectors, too. Due to low energy prices and limited payment, industrial enterprises have not had any incentive to reduce energy consumption or to invest in more efficient technologies. Thus, low effective prices of energy resources have been a major cause of the high energy intensity of the Russian economy (Directorate General, 1998, p. 123).10 While it is clear why the level of energy efficiency in Russia has not improved considerably, it is interesting to examine why energy intensities have not dropped more dynamically in the three selected CEE countries despite the advanced stage of economic reforms, and why there has been significant progress in Poland alone. An attempt to explain these phenomena may lead us in two directions. First, the rationale for continuing high energy intensity in CEE can be found in a misinterpretation of the previous data about the energy intensities of the centrally planned economies. There are firm reasons to believe that the energy intensities of the former communist economies were in fact much higher than previously reported. Most of the historical data about TPES in the former communist countries, including the USSR, can be accepted with a certain degree of confidence. Owing to the different sources, including both the official domestic statistics, and international publications, TPES time series for the communist economies can easily be obtained and confirmed. However, the GDP data are much more questionable. It is well known that most official data for all of the communist countries were largely overvalued, for propaganda reasons. Soviet macroeconomic data, highly susceptible and subject to manipulation at all levels, presented the most striking example of statistical abuse. In the early 1950s, in order to find out real data about the state of the Soviet economy, the US National Bureau of Economic Research undertook a comprehensive study led by G. Warren Nutter (Moore, 1992). A collection of statistics, presented in five volumes and edited by Warren Nutter, brought a much more realistic image of Soviet economic performance (Nutter, 1956). This project was followed by

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a series of articles (Nutter, 1957a, 1957b and 1966a, Nutter et al., 1962) and books (Grossman, 1960), aimed at clarifying the size and essence of Soviet economic growth. Nutter noted three major defects in Soviet data: the selectivity of published data, ambiguity of definitions and the tendency to over-report output (Moore, 1992). All the methodological fallacies of official Soviet statistics were also present to a certain extent in other communist economies. That is the reason why all COMECON countries reported highly overvalued GDP data. Even some other Western studies (Directorate of Intelligence, 1988a, 1988b and 1991) over-estimated output for the Soviet Union and other communist economies (Moore, 1992). According to Moore (1992), Nutter, in one of his later papers (1966b), was also fully aware of the exchange rate problems.11 The overvalued currencies and unrealistically high fixed exchange rates of the communist countries, also contributed to the overvalued GDP data. Another set of problems appeared in purchasing power parity (PPP)based estimations. In this estimation domestic prices are used for purchasing parity calculations. However, so-called hidden inflation was constantly present in all of the communist countries. The practice of maintaining unchanged domestic prices over many years also overvalued GDP on a PPP basis. In fact, most products were unavailable on the official market and at official prices. Black-market prices were much higher, so real purchasing power was much lower. The impact of hidden inflation in aggregate output calculations has almost surely grown as output has become more complex in both product line composition and the nature of the products themselves (Moore, 1992). That is the reason why PPP-based GDP calculations were highly suspect and should be viewed with great scepticism. As a conclusion to the first argument, it can be stated that real GDP in all of the communist economies, including the USSR, was lower than the numbers used for energy-intensity calculations. We therefore argue that during the communist era real energy intensity in CEE was much worse, based on closer-to-reality, lower GDP estimations. The contemporary transitional economies of Poland, and especially Hungary and the Czech Republic, still have somewhat high energy intensities, as compared to OECD standards, although a significant improvement in energy efficiency has occurred. Second, an important reason why the energy-intensity gap between CEE and OECD countries has not closed very rapidly lies in trends in transport energy use, raised above in the section on positive legacies of socialism. Since there is a strong shifting trend in the modal split of passenger travel from public transport to car transport, this is resulting in an increase in energy consumption per passenger kilometre travelled. This, consequently,

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Economic and environmental policies in transition economies

increases the specific energy consumption for travel, slowing the decline of national-level energy intensity. Third, another potential explanation for the high energy intensity of the selected CEE economies is not incompatible with the first argument. Energy intensity, being closely related to energy efficiency in industrial and residential sectors, depends highly on behavioral and organizational issues. Energy intensity in the household sector largely depends on residents’ behaviour. Changes in the pattern of consumer behavior demand not only time, but also sufficient financial resources to be implemented. During the initial phase of economic reforms, a transitional recession has been observed in all of the CEE countries (The World Bank, 1996). In an atmosphere of reduced living standards, there was not enough motivation to change the pattern of consumer behavior. In spite of the fact that energy prices increased, most consumers did not know how to improve the efficiency of their energy use apart from purchasing more expensive appliances that they could not afford. In the industrial sector of communist economies, high energy intensity was part of a common organizational pattern. A majority of the managers, engineers and technicians were trained to rely on cheap and abundant energy. The illusion of abundant, nearly unlimited, energy sources was one of the pillars of communist education. As described above, most of the communist countries depended heavily on Soviet energy sources. Excessively high energy intensity, and thus high demand for fuels, could be regarded as a way of maintaining dependence on the Soviet Union. A certain amount of time is needed to change an established technical organization, together with a high amount of capital for technological changes. This argument can offer an explanation for the still high energy intensity of CEE countries. Among CEE countries, the Polish economy presented the highest rate of improvement in energy efficiency, a sharp and persistent decline of energy intensity from 1991 (Figure 11.14). This is partially due to the shift in the fuel structure away from coal (Figure 11.15). In addition, the sectoral shift in the economy from heavy industry to less energy-intensive branches has been more pronounced than in the other two countries. It is possible that this unique improvement can also be partly attributed to the Polish government’s efforts to improve energy efficiency. The Polish have introduced several programs aimed at improving energy efficiency, including various subsidized schemes for enhancing thermal efficiency in buildings and space heating. For instance, in the period 1991–97 there were state subsidies to housing cooperations to enhance the thermal efficiency of buildings. In 1998 a Fund for Thermal Rehabilitation

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Share in primary energy use (in %)

100 90 Other Natural gas Petroleum Coal

80 70 60 50 1988

1990

1995

1996

1997

1998

1999

Source: Third national communication to the COP to UNFCCC.

Figure 11.15

Development of the structure of TPES in Poland, 1988–99

has been established, which offers subsidies as high as 25 per cent of the initial costs to households, cooperatives, small producers and municipalities for improving energy efficiency in heating. Furthermore, since 1991 environmental funds have financed projects that aim at reducing emissions in the cities (Raczka, personal communication). These practices are definitely not the sole reason why Poland has made the most progress in this sphere, since some similar programs were present in the other two countries as well. However, Poland’s unique progress may be rather misleading due to some differences in the ‘baseline’ conditions: Hungary had already undertaken many of its economic reforms in the 1980s, so its energy intensity at the end of that decade was already lower than that of the other two countries. Thus, Hungary began from a lower baseline than Poland at the fall of the Berlin Wall. One of the essential characteristics of the Polish transition process was a very rapid structural change, taking the form of a large shift of resources from state-owned enterprises to de novo private firms (Rostowski, 1998, p. 333). De novo private firms contributed strongly to the successful transition and growth of the Polish economy. The private sector created from the ground up played a decisive part in these rapid changes (Winiecki, 1996, p. 42). Such private firms, characterized by new organizational patterns, responded much better to increased energy prices. In contrast to the other transitional economies, where the privatization process simply altered the ownership structure of the economy, changes in Poland

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Economic and environmental policies in transition economies

brought both new ownership and new organization. Instead of inheriting the previous system’s organizational legacies, Poland created new organizational structures that were more entrepreneurial and usually less capital intensive (Rostowski, 1998, p. 346). This is also another factor contributing to the energy-efficiency improvements in the Polish industrial sector.

THE REMAINING AGENDA OF TRANSITION TOWARDS A MORE SUSTAINABLE ENERGY SYSTEM So far, we have analysed the reasons for the high levels of energy intensities in the former communist countries by identifying the related legacies from the centrally planned economy. We went on to outline a policy agenda to address these legacies. We reviewed the reforms implemented in the energy industry and the related reforms in the economy, and examined how much progress had been achieved in the reduction of high energy intensities. We have concluded that the energy-intensity gap has only worsened in Russia, and has not yet been closed in the CEE countries. In the preceding section we analysed the reasons for this. Table 11.2 summarizes the progress made in the policy goals outlined above. The trends shown in this table underline our explanation of energyintensity developments. Energy intensities have decreased in countries which have made substantial progress in economic reforms and energy sector restructuring (CEE countries), thereby addressing most of the legacies of communism affecting energy efficiency. By contrast, in Russia, where the transition to a market economy is incomplete and energy sector reforms have not been radical, energy intensities increased further instead of declining. Thus, we can restate that the first key step towards decreasing the worldrecord energy intensities of former socialist countries is the general transition to a market economy, including the restructuring of the energy sector. However, a competitive economy and a market-based energy sector alone are not sufficient to close the energy-intensity gap in the short term. As illustrated by the second part of Table 11.2, progress in more direct energyefficiency policies beyond the general economic restructuring has been much more limited. While most counties have identified improvements in energy efficiency as one of the key national energy policy goals, concrete steps in this direction have been limited. Hence, if former communist countries are to reach the levels of energy efficiency in the current EU, energy efficiency needs to be more directly and consistently targeted by policies

257

Transition to a market economy Privatization of the economy (as a percentage of private sector in GDP)1 Privatization of the energy industry (electricity here) Liberalization of the energy industry Lifting energy price subsidies2 Consumption-based billing Introduction of metering4 Increasing energyefficiency awareness Energy-efficiency education of experts

Policy goal to address factor contributing to high energy intensities (see Table 11.1) Completed Largely completed (87% of GDP is from the private sector) Largely completed Start planned for 2003 Completed3 Mostly completed In process Limited progress Limited/no progress

Partially completed (67% of GDP is from the private sector) Started

Started

Completed

Mostly completed

In process

Limited progress

Limited/no progress

Hungary

Largely completed

Poland

Limited/no progress

Limited progress

Limited/no progress

Limited/no progress

In process

Partially completed

Mostly completed In process

Not completed

Not started

Partially completed

Started; further progress needed Partially completed (about 70% of GDP is from the private sector)

Russia

Start planned for 2002 Completed

Largely completed (80% of GDP is from the private sector) Partially completed

Completed

Czech Republic

Status of the implementation of policy goal

Table 11.2 The status of the implementation of the policy agenda outlined in Table 11.1 in the three CEE countries discussed

258

(continued)

Improvement needed In process Much progress needed

Further progress needed

Improvement needed

In process

Much progress needed

Hungary

Worsened during the 1990s Much progress made in 2000; further progress needed

Progress needed

Poland

Much progress needed

In process

Improvement needed

Worsened during the 1990s Further progress needed

Czech Republic

Status of the implementation of policy goal

Much progress needed

Not applicable

Improvement needed

Situation worsened during Putin administration

Worsened during the 1990s

Russia

Sources: For the Czech Republic and Poland: European Commission (2001a, 2001b). For Hunagary: Dresdner Bank (2001). For Russia: EBRD (n.d.).

Notes: 1 Data for the share of the private sector in GDP of the Czech republic and Poland are for 2000. Data for the share of the private sector in Hungary are for 2001. Data for Russia is undated. 2 In the majority of countries of the world, some form of subsidy exists in energy pricing. Therefore in this row we consider the lifting of price subsidies ‘completed’ if energy subsidies remain within levels prevalent in OECD countries. 3 Hungary is still cross-subsidizing natural gas. 4 The most important impediment to consumption-based billing is the lack of meters. The installation of meters, and therefore metering, is in process where appropriate.

Data collection on end-use practices Establishment of energy-efficiencyrelated state institutional background Open access to information Harmonizing environmental legislation with EU Improvement of enforcement

Policy goal to address factor contributing to high energy intensities (see Table 11.1)

Table 11.2

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259

and institutional and educational reforms. Specific policy goals to be pursued include, but are certainly not limited to: ●

● ●

●

●

●

●

● ●

●

completing the legislative framework for energy efficiency policy, harmonized with the EU acquis communitaire. This includes performance standards, building codes and certification, and labelling schemes; strengthening of the enforcement of related legislation and policies; the introduction of voluntary market transformation programs aimed at industries and businesses (this can be especially important for many newly establishing enterprises); the incorporation of energy-efficiency understanding into the curriculum at all educational levels (elementary to graduate level); expert training and retraining of the elder generation of relevant experts and skilled labourers; institutional and financial commitment from the government by the establishment (or reinforcement) and empowerment of the institutional structures for energy-efficiency policy, and by commitment of financial and human resources for the purpose; the rational, openly advertised and transparent distribution of energy efficiency and renewable energy funds; consistent end-user data collection and reporting; establishing or strengthening the relevant research and development capacities; and policies reinforcing the high share of public transport and rail freight in the modal split.

In the three selected CEE countries, moderate progress has been made on some of the above. Unfortunately it is beyond the scope of this chapter to go into details over the specifics of this progress by country. The list above shows that funding for energy efficiency and renewable energy is, while important, not the only essential element of improving energy efficiency. While almost all of the above items require some level of funding, some measures, such as energy-efficiency performance standards and labelling, education, and so on, have minimal costs. Thus, the limited availability of state financing alone is not a legitimate excuse for not pursuing radical energy-efficiency policies. On the contrary, it is typically easier to establish the legislative and policy framework before economic transition so that the new economy is already based in a calculable financial and legal environment. Once the business sector and industrial production are established, it is much more difficult to introduce restrictive legislation such as performance or environmental emissions standards.

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However, even if all the policies suggested above are pursued, a dramatic change will not occur overnight. Some aspects of the economy, such as corruption, non-payment, electricity theft, weak enforcement, and the grey or black economy, all affecting economic and therefore energy efficiency, are likely to take a long time to disappear, since these have become culturally rooted over decades of communist rule. The cultural and behavioral legacies of communism, present in the working attitudes, organizational behavior and all other levels of operation, are very difficult to transform. Even with the most advanced economic and legislative reforms, these are likely to persist for at least half a generation, slowing progress in economic and energy-efficiency improvements. For instance, the state may devote funds to energy efficiency in vain. If the implementing agency is forced, for administrative reasons, to distribute the money within a few weeks, the funds may result in a very limited value per invested euro.

CONCLUSION The goal of this chapter was to identify the most important policy agenda for a sustainable restructuring of the energy sector in Central and East European countries. First, we have demonstrated that the key to a more sustainable energy sector in these countries is the reduction of world-record energy intensities. We have identified the legacies of the centrally planned economy which contributed to these world-record energy intensities. We have outlined a policy agenda which could overcome these legacies as part of the economic restructuring process. We have pointed out that at the dawn of transition a unique window of opportunity existed for creating the basics of an economy which is more energy-efficient in some respects, such as transport, than the developed economies. We have, then, summarized the progress which has been made over the first decade of transition in the relevant economic reforms and energy sector restructuring. We have also examined the developments of energy intensities over the past decade, and shown that the energy-efficiency gap between the EU and CEE has only increased in Russia, and has not improved significantly in Central European countries. We have analysed the reasons for this slow or lack of progress. We have demonstrated that radical economic reforms and energy sector restructuring are a key to the improvement of energy intensities. However, they are not sufficient in and of themselves. If CEE countries seriously aim to bringing down their energy intensities to levels close to those in the EU, they need to implement major energy efficiency policies and establish or reinforce the relevant institutional back-

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ground. It has been pointed out that the ideal is to pursue these reforms at the beginning of the transition process so that the new business and industrial sector is already based in a sustainable and calculable legislative and policy framework. We have drawn attention to the window of opportunity in the reinforcement of high public transport usage as a way to leap-frog towards a potentially more sustainable transport system than in the EU. Unfortunately, many of the windows of opportunity for leap-frogging have already closed for CEE countries, but they still often exist in slowly transforming economies, such as Russia and other former Soviet republics. However, such leap-frogging requires ingenious and dedicated policymakers who dare not to copy Western policies, but to tailor new ones to local conditions. But the West, especially multilateral financial institutions, is also required to acknowledge and promote different, new pathways for development. Finally, we have pointed out that even if the most radical policy, legislative and institutional reforms are implemented, the energyefficiency gap will take time to close due to the slower process of cultural and behavioral change.

NOTES * 1. 2. 3. 4. 5. 6. 7. 8.

9. 10.

The authors of this paper would like to thank those who contributed their time, effort and expertise: Szilard Asztalos, Andrzej Baniak, Anna Loguinova, Jan Raczka and Silvia Lazarova. More detailed figures will follow. Certainly the citizens have not directly consumed all this energy, but their per capita share of national primary energy consumption was very high. Based on data from Italy, France, the United Kingdom and Germany. In both cases, price subsidies are considerably higher for the residential sector than for the industrial sector. World Energy Outlook reports that non-payment of energy bills totalled US$ 85 billion in 1997 in the Russian Federation (IEA, 2000, p. 115). With the oil and gas price hikes of 2000 and 2001, distributors were not allowed to pass all costs on to consumers. In this chapter, the terms ‘real GDP’ and ‘GDP’ are used interchangeably. Real GDP figures are computed by using the price levels of 1990 and the yearly average 1990 exchange rate for US dollars. For electricity generation, Hungary presents an exception. Unlike in any other CEE or CIS economies, electricity production in Hungary increased steadily in the early 1990s. Before 1990, Hungary imported a large volume of electricity at a low price from the Ukraine (the former Soviet Union). During the 1980s, on average 35 per cent of total demand was covered by imported electricity. Since 1989, imported electricity has fallen dramatically, and this accounts for the continuous increase in domestic generation. Another point of interest is that, in all countries considered, the total decline in electricity consumption has been smaller than the total fall in TPES for the period 1989–99. This suggests that electricity is reinforcing its share in total energy demand. World Energy Outlook provides empirical evidence on the interrelationship between electricity prices and energy intensity. It compares the electricity intensity of GDP and

262

11.

Economic and environmental policies in transition economies households’ electricity prices across countries. The graphical analysis, based on data for 27 OECD countries and 22 non-OECD countries, reveals a strong inverse relationship between the two, which is difficult to explain solely by structural factors (such as climate and geography.) This suggests that prices, through their impact on energy demand and efficiency, are one of the fundamental variables determining energy intensity (IEA, 2000, pp. 40–41). ‘Nutter was fully aware of these problems; in a comment on Thornton’s paper, he makes the point that all such estimates are sensitive to the choice and adjustment of weights used in constructing ruble–dollar conversion ratios’ (Moore, 1992).

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12.

Reorganization of environmental policy in Russia: the decade of success and failures in implementation and prospective quests* Vladimir Kotov and Elena Nikitina

INTRODUCTION In the 1990s, the European countries of the former socialist bloc entered a new era of economic and political development that marked a transition to a market economy and democracy. Many of them adopted new environmental policies and formulated renewed commitment to sustainable development. Among the characteristics of their new environmental policy were institutional innovations and wider participatory patterns, including an increased role for business, locales, the public, and non-governmental organizations (NGOs) in environmental policy implementation, expanded support by the West for environmental capacity building and the promotion of integration of environmental concerns into economic and democratic reforms. During the last decade, Russia, as one member of this group was actively involved in reorganization of its national and international environmental policies. Among the lessons learned from the previous decade was that, together with new broader opportunities for institutional innovations and for the introduction of new instruments for environmental management, the specifics of changes in economic, social and political systems as well as the instability of their major parameters imposed additional constraints on environmentally sustainable development. In many cases this resulted in failures in domestic and international implementation of new institutional responses. By the turn of the century, the gap between progressive environmental policy goals and the reality of putting them into action increased considerably. As a result, many modern and

265

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‘standard’ instruments of environmental management introduced during the recent decade produced ‘non-standard’ outcomes. Created mostly according to their Western prototypes, new environmental mechanisms aimed at responding to environmental threats lost part of their effectiveness when implemented within a general domestic institutional framework deformed by corruption, weak government at all levels, a shadow economy, influence from interest groups and low public control over environmental decision-making. Adaptation of environmental institutional innovations, including those transferred from the West, to the Russian reality of the transition period appeared to be quite painful and subject to many distortions. Our analysis indicates that success or failure in environmental responses depend not only on the design of environmental policy as such, but to a greater extent, on progress in domestic political reforms, the effectiveness of new economic institutions and the ability to overcome economic depression and financial crisis. Despite significant institutional innovations and environmental reforms, the real opportunities for environmental problem-solving decreased sharply in Russia during the 1990s; this was accompanied by diminishing concern over environmental security among the public and policy-makers. Within the sustainable development schemes, economic priorities dominate environmental ones. At the turn of the century, the new Russian government initiated efforts towards economic recovery and to overcome the weakness of government authorities. A new round of liberal reforms and the strengthening of institutional performance are expected to increase capacity for environmental policy implementation. However, it has yet to be seen to what extent it would be possible to foster already commenced economic growth in ways that protect the environment.

MAJOR FEATURES OF THE REORGANIZATION OF RUSSIAN ENVIRONMENTAL POLICY IN THE 1990S From the beginning of the 1990s, Russia started to elaborate a new environmental policy aimed at addressing the environmental degradation which was inherited, to a large extent, from the Soviet era, which was characterized by extensive and unsustainable use of the environment. Transition to new economic and political systems brought about a renewed commitment to sustainable development. During the last decade, Russia redefined its approach to environmental security and designed new schemes to respond to environmental problems. An important feature of this policy was the formation of a new domestic environmental management system under

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considerable pressure from the West. A variety of institutional mechanisms applied in market societies were transferred to and adopted by Russia during this decade. Major innovative elements of environmental policy reform in the 1990s included the following: ●

●

●

●

●

●

●

elaboration of the new environmental legislation and adoption in 1991 of the first framework environmental law in the history of Russia, which was later supplemented by special laws in particular spheres of nature protection; significant institutional changes in environmental management, including the creation of a specialized governmental institutional structure responsible for the protection of the environment, and the establishment of institutional horizontal and vertical subsidiarity; decentralization of environmental management with the transfer of authority from the national level to the regional and local levels; introduction of economic mechanisms of environmental management, including the polluter-pays principle and pollution charges, and the creation of a system of non-budgetary environmental funds; introduction of obligatory environmental impact assessments for all types of economic activities and industrial projects; declaration of environmental glasnost and free access to ecological information; expansion of participation in the globalization process and in international environmental agreements.

Formation of a new institutional framework for environmental management can be regarded as one of the successes of the new Russia. Despite some widely held perceptions both in the West and inside Russia that there is an urgent need for institutional capacity formation in the environmental sector, in fact, these basic elements are already in place and are embedded in ongoing market reforms. However, scrupulous analysis of the effectiveness of new policy implementation during the 1990s has indicated that there are still significant problems in their performance. Today, the results of institutional reform appear impressive, but their effects both on environmental problem solving and the behavior of the main domestic polluters seem to be more modest than expected. Moreover, during the 1990s there was a widening gap between the intentions of the new environmental policy, and their implementation, and translating policy goals into action. This specifically relates not only to national environmental policy, but also to domestic implementation of international environmental commitments.

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BARRIERS TO NEW POLICY IMPLEMENTATION The economic and political transition in Russia brought about constraints upon environmental policy implementation. Alongside significant positive opportunities for the application of new instruments of environmental management, this has negative implications for the process. During the 1990s environmental policy has become increasingly dependent on specifics of economic and political development, on overall instability in the country. It appears that during the transition period, within the sustainable development schemes officially advertised, the environmental priorities that were at the top of the national agenda at the start of the reforms, have receded before economic goals. Ecological concerns were not given a high priority in the programs of the prominent politicians and political parties. According to public polls, while the environment ranked high – second or third – as a public concern in the late 1980s, it has slipped to tenth place by the mid-1990s, consistently appearing below other concerns such as wages, prices, crime and social security. All these new realities have negative implications for implementation of environmental policy and for ecological problem solving. The decade of transition in Russia introduced its modifications and limitations into new environmental policy performance. Recently introduced environmental instruments were losing their effectiveness within a general institutional framework deformed by corruption, the weakness of the government, and vulnerable to group interests. A variety of ‘situational’ factors rooted in the economic and political systems’ specifics of the transition period had a negative impact on environmental problem solving. These factors can be summarized as follows: ●

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●

● ● ● ● ● ● ●

general weakness of state authority and governmental control at all levels, including weakness of environmental institutions to perform their functions; deeply penetrating corruption and ‘status rent’ actively applied by the bureaucracies; a sharp increase in a shadow economy accounting for 40 per cent of GNP; under-reformed property-rights; institutional uncertainties in the investment climate; economic and financial crisis; considerable decrease in investments; aging of industrial and purification equipment; illegal capital flows from Russia to the West; Russia’s high external debt to the West, with a high portion inherited from the Soviet Union;

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269

low public control over the environmental performance of government administration.

The cumulative negative effect of these ‘situational factors’ led to serious deformations in the application of environmental management instruments and environmental policy performance. The success or failure of environmental policy depended not only on the design of that policy as such and on the instruments selected, but to a greater extent, on the progress of domestic economic and political reforms, as well as on the consolidation and effectiveness of new economic and governmental institutions. The economic instability and crisis that characterized the transition period of the 1990s in Russia superseded environmental policy advances. Thus, the standard instruments of environmental management, which in many cases had effective results when used in the West and which had recently been borrowed by Russia, often had unexpected and non-standard results when applied without preliminary adaptation to the specifics of the transition period, and without ‘protection’ from the negative impacts of situational factors. These obstacles should be taken into serious consideration in designing international cooperation strategies, including international assistance to environmental management and capacity building in Russia. Indeed, inadequate attention and assessment of the negative impacts of these factors often led to failures in transfer of the Western models and practices of environmental management that had been at the core of cooperation between Russia and the West in the 1990s. These factors also affected domestic implementation of Russia’s obligations under international environmental agreements.

IMPLEMENTATION EFFECTIVENESS AND IMPLEMENTATION PROBLEMS What were the major results and effects of new environmental policy implementation during the 1990s? Was it able to contribute to environmental problem solving and to amelioration of the environmental situation in the country? Did it have an impact in forcing the major environmental polluters to change their behaviour to become environmentally responsible? A brief overview of the environmental situation indicates that, by the end of the century, according to official environmental data, about 15 per cent of the territory of the country with a population of about 60 million were regarded as zones of ecological crisis. Environmental reports indicate that destabilization of the environmental situation has a direct link to the

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deterioration of human health. Russia ranked only 51st in the world for average life expectancy, and 62nd on the human development index calculated regularly by the United Nations Development Program (UNDP) (UNDP, 2000). Together with major demographic trends, environmental stress was among the causes for such an alarming situation. Indeed, the quality of 70 per cent of the surface freshwater did not meet existing norms. From the total amount of waters discharged, only 15 per cent were thoroughly purified, while about 28 per cent were untreated. Half of the population was drinking water that did not meet sanitary requirements. Air pollution also directly affected human health. In 185 cities with about 40 per cent of the country’s total population, the level of air pollution exceeded existing standards (Gosuidarstvennyi, 1999). There have been a number of assessments and rankings of environmental problems in Russia. All include the following major problems: drinking water quality, air pollution, pollution with toxic and radioactive wastes, and ecological deterioration as a result of industrial accidents. The scale of environmental insecurity varied across the vast territory of Russia, depending on the level of anthropogenic pressures and ecological degradation.1 However, analysis of dynamics during the 1990s in the major indicators of human pressures on the environment, and, particularly, of the trends in major polluters’ emissions, revealed that they have substantially decreased over the last decade. Tables 12.1 and 12.2 contain data on the dynamics of some environmental indicators in Russia in the 1990s. They show, for example, that air emissions from stationary sources declined during the decade by 46 per cent, and discharges into water bodies decreased by 25 per cent. At first glance, the data characterizing emissions reduction during the period when the new environmental policy was initiated in Russia seem to be very encouraging. However, more scrupulous analysis shows that the main reason for improvements in environmental indicator trends could not by and large be attributed to the application of new management instruments nor to enforcement of new environmental legislation. Indeed, the major cause for the decrease in water and air discharges and in emissions of greenhouse gases in Russia during the 1990s has been the decline in industrial production and the curtailing of economic activities. The Russian economic depression of the 1990s appeared to be an important tool in meeting the goals of many domestic environmental programs and in achieving compliance with obligations under international environmental agreements. In many cases a phenomenon of compliance without implementation occurred (Kotov and Nikitina, 1996), as a great portion of emission reduction was caused by industrial production decline, but not by installation of purification facilities and special anti-pollution measures

271 1107.5 ⫺8

1106.1 – ⫺18

99.6

27.1

22.0

28.2

1992

⫺14

94.9

27.2

19.0

24.8

1993

⫺21

86.9

24.6

13.5

21.9

1994

Source: RF National Environmental Reports (various), Ohrana (2001), Rossiisky (2000).

28.0

17.3

21.0 27.8

31.8

1991

34.1

1990

Dynamics of environmental indicators and GNP in Russia

Air emissions from stationary sources (mill. tons) Air emissions from automobile transport (mill. tons) Discharges of polluted waters (bill. cub. metres) Water use from water bodies (bill. cub. metres) Industrial production (% from previous year)

Table 12.1

⫺3

86.6

24.5

11.0

21.3

1995

⫺4

82.6

22.4

11.0

20.3

1996

0

81.3

23.0

11.3

19.3

1997

⫺5

76.9

22.0

11.8

18.7

1998

⫹8

77.9

20.7

12.2

18.5

1999

⫹9

–

20.3

–

18.8

2000

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Table 12.2

Economic and environmental policies in transition economies

Dynamics in greenhouse gas emissions in Russia

CO2 CH4 N2O HFCs PFCs Total emissions

1990 (Giga grams of CO2 eq.)

1996 (Giga grams of CO2 eq.)

Change 1990–96 (%)

2 372 303 26 504 225.7 9.665 31.630 3 040 062

1 495 920 18 544 131.7 5.915 30.262 1 962 441

⫺37 ⫺30 ⫺42 ⫺39 ⫺4 ⫺35

Source: Russian Federation (1998).

introduced by producers in response to the introduction of new instruments of environmental management. In fact, during the economic depression, industrial production and GNP shrank considerably (by about 55 per cent and 50 per cent respectively, from 1990 to 1997). As a result, air and water discharges from industry and agriculture dropped sharply. However, the rate of decrease in emissions was much lower than the decline in economic activities. This is a crucial issue, since the aging, damage to, or switching off of purification equipment compounded the problem. The environmental regulatory measures to reduce pollution were not as effective as expected at the start of reforms. At the same time, implementation of special policies and mitigation measures accounted for some comparatively minor effects. For example, within climate change policy the effects of mitigation measures, although quite modest, have been registered. Some experts suggest, that about 60–70 per cent of emissions reduction in the energy sector during the recent decade was attributed to economic decline, while about 8–12 per cent due to wider use of natural gas and structural changes in the economy (Mastepanov et al., 2001).2 Within a number of international environmental treaties, Russia complied with its commitments, but, at the same time, it did not take serious measures to implement them. Over-compliance by Russia with its commitments under the Convention on Long-range Transboundary Air Pollution and the 52 per cent decrease in sulphur dioxide emissions against the 30 per cent required by its sulphur protocol was attributed mainly to the reduction in industrial production. The same cause could be identified for the reduction, by half, of Russia’s pollutant discharges into the basin of the Baltic Sea during the 1990s. This contributed to meeting the goals of the Convention on the Protection of the Marine Environment of the Baltic Sea.

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An important question is how emissions will be controlled when the economy recovers. Although the official environmental statistics for the new century are not yet available, a reversal of the decline in emission dynamics is expected at this point due to new trends in the macroeconomic situation and a shift to economic growth in the country. In 2000, industrial production in Russia was officially reported to have increased by 9 per cent from the previous year with positive dynamics in some economic indicators registered from 1999. Most environmental indicators are supposed to follow the major trends in industrial production. It seems that environmental management systems are unlikely to be able to deal effectively with the problem in their current form. More concise efforts are needed from implementators of environmental policy to enforce and adjust new instruments of environmental management to the current macroeconomic situation. The following sections of this chapter aim to analyse the particular elements of the environmental reorganization in Russia in the 1990s, and to assess the outcomes of environmental policy innovations. They aim to explore the questions why and how the effects of the newly introduced instruments have been deformed by economic and political development in the country during the 1990s.

INNOVATIONS IN THE INSTITUTIONAL FRAMEWORK FOR ENVIRONMENTAL MANAGEMENT Administrative Reorganization: De-greening of the Government in the 21st Century? Among the prior results of the 1990s environmental reform in Russia was a thorough reorganization of the institutional framework of environmental management with the creation of a specialized governmental environmental protection body. That was a significant achievement, since under the Soviet regime there was no environmental agency responsible for environmental protection and implementation of national environmental policies. Formerly, environmental protection responsibilities were dispersed among 16–18 ministries engaged simultaneously in economic activities and environmental protection: an institution had to ensure environmental enforcement over its own activities which were mainly aimed at utilization of the environment. The result was that economic interests took priority over environmental ones and that nature and its resources were severely plundered. Institutional changes were initiated at the end of 1980s in the course of perestroika in the USSR when, in 1988, the State Committee on

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Nature Protection was formed (similar committees had been created in the Soviet republics, including Russia). By the end of 1991 the status of the environment was elevated, and the Russian Federation (RF) Ministry of Environment and Natural Resources Protection was created. This major federal institution with a special competence was intended to combine regulatory, licensing and control functions in environmental protection. During the 1990s and especially in the second half of the decade, the bureaucratic competition between government institutions for control over natural resources and for access to financial flows in this sector was very strong in Russia; it was supplemented by lobbying from powerful industrial groups and political elites. Gradually, the status of the federal environmental agency in the government hierarchy and its role in decision-making were diminished during the last decade. This reflected the gradual weakening in the position of the environmental protection authority in the power structure. In this period, the environmental agency was under constant institutional reorganization, and some of its newly acquired functions had been withdrawn from its competence. In the course of competition at the top level for control over the use of natural resources and minerals, some of the responsibilities of the former Ministry of Environment (that is, protection and rational use of natural resources) had been transferred to the newly established RF Ministry of Natural Resources (MNR). Later, its formal status within the government structure suffered a further decline, and in 1996 the newly created Ministry of Environment was transferred into the State Committee for the Environment. This had negative implications for environmental problem solving, and as a result, the head of the environmental agency lost some of its influence in the government because it was only the heads of ministries, but not of state committees, who were members of the government and had voting rights in decision-making. The Committee acquired a weaker position relative to many other government institutions. Protests by the scientific community and leading environmentalists, the public, and members of the State Duma’s ecological committee against such administrative reorganization did not help. The abolition of this ministry reflected the low priority for environmental concerns in the government and among politicians. Finally, the culmination of these negative trends in the institutional structure of environmental protection has been a complete dismantling of the environmental protection agency (in the course of the next governmental reorganization in 2000), and the transfer of all its functions to the MNR. The latter was a pro-development entity and it was expected to combine the functions of both economic use of natural resources and their protection from over-exploitation. It seems that a similar design in governmental structure had already been used in Russia, and it was not effective.

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Combined in the same governmental body, the interests of economic use of the environment usually predominated over protection interests and over the sustainable use of natural resources. So, by the turn of the century, the situation reverted back to where it had been at the start of the environmental reforms in the early 1990s. In the course of such ‘modernization’, many positive results in administrative capacity building during the 1990s were erased with negative effect on environmental problem solving. Recent institutional reorganization manifested the weak position of the environmental protection institutions in the modern structure of power in Russia. Hopes at the beginning of the 1990s for an improving environmental situation with institutional reforms did not bear fruit. Administrative competition and the lobbying of interest groups resulted in the failure of institutional design for environmental protection. The power of the state in Russia has greatly decreased, in terms of its ability to enforce environmental regulations. Recent weakening of its authority vis-à-vis industrial polluters and various potential violators of environmental rules has negative implications for the environment. The complexity and conflicting pressures inherent in this situation make it difficult for governmental organs to wield much influence in the environmental area. Many government acts have not been enforced, and many domestic actors are not complying with governmental environmental regulations. Decentralization of Environmental Management With the development of federalism in Russia during the last decade, regions began to play an increasing role in environmental policy. This was a new phenomenon, since during the Soviet regime regions played little role, and in fact, the regions were unable to implement their own environmental policies, and their environmental interests were subdued. As a result of changes in the domestic political system during the 1990s, regional authorities acquired larger roles in promoting environmental policies within their territories. According to the new constitution, the protection of nature became a joint responsibility of the federation and the regions. As part of new environmental policy, the federal level began to share its authority with the regions and locales. It seemed that the federation was doing this rather willingly, dividing its responsibilities and practical efforts in environmental protection with the regions. According to the national 1991 Law on Environmental Protection, the joint responsibility of the federation and the regions includes: ● ●

elaboration and implementation of environmental programs; establishing fees for pollutant discharges;

276 ●

● ● ●

● ●

Economic and environmental policies in transition economies

allocation of permits for the use of natural resources and for the disposal of wastes; governmental environmental impact assessments; governmental environmental controls and monitoring; decision-making regarding the closure of industrial enterprises damaging the environment; organization and maintenance of nature reserves; environmental education.

In the 1990s, what Russian institutions performed environmental functions at the regional level? As a result of environmental reform the newly established territorial branches of the federal Ministry of Environment acquired this responsibility. These regional environmental bodies have been formed in all 89 subjects of the federation (in republics, oblasts, and autonomous okruigs). In turn, they established territorial affiliations in the locales (municipalities). Regions and locales became more active players in domestic environmental policy implementation. They interacted directly with economic actors: they controlled and inspected enterprises, enforced environmental regulations, imposed limits on companies’ emissions, allocated licences and fixed rates for pollution fees. Particularly important was the fact that the majority of revenues accumulated from the recently introduced system of pollution charges were directed to the local and regional level. Further dissemination of these financial resources for environmental protection purposes went to territorial environmental organs. The new system of decentralized environmental management with new regional structures has only been in force in Russia for the past decade. Together with its positive features, serious problems emerged in the course of its implementation, and the regional institutional framework was characterized by a number of distortions. In Russia, decentralization, especially the transfer of management functions from the centre to the regional (local) level, was associated with great hopes for improving environmental management, which was supposed to bring the decision-making process closer to the objects in need of protection. However, these hopes have not been realized in many cases, and on the contrary, decentralization has sometimes aggravated environmental problems. The general cause is that the formation of democratic institutions at the local level has proved more difficult than at the federal level. Local elites retained power over the majority of local institutions, spreading their control over environmental protection, over the development of natural resources and over the financial resources allocated for these purposes. Quite often this has not been to the benefit of the environment and sustainable development, but in the elites’ own interests. Having eliminated control from above, local authorities have

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277

managed to avoid democratic control and accountability before the public, which is of particular importance in the environmental sphere. Under a weak public control, economic interests usually appeared to be stronger than environmental ones, and this is clearly manifested at a local level. The local elites tried to obtain the right to deal with natural resources with a free hand, and in many regions they have succeeded. According to major analysts, corruption in the regional and local state authority was much more severe than in the centre. Violations of environmental regulations became more numerous. Officials often accepted bribes in exchange for granting timber licences and licences for other types of natural resources, permitting developments within conservation areas, and falsifying tender results for the use of natural resources. During the 1990s the territorial environmental organs appeared to be in a dual subordination both to the federal environmental agency, and to the regional administration simultaneously. The rights of the federation and the regions over territorial environmental organs overlapped. Dualism resulted in an escape from responsibility, in vagueness of both the rights and obligations of territorial environmental organs. At the same time, this seriously complicated the decision-making process. In fact, many territorial organs of the federal environmental agency ended up, by the turn of the century, under the complete control of the regional administration, which was skilfully spreading its influence over environmental activities. In particular, such control became tight when it related to the allocation of financial resources for environmental protection, and, especially, to resources accumulated in environmental funds. Local administration attempted to extend its authority over regional environmental funds, and not always to use them for ecological purposes. Local administrators also attempted to participate actively in environmental decision-making, by interfering in the actions of environmental organs to impose pollution charges over particular polluters, and by influencing the results of environmental impact assessment. For example, regional administrations decided not to close polluting enterprises because of their economic or social importance for the regions, completely disregarding the contrary position of environmental organs, which were based on ecological considerations. By the end of the 1990s, institutional controversies between the federation and the regions escalated. Significant contradictions were accumulating between federal and regional environmental and conservation laws and norms, and clear separation of functions between the two levels had not been achieved. Another feature was a shift of focus in environmental interactions between federal and regional levels of authority: the competition for the right to control natural resources and for access to financial flows from their export has turned out to be at its core. The main question

278

Economic and environmental policies in transition economies

was who would control these resources – elites (authorities) in the centre, or elites (authorities) in the regions. The red tape in this competition has not been control over rational use of natural resources and their environmentally benign exploitation, but who would benefit financially from their use. Environmental protection policy in regions rich in natural resources appeared to be dependent on and subordinated to resource-use issues. Environmental protection in the regions was gradually receding from the political foreground towards a periphery of political and policy-making interests. Use of natural resources was becoming a priority item on the economic and political agenda in the regions. Finally, the reorganization in 2000 of the environmental protection authority at the federal level affected regional institutional capacities as well. The former regional/local committees on environmental protection, forestry and natural resources had been united under the regional branches of the MNR. Following the general reform in vertical subsidiarity under the new government of Vladimir Putin, which intended to sort out problems in interaction between the federation and the regions and to eliminate the discrepancies in federal and regional laws, the MNR territorial structure was modified. Within its eight major regional Departments on Natural Resources3 about 74 regional Committees of Natural Resources were established (data as of August 2001) (Territorialnye, 2002);4 it also includes 21 water basins and forest management bodies in different regions of Russia. It is too early to evaluate the effectiveness of this new territorial scheme in environmental protection, but it seems that major problems related to institutional organization of environmental protection at the federal level are entirely replicated in the regions.

ECONOMIC MECHANISMS OF ENVIRONMENTAL MANAGEMENT: DEFORMATIONS IN APPLICATION Payments for Pollution After 1991 the new system of environmental management in Russia had introduced pollution charges. These became the major economic instrument of environmental management. Today charges are established for air and water pollution and for solid waste disposal.5 There has been an intention to spread payments for pollution to other types of pollutants and spheres, such as radioactive wastes disposal, electromagnetic pollution and noise, marine pollution, ground-water pollution, carbon dioxide emissions, and the production and consumption of ozone-depleting substances (ODS).

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279

However, this system faced not only methodological problems, but also necessitated counteracting the interests of powerful industrial groups. For example, the efforts of environmental organs to introduce earlier payments for CO2 emissions had been suppressed by the powerful energy lobby. The system of pollution charges was intended to provide incentives for firms to reduce emissions. In practice, it appeared not to be as effective as envisioned. Some factors of the internal design of this system, coupled with the effects of situational factors of the transition period, accounted for deformations and limitations in implementation of these schemes. One of the reasons is that the fees assessed are much lower than the cost of investing in more environmentally responsible technologies. The result is that polluters sometimes preferred to pay for pollution above allowable limits of emissions rather than investing in environmental facilities.6 At the same time, the environmental organs were not able to increase the basic fees, as they were guided as well by economic considerations to protect domestic producers against environmentally related closure. Certain modifications have been introduced into the system during the 1990s that have considerably corrupted its design (Kotov and Nikitina, 1998). Many Russian firms were exceeding their allowable emissions and incurring fivefold increases in fees. Enterprises complained to the regional administration that increases in payments for pollution would result in their bankruptcy, and they would be forced to close. Instead of closure, the regional organs introduced (‘as an exclusion’) certain concessions for environmental payments, that is, a ‘provisionally coordinated level of emissions’ for particular polluters. In this case, a firm still paid higher fees, but could deduct all of them as costs (in comparison with the above-mentioned normative deduction from its income). Such protectionist measures were applied not only to firms experiencing severe financial deficit under economic crisis, but to rich and powerful producers, such as, for example, Norilsk Nickel or Almazy-Sakha. In return, an enterprise had to set up a program of measures to reduce its emissions to allowable levels, and it promised to meet its goals, while environmental authorities were to control its implementation. However, the latter often have been weak at enforcing control over actual anti-pollution activities and emission reductions by a company. As a result, the use of provisionally coordinated levels of emissions increased during the 1990s, while the effectiveness of pollution charges decreased. Another modification contributing to deformation of the previously established regulatory mechanism was the development of a system of offsets of pollution payments against environmental measures undertaken by an enterprise. During recent years the share of offsets has rapidly increased. By the mid-1990s, the release of payments for pollution as offsets

280

Economic and environmental policies in transition economies

had been extremely high: twice as big as the collected sum of payments for pollution, and their levels have increased since then; about 2000 enterprises were using offsets. Such a regulatory mechanism could be effective in general, but under current domestic conditions, it has experienced a great deal of distortions. Indeed, institutional control and verification of the use by a firm of offsets to finance implementation of their environmental programs are still poorly developed. There is no guarantee that offset funds will be used effectively according to ecological priorities. For example, sometimes firms unilaterally decided to use offsets and not to transfer payments for pollution into environmental funds without coordination with environmental organs. Moreover, under current economic conditions, the offset sums were too low to provide true environmental reconstruction. As a result, the system of offsets was often used to camouflage the release of producers from pollution payments. In addition, inadmissible practice was introduced when the level of pollution charges was reduced for particular polluters, or they were even exempted from pollution taxes. For example, in 1996, according to official data about 2414 firms in Russia were exempted from payments for pollution, and for 1251 firms the level of payments was reduced (among them, such large energy companies as Rosneft) (Komarov, 1998). In these cases, the government clearly demonstrated a priority of economic interests over environmental ones, thus contributing to a decline in the effectiveness of economic mechanisms of environmental management. The system of pollution charges faced enormous obstacles to implementation because of the weaknesses of governmental authority. It offered producers another means of avoiding pollution charges: simply not paying them. Incredible as it may seem to people in the West, and despite the nominal existence of penalties, the practice of not meeting one’s financial obligations was widespread in Russia in the 1990s. Firms have evaded taxes, defaulted on bank loans and failed to pay their suppliers and employees; black market transactions were rampant. Territorial environmental organs, subordinate to the local administration, were often too weak to apply true levers of control and enforcement on polluters. In many regions, the annual level of collection of payments was lower than expected (in Sakha Republic, for example, it was about one-third of the expected revenue). These modifications and revisions to the system of pollution charges have been undertaken as a means of adaptation to domestic development trends. They were mainly induced by economic considerations and because of the impact of the economic crisis in the 1990s. These revisions were also a result of lobbying by producers. A number of considerable privileges were granted to polluters that served against the goals of the original pollution charges system. When economic concerns alone governed adaptation of

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new environmental instruments, they often brought negative results. When lobbying and corruption were added, devastating outcomes were generated. The government authorities introduced these revisions of the system of pollution charges by the end of the last decade, and currently their modified versions are still widely used.

ENVIRONMENTAL FUNDS Together with the introduction of payments for pollution, a system of governmental non-budget environmental funds was established at the beginning of the 1990s to finance environmental protection activities.7 They were supposed to be a new source of financing environmental protection. While in the West pollution charges are a form of taxes, in countries with economies in transition they take a non-tax form8 and are accumulated in non-budget environmental funds. Russia established a three-level system of local, regional and federal environmental funds: they are organized in all jurisdictions of the Russian Federation.9 Environmental funds can be regarded as a typical form of adaptation of economic mechanisms of environmental control in countries with economies under transition. In the 1990s, they were used in most of the countries of Central and Eastern Europe as a transitional form of adaptation to a market. In Russia, in the process of their introduction, the lessons of the countries of Central and Eastern Europe were taken into account. Environmental funds there were at various stages of development, and they were established for financing mid-term and long-term projects in the countries where market economies were not fully developed, the banking system was under formation, banking rates were high, and financial institutions were not yet interested in funding environmental projects. It was expected that under developed market systems a shift would take place from non-budget environmental funds to payments for pollution in the form of regular taxes as currently occurs in the West. By the end of the 1990s about 200 million dollars had been transferred annually to environmental funds: for such a large country as Russia this figure was quite modest. The share of environmental funds financing environmental protection was much lower than predicted. The major reason was the low level of collection of pollution charges against the projected level. This accounted for only about 40–50 per cent. Environmental bodies aimed to increase this level by revising the mechanisms of indexation of charges, by re-evaluating the basic levels of payments and their further increase, by establishing charges for other types of pollution, by shifting to crediting operations, and so on (Ekologicheskye, 1997).

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Meanwhile, during the 1990s the financial authorities took advantage of the system by attempting to incorporate environmental funds into the consolidated budget (such consolidation violated the federal 1991 Law on Environmental Protection). The decision about consolidation illustrated once again the weak position of environmental institutions in the hierarchy of power within government at all levels. It provided additional opportunities to regional and federal authorities to control environmental funds. After the consolidation of environmental funds, the territorial environmental organs, in many cases, had been alienated from management of these funds, and decisions were undertaken unilaterally by regional and local administrations. Among other negative results was the fact that in some cases the regions used the money from the environmental funds for purposes other than environmental protection, which is contrary to the environmental legislation.

FINANCING ENVIRONMENTAL PROTECTION There have been three major sources of environmental financing in Russia: the state and local budgets, environmental funds and the resources of enterprises. Serious problems and severe shortages in financing environmental protection were registered in the 1990s, and these were among the major obstacles for environmental protection. Indeed, during the 1970s and 1980s the budgetary financing of environmental protection was a major practice in the Soviet Union. It provided respectable, but stable financial transfers into the sector. In the 1990s, the situation was modified completely; traditional budget sources have decreased significantly. The state budget crisis in Russia had the greatest negative implications for solving environmental problems. For several recent years experts have characterized the state budget as ‘anti-ecological’, and the share of budget spending for environmental protection has decreased dramatically. For example, in 1997 environmental expenditures from the state budget shrank to 0.4 per cent of total expenditures as compared to 0.6 per cent in 1994. In the 1997 budget, environmental protection (as well, rather oddly, as hydrometeorology and cartography) accounted only for 0.09 per cent of GDP. Underfinancing in the state budget of governmental environmental institutions was characteristic during the 1990s. In this case, ‘underfinancing’ refers to the fact that even those limited resources allocated by the state budget to environmental protection have not been transferred in due time and in their entirety, and often amounts were just nominal. Governmental financial support for implementation of major governmental environmental programs declined, and such a trend definitely calls

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into question the prospects of their realization. According to different estimates, only 5–10 per cent of resources required by adopted governmental environmental programs were actually covered by budget financing. For example, the major 1996–2000 federal program on climate change was supported by funding for only for 3–4 per cent of required resources, causing serious failures in implementation. Despite that, the government was still ambitiously adopting various new environmental programs, but all of them had one feature in common: they would not be implemented as they were not supported by real financing. Although some innovations have been introduced into the financing of environmental protection, still, there are serious concerns whether the major federal environmental programs10 will be successfully executed if effective financial mechanisms are not put into action. With their underfinancing and the general curtailing in industrial investments during the economic crisis, environmental investments have been very low during the 1990s.11 During the last decade total capital investments in environmental protection decreased annually by about 88 per cent over the previous year average (Rossiisky, 2001). As a result, in the 1990s the putting into operation of air and water purification equipment has steadily declined several fold (Figure 12.1). This situation will, of course, have very negative consequences in the long run, and will aggravate the already insecure environmental situation in the country.

25

10

Water purification facilities (mill. cubic m/day) Systems of water recycling (mill. cubic m/day)

5

Flue gas scrubbers (mill. cubic m/hour)

20 15

Note:

00 20

98 19

96 19

94 19

92 19

–9 01 86

19

19

76

–8 01

0

1 Annual

average.

Source: Ohrana Okruizhauishei Sredy v Rossii (2001), RF Goskomstat, Moscow; Rossiisky Statistichesky Ezhegodnik (various years).

Figure 12.1

New Russian environmental facilities, 1976–2000

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New trends in the financing of environmental protection may have positive implications for environmental problem solving. These new trends relate to certain innovations in the structure and sources for environmental financing. Importantly, the share of non-budget sources for capital investment in environmental protection and the rational use of natural resources increased, accounting for about 78 per cent in 2000, and becoming the major source of revenue. Another innovation was that the resources of enterprises were turning into an important source of financing environmental protection and natural resources conservation, contributing annually, according to official statistics, to about three-quarters of total capital environmental investments.12 The structure of different sources of financing, including the federal budget, the budgets of federation subjects and locales, the resources of enterprises and environmental funds across various sectors of environmental protection are presented in Figure 12.2. This trend was also one of the reasons for positive dynamics in capital investments at the turn of the millennium: 2000 was the first year, in contrast to those of the last decade, when capital environmental investments increased, by 133 per cent, from the previous year (Ohrana, 2001). At the same time, the role of environmental funds was much less than desired: their share is about 4 per cent in the structure of environmental protection financing in Russia. For the next decade, the Russian government intends to increase its support and spending for environmental protection and natural resource conservation. The recently adopted major federal environmental program ‘Environment and Natural Resources 2002–2010’ envisages financing at a level of about $5.8 billion for the next decade, of which about 24 per cent is expected to come from the federal budget, 31 per cent from regional and local budgets, and 45 per cent from non-budget sources and the resources of enterprises (Federalnaya, 2001). The environmental strategies of the Russian government for the next decade are also based on a wider use of new and non-traditional mechanisms for expanding environmental investments, including foreign investments. For example, Russia is expected to establish adequate national institutional frameworks for the application of such international tools as joint implementation and emission trading, which would promote green investment in Russia. It is expected that joint implementation projects in Russia (in the energy sector, forestry and landfills) undertaken under the climate change international regime would attract additional foreign investment and result in the reduction of greenhouse gases and other air pollutants. This would significantly contribute to natural resource conservation and energy savings. At the same time, the innovative idea of the recently proposed ‘Green Investments Scheme’ (Moe et al. 2001) suggests

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Part 1

Protection and rational use of natural resources

Protection and rational use of soils

Part 2

Protection and rational use of water resources

Source:

Air protection

Federal budget

Resources of enterprises

Budgets of federation subjects

Other sources

Ohrana Okruizhauishei Sredy v Rossii (2001); RF Goskomstat.

Figure 12.2 Sources of capital investments in environmental protection and natural resources conservation in Russia, 2000 (%) the use of revenues from international emissions trading for the development and implementation of energy efficiency improvements and energy savings projects in Russia. This provides the rationale for additional investments in the Russian energy sector that would lead to higher energy efficiency and environmental amelioration. Among other ideas currently being discussed by Russia and Finland, are mechanisms of debt-for-nature swaps in attracting investments to improve the environmental situation in the Baltic basin. Role of Foreign Assistance Active debates are currently under way over the role of the West in the financial support of environmental problem solving and capacity building in Russia. According to some estimates, over $1 billion has been committed by foreign governments and international organizations during the past decade to address the issues of environmental protection and natural resources management in Russia (US Agency for International Development, 1998). At the turn of the century, about 30 donors (governments and international organizations) were actively taking part in environmental aid to Russia. During the 1990s, there have been various

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assessments of foreign aid contributions to the environmental sector. Some experts have evaluated the foreign share at approximately 40 per cent of total environmental expenditures in Russia, which seemed to be a significant overestimation. Others assessed the share of external sources in environmental financing more modestly – at about 7 to 8 per cent in 1997. During the 1990s, despite the growing scale of foreign environmental support in all former Soviet states, the share of foreign sources was much lower than domestic sources of finance (the highest share among Newly Industrialized States (NIS) countries, 15 per cent, was in Estonia). In general, the foreign assistance received by the countries of Central Europe was higher than in the NIS (approximately four fold), and it accounted for ECU 23.0 per capita in the CEE as compared with ECU 8.2 per capita for NIS (‘The Effectiveness of International Financial Instruments’, 1995; Zelenyi Mir, 1997). Western programs of environmental support to Russia paid significant attention to assisting institutional capacity building, to the modernization of domestic environmental policy towards the application of market instruments of environmental management, and to promoting sectoral measures in environmentally vulnerable areas. The majority of resources were going not to the central government, but directly to the regional and local levels. For instance, about 80 per cent of the International Bank for Reconstruction and Development (IBRD) environmental credits were allocated in the 1990s to oblasts and locales. The relative role of Western financing was higher for environmental problems that threaten the environmental security of the West and for global environmental problems. This related to such issues as transboundary air pollution, treatment of radioactive wastes, protection of freshwater quality, regional seas, natural resources that are important to enhance the national security of the West, or for global problems such as biodiversity conservation and climate change. International financial transfers supported implementation of certain domestic environmental programs and promoted compliance with Russia’s international commitments. Quite often multilateral and bilateral donors have attempted to make this aid conditional on performance. For example, in the 1990s Russia was facing serious difficulties in meeting its obligations under the Montreal Protocol to the 1985 Vienna Convention for the Protection of the Ozone Layer. In 1995, Russia (as a country with an economy in transition) submitted a statement to the secretariat of this convention to extend for five years the ODS phase-out period and to allocate international assistance for this program. After analysing this statement, the secretariat put forward several conditions (compliance with data-reporting requirements, the elaboration of a detailed domestic phase-out program with feasible dates for the phase-out of each gas by each sector) and if these

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were fulfilled, the privileges would be granted. Finally, upon meeting these requirements, Russia obtained international financial assistance for the implementation of its phase-out program and of its international obligations. The Global Environmental Facility (GEF) was to cover about 60 per cent of the total costs of conversion of aerosol and refrigerator-producing facilities, with the rest to be financed from domestic sources. Many environmental programs of international institutions in Russia could be regarded as ‘no-regret’ options linked to commercial and economic development projects. For example, the World Bank’s environmental project aimed at adopting ozone-layer-saving technologies was integrated with the implementation of a project on the use of natural gas in oil developments. According to expert estimates, the latter was supposed to partially compensate the costs of environmental assistance. On the other hand, GEF climate-related projects were associated directly with the expanding activities of the World Bank in the Russian energy sector, and global warming mitigation has been an integral component of the energy projects of the World Bank in this country. An oil ‘rehabilitation project’, costing $1.035 billion and to be financed by an IBRD loan of $610 million was approved in the first half of the 1990s; it supported efforts against the decline of oil production and exports in the near future by making the industry more efficient, whereas reducing emissions of greenhouse gases was among its direct goals. Although international financial transfers from the West have been important for Russia, the mobilization of domestic resources for environmental protection is also of priority. One cannot claim that internal resources do not exist in this country. Rather, because Russia, in transition, faces many pressing needs simultaneously, available resources are often directed to purposes other than environmental protection. Moreover, often resources are abundant but public control is weak, a large informal (shadow) economy exists outside governmental control, and many resources are potentially available but untapped for public purposes. Billions of dollars illegally fly into private accounts abroad while the Russian government seeks much smaller sums to be transferred from the West as assistance. The enforcement of strict institutional controls over the allocation of financing, their redistribution and use are of high priority today. All foreign environmental assistance projects are implemented within a specific domestic arena, and current ‘situational factors’ define, to a large extent, their success or failure. The majority are facing similar obstacles to implementation as faced by domestic environmental projects. Today, there is a need for donors to revise the approaches to environmental assistance formed during the 1990s and to elaborate new strategies, taking into account recent economic, social and political reforms. Modifications in the

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structure, mechanisms and tools of environmental assistance in conformity with new parameters are necessary. Without such adaptation to the domestic framework, the foreign environmental support risks a loss in effectiveness as one of the environmental policy tools of West.

PROSPECTIVE QUESTS Current Russian debates centre on issues as to how to make environmental protection policies more effective, what new mechanisms should be incorporated into already established patterns, or how instruments should be improved and adapted to national economic and political reforms. An important feature of new emerging approaches is the acceptance and support of the sustainable development concept in environmental policymaking, an emphasis on close links between the effectiveness of environmental policy and further progress in liberalization, and a strong conditionality of success in environmental reform on further integration of Russia into the international community and participation in globalization processes. The Putin government acknowledges that success in the implementation of environmental protection strategies is defined, to a large extent, by the results of market and democratic reforms that create the necessary systemic framework for environmental management and serve as a precondition for environmental amelioration. Recently, with renewed economic growth in Russia, more active attempts have been made to integrate environmental policies into economic development and to include the assets of nature in social and economic systems. The encouraging sign is that the Ministry of Economic Development and Trade, headed by German Gref, takes part in environmental decision-making and makes attempts to interlink strategies of economic development with environmental concerns. During the previous decade, these two elements were more autonomous. At the same time, it’s too early to evaluate the results of these efforts. Further developments will demonstrate whether the new government succeeds in fostering economic growth in ways that protect the environment and provide resources for investments in clean technologies. A new environmental doctrine is currently being elaborated in Russia (Ekologicheskaya, 2002). This doctrine is supposed to govern future national and international environmental policies, and the adaptation of environmental mechanisms to meet the new challenges created through market and democratic reforms. Some new approaches to the innovation and adaptation of environmental instruments were also suggested by the government within its recent strategy of social and economic development

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through 2010 (Proekt, 2001). This strategy outlines some approaches towards the modernization of the institutional framework for environmental management and its major instruments, and attempts to integrate environmental policy implementation with social and economic development. The core approaches concentrate on the following: ●

●

●

●

The major focus of domestic environmental policy in a short-term perspective will be on promoting environmental and human security, particularly through the rehabilitation and amelioration of the environmental situation in areas of environmental crisis that are typically characterized by the development of heavy industries and non-deep processing of mineral resources. Thus, the governmental program is aimed at promoting, by 2002–2004, positive ecological dynamics within these areas and then stabilization, by 2010, of the environmental situation and rehabilitation of zones in environmental crisis. Particular economic mechanisms and incentives for potential investors are envisaged for these regions. Equally importantly, attention is paid to the improvement of human health in ecologically damaged regions. While formerly, it was widely and superficially exploited and advertised in Russia, the concept of environmental and human security has obtained concrete meaning and a new focus. Its major components are linked now with enhancing safety and control over potentially dangerous activities, the scaling of priorities in health care and demographic and migration policies, the mitigation of the negative environmental consequences of emergencies, prevention and control over the spread of genetically modified products and alien species of wildlife, and the prevention of ecological terrorism. Industrial transformation and structural economic reforms in Russia are believed to contribute to environmental problem solving. The socio-economic program underlines that envisioned changes in industrial infrastructure, the closure or modernization of outdated enterprises, on the one hand, and the development of new industrial capacities oriented towards market conditions, hi-tech, energy efficiency and the deep processing of raw materials, on the other hand, will decrease pressures on the environment. Modernization of enterprises, especially in energy and resource-intensive sectors guided by Western standards are expected to promote realization of environmental policy goals that would target changes in the behaviour of industrial polluters and extensive users of natural resources. As in a mid-term perspective, the national balance of payments is expected to be maintained to a high extent through the export of

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natural resources, and, particularly, energy resources. Considerable attention is paid to assessment of the possible environmental impacts of export-oriented developments. Further expansion of resource exploitation will result in new sites and new territories for the mining industries; that might negatively affect the extremely fragile ecosystems of the Russian Arctic and Far East. Although the government emphasized that preservation and enforcement of environmental norms is of crucial importance in this respect, these particular strategies face a great deal of opposition and provoke debates among the scientific community and environmentalists. At the same time, new tax and tariff policies are suggested that will promote the reorientation of exports of raw natural resources towards exports of deeper processed products. Russia’s integration into the international community and participation in the processes of globalization are believed to be an important factor in environmental problem solving in the country and in the further development of its national and international environmental policies. This relates, first, to Russia’s entry into the WTO and the standardization of its norms and regulations. Second, this includes harmonization of national environmental standards with their international analogues. Third, more scrupulous attention will be paid to compliance and implementation of Russia’s obligations under global environmental agreements, as well as wider application of such international mechanisms as joint implementation and international emissions trading as a means of expanding investments into ecologically and environmentally benign projects. Also, environmental factors are expected to be actively used for the formation of a favourable climate for foreign investments and for increasing the competitiveness of domestic products and services in international markets. Russia’s participation in problem solving within the global environmental change agenda is expected to be more profound and substantial, in contrast to its former activities.

NOTES * 1.

This chapter is based on the results of research performed within the EU/INTAS project Sustainable Water Management Systems in NIS: Problems of Transfer and Adaptation. Of 89 Russian regions under evaluation, 26 faced the most severe problems with discharges of harmful pollutants into water bodies, 29 – hydrochemical pollution of surface waters, 30 – air discharges from stationary sources, 38 – high levels of air pollution in the cities, 28 – pollution and depletion of ground waters, 37 – risks associated with toxic wastes treatment, 36 – radioactive pollution, 20 – soil degradation.

Reorganization of environmental policy in Russia 2. 3. 4.

5.

6.

7.

8. 9.

10.

11. 12.

291

The rest can be attributed to the initiation of institutional reforms in the energy sector. Departments on Natural Resources were established in the following regions: Central, Northwest, Southern, Privolzhsk, North Caucauses, Urals, Far East and Siberian. It is peculiar that some large and powerful federal jurisdictions, such as, for example, Sakha Republic, Bashkortostan, Sverdlovsk, Moscow, Rostov, Novosibirsk, Nizhegorodskaya, Habarovsk oblasts have not yet reported the establishment of regional committees on natural resources. Under the system of pollution charges a firm may emit various types of pollutants up to individually specified limits but is required to pay fees. The fees are increased fivefold against the basic rate when a polluter exceeds allowable limits. Payments for pollution within allowable limits are subtracted from the costs of production, and payments above allowable limits are taken from the polluter’s income. Differentiated basic fees for each pollutant were fixed by the federal organs, while limits of allowable emissions are set by its regional (or local) branch for each particular enterprise in the region. These emission limits are incorporated into a licence allotted to a polluter. On this basis, the level of payments (for each polluting substance) is established for each particular firm by territorial environmental organs. This regulatory mechanism incorporates changes in inflation (by using the index on inflation established by the federal government). For example, according to earlier assessments by the World Bank concerning Pechenganickel and Severonickel non-ferrous facilities located on the Kola peninsula, annual payments for pollution by these two major polluters in the Russian North were about 1000 times lower than the level of investments necessary for transformation in the patterns of their behaviour. Financial resources derived from payments for pollution are deposited in governmental non-budget environmental funds. They also accumulate fines for pollution and other transfers. Currently the major part of these funds – about 80 per cent – comprise payments for pollution. Pollution charges in Russia take a non-tax form, and only 10 per cent of total finance generated through pollution charges is transferred as taxes to the state budget, the rest goes to non-budget environmental funds. The mechanism for the distribution of financing within the system of funds between different levels is as follows: after deduction of 10 per cent of revenue accumulated from environmental charges and fines into the federal budget, 60 per cent goes to the local level, 30 per cent to the oblast and republican level, and 10 per cent to the federal level. Ten per cent of the 60 federal programs for implementation at the beginning of the 2000s are in the environmental field. The major new federal environmental program for the next decade ‘Environment and Natural Resources’ adopted in 2001 embraces 12 subprograms in major sectors of environmental protection and natural resources conservation. However, the shrinking rates of investment in the environmental sphere during the decade were lower than in other sectors. Among industrial sectors, firms in the fuel industry were the major sources of capital investments in environmental protection and the rational use of natural resources ($293 million in 2000); they were followed by non-ferrous companies ($79 million).

REFERENCES ‘The Effectiveness of International Financial Instruments for Environmental Investment in CEE Countries: Recipients’ Perspectives’ (1995), Bundesministerium für Umwelt Österreich/UK Department of the Environment, Band 37. Ekologicheskye Fondy Rossiiskoy Federacii (1997), Moscow: Goskomekologia. Ekologicheskaya doktrina Rossiiskoy Federacii (2002), Project, 2nd edition, Moscow (Environmental doctrine of the Russian Federation).

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Federalnaya celevaya programma ‘Ekologia i prirodnye resuirsy Rossiiskoy Federacii, 2002–2010’ (2001), Moscow: RF Ministry of Natural Resources Federal programme ‘Environment and Natural Resources, 2002–2010’. Gosuidarstvennyi Doklad o Sostoyanii Okruizhauishei Prirodnoy Sredy v Rossiiskoy Federacii, Moscow, various years [State environmental report of the Russian Federation]. Komarov A. (1998), Analiz deitelnosti territorialnyh komitetov po ohrane okruizhauishei sredy sistemy goskomekologii Rossii, Moscow: State Centre of Ecological Programs [Assessment of activities of territorial environmental organs within Goskomekologya system]. Kotov, V., and E. Nikitina (1996), ‘To Reduce or to Produce? Problems of Implementation of the Climate Change Convention in Russia’, in J. Poole and R. Guthrie (eds), Verification 1996, Boulder, CO: Westview Press. Kotov, V., and E. Nikitina (1998), ‘Environmental Protection and Capacity Building in Russia’, in M. Andersen (ed.), Environmental Policy and the Role of Foreign Assistance in Central and Eastern Europe, Denmark: KPMG/CESAM, Paritas Grafik. Mastepanov A., O. Pluzhnikov and V. Gavrilov (2001), ‘Post-Kyoto Energy Strategy of the Russian Federation, Outlooks and Prerequisites of the Kyoto Mechanisms Implementation in the Country’, Climate Policy, 1(1). Moe A., K. Tangen, J. Stern, M. Grubb, V. Berdin, T. Sugiyama and A. Korppoo (2001), ‘A Green Investment Scheme: Achieving Environmental Benefits from Trading with Surplus Quotas’, Briefing Paper, Climate Strategies. Ohrana Okruizhauishei Sredy v Rossii (2001), Moscow: RF Goskomstat [Environmental Protection in Russia]. Proekt programmy Socialno-ekonomicheskogo Razvitia Rossiskoy Federacii na Perspektivy (2001), Moscow: Ministry of Economic Development and Trade [Draft programme of Future Social and Economic Development of the Russian Federation]. Rossiisky Statistichesky Ezhegodnik (2000), Moscow: RF Goskomstat. Rossiisky Statistichesky Ezhegodnik 2001 (2001), Moscow: RF Goskomstat [Russian Statistical Annual 2001]. Russian Federation (1998), Second National Communication of the Russian Federation, Moscow: FCCC/IDR.2/RUS. RF National Environmental Reports (various years). RF Goskomstat, Moscow; Rossiisky Statistichesky Ezhegodnik (various years), Moscow: RF Goskomstat. Territorialnye organy Ministerstva Prirodnyh Resuirsov i organizacii nahodiashiesya v ego vedenii (2002), Official website of the Ministry of Natural Resources, February [Territorial organs of the RF Ministry of Natural Resources and organizations within its competence]. UNDP (2000), UNDP Human Development Report 2000, USA: Oxford University Press. US Agency for International Development (1998), Moscow, Russia. Zelenyi Mir (1997), No. 20.

13.

Policy in transition: a new framework for Russia’s climate policy* Vladimir Kotov

EVOLUTION OF RUSSIA’S CLIMATE POLICY: FROM THE 1990S INTO THE 2000S Today, the climate policy of Russia is often evaluated in order to answer the question: will Russia ratify the Kyoto Protocol? The search for this answer is based mainly on already formed stereotypes regarding this policy and its major features in the 1990s. However, Russian climate policy is rapidly changing, and it seems that the rate of change is accelerating. Ratification of the Kyoto Protocol is one of the most important items on the current Russian climate policy agenda. It cannot be regarded only within the framework of climate policy. The issue of ratification is a focal point where various interests are concentrated and collide: not only the interests of climate policy as such, but interests rooted in economic, energy and structural policies as well. Thus, adequate evaluation of current processes under way within Russia’s climate policy, including the prospects for Kyoto ratification, is possible only (1) within a broader socio-economic and political framework, (2) taking into account recent changes in economic and administrative structures and (3) after identifying the interests of the major actors participating in the Russian climate policy formation, and their possible impacts on it. Russia’s climate policy has several specific features. The first is that its formation was, and still is, under conditions of transition. The climate policy institutional structure remains fragmented; thorough design has not yet been established, and many institutions have yet to be formed. The major reason for this is not only that the Kyoto Protocol is not in force, but also because of uncertainties regarding the design of institutions to implement the international regime for climate change. This situation of flux exists because a number of important changes in the economic and political system of Russia initiated in the early 1990s were not finalized during 293

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the last decade. The effectiveness of climate policy mechanisms and instruments is directly linked to the functioning of economic and administrative mechanisms and instruments. Because the latter suffer from functional failures or are completely absent, climate policy appears to be powerless and is by no means reliable. Thus, Russia’s inclusion by the FCCC in a group of countries with economies in transition is not only of a formal character, it reflects the state of the art in institutional capacity building of economic and administrative systems. Second, the peculiarity of Russia’s climate policy in the 1990s was that its formation and implementation were developing under conditions of deep economic depression. Developed countries have never experienced such deep and long-standing declines in production, that is, ⫺50 per cent in industrial production, and ⫺45 per cent in GDP during the 1990s. Such decline has two effects on climate policy. First, the government was unable to fulfil its obligations in financing climate policy, including further development of climate science, greenhouse gas (GHG) inventory compilation, and support of national reporting, and so on. Another equally important implication of economic depression has been carefree attitudes towards quantitative limitations of GHG emissions and to the prospects of their growth. While other countries with emission limitation targets pay constant attention to problems of compliance with their obligations and to the adoption of necessary mitigation measures, Russia was not in a hurry to adopt implementation measures, assuming that there was a significant reserve period in which to introduce them. The third important peculiarity of Russian climate policy is that public perceptions during the 1990s of the importance of climate change policy was extremely low. This is one of the main features impacting Russian climate policy, no less important than the negative role of economic depression. Taking into account public attitudes towards the problem and the place of this issue in the programs of political parties, global warming and climate change mitigation would appear to be at the bottom of the public agenda in Russia. Recently, non-governmental organizations (NGOs) have become active on this issue; but the activities of NGOs in Russia, unfortunately, are still of a decorative character, and the public does not take a real part in their efforts, which are mostly limited to a small group of participants. Public opinion polls indicate that the population of Russia is primarily concerned with solving problems related to survival, and the public is most interested in addressing extremely low salaries and pensions (which are below the living minimum), growing rates of unemployment, criminal activity and insecurity. The fourth important point is that, in Russia, national interests in climate policy were never clarified. In the 1990s, there was no public discussion

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about what is in the national interests of Russia in terms of climate policy. This relates both to domestic and international climate policies. Indeed, in Russia climate policy is also subject to the pressure and influence of many interest groups. Too many non-clarified, but important details remain. Without clarification, Russian climate policy will be lacking the necessary clarity for its realization that could help avoid future fluctuations and failures. This lack of clarity will reduce its effectiveness or even lead policymakers to strive for goals that may not correspond to national interests. The fifth important peculiarity of Russian climate policy in the 1990s is the weakness of its major institutions. The institutions overseeing climate policy are extremely weak in contrast to other institutions within the structure of the government. The governmental body that was responsible for climate policy implementation in Russia, the Interdepartmental Commission on Climate Change (ICC), was not able to enact solid and independent policy. The major reason was that ICC was headed by an institution with low bureaucratic resources (Hydromet). The weakness of the department responsible for climate policy was part of the reason for its passive stance, for the lack of its dynamics, and was defined by its lagging behind in institutional capacity building. As a consequence, climate policy entered into the new millennium with inadequately developed institutional infrastructure and considerable gaps in its legislative basis. Due to a severe financial deficit to support prior climate policy measures, the government attempted to attract resources from foreign sources. Compilation of the GHG emissions inventory and preparation of the National Communication were performed with financial support from abroad. This could explain one of the reasons for the passive behaviour of the Russian delegation at the international climate negotiations. The sixth peculiarity of Russian climate policy in the 1990s was its one-sided orientation. Thus, the transitional period, especially its initial phase during the 1990s, had a negative impact on climate policy formation and defined a number of its weaknesses and shortages, as well as the incompleteness of its institutional framework. However, since 2000 there have been significant changes in Russian climate policy. Their consequences in some cases are of a long-term character, and these will probably continue in the future. The first change was associated with Russia’s emergence from economic depression and the commencement of economic growth. From 1999 to 2000, GDP increased by 20 per cent, and in 2002 and 2003 further economic growth is expected. The government has announced ambitious plans to speed up economic growth: its goal for the period 2000–2010 is annual growth rates of GDP at 5–6 per cent. While previous cabinets also had

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economic growth targets, they were never realized. It seems the current situation is different: the current governmental program of economic growth is supported by a number of radical institutional modifications, as well as by political stabilization, which is already taking place. A second change is associated with institutional reforms already under way in Russia. In 2000, Russia entered into a new round of radical reforms of its economic and political system, which ceased under the Yeltsin presidency, and were renewed with Putin’s coming to power. The government managed to pass through the State Duma a set of liberal laws which are able to influence the economic development of Russia. Being liberal in content, they significantly simplify the Russian business regulations. They reduce transaction costs, simplify or abolish many bureaucratic procedures, strengthen property rights mechanisms and increase owners’ responsibility for the consequences of their decisions, remove some of the shadow economy, and limit bureaucratic arbitrariness. This so-called ‘modernization’ may have a significant impact on the behaviour in enterprises’ climaterelated business. The recent changes seriously affect major investment institutions, institutions in the energy sector, as well institutions of the climate policy. Thus, the framework, within which climate policy is being and will be implemented, is currently being built in Russia. As to Russian climate policy, the third change is of particular importance. Opportunities opened by the Kyoto Protocol have turned the climate policy of Russia away from the traditional environmental protection sector, which did not result in more than additional spending and a headache for the Russian government, into the sphere of big business. Potential incomes in this sector may be comparable with the most beneficial branches of the Russian economy, that is, the oil and gas businesses. The fourth change is a shift of public attitudes towards climate policy. When, in 1994, the government of V. Chernomyrdin was deciding who should be in charge of the Interdepartmental Commission on Climate Change and assigned this role to Hydromet, certainly, it was hardly expecting to delegate to it leadership over such major business sectors. While the prospects for application of the Kyoto tools were becoming more realistic, the evolution of climate policy was developing along new tracks. In two quite narrow, but important groups of Russian society, interest in climate policy emerged. This interest is of a pragmatic and mercenary nature, and it is linked to opportunities opened up by the flexible mechanisms. These interested groups are, first, the directors of enterprises in those industrial sectors where application of the Kyoto tools promises considerable benefits, and, second, the bureaucrats at the federal and regional levels who might be involved in regulation of the domestic application of the Kyoto Protocol. Forecasts regarding a multi-billion windfall of profit for Russia

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in the case of Kyoto enforcement excited the entrepreneurs and bureaucrats. By establishing control over climate business they tried to provide benefits for themselves. Thus, the new feature of Russian climate policy which started to emerge from the second half of the 1990s is competition for control between interest groups. It may be argued that interest groups affect climate policy not only in Russia, but in the countries of the West as well. However, in these countries, public interest in climate policy is high, and a powerful green movement is in existence there; climate policy plays an important role in political competition between political parties. Thus, in these countries, the actions of administration and enterprises would inevitably be under the control of such forces as would try to realize the national interest and to limit the impacts of the interest groups. The situation is completely different in Russia. As was noted above, the public, green movement and political parties do not control climate policy implementation. Thus, climate policy is at risk of turning into the object of pressure and influence from interest groups. The fifth shift in Russia’s climate policy is that today control over climate policy in Russia has shifted into the hands of the Russian Federation (RF) Ministry of Economic Development and Trade (MEDT). The representative of this ministry became the co-chair of the ICC, and a possible reorganization of this body together with enhanced status was announced. During the 1990s Hydromet guided climate policy into a deadlock, not due to ill will, but primarily because of a lack of administrative resources. Entry into the ministry with high bureaucratic authority (as to this indicator, the MEDT holds a leading role within government) has been considered logical for a long time, and such changes could have a positive effect. Currently, it is clear that big money could be circulating in climate business, and the interests of influential players would be involved, while the role of arbiter of these processes is not within the power of every actor. There is always a danger that without such responsibility, influential actors might block climate policy implementation. As a result of establishing control of the MEDT over climate policy, the stance of the ICC has increased within the governmental bureaucratic hierarchy. Of particular interest would be the issue of interaction between climate policy and Russia’s policy of economic growth. Certain conflicts have always existed between climate policy goals and economic goals. Such conflict was not a danger for Russia in the 1990s, since it was in a deep economic depression. The situation has been modified from 1999 to 2002. The goal of economic growth is correlated with the interests of the public, which at the present time focus mainly on hunger and unemployment. Economic growth is one of the major priorities of Putin. Under these

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conditions, it becomes obvious that it is scarcely possible for climate policy instruments to be realized in Russia if they are in direct conflict with economic growth. It seems, in the near future, that climate policy and its instruments are unlikely to have an impact on economic growth rates; on the contrary, climate policy is likely to be subordinate to economic growth. For example, in these conditions it is difficult to imagine the introduction in Russia of a carbon tax as a result of climate policy considerations, especially if this would have a negative impact on economic growth. The shift in Russian climate policy to the MEDT will not lead to its independence within the general system of governmental policies. The extent of climate policy subordination to economic policy will be very high. Specifically, in Russia, a number of energy and economic policy instruments which climate policy intended to use for GHG emission reduction (increase of gas and electricity prices, switch off for non-payers) face active social opposition, and their application depends on the government’s persistence. Thus, the new period of institutional changes Russia recently entered is an extremely challenging period. Many recent forecasts of the development of Russia’s climate policy that appeared quite trustworthy are likely to become much less so. This does not mean that these forecasts were bad, it only means that the political and economic situation in Russia is now changing radically compared with the second half of 1990s and, as a result, economic and institutional shifts are emerging that were hardly possible to take into account previously.

EMISSION TRENDS AND ECONOMIC GROWTH: MAJOR SCENARIOS FOR RUSSIA The decision of the US government to exit the Kyoto Protocol (KP) was justified by its inconsistency with national interests: it was expected that quantitative limitations of the Kyoto Protocol might significantly slow down the country’s economic growth. In June 2001, questions about the relationship between the KP and economic growth were raised by the Ecological Committee of the State Duma at the preliminary hearings on Kyoto ratification: (1) Won’t Russia exceed quantitative GHG emission limitations set up for her by the Kyoto Protocol? (2) Won’t these limits lead to the imposition in the near future of barriers to economic growth in Russia? According to the representative of the government, all possible scenarios of economic development in Russia and possible emission scenarios have been analysed. The conclusion was reached that Russia would not face any misfortunes in that respect. Neither in 2010, nor in the first budget period of 2008–12 were emissions predicted to exceed the

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1990 base level and limits would not be placed on economic growth (WWF, 2001). In the 1990s, the problem of compliance or non-compliance with the Kyoto Protocol obligations had not been acute for Russia. The same could be said of the problem of economic growth, since there had been no economic growth at all. However, conditions have changed and today, it is necessary to make estimates of economic growth rates and of possible GHG emissions. The reason is evident: Russia has emerged from the economic depression, has begun to experience economic growth, and economic growth is among the major priorities of the policies of the new government. This resulted in increased attention to those emission scenarios which had been developed previously, as well as to the elaboration of new scenarios. According to the IPCC Working Group III (WG-III), emission scenarios are projections of anthropogenic gas emissions based on a coherent and internally consistent set of assumptions. Where there are several such scenarios, then, inevitably the question arises: which one among them is better and more reliable (IPCC, 1994, pp. 31, 34, 37)? WG-III considers that uncertainty regarding future emission projections can be attributed ‘only to a certain extent’ to differences in the models used: ‘Differences in the models serve as an explanation only for a small part of the wide spectrum of emission assessments published in the literature. To a major extent the broad range is explained by the differences in the assumptions of the scenarios’ (IPCC, 1994, p. 36). Assumptions regarding economic growth, quality of organic fuel and growth rates in the efficiency of energy use have the highest impact on emission forecasts. Since there are no commonly accepted criteria for the evaluation of scenarios, as an alternative WG-III suggests analysing the ‘reasonableness’ of assumptions (IPCC, 1994, p. 28). WG-III experts stress the necessity of renewal of scenarios and the development of new scenarios. The process of renewal is of utmost importance for countries with economies in transition in order to take into account recent information on economic transformation and possible technological modernization. Here, new scenarios of economic development are necessary, as well as analysis of climate policy, of new mechanisms and programs, and GHG emission reductions achieved through their implementation (IPCC, 1994, p. 33). This methodological approach WG-III suggests, is of special importance for Russia as a country where serious institutional changes are still under way. Below, I would like to compare the main scenarios of GHG emission in Russia. Not only their outcomes will be compared, but also the assumptions they are built on. Comparison is concentrated especially on scenarios of the First National Communication (FNC), of the Second National

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Communication (SNC), of the Study on Russian National Strategy of GHG Emission Reduction (SRNS), of the IIASA and of the RF Ministry of Energy (ME). The main conclusions from these studies are the following: (a)

The First National Communication of the RF concluded with confidence that energy-related CO2 emissions in 2010 would not exceed their 1990 level (First National Communication, 1995, p. 51). (b) The Second National Communication of RF indicated that ‘only under favourable economic conditions and correspondingly increased investments into energy saving (optimistic scenario) the emission level in 2010 might equal or comprise 90–92 per cent from 1990’ (Second National Communication, 1998, p. 93). The FNC and SNC were produced with a time difference of 2.5 years. However, in the SNC, the prospects of GHG emission reduction by 2010 in Russia are not so optimistic, and the reduction level is not so high; one of its scenarios even envisages increases in emissions from the 1990 base year. (c) The Study on Russian National Strategy of Greenhouse Gas Emission Reduction (SRNS) of the World Bank and the Bureau of Economic Analysis resulted in the following main conclusions: 1. In the absence of new technologies, but under rather rapid GDP growth (4.5 per cent) Russia will not have any significant volume of quotas for trade in 2008–12. There will be a problem of compliance with the national commitments under the Kyoto Protocol. 2. Implementation of new technologies, but without introduction of a carbon tax would not be effective enough. According to this scenario trading potential accounts for 1.75 billion tons of CO2 equivalent. 3. With a carbon tax ranging from $2.5 to $25 per ton of CO2, Russia would have excessive quota allowances that could potentially be sold in the event of an early start to transactions, that is, before 2008. Trading potential during the five years is evaluated in this scenario as up to 2.7 billion tons of CO2 equivalent. (d) The main conclusion of the SRNS: without special policy, under current business-as-usual development, Russia will have serious problems with meeting its commitments under the Kyoto Protocol. In the event of the implementation of additional, intensive GHG emissions reduction policy, including international cooperation, Russia could get substantial resources for climate change activity required by the Protocol and future mitigation measures (World Bank, 1999, section 1, pp. 4–5).

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Comparisons between the SNC and SRNS scenarios pose a number of questions, such as how the SRNS was able to estimate the emission reductions at a level considerably exceeding the levels presented by the SNC scenarios while the rates of economic growth in both studies were assumed to be almost equal (4.4 per cent and 4.5 per cent, respectively). It is well known that the size of emission reduction potential depends on what figures are selected for rates of economic growth and energy savings. Experts from both research teams selected similar rates for GDP growth. Both of them borrowed these figures from the official Medium-Term Strategy of the RF government. As to another important factor, energy intensity, nothing is completely clear. SNC scenarios envisage a decrease in energy intensity (from ⫺0.5 per cent to ⫺2 per cent annually). In fact, all three scenarios of the SNC differ from each other, first, by the energy-intensity indicator. The SNRS mentions nothing about the size of coefficients for energy intensity. Instead, there is a reference to the lack of (in one scenario) or presence (in two another scenarios) of endogenous technical progress. From references to the model, it is possible to find out the following: the general assumption of the model was that, after the start of market reforms, gradual replacement of outdated technologies by more efficient modern technologies takes place. The latter are characterized by both lower resource use and by emission reduction. During the adjustment period, ‘old’ and ‘new’ equipment operate in parallel. For ‘new’ technologies, corresponding data referring to the USA, Japan, Great Britain and some other developed countries were taken into account. The SRNS gives no information about the year from which new indicators with the more efficient technology are taken in the calculation and about the size of these indicators. The capital turnover process was simulated by SRNS. ‘Old’ capacities are depreciating, having two sources of depreciation: regular aging, and lack of competitiveness due to trade liberalization. Fixed investments are directed to the sectors where available capacities are insufficient to produce goods in the quantities required to meet expected demand. It was suggested that all investments produce ‘new’ efficient capacities. Thus, the SRNS model seems to have the following premises: ●

● ●

●

‘reforms’ automatically lead to a resumption of the investment process; all investments are transferred into so-called ‘new’ equipment; the model incorporates this ‘new’ equipment via very high efficiency indicators that exist in the USA, Japan and Great Britain; this equipment is characterized by both lower resource consumption and lower emissions (no concrete figures are indicated).

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Thus, significant emission reduction, and hence a significant level of emission trading potential seem to be assumed, primarily, due to the fact that extremely high levels of energy efficiency indicators have been incorporated into the model beforehand. In October 1998, IIASA published its forecast of the GHG emission dynamics in the countries of the Former Soviet Union (FSU), and particularly in Russia. The specifics of IIASA’s scenarios are that it forecasts emission reduction potential in Russia not only in physical units (t/C), but also it estimates the value of this ‘surplus’ or ‘bubble’ (billion dollars) (Victor et al., 1998).1 The size and value of the ‘bubble’, according to the IIASA, will depend on the level and timing of economic recovery in Russia relative to the first budget period (2008–12) as well as on technological choices. As the authors of the IIASA scenarios note, other scenarios, in contrast to their own, underestimate the depth and length of recession in the FSU countries. IIASA employs six scenarios, which encompass three cases of future development (A, B and C), subdivided into six alternative scenarios (A1, A2, A3, B, C1 and C2). Case A envisions a future of impressive technological improvements and consequent high economic growth. It has three variants, which reflect alternative futures for fossil fuel resources that can be tapped and non-fossil technologies. In scenario A1, oil and gas are abundant and remain dominant fuel sources. In scenario A2, oil and gas are scarce, and, thus, coal becomes a dominant source. In scenario A3, improvements in non-fossil technologies (renewable and nuclear) lead to the long-term elimination of fossil fuels. Case B is a ‘middle course’ scenario. Case C envisions substantial technological progress. In scenario C1, nuclear power is a transient technology. In scenario C2, new reactor technologies lead to renewed growth in nuclear energy over the same period. For the Kyoto period, the most important differences between the scenarios are the level of economic growth (high in A, moderate in B and C) and the technologies employed (high carbon in A2; medium carbon in A1 and B, low carbon in A3, C1 and C2). In all scenarios, the countries of the FSU are in surplus. However, only Russia and the Ukraine, according to IIASA, are likely to sell substantial quantities of bubble permits. IIASA considers that other studies overestimate emissions from the countries of the FSU. One of the reasons for that is that ‘even the few available shorter-term scenarios have systematically underestimated the depth of economic recession’. Each IIASA scenario for Russia yields a significant carbon bubble. The smallest bubble (9 Mt/C) occurred in scenario A2 (high economic growth and carbon-intensive technologies). The largest bubble (877 Mt/C) is in the middle course (B) scenario, which IIASA suggests as the most likely outcome. In this

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scenario, continued weakness in the FSU economies dampens growth in emissions. IIASA’s scenarios are also based on long time spans for the rates of energy intensity improvement: ⫺0.9 per cent annually during the period of 1990–2020, and ⫺0.7 per cent annually during the period 1990–2050 (scenario B). They are even higher in scenario C. In scenario A, they are also higher for the period 1990–2050, but lower for 1990–2020 (⫺0.3 per cent annually for 30 years).2 According to IIASA, the emission targets adopted for Russia in the Kyoto Protocol far exceed the likely level of emissions for the country and Russia could sell its surplus if the Protocol enters into force. In the ‘middle course’ scenario, the value of the total carbon surplus during the budget period 2008–12 is 20 to $150 billion US$ ($4 billion to $26 billion US$ per year; the surplus does not burst until 2040). This flow of assets could exceed Russian earnings from natural gas exports ($10 billion in 1997). Differences in the valuation of Russian potential within the framework of the same scenario are connected with the fact that amounts of GHG emissions in physical units are multiplied by different prices ranging from $20 to $150 per tC. The authors explain variations in prices, first of all, by macroeconomic factors (supply–demand relation). Even under the conditions of a transparent market, prices for the surplus permits sold by different countries will be different. These differences will result, primarily, from the variations in the level of organization of these countries’ institutional structures and from the quality of their operations. The RF Ministry of Energy (ME) forecast is important for a number of reasons. First, it is based on higher rates of economic growth in Russia. Thus, it takes into consideration significant changes in the priorities of government economic policy that have already occurred. Second, the rates of economic growth in this forecast are tied to changes in the indicator of GNP energy intensity. Third, this is an official forecast. During the period from 1999 to 2001 Russia’s GDP increased by 20 per cent, and a continuation of economic growth is also expected in 2002 and 2003. According to estimates undertaken in preparation for hearings on KP ratification in the Ecological Committee of the State Duma, CO2 emissions in Russia in 2010, and in the first budget period 2008–12 should not exceed their base level (1990) (State Duma, 2001b; RIIA, 2001). According to the forecast of the RF Ministry of Energy, carbon dioxide emissions from the energy sector even in 2020 won’t reach the base level of 1990, though this forecast is based on the assumption of very high annual GDP growth rates of 5–6 per cent. The forecast of the RF Ministry of Energy envisages two options in CO2 emission dynamics from the energy sector in Russia: ‘favourable’

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(option N1) and ‘low-emission’ (option N2). According to option N1, carbon dioxide emissions will account for 1.75 billion tons in 2005, 1.87 billion tons in 2010, 2 billion tons in 2015 and 2.2 billion tons in 2020. In the base year (1990), carbon dioxide emissions from the energy sector were 2.236 billion tons. According, to option N2, the level of carbon dioxide emissions would be even lower than under option N1, that is, by the end of the forecast period (in the year 2020) they will account for 1.84 billion tons. Thus, the emission limit set up for Russia by the international regime to the RF Ministry of Energy is not expected to be exceeded. However, evaluating the scenarios of the ME must take into account that future compliance by Russia with its commitments within the international climate regime even under long-term economic growth is of a conditional character. Indeed, these scenarios are based on the assumption of extremely high (4–5 per cent) growth in energy efficiency rates (decrease in energy intensity). The forecast of the Ministry of Energy (based on annual GDP growth rates of 5–6 per cent) predicts a no less than three-fold increase of GDP by 2020 from 1998. ‘It is supposed that three-fold increase in GDP cannot be accompanied by corresponding growth of energy consumption. We consider the increase of energy efficiency of the national economy to be an obligatory factor in providing economic growth,’ is noted in the document of the Ministry. ‘In other words, in case the 4–5 per cent growth in energy efficiency is not provided, there would be no 5–6 per cent increase in GDP’ (State Duma, 2001a, Annex 2). Thus, this forecast is (1) initially based on desirable GDP growth rates; and (2) the energy efficiency (decline in energy intensity) indicators were calculated at rates that should be necessary for providing GDP growth within these scales. Without an improvement in energy efficiency, economic growth should not be expected. This means the considerable growth of CO2 emissions is also not to be expected. Most of the scenarios analysed above indicate a considerable non-used emission quota in Russia, although the size of such a quota varies across scenarios. In order to evaluate the reliability of these forecasts it might be useful to apply the approach recommended by the IPCC WG-III, and to compare the assumptions on which these scenarios are based. Depending on the assumption of economic growth rates used in a particular scenario, they can be subdivided into two major groups. Three scenarios are based on high annual GDP growth rates. The SNC envisages this rate at 4–4.4 per cent, the SRNS at 4.5 per cent and the RF Ministry of Energy at 5–6 per cent. The basis for such assumptions was the growth rates indicated by a governmental programme that was in force when a scenario was developed. High rates of economic growth, on which a

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particular scenario within this group is based, define the emerging problem of Russia’s compliance with the GHG emission limitation. Another type of scenario is the IIASA scenario. Assumptions on economic growth are not based on the economic indicators suggested by the government, but seem to be based on the authors’ own estimates. IIASA’s scenarios assume deeper GDP decline in Russia, and a later exit by Russia from economic depression. As to the effects on GHG emission dynamics, lower rates of economic growth are likewise assumed. As a result, IIASA’s scenarios predict a considerable surplus (bubble). Neutralizing the effects of high GDP growth rates on GHG emissions in a number of scenarios takes place in approximately the same way as when high economic growth rates were introduced: these scenarios are based on high rates of energy intensity decline (or, increase in energy efficiency) that are borrowed from governmental programs (Second National Communication, 1998). The RF Ministry of Energy faced certain problems while making its forecast: by borrowing the 5–6 per cent GDP growth rate from the governmental program of modernization it had to introduce in its forecast an extremely high annual energy efficiency growth rate of 4–5 per cent. As to IIASA, it operates with GDP energy intensity decline in the interval of ⫺0.3 to ⫺0.9 per cent, which is considerably lower than that of the RF Ministry of Energy. The selection of rates for energy intensity decline needs to be substantiated, but not all authors accomplish that. The SRNS forecast is based on the assumption that Russia would apply in its energy sector the most advanced energy-producing technologies available in the USA, Japan and Great Britain. These technologies are to be transferred to Russia together with significant investment flows into the energy sector, which would be possible as a result of institutional reforms and economic policy measures (carbon tax). Whether transfer of advanced technologies into the Russian energy sector from the West is realistic is not questioned by this forecast; it is just assumed. As was mentioned above, the RF Ministry of Energy established high growth rates in energy efficiency in its forecast by declaring that there would be no economic growth of 5–6 per cent unless there was 4–5 per cent energy efficiency growth. Simultaneously, with such a declaration the question about Russia’s possible non-compliance with its emission reduction targets is answered quite successfully. If GDP growth takes place, it will take place on the basis of an increase in energy efficiency, and, hence, a significant increase in GHG emissions will not occur. If there is no increase in energy efficiency, there will be no economic growth, and, hence, no emission growth. The problem that emerges in this context is not only in the reliability of a forecast; it is defined by how the results of the forecast will be applied in

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the decision-making process. Rather often such models are used as a decisive argument in undertaking particularly important policy choices. Policymakers assume that there are no errors in the models, and ‘group interests’ do not interfere in the construction of such models. Because ‘mathematics only’ operates in the process, it does not allow any interference or the impacts of interests on the results of modelling. The policy-makers are sure that if scenarios indicate that Russia will not exceed GHG emission targets and these emission limits won’t pose a barrier to economic growth, then it will be that way. Relativity of models and the role of assumptions are not taken into account by the policy-makers, since they are not aware about the insights of the modelling process, they are not informed about its mechanics, and they do not have enough time to deepen their understanding of the subject. Another problem associated with designing GHG emission scenarios for Russia is the problem of the reliability and availability of statistical data. It is important not only to have a good model design, but also to know on what particular statistical base this model will be functioning. These problems emerge not only at the stage of GHG inventory compilation, but also at the stage of GDP accounting. This is because there is a significant nonformal sector in Russia, and a lack of clarity on how it affects official data on GDP. There are various estimates of the share of the informal sector in GDP, and they fluctuate from 10 to 40 per cent. Most of them are really evaluations that are often politicized and serve as arguments for policymakers. The RF Committee on Statistics did not inform the public about the results of its assessments in the subject. However, it is known that it regularly increases the initially calculated GDP level (recently by 20–25 per cent), thus, incorporating into it the non-formal sector. It is difficult to assess to what extent the non-formal sector affects statistical data on energy production and consumption, and hence, energy intensity and GHG emission data, as official statistics on the non-formal sector in energy production and consumption are not transparent. But there are indications that, for example, in the petrol business, shadow operations are on a massive scale.3

INSTITUTIONS OF RUSSIA’S CLIMATE POLICY Climate Policy Body Russia’s climate policy (and the ICC) in the 1990s was engaged in (1) negotiations within the framework of the Climate Convention, and the formulation of Russia’s positions at these negotiations, (2) submission of

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National Communications (with GHG inventories) to the Secretariat of the Climate Convention and (3) control of scientific research in the area of global climate. The construction of the national institutional structure of the climate policy was oriented towards the implementation of these functions. Thus, Russia’s climate policy was involved first of all in implementation of the United Nations Framework Convention on Climate Change (UNFCCC). In the former USSR, the implementation of international environmental agreements was assigned to an institution specially created for this purpose – an interdepartmental commission. The same was done to implement FCCC domestically. The Interdepartmental Commission on Climate Change (ICC) was created with about two dozens ministries and state committees as its members (Russian Federation, 1994). The majority of the members of the group were industrial ministries – producers and consumers of fuel and energy. A high number of other ministries and committees were also included in the ICC. According to the ordinance of the RF government, the key objectives of the ICC were as follows: (1) coordination of the ministries’ efforts to reduce the negative impact of economic activities on climate, (2) coordination of the ministries’ and organizations’ efforts to fulfil the obligations of the RF under the Climate Convention and (3) organization of RF participation in the official bodies of the Climate Convention. To fulfil these objectives, the Interdepartmental Commission on Climate Change, according to the ordinance of the government, (1) gives recommendations to enterprise on GHG emissions reduction on the basis of the use of environmentally clean technologies; (2) organizes and coordinates the efforts of the ministries to undertake measures aimed at the fulfilment of the RF obligations under the Climate Convention; (3) defines the position of the RF delegation at the Conference of the Parties (COP) and protocol negotiations; and (4) participates in the development of laws on the problems associated with climate change. At first glance, the construction of the institution entrusts it with broad authority; the institution is capable of pursuing an effective climate policy and of ensuring the fulfilment of Russia’s obligations under the Climate Convention; the institution possesses all the necessary instruments for it. Actually, this is far from true. This ordinance of the government created a very weak organization. Its weakness predetermined, to a great extent, the weakness and inconsistency of Russia’s climate policy in the 1990s. Although the form of the interdepartmental commission remained the same, however, the possibilities of this institution have changed. From this point of view, ICC in the 1990s was a typical institution of the transitional period: old form but without old possibilities; a remainder of the old system not adapted to the new situation. Further, in the command economy each

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ministry – member of a commission – possessed enormous authority, especially towards industrial enterprises included under their structure: ministries controlled their activities thoroughly. Within the market economy, industrial ministries have lost the majority of their former power: enterprises united with them are being privatized and are independent. That is why an Interdepartmental Commission with such ministries as its members also became a weak institution. Formerly ICC was able to give orders to enterprises via their ministries. Nobody can give orders to private firms today. That is why the government ordinance about ICC speaks only of recommendations from the Commission to industrial companies, no more. Old methods of management do not function, but the Interdepartmental Commission on Climate Change has not mastered new management methods. Another reason for the weakness of the ICC lies in the properties of the organization that oversees it. According to government decree, Hydromet (Russia’s Federal service on Hydrometeorology and Environmental Monitoring) had to play the leading role in ICC. According to the decree, the head of Hydromet was put in charge of the ICC as well. Hydromet was not considered a powerful institution within the national bureaucratic hierarchy. Hydromet’s influence and weight were clearly insufficient to pursue independent climate policy within the ICC in order to coordinate differences in the interests of individual ministries in the climate policy, in order to ensure its financing and pass laws through the government and parliament, and to force ministries to implement necessary measures. Work on a GHG inventory progressed with great difficulty, owing to the shortage of budget financing. The First National Communication was submitted to the Secretariat after a considerable delay, while the quality of the first inventory also left much to be desired (Kotov and Nikitina, 1996). Climate Policy Law A decade has passed since Russia signed the Climate Convention and assumed serious obligations. It would appear that the creation of a legal base ensuring an effective climate policy would be the first thing that the parliament, the government, and subsequently, the body which the government entrusted with national implementation of the international climate agreement signed by Russia, should have enacted during this period. Unfortunately, such legal support for climate policy is still absent in Russia. Failures of climate policy on this crucial issue are the best possible reflection of the ICC position in the contemporary system of authority.

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Some people say that the legal situation supporting climate policy is not so dismal. One opinion is that certain elements of the climate policy legal support are contained in other legal acts adopted recently. According to this view, references are made to the legislation on environmental protection, on atmospheric air protection, the law on the Climate Convention on ratification, the Forest Code, a number of government ordinances and instructions in the energy sphere, and, first and foremost, to the Federal Climate Program. As far as the above-mentioned environment protection laws are concerned, their study clearly shows that they do not create any specific legal base for the regulation of GHG emissions. Nothing similar to the legislation on atmospheric air protection or the Water Code with their regulatory mechanisms has yet been created in the sphere of GHG emissions regulation. If an urgent need for such regulation and for the adoption of measures to limit emissions emerges in the near future, it remains absolutely unclear how to do that legally. Application of GHG emission reduction mechanisms entails a number of stumbling blocks, and the creation of the legal base for these mechanisms will require much time and will be attended by serious difficulties because it will find itself at the centre of group interests. Federal Target Program on Climate Change In 1996, a special climate program was approved by ordinance by the RF government. It was awarded status as a federal target program and was promised budget financing (Russian Federation, 1996). The Federal Target Program on Climate Change, according to its provisions, should ensure (1) ‘fulfillment of the RF obligations under the Convention’ and (2) ‘implementation of a complex of measures aimed at the prevention of negative consequences of the climate change in the RF’. Thus, one of the declared goals of the Federal Climate Program should have been climate policy implementation. However, it became clear quite soon that it was a program to deal with the design of measures on paper rather than with the implementation of concrete measures of climate policy. Only after these measures within the Federal Target Program were developed in 1997–2000, would the next special program deal with their implementation. The organizations and the personnel that worked within the framework of the Federal Target Program constantly complained that the state did not fulfil its obligations concerning its financing: ‘. . . current funding of the Program can not be considered as satisfactory even for the first steps of activity’ (Hydromet, 2000). Unending problems with funding forced the R&D Institute of Hydromet that should have developed the new federal program to use American sources of funding. Preparation of the ‘Climate Change

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Action Plan Report’ began in 1997 with the support of the US Department of Energy and Environmental Protection Agency (EPA). The Climate Change Action Plan would probably become a basis for the new climate program. Using an institute to administer state programs is not a novelty for Russia: it was common during the Soviet period. Such programs were also in great abundance in Russia during the 1990s. It would be a delusion to believe that this institute can be fully transferred from one system to another: in contemporary Russia other methods of rare resources allocations have moved to the foreground. Most of these programs had one common inherent feature in the 1990s: they were not implemented, remaining paper instruments. Lack of financing was the reason for their failure. The new RF government intends to reanimate the institute of state programs. For this purpose, the government reduced drastically the number of federal target programs, leaving only 61 programs in 2002 and simultaneously improving their funding. The program on Climate Change was not among the programs that survived. According to Y. Izrael, the former head of Hydromet, the Federal Target Program on Climate Change was abolished (Izvestia, 2002). Climate Policy Institutions: Future Configuration The Kyoto Protocol, after it is ratified by the Parliament, will become a new important (external) factor that will affect the formation of Russia’s climate policy.4 In order to realize the provisions of the KP, Russia will have to adopt a range of legal acts to create the necessary legal framework for climate policy. Primarily, Russia will have to identify a state body (bodies) that will be responsible for the implementation of the Protocol. The identification of the body responsible for the efficient functioning of the emissions trading mechanism and the joint implementation projects will represent a special issue in this context. Legal regulation of allocation both inside the state bodies and between legal entities (enterprises and organizations) that are sources of GHG emissions, on the one hand, and state regulating bodies, on the other hand, will assume a special importance. It is deemed necessary to resolve, first, the following issues: 1.

Who will have property rights in AAU: (a) the state, (b) municipalities, (c) enterprises, (d) or some combinations of these actors?

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4.

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If the state acts as the owner of AAU the following question inevitably arises for Russia as a federated state: what level of state authority will the owner of these rights represent, that is, the Federation, the regions (Federation subjects), or the Federation and the regions (here the question arises on the sharing of these property rights)? Who will carry out trading transactions from the Russian side: the state or legal entities (enterprises and organizations) and citizens (or will a combined system be chosen)? What will be the legal regime that will serve as a framework for undertaking trading transactions? Clearly, in the case of Russia it will involve foreign economic deals, since, first, the parties to the deal will have a different state affiliation, and, second, foreign currency will be used as settlement (Orlova, 1998, 53–60).

One of the reasons for Russia’s delay with institutional capacity building in climate policy has been the lack of the necessary balance of interests between different agencies for the control of regulation over the future climate business. Each adversary proposed its own plan of institutional construction. However, these proposals on the design of the future institutional structure remained unrealized, yet are of considerable interest. The institutional structure that should be established in Russia in the near future, with increasingly less time remaining for its construction, will not be built from scratch. This aim will be accomplished by (1) using the intellectual reserves that have already been accumulated; (2) using, at least partially, the regulatory mechanisms that are available in certain other areas, but that could prove necessary for the regulation of the climate sphere; (3) taking into account the interests of those agencies that manage to preserve their influence on institutional capacity building. Thus, proposals on institutional construction already available in the past can form the basis for the configuration of the climate policy institutional structure that will appear in Russia in the near future. Or, on the contrary, they can mark an unacceptable pathway in future institutional capacity building. During 1998–99 two main projects of the future domestic institutional structure were competing with each other. The first was the project of the former RF Committee of Environmental Protection (CEP). The project announced that CEP had mechanisms for rationing atmospheric emissions and issuing licences for these emissions, as well as the system of emission sources inventory and monitoring, at its disposal. This claim actually constituted a declaration that the agency already possessed the necessary basis for the creation of a national quotas trading structure, or at least its most important components. A mere trifle was needed to supplement the instruments already available.

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The atmospheric emissions management at the disposal of the CEP is a block of institutions establishing the norms of atmospheric emissions. The process of rationing is based on medical standards of the state of the atmosphere; they determine maximum allowable concentrations (MACs) of pollutants. The territorial bodies of the CEP establish maximum allowable emission norms for each physical source of emissions (there can be several sources of emission at one enterprise) taking into account other sources of pollution located nearby. These norms serve as a basis for granting emission permits to each source by these bodies, as well as for subsequent control over the fulfilment of obligations established by these permits. Today, MACs are established for a great number of gases. But if we take greenhouse gases, there are norms available only for methane and some ozone-depleting substances (and these are medical norms). Each enterprise having stationary sources of atmospheric pollution submits a report on its atmospheric emissions to the territorial body of the CEP, in accordance with the form ‘2-tp (air)’ which is well-known by each enterprise in Russia. Additionally, an enterprise’s ecological passport is compiled based on an inventory that is made once every five years. This passport contains important information on technologies, raw materials and fuel utilized by the enterprise, including per unit of products, harmful emissions and so on. The CEP idea was to use the instruments it had at its disposal, and, primarily, the form ‘2-tp (air)’ and the ecological passport of an enterprise with the aim of managing GHG emissions. The existing system of enterprise reporting should have been supplemented by more detailed information on fuel and energy consumption, by the system of GHG emissions reduction stimulation, by the establishment of a system of limits for their emissions of stationary sources and by a tax on emissions by mobile sources. This plan included an important item whereby it was envisaged that allowances should be allocated not only among enterprises, but among regions as well. Subsequently, regional authorities became important players in the crucial issue of AAUs allocation. This proposition was made in order to ensure the passage of the project domestically. Other interesting points were to be found in this plan: a scheme for the distribution functions to control climate business between different departments. Seven main agencies were supposed to take part in this management, including such bodies as the Ministry of Fuel and Energy, the Ministry of Economy, the Ministry of Finance, the Ministry of Transport, as well as the Russian Forest Commission and the State Committee for Statistics. It is interesting that Hydromet, the chair of the ICC, was not mentioned in this scheme at all, nor was the ICC itself. The scheme allocated the following functions to the Ministry of Fuel and Energy: (1) primary inventory of

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emissions (together with three other agencies); (2) development of the monitoring system (together with three other agencies); (3) development of sectoral forecasts (together with two other agencies); and (4) implementation of investment projects (together with three other agencies). The Environment Protection Committee intended to retain the execution of the following crucial functions: (1) transactions certification; (2) accounting of quotas use and registration of deals (working with Goskomstat, which was bound to deal with purely technical accounting functions); (3) primary allocation of quotas (in association with the Ministry of Finance and the Ministry of Economy); (4) organization of financial flows (with the Ministry of Finance and the Ministry of Economy); (5) primary inventory of emissions and development of the monitoring system (with three other agencies); (6) development of the control system (with the State Forest Commission, which would have performed this work only for its sector, while the Environment Protection Committee would have been responsible only for all other sectors). Therefore, the Environment Protection Committee would occupy the key positions in the institutional structure of GHG emissions domestic regulation under this project (Russian-American Workshop, 1998, pp. 71, 73).5 This plan was not fated to be carried out. In August 1998, the deepest financial crisis broke out in Russia. Nobody had time to spare for the issues of institutional capacity building in climate policy. However, Russia began to recover from the consequences of the 1998 crisis amazingly quickly. In addition, since the post-Kyoto period had already began, the pause ended. In early 1999, the RF Ministry of Fuel and Energy published its design of the institutional structure.6 Key features of this project were as follows (Ministry of Fuel and Energy, 1999): Distribution of functions of the control of climate affairs between the Federation and the regions The functions of the future quotas market regulation were supposed to be concentrated at the Federation level. Therefore, the regional authorities were excluded from the management of climate business. There was reasonable apprehension among the regional authorities who would have regarded financial resources generated by the sales of quotas as an administrative rent that they rightfully owned, and very little of these revenues would have been invested in energy saving. It is true that the Charters of the regions contain a provision that the management of the regions’ natural resources is within the competence of the Federation and the regions. However, the natural resources that climate policy deals with cannot be tied to a regional territory. They fall under the category of federal natural resources that are envisaged by the RF legislation.7

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The issue of property in natural resources demarcation and management thereof is rather painful for the RF. A prolonged litigation on this issue is under way between the Federation and the regions; the legislation created considerable confusion in this sphere; and there is a serious overlap of competence here. Presumably, it will be possible to avoid all this confusion in the AAU issue; otherwise, the quotas market and the RF climate policy will encounter numerous uncertainties and risks unknown to other countries. The greatest trouble will be in store for the Kyoto mechanisms in Russia primarily if these instruments become an object of competition between the Federation and the regions. However, progress in political stabilization allows us to hope that this will not happen. The role of the ICC The Ministry of Fuel and Energy has indicated that it is willing to view the Interdepartmental Commission on Climate Change (ICC) as a high level body within the government. However, one bureaucratic nuance should be taken into account: the project considers the possibility of preserving the ICC only under the chair of a Minister. It is known that the ordinance of the government on the establishment of the ICC charges the head of Hydromet with its chair. However, the head of Hydromet does not hold ministerial rank and neither does the head of the CEP. Thus, this item in the latter project severs these two competing departments from the governance of the Commission and practically proclaims the replacement of its chair. One cannot ignore the obvious fact that Hydromet, as the head of the ICC, clearly did not have enough bureaucratic weight. Hydromet was unable to play the role of arbiter in the conflicts that occurred in the past and will undoubtedly occur in the future between Russian bureaucratic heavyweights. The prospects of creating a specialized institute managing the Kyoto Protocol implementation activities will be closely connected to whether being able to control this new organization falls in with the plans of the strongest bureaucratic players. Introduction of the intermediate level in climate policy management8 This level is extremely important. It is clear that the interests of individual ministries in climate policy will be realized through the activities of these sectoral intermediate bodies. It is also clear that these sectoral bodies will draw upon themselves a certain proportion of functions that the high-level body (the ICC or a specialized body) would have assumed otherwise, as well as a proportion of functions at a lower level, that is, the level of enterprises. This project, on the one hand, created a space for reaching an agreement between different departments, and, on the other hand, strengthened the position of the Ministry of Fuel and Energy itself. The enterprises of this

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Ministry account for the lion’s share of CO2 emissions, and it maintains its control over climate policy owing to this intermediate body. Limited role of enterprises Free access of enterprises to the international quotas market is not envisioned in this project, though enterprises and organizations are mentioned in its plan only in one context, that is, solely as project participants in joint implementation projects. However, according to this outline, even with this status they will not enjoy the right to offer their share of carbon credit for sale. It is possible to conclude from this project that enterprises and organizations will be unable either to buy or to sell quotas on the international market. As far as the domestic market is concerned, the character of enterprises’ participation therein has not been clarified. ‘Order of organization of AAU quota transfer’ It is noteworthy at this point that the order is established through the approval, by an ordinance, of the government, rather than by the adoption of a law. This is not unusual for Russia; this was the method of approval for countless provisions and instructions developed in the depths of the government. This practice actually means that an interested department develops rules of the game for itself. This approach is regularly criticized. Nevertheless, it was decided to use this mechanism once again. It is hardly worthwhile to forecast for how long it will take for the adoption of a law that would place this mechanism on a stronger foundation, independent of departmental interests. Bilateral cooperation An emphasis on bilateral cooperation is clearly visible in the project. It corresponds to the general approach to this issue prevalent in Russia, manifesting a marked interest in cooperation in the climate sphere on a bilateral or multilateral basis but with a limited number of participants. Certain comments to the Kyoto Protocol that appeared in Russia proceed from the assumption that the Protocol envisages four, rather than three, mechanisms of cooperation (quotas trading, joint implementation projects and Clean Development Mechanism (CDM)), and include a mechanism of bilateral cooperation therein. Mechanisms for CO2 emissions monitoring This point plays an important role in the project initiated by the CEP. Its project was based on the claim that the CEP possessed technical mechanisms for rationing atmospheric emissions of gases, for accounting and control at the enterprise level, for their licensing and so on. The proponents of a different approach to this issue proceed, however, from the assumption

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that, in contrast to other harmful atmospheric emissions, CO2 emissions do not require physical measuring by special metering devices and gas analysers. The volume of these emissions is calculated based on fuel consumption. However, this information is regularly collected and calculated by the State Statistics Committee and is supplemented by sectoral statistics from the Ministry of Fuel and Energy. The famous form ‘11-ter’ serves as a source of primary data on this issue. All big and mid-sized enterprises are obliged to fill it out (that is, all stationary producers of energy and heat) and it allows for accounting in accordance with the methodology of the IPCC. When Russia has to submit this data on CO2 emissions in the National Communication under the FCCC, the calculations will have to be carried out anyway in accordance with the methods recommended by the IPCC. Thus, the form ‘11-ter’, rather than ‘2-tp (air)’, is of crucial significance for CO2 emissions calculation. The Ministry of Fuel and Energy and the State Statistics Committee control these figures. As far as other GHGs are concerned, an extension of the form ‘2-tp (air)’ will probably be needed. Alternatively, if this operation proves to be expensive, these types of gases will have to be excluded from the list of gases that Russia is going to trade in the near future (Russian-American Workshop, 1998, pp. 76–7. In the preliminary hearings of the Environmental Committee of the State Duma on the KP ratification the government was recommended to prepare and introduce into the State Duma projects on the following legislation: ●

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quota allocation at different levels, including from the national level to the level of an enterprise; property rights on certified GHG emission reduction and rules for their transfer (amendments to existing legal acts); certification of GHG reduction; a national monitoring system of anthropogenic GHG emissions and their absorption by sinks; incentive mechanisms for elaboration and implementation of projects of GHG emissions reduction and of their sequestration according to the procedures of the climate change regime.

‘MODERNIZATION’ AND CLIMATE POLICY New Approaches to Economic Growth in Russia If the authors of GHG emission scenarios, which have been analysed above, did not calculate the meaning of rates of economic growth and

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energy efficiency by themselves, they borrowed them from governmental macroeconomic and energy programs which were developed in the 1990s. However, today, most of these programs are invalid. Their substitution for other programs was initiated. The most important among them is the ‘RF Development Strategy up to 2010’, which announces the Modernization Plan (Centre for Strategic Developments Foundation, 2000).9 The government has changed its goals, its priorities, and the instruments for achieving those goals. Russia’s transition to radical modernization of its economy envisions the renewal of macroeconomic and energy policies, changes in institutional structure and, subsequently, will have an impact on Russia’s capabilities in emission reduction and quotas trading. The modernization program outlines the following priority tasks: ●

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In contrast to all previous periods, a qualitatively new situation emerged in the country for the solution of fundamental problems. The political situation stabilized, the economy is recovering, and the population is ready to accept changes. The objective of the RF Development Strategy is to use this chance for radical economic renewal of the country and to undertake modernization. Key goals of Russia’s Development Strategy are to prevent the further widening of the gap between Russia and developed countries in the mid-term perspective, and to re-establish Russia’s position as one of the leading countries in international development in the long term. The Development Strategy argues that it is possible to achieve these goals only as the result of economic modernization. Economic growth with rates consistently exceeding the growth rates of the world economy is the only way to narrow the current gap between Russia and developed countries. The implementation of the Strategy should ensure GDP growth rates of at least 5 per cent per year on average over a 10-year period. This will make it possible to increase GDP volume by some 26 to 28 per cent by 2005 and 70 per cent by 2010 (as compared to 1999). In certain years rates of growth may increase to 8–10 per cent; in that case there may be greater growth of GDP volume by 2010. The Development Strategy intends to ensure the financing of economic growth to a considerable extent by preventing capital flows from the country. The illegal capital drain exceeded 10 per cent of GDP in 1999. This represents an enormous, currently unutilized method to increase domestic potential for economic growth. The decrease of capital flow volumes by 50 per cent could permit an increase in investments of approximately 30 per cent.

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Foreign investments represent another source of growth financing; however, significant inflows of foreign capital will be possible only with a certain lag, after the activity of domestic investors becomes sustainable.

Institutional Modernization Institutional modernization represents a decisive prerequisite for the implementation of the economic growth program and for the changes that will serve as a basis in the energy sphere. At the same time, this will provide a new framework for Russia’s climate policy, which creates the institutional environment for its implementation. Tax reform, deregulation and reform of property rights play a key role in the strategy of modernization. Anti-bureaucratic laws The major goal of the package of so-called anti-bureaucratic laws is to simplify the procedure of market access, and to make it easier to perform the activities of small and medium-sized enterprises. Another goal was to serve as a counter-force to governmental corruption, not by establishing additional control over bureaucrats, but by reducing the possibility that they can interfere in the economy. According to the new law the registration of newly established companies is to be passed on the principle of ‘a single window’. This means that a large number of organs and their officers will no longer participate in registration procedure. All actions for registration are concentrated in a single body responsible for keeping register books on formation, liquidation and reorganization of companies. After submission of registration documents, the company will know within five days whether the company has been incorporated or has been denied, and for what reasons (Kommersant, 2001d). Now, only activities that potentially threaten the rights and health of the public, and national security and defence are to be licensed by the state. In the draft of the law presented by the government, the number of activities subjected to licensing was reduced from 2000 to 104. During the discussion in the Duma the proposed number only increased by a dozen (Nezavisimaya Gazeta, 2001). Tax Reform The poor rate of tax collection represented the key problem. Tax reform foresees, on the one hand, a lessening of the fiscal burden, and, on the other hand, the limitation of opportunities for tax evasion.

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In 2000 Parliament adopted a law to reduce income tax. The new law abolished the progressive nature of the income tax system and replaced it with a flat income tax with a single and drastically reduced rate of 13 per cent. The shift to a flat income tax is quite risky and the government had many doubts before this decision was made. But, it soon appeared that the risks were worthwhile: revenues from the income tax increased by 70 per cent (Kommersant, 2001f). Simultaneously, the statistics demonstrated an annual increase in average salaries during this period of 45.2 per cent. This indicates a move towards the rejection of illegal salary schemes and a withdrawal from the shadow economy. The government introduced new regulations on business profits: tax on profits was reduced from 35 to 24 per cent. Simultaneously, all privileges on this type of tax were removed (Kommersant, 2001f). The new tax on profit creates the conditions for an increase of transparency in the activities of Russian corporations. Changes in property rights Privatization did not result in noticeable investments in Russian enterprises. This occurred, to a considerable extent, because the rights of state ownership in the Russian economy eroded while new mechanisms guaranteeing ownership rights were not completely formed. New legislation on privatization foresees a number of innovations. It eliminates privatization privileges to the employees of enterprises. Managers of enterprises forced employees to transfer their shares to their managers, with extremely ineffective results for these enterprises: the managers have not been the owners of an enterprise, but at the same time they have not been under the control of the owners. This ineffective mode of privatization will not be applied in the future. A new edition of the law ‘On share-holding societies’ entered into force on 1 January 2001. Its amendments envisage important corrections in the rules of corporate management.10 They intend to protect the owners of a company (that is, its shareholders) against tyranny by its own managers (Kommersant, 2001c; Kommersant, 2001g). The new land code has already entered into force. This means that a new market, the land market, has been created in Russia. The new land code has changed the rules for land turnover in the country. It significantly enlarges the list of land lots that can be sold and purchased. These are not only the land plots beneath buildings in rural areas, but also land sites in the cities, including not only land beneath dwellings, but also land with industrial and other facilities on them. The code does not limit the size of lots. New regulations assign to foreigners similar property rights for non-agricultural lands as to Russian citizens (Kommersant, 2001e).

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The new labour code was a result of a compromise between the government and the trade unions. The former code allowed dismissal with the consent of trade unions. The new code contains 14 basic items according to which an employee can be expelled without the need to notify a trade union, and three items according to which the trade union’s position has to be taken into account. In all these cases a trade union, after getting the draft order from the administration about the worker’s dismissal, has the right to disagree and to apply for arbitration with the Federal Labour Inspector, or go to court. According to the new labour code, not all trade unions at an enterprise have the right to sign a collective agreement, only the largest among them can. Modernization in the Energy Sector Energy problems and energy policy In the 1990s, the Russian energy sector encountered a number of serious problems in its development: ●

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In the 1990s, domestic consumption of fuel and energy in Russia declined considerably, by 30 per cent for primary energy resources and 23.7 per cent for electrical energy. At the same time, the decline in domestic fuel and energy consumption was significantly smaller than the decline in industrial production (about 50 per cent). In the 1990s, the energy intensity of GDP (energy consumption per GDP unit) increased considerably. Currently, this indicator in Russia exceeds the level of energy intensity in industrially developed Western countries by 3.5 times. The domestic industries that were characterized by low energy intensity (that is, machine-building, light and food industries) were displaced from the economic structure. In addition, energy consumption per GDP unit grew as a result of insufficient loading of facilities. Therefore, the energy intensity of the economy grew by 21 per cent in the 1990s. Distortions in the state pricing policy for energy resources deprived energy producers of financing opportunities. The fuel and energy sector continues to play the principle role in subsidizing enterprise and the public with low tariff rates. The Russian oil and gas sectors are highly dependent on the state of the world energy market. Oil export price fluctuations of and subsequent changes in natural gas export prices made the financial position of the fuel and energy sector extremely unstable. The amount of investment in all sectors of the fuel and energy industry in 1999 decreased by 70 per cent over the 1990 rate. This makes it

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impossible to offset the natural aging of the production facilities. Taking into account the high capital intensity of the fuel and energy sector, this trend can turn the energy sector into a major obstacle to economic growth. The Strategy of RF Development seeks to meet the following objectives through energy policy: 1.

2.

A reliable fuel and energy supply for the needs of the growing economy. This is the key goal of fuel and energy sector development. The fuel and energy complex should not be allowed to become a factor limiting envisioned economic growth. Fuel and energy sector development should focus on increasing fuel and energy efficiency. The transition to an energy saving mode is based on the following measures: ●

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growth of prices for fuel and energy resources to a level stimulating energy-savings measures; changes in the structure of Russian industry and GDP: state support of the development of sectors with low energy intensity; implementation of organizational measures aimed at energy saving; reorganization of natural monopolies in fuel and energy production (Gazprom and RAO UES).

Initial stage measures According to the Strategy of RF Development there appears to be no alternative to the transition from a dominant role by the fuel and energy sector to high technology and resource-saving industries. However, economic growth at the initial stage will be supported mainly by the previously created potential of free facilities in combination with their upgrading. At this stage, economic restructuring and the increase of energy efficiency will manifest rather weakly and Russia will have to continue its inertial development with the fuel and energy complex dominating the economic structure. Substantial increases in investments in the energy sector can hardly be expected during the initial period of reorganization. The measures that should be implemented at this stage include the following: 1.

2.

solution of the problem of non-payments by consumers of energy resources, elimination of non-cash forms of settlements and guarantee of governmental organizations’ payment for energy; elimination of cross-subsidizing of energy resource consumers;

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increase of prices and tariffs to the level of costs reimbursement with a gradual increase of their investment component; achievement of transparency by energy sector monopolies; restructuring in RAO UES Russia and Gazprom, development of competitive relations in the oil industry and completion of the coal industry restructuring; introduction of energy use standards; implementation of energy-saving programs at the municipal and regional levels and in the residential sphere.

4. 5.

6. 7.

Pricing policy In the 1990s energy prices decreased relative to other prices. According to the Strategy energy prices will begin to play a crucial role when the following conditions are met: ●

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Prices for fuel and energy resources will increase, approaching world prices level. Energy tariffs regulated by the state should be raised to a level ensuring costs reimbursement. The investment component in energy tariffs should be increased. Cross-subsidizing should be terminated. Tariffs for industrial consumers will become equal to tariffs for the public. The growth of prices should be accompanied by the creation of a system of subsidies for the poorest groups of the population. The subsidizing of inefficient enterprises through low energy tariffs should be terminated. The problem of non-payment for fuel and energy will be solved, including the non-payment problem in government organizations. The RF government develops mid-term (up to five years) balances of fuel and energy resources production and consumption envisioning the decrease of the natural gas share in domestic consumption. Prices for energy resources should be differentiated by regions.

Taking into account forecast dynamics of the exchange rate, an average price for kWh of electricity will amount to 2.5–2.6 cents in 2005, while an average price for a cubic meter of gas will amount to 2.8–2.9 cents. The growth of tariffs for the population will significantly outpace the growth of tariffs for enterprises. Energy monopolies’ restructuring It is believed that it will be impossible to resolve the problem of energy intensity and of attracting investments without the restructuring of natural

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monopolies in the electricity and gas sectors. Restructuring would represent a basis for decreasing energy production costs in these industries. The policy of the state that holds a controlling interest in natural monopolies will be aimed at the completion of the following tasks: ●

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separation of natural monopolistic and potentially competitive types of business activities and improvement of costs transparency; preservation of integrated systems advantages, that is, technological unity, manageability and reliability; division of tariffs into monopolistic and competitive component; levelling out of taxation conditions for producers and consumers of different types of fuel; creation of conditions for the emergence of new market participants; ensuring the access of independent producers and consumers to the services of energy monopolies.

Energy reform: provisional results Energy reform implementation in Russia is developing according to the scenario contained in the Modernization Program. However, there is an important difference between this program and the actual situation: reforms in the energy sector are occurring with extreme conflict. Reform is very unpopular among the public and constant social resistance hinders its implementation. Non-payers (the municipal authorities, the heads of the government organizations and the directors of enterprises) skilfully use this to their advantage. The RF president is constantly involved in such conflicts: he is expected to play the role of arbiter. The opponents of the president and of his liberal reforms expect that as a result of energy reform and reforms in the residential sector the president will lose popularity. Currently, energy reform is developing in four major ways: (1) increase in prices and tariffs, (2) liquidation of non-payments for energy, (3) reorganization of energy monopolies, and (4) revision of the energy balance. So far, the Russian energy policy has failed to attain the goal of raising energy prices and tariffs up to world levels: the gap between world and domestic prices is still considerable. In 2002, the government planned to increase prices and tariffs up to a maximum of 35 per cent (it’s necessary to take into consideration the annual inflation rates of 14–18 per cent). But then it had to take a step backward and decreased this ceiling to 20 per cent. The government was afraid of the possibility of an Argentinean scenario in Russia, and was cautious in its behavior. There has been serious success in the liquidation of non-payments. RAO UES especially achieved this through the application of strict and unpopular measures. There was an impression that nothing could be done to solve

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the non-payments problem because it had become a stable institution within the Russian economy and a norm in energy consumers’ behavior. However, RAO UES managed to change this trend: the major tool has been electricity switch-offs. But, this application has caused bitterness among the public. As to the reform of energy monopolies, for a long time this reform has stalled at the stage of concept elaboration. Only RAO UES has finalized corporate restructuring. Its passage through the government has not been easy and was accompanied by a great many conflicts. Gazprom’s restructuring plans have yet to be elaborated. Recently, the RF president managed to replace the heads of this company. Now progress is expected to develop more rapidly. The general principles of energy monopolies’ restructuring remain as outlined in the Modernization Program (selection inside a company of a competitive sector and a sector where tariffs would be regulated by the state). Modernization: impacts on emission trends The RF Development Strategy 2010 does not contain an outline of Russia’s climate policy.11 Nevertheless, the RF Development Strategy is directly related to the prospects of Russia’s climate policy and its mechanisms. It related to the specifics of the climate change problem and the mechanisms for its solution – they are closely linked to economic mechanisms. The RF Development Strategy contains a number of projections for such economic development parameters that serve as a basis for the elaboration of emission scenarios. In particular, it relates to such parameters as are used as assumptions in these scenarios. Among these are rates of economic growth, changes in GDP structure, energy intensity, the structure of energy balance, prices of fuel and energy, subsidies to the industry and the public through the level of tariffs, investment mechanisms, and so on. The Strategy for RF Development outlines the major directions in the development of these parameters (but does not always contain data on their particular level). Thus, a question emerges: what is the relationship between the most important parameters (assumptions) that served as a basis for the former scenarios and the current parameters that are used as key elements in the RF Development Strategy? Parameters of economic growth The rates of economic growth that are laid out in the RF Strategy are higher than those used in most of the former emission scenarios. The Second National Communication was based on growth rates of 4.4 per cent; the scenario of the World Bank and the Bureau of Economic Analysis (BEA) were based on 4.5 per cent. IIASA scenarios were based on the assumption

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of lower rates of economic growth. The RF Strategy envisions rates of growth accounting for 5 per cent only as a minimum and desirable growth rates of 8 per cent or even of 10 per cent. According to the World Bank the growth of Russia’s GDP from 1999 to 2001 was 20 per cent (Kommersant, 2002). The continuation of economic growth is expected in 2002 and in 2003 (approximately 4 per cent annual growth of GDP ). Parameters of energy intensity These parameters particularly predetermine the major differences in emission scenarios. The SNC used for its scenarios the coefficients of changes in energy intensity borrowed from the governmental RF Energy Strategy. The parameters of energy intensity in the World Bank and BEA scenarios played the key role, but no information was provided on their particular level, although some information on the procedures (not always transparent) of their calculations was supplied. The Energy Section of the RF Strategy indicates the new parameters of energy intensity. The scenario of the RF Ministry of Energy envisions substantial growth of energy efficiency (4–5 per cent). The change in these parameters looks quite impressive, and some questions regarding the methodologies used in its calculation might emerge. According to the Ministry, the growth of GDP would take place either under an insignificant increase in organic fuel consumption and very high rates of energy efficiency, or it will face the obstacle of lacking additional energy resources. Energy balance There are considerable differences between the scenarios and the modernization plan. The RF Strategy is based not on the increase in the share of natural gas in the energy balance (that was the assumption of former emission scenarios) but, on the contrary, on the decline of its share. The share of natural gas is expected to decrease, while the share of coal and black oil is expected to increase. Inevitably, this will negatively affect GHG emission dynamics. Prices and subsidies The RF Strategy predicts a significant increase in energy prices, as well as the lifting of subsidies. Similar assumptions were also compounds of the former scenarios and of the energy programs from which they were borrowed. There is nothing new on this issue, except for one very important item, the price of natural gas. According to the former scenarios, the price of natural gas had to remain at a considerably lower level in comparison with other types of fuel. In the Strategy of RF Development, the price of natural gas would not only grow, but it would be at the same level as the

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prices for other types of fuel, or it might even surpass them. This would be the result of changes in energy prices formation. Previously the formation of prices was based on costs; from now on they are supposed to be based on the quality of fuel. Recent estimates of carbon dioxide emissions According to estimates undertaken in preparation for hearings on KP ratification in the State Duma, CO2 emissions in Russia in 2010 and in the first budget period 2008–12 should not exceed the base level (State Duma, 2001b; RIIA, 2001). According to the forecast of the RF Ministry of Energy prepared for the parliamentary hearings on the Kyoto Protocol, carbon dioxide emissions from the energy sector even in 2020 will not reach the 1990 base level. This forecast predicts a ‘favourable option’ for carbon dioxide emissions. In 2005 they will account for 1.75 billion tons, 1.87 billion tons in 2010, 2 billion tons in 2015, and 2.2 billion tons in 2020. In 1990, carbon dioxide emissions from the energy sector were 2236 million tons; however, this forecast is based on the assumption of extremely high growth in energy efficiency rates. The Modernization Program, with its goals and instruments, is the principal priority that guides Russian policy. It might be naïve to expect climate policy to be an exception that will fall below this priority. Today, the main parameters determining the volume of GHG emissions in Russia are beyond the control of the instruments of climate policy. Currently, Russian climate policy is determined by economic goals, rather than by environmental constraints. If Russia ratifies the Kyoto Protocol, it will not be done only for environmental reasons, but also due to economic and foreign policy considerations. The same applies if the protocol is not ratified. Apparently, the policy of economic growth, and, subordinate to it, energy policy, will determine the GHG dynamics, at least in the mid-term perspective. Therefore, the economic growth policy, energy policy and their institutions have a direct impact on the volume of GHG emissions. They form the distant institutional environment for Russia’s climate policy. Climate policy became subordinate to economic policy, with its own objectives: to speed up economic growth and to eliminate all obstacles to it. The problem with Russia’s climate policy is that all actions undertaken within the framework of economic (and energy) policy are beyond the influence of the climate policy. On the contrary, the key parameters defining the volume of GHG emissions today are directly dependent on the policy of economic growth and energy policy. It is hardly surprising that the issues of climate policy turned out to be at the periphery of the supreme state authorities’ attention. An overwhelming majority of the population cannot withstand the further consequences of a depression and support the

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goal of economic growth as a key priority. Russia, having formulated its main strategic objective as the transition to high and sustainable rates of economic growth, did construct mechanisms of domestic climate policy that would have provided an opportunity to control the volume of GHG emissions under conditions of economic growth. Today, it is necessary to admit that a certain gap exists between the new macroeconomic goals and new macroeconomic policy, on the one hand, and the availability of a necessary institutional infrastructure to conduct national climate policy, on the other hand. Meanwhile, further delays in institution building for Russia’s climate policy will result in the exacerbation of its problems. Prospects for Kyoto Protocol Ratification For the Kyoto Protocol to come into effect, it must be ratified by more than 55 countries, and the total amount of GHG emissions from industrialized countries of FCCC Annex I (developed countries and countries with transitional economies) ratifying the protocol must exceed 55 per cent of the total amount of gases emitted by all industrialized nations in 1990. This means, for example, that if two countries with as a large a share of world emissions (in 1990) as the USA and Russia do not ratify the Kyoto Protocol, it will not enter into force. Today, it is clear that the USA will not ratify the protocol. Thus, the further fate of the KP depends on ratification by Russia. I will analyse now the ratification issue in the context of major shifts in Russian climate policy. In particular, it is important to analyse the prospects of the Kyoto ratification from the standpoint of the interests of those main actors who will take part in the ratification process. As we know, recently the interests of the major actors in international climate policy have not been constant; perception of the national interest is changing. KP was in accordance with national interests from the point of view of one administration in one country, and the same treaty later appeared not to be in accordance with them from the point of view of another administration of the same country. Thus, shifts in interests are not so unusual in international climate policy. Assessments of the Kyoto Protocol and Marrakesh Accord in Russia At the end of the 1990s, positive assessments of the Kyoto Protocol prevailed in Russia. According to this point of view, the Kyoto Protocol was signed in the form that corresponded to Russian interests: 1.

Carbon credit became a legitimate method of realization of CO2 emissions limitations.

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2.

3. 4. 5. 6. 7. 8.

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Unutilized quotas for CO2 emissions could be sold on the international market in addition to the carbon credit acquired as a result of the implementation of the projects aimed at emissions reduction. The 1990 level was fixed as the baseline. The Russian emissions quota was established at 100 per cent of the 1990 level. A five-year effective period of the quotas was established. The term ‘hot air’ is absent in the Kyoto Protocol. Sinks (though in a limited form) were taken into account while meeting obligations on emissions reduction. A joint fulfilment of quantitative obligations concerning GHG emissions (item 1 of the Article 3 and Article 4 of the Protocol) that should be based on agreement between the countries was allowed.

At the same time Russia disagreed with a number of positions presented by the European Union. First, it rejected the EU positions on ‘additionality’. Russia believed that this instrument imposed unjustified quantitative limitations on quotas trading, that the term ‘ceiling’ on the trade introduced a limitation under which it would be impossible to sell a greater number of GHG emission units than were received owing to the realization of national measures. Second, it related to the issue of ‘eligibility’. Within its framework, it was supposed to organize preliminary inspections of the country in addition to use of the national system of monitoring, annual inventory and submission of reports, as well as activity of the body on deal registration. A ‘group of experts’ should carry out this inspection with regard to the correspondence of the national system of trading to certain international requirements. The Secretariat of the Convention would inform the participants of the Convention on the eligibility of the country to participate in trading only after such an inspection. Russia supposed that the groups of experts were endowed with control and permit functions by this proposal of the EU that they do not have under the Kyoto Protocol. According to Article 8, they should only review information contained in the inventory and national communications and confirm (or not confirm) the adequacy of information provided by the countries in these documents. Russia believed that expert inspections always provide an opportunity for arbitrary interpretation of rules and carry out this inspection to ensure that the national trading system meet, certain international standards. Hence, the approach from the position of deregulation in this area will safeguard the Climate Convention from excessive debates and transition to an extremely unstable situation. It is necessary to inspect, but to inspect only what is subject to unambiguous

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assessment and does not leave room for arbitrary interpretation. It should not be possible to transform inspections and assessments into a method of blocking the mechanisms of the Kyoto Protocol that their opponents were unable to block at the negotiating process stage, but trying to retaliate, will block at the implementation stage. Thus, the special emphasis in Russia’s position was aimed, primarily, at preventing arbitrary interpretation and arbitrary application by the Convention bodies of the rules that permit their unfair construing and transform the procedures of ‘assessment’ and ‘compliance’ into instruments of fault-finding and pressure. A direct threat existed that the positive results that Russia had achieved in the course of negotiations on the Kyoto Protocol would be eliminated at the stage of implementation through purely technical and procedural measures. However, Russia tried to settle all the differences in positions through negotiations, that is, within the framework of the Kyoto Protocol. Russia’s position was aimed at improving the Kyoto Protocol and its rules, and thus, to shape it more comprehensively to meet Russia’s interests. But Russia did not aim to break the Kyoto Protocol, and its position has been of a constructive, but not of destructive character. The results of negotiations, which have been under way for many years and were finalized by adopting the Marrakesh Accord, were also perceived in Russia as contributing to its general interests: 1.

2.

3. 4.

5.

Russia, as a country with an economy in transition, is not obliged to finance the funds for developing countries assistance formed within the climate change international regime. Documents adopted in Marrakesh point to the activation of the Global Environment Facility (GEF) in providing assistance to transition economies for the construction of their national GHG inventory compilation systems, for building emission forecasts, for assessments of various economic sectors’ vulnerability to climate change, for performance of research education and monitoring programs. Excessive limitation on international emission trading was avoided. The concept of an emission quota reserve for the commitment period (2008–12) was adopted, and according to it, it is possible to sell all ‘free quotas’ calculated on the basis of the last inventory, or 10 per cent of the country’s emissions in 1990 (depending on which level appears to be higher). All quotas, excluding a number of limitations on forestry quotas and quotas attributed to the performance of international projects, can be banked and transferred to the next commitment period, which will allow Russia to store quotas for the next period of

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6.

7.

8.

9. 10.

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2013–17 when its emissions might approach or exceed the level of its commitments. Conditions for the beginning of international emissions trading (that is, ratification, inventory, national register, national reporting) were constructed in a simple form. An introduction into international emission trading rules of special units for sinks accounting in order to distinguish them from emission reduction quotas was an important measure hindering the collapse of the international market through the invasion of cheap forestry quotas from tropical countries. Limitations for developed countries in obtaining forestry quotas through CDM (to not more than 1 per cent of their national emission quota) were introduced. Nations could include carbon sequestration from forestry measures in their national CO2 accounts. The agreed-upon compliance regime does not envisage financial sanctions (Kokorin, 2002).

Preparation for ratification of the Kyoto Protocol The Kyoto Protocol signed by Russia is an interstate agreement that will become binding for its members after its ratification and entry into force. The Russian Federal Law establishes the procedure for the ratification of international agreements (‘On International Agreements’, 1995). The State Duma should adopt the Federal Law on the ratification of the Kyoto Protocol, and, after that, this Law should be considered by the Federation Council, another chamber of the Russian Parliament. Then, the ratification law has to be passed by the RF President for signature (he may sign the ratification law, or decline it). Until now, it has been supposed that the Kyoto Protocol would not be ratified in an atmosphere of intense struggle in Russia. The preliminary hearings on the Kyoto Protocol organized by the Ecological Committee of the State Duma were held in the Parliament on 18 June 2001, and their results totally confirmed this assessment. Most of the participants supported the idea of Kyoto entering into force. The Ecological Committee did not support US actions towards the Kyoto Protocol. At the same time, parliamentarians have put forward a number of conditions: 1. 2. 3.

the Kyoto text is not subject to any revisions; the door for US return should not be closed; the principles, norms and rules of the KP should not impose an additional financial burden;

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5.

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the mechanisms of Joint Implementation and International Emission Trading should not be discriminated in contrast to the Clean Development Mechanisms; an early start in the application of the Kyoto mechanisms would allow the preconditions for stable progress in global reductions of GHG emissions to be established.

Thus, positive assessment of the Kyoto Protocol, which was characteristic of Russia in recent years, as well as positive assessments of the Marrakesh Accord, and also the results of preliminary hearings on Kyoto ratification in the Ecological Committee of the State Duma, all seemed to indicate that a positive decision on ratification was predetermined, and ratification purely a technical issue. Preparation for ratification was on the agenda for the regular meeting of the RF government of 14 March 2002. The meeting took place, but Kyoto ratification was not considered. Initially, this was interpreted as the result of an excessive agenda overburdened with many other issues. In fact, it was overburdened: Kyoto ratification was one of a number of N5 issues on the agenda, and prior to it were such important issues as Russia’s positions regarding entry into the World Trade Organization (WTO) and introduction of turnover of agricultural land to cities. The mass media even assumed that discussion on Kyoto ratification had been delayed until the next meeting of the government. Not a single meeting of the government has been held since then, but the ratification issue has not been considered. Although the press service of the government did not announce any delays in discussion of this issue, it became clear that the delay on the ratification issue was not incidental. Indeed, on the eve of its discussion in the government a number of publications appeared in the Russian press seriously criticizing the protocol, and indicating that it directly contradicted the interests of Russia. Also, a number of declarations of high-ranking officials appeared. The head of the Ecological Committee of the State Duma, Vladimir Grachev, who was recently among its active supporters, noted that ‘the Kyoto Protocol for industrial gas emissions cuts has turned into “a smoke screen” for dictate in international trade and it no longer promotes improvement of the ecological situation in the world . . . One might get the impression that countries of the EU believe that Russia is simply obliged to ratify the protocol but this position is deeply erroneous’ (BBC Monitoring Service, 2002). This was followed by a declaration by Alexander Popov, the head of the environmental department at the RF Ministry of Energy, who noted that ‘if we cannot secure buyers [for our carbon dioxide emission credits], it will be meaningless’, suggesting that Russia will not hurry to ratify the agreement

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until it can secure a way to make up for the gap caused by the US exit (Yomiuri Shimbun, 2002). Arguments of the opponents of ratification The most serious arguments that have been offered by the mass media on the eve of the supposed meeting in the government can be summarized as follows: 1.

The Kyoto Protocol is not worth as much without the US, China and developing countries’ participation in GHG emission limitations. An increase in emissions in these countries significantly exceeds the decline that could be achieved by the members of the Protocol which undertook quantitative emission limitation commitments. Thus, the value of the commitment seems to be negative, as it creates the illusion of problem solving without really solving anything. 2. The legal construction of Kyoto and the FCCC is unique: Kyoto implementation procedures are voted on by the countries with quantitative limitations, and by countries without any of them. Within this strange legal framework the countries without any quantitative limitations come forward with initiatives for severe sanctions for non-compliance. 3. The Kyoto Protocol is a classic example of double standards, especially since it ignores the real emission reductions undertaken in Russia during the period after 1990. Real emission reductions in Russia are declared as a fiction. It is as if Russia has to excuse itself because its emissions came about by means that are not thought desirable by other countries. Simultaneously, CDM emission reductions in developing countries are acknowledged to be of value regardless of the rapid increase in the total emissions of these countries. 4. Ratification is the major trump card for Russia, and it could be a political failure to lose this chance. This opportunity might be utilized to solve economic problems, particularly to address external debts. These cannot be solved within the context of the Kyoto Protocol; however, there is a chance to meet the goal within the political bargaining process. There has been a similar precedent of ‘debts for nature swaps’ that was applied and tested in Poland (‘Expert’, 2002). Discussion of Kyoto Protocol ratification was on the agenda of the meeting of the government one month later, on 11 April 2002. What were the main decisions of the government on KP ratification in this meeting? First, it was indicated that ‘active participation of Russia in activities aimed at preparation of a decision about Kyoto Protocol ratification is

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reasonable’. And second, ‘a directive was passed to elaborate the plan of measures necessary for taking the decision on ratification of the Kyoto Protocol’. In particular, this plan has to include the development of drafts for legal acts for Kyoto Protocol implementation in Russia. It also envisions ‘preparation and submitting to the government of the draft of the National Report on climate change’. In this case, it is important to look at the deadlines: for ‘plan of measures’ it is one month, for ‘the draft of National Report’ it is three months. Hence, it is obvious after this meeting of the government that ratification of KP is not yet ready to be passed to the State Duma. The government, in its meeting, made a decision not about ratification (which is a necessary step for submitting the draft of ratification law of KP into the State Duma), but about preparation for ratification. This means that it has postponed the governmental decision about ratification. Thus, the ratification process remains at the stage of decision-making by the government, and is not yet with the State Duma. Based on the decision of the government about preparation of a National Report on climate change (the State Duma will not consider the ratification issue without such a Report and three months were given for its preparation), it is clear that the current session of the State Duma is not due to consider ratification before its closure for vacations. Realistically, the Duma is believed to be able to start the ratification process only in the autumn. Preparation for Kyoto ratification by the State Duma is an important undertaking. And if it is not well prepared there might be serious losses at this crucial stage. The issue of national interests in climate change mitigation has still not been completely clarified in Russia, and there are a great many uncertainties. Opponents of Kyoto use this to their benefit, and there is no general consensus regarding this issue. Thus, the preparation stage, and elaboration of the National Report on climate change is absolutely necessary (another question is why this work was not done earlier). Prospects for ratification: role of economic interests How serious is the newly emerged situation regarding Kyoto Protocol ratification by Russia? What are the prospects for ratification within this new context? The absence of environmental concerns among the top priorities of the Russian public plays a sad role in the ratification story, as ratification does not have strong support due to ecological concerns from the public, political parties, green movement and mass media. So far, success in the Kyoto Protocol ratification process can be attributed to economic interests and to actors guided especially by economic interests. That’s why it seems rational to base any assessment of the prospects for ratification on an analysis of

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the expectations of the main actors interested in ratification, and to compare them with the recent estimates of the economic consequences for Russia of KP entry coming into force. However, there are two important groups of Russian society that have an interest in ratification of the Kyoto Protocol. These interested groups are: first, the directors of enterprises in those industrial sectors where application of the Protocol tools promise considerable benefits, and, second, the bureaucrats at the federal and regional levels that might be involved in regulation of domestic application of the Kyoto Protocol. The possibilities of the application of Kyoto tools and the prospect of considerable reserves from unused quotas have turned climate policy in Russia from a traditional environmental protection area into the sphere of future climate business. Income from this sector might be comparable to the most beneficial branches of the Russian economy. The USA was considered as the major potential buyer on the future international emissions trading market. Now it is obvious that at least during the first budget period (2008–12) this buyer would be absent from the market. This should significantly affect the demand–supply relationship, and, hence, it would result in considerable price reduction in tradable permits. In this case there would be no ‘windfall’ for Russia. During the second budget period (2013–17) Russia might not have a surplus in unused quotas due to changes in the macroeconomic situation that result from GDP growth. Increase in demand for natural gas deliveries to Western Europe, which used to be considered an additional benefit for Russia from Kyoto Protocol enforcement, will probably also not be realized. This is because the EU is reorganizing its gas market, transferring to suppliers all risks for investments in the construction of transcontinental gas pipelines. While in the spring of 2001, preparations for Kyoto ratification in the State Duma held significant expectations, after the US exit such expectations might be altered. Scenarios for the price dynamics in this market are gloomy. As a result, incentives for Russia’s ratification of KP became smaller. Today, it is evident that Russia will not benefit economically from the significant emission reduction that has occurred in Russia. That has caused not only a feeling of disappointment in the economic benefits associated with the Kyoto Protocol, but also a feeling of unfairness and the application of double standards. All these considerations taken together explain the disappointment towards the Kyoto Protocol that can be seen in the arguments of opponents of the Kyoto Protocol. At the same time, the government hopes as before that quotas can be used to attract foreign investments into Russian enterprises in the framework of JI projects, and quotas formed within such projects can cover credits for these projects. It is believed that Russia will ratify the KP in 2002, but it will not be in a hurry

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to do that by any special date (for instance, by the beginning of June, in order for KP to enter into force during the World Summit on Sustainable Development).12 Of coarse, new actors and new interests could change the framework of Russia’s climate policy in the future; ratification would make this framework much more stable.

NOTES *

1. 2. 3. 4.

5.

6. 7.

8. 9.

10. 11. 12.

This chapter is based on the results of a study for the Asia-Pacific Network for Global Change Research (APN) and Institute for Global Environment Strategies (IGES) project ‘Policy Design of Climate Change Collaboration in Northern Asia: Possible Options and Constraints for Cooperative Effort between Russia, Japan, China and Korea’ and of a study for Japan Society for Promotion of Science (JSPS). The term ‘bubble’ in the text was changed by authors in the later publication to the term ‘surplus’. It is important to notice that during the 1990s, energy intensity has not declined, but significantly increased, by 21 per cent. The petrol business is one of the most profitable in Russia today. The Kyoto Protocol contains both norms with hard obligations (Article 3 with the quantitative obligations on limiting GHG emissions) and soft obligations for participants. The latter are formulated in the form of recommendations. In particular, this form is applied to domestic climate policy. The element of flexibility is achieved in this case by the ‘parties aim at’ formula. This gives Russia, as a country with an economy in transition, the opportunity to use the policy with instruments and measures corresponding to the greatest extent to the specifics of its transition period. ‘The RF State Committee of Environment Protection is the main body of the GHG emissions state management. It is the principal federal body responsible for the policy in the sphere of atmospheric pollution reduction. The regional divisions of the State Committee are charged with the practical implementation of this policy. Proceeding from practical considerations, the regional divisions often work with the regional and city administrations and under their control.’ It was made via publication of its research institute. It is possible that disputes will emerge in the future between the Federation and the regions on the issue of revenues from sinks as a result of reforestation and restoration of forests. Besides, the Russian Federation received an AAU quota under the Climate Convention and Kyoto Protocol. The majority of big enterprises that could become sources of carbon credit in the future are also in federal, rather than regional, hands. Russian ministries and agencies which serve as general authorized organizations and oversee quotas set by higher level bodies are considered to be at the intermediate level. In 2001, on the basis of the Strategy the ‘Major directions of social and economic development of the Russian Federation in long-term perspective’ and ‘Program of social and economic development of the Russian Federation for mid-term perspective (up to 2004)’ were adopted (Kommersant, 2001a, Kommersant, 2001b). About 436 000 shareholding societies have been registered in Russia. The mid-term governmental program, although in a laconic form, indicates the climate policy goals. The head of the department responsible for climate policies in the Ministry of Trade and Economic Development, Vsevolod Gavrilov, mentioned that ‘We will try to ratify the pact within the year, but we cannot make it by the time the World Summit on Sustainable Development is held . . .’ (see Yomiuri Shimbun, 2002).

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REFERENCES BBC Monitoring Service (2002), ‘EU policies could mean Russia backs out of Kyoto climate agreement’, UK: 22 March. Centre for Strategic Developments Foundation (2000), Strategy of the Russian Federation’s Development till 2010. ‘Expert’ (2002), No. 10, 11 March. First National Communication of the RF to the Secretariat of UNFCCC (1995), p. 51. Hydromet (2000), ‘Executive Summary’, Climate Change Action Plan Report. IPCC Report (1994), Working Group III; Russian version. Izvestia (2002), 8.02. Kommersant (2001a), 23 March. Kommersant (2001b), 31 May. Kommersant (2001c), June. Kommersant (2001d), 13 July. Kommersant (2001e), 16 July. Kommersant (2001f), 23 July. Kommersant (2001g), 8 August. Kommersant (2002), 30 January. Kokorin, A. (2002), ‘One More Successful Step to Practical Realization of the Kyoto Protocol’, WWF official website, 12 November. Kotov, V., and E. Nikitina (1996), ‘To Reduce or to Produce? Problems of Implementation of the Climate Change Convention in Russia’, in J. Poole and R. Guthrie (eds), Verification 1996, Boulder, CO and Oxford: Westview Press. Ministry of Fuel and Energy of the Russian Federation, Institute of Energy Strategy (1999), ‘Just the Government of the Russian Federation is finally responsible for distribution and use of quotas’, Post – Kyoto Energy, March. Nezavisimaya Gazeta (2001), 12 July. ‘On International Agreements of the Russian Federation’ (1995), 15 July. Orlova, O. (1998), ‘Certain Legal Issues of Adoption of the Kyoto Protocol’, working paper at the Russian-American Workshop on Quotas Trading, Moscow, pp. 53–60. RIIA (2001), RIIA Report on Moscow Workshop, 14–15 May. Russian-American Workshop on Trading in GHG Emissions Quotas (1998), July, Moscow. Russian Federation (1994), Government Resolution No. 34, 22.01. Russian Federation (1996), ‘Federal Target Program “Prevention of Dangerous Climate Changes and their Negative Consequences” ’, Ordinance no. 1242, 19 October. Second National Communication of the RF to the Secretariat of UNFCCC (1998), p. 93. State Duma (2001a), ‘Estimation of Development of Russian Energy Sector’, Papers prepared for hearings on KP ratification in the Environmental Committee, 18 June, Annex 2. State Duma (2001b), ‘Papers prepared for hearings on Kyoto Protocol ratification June 18’. Victor, D.G., N. Naki´cenovi´c and N. Victor (1998), ‘Interim Report: The Kyoto Protocol Carbon Bubble: Implications for Russia, Ukraine and Emission

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Trading’, Laxenburg, Austria: International Institute for Applied Systems Analysis, October. World Bank (1999), Study on Russian National Strategy of Greenhouse Gas Emissions, Washington, DC: World Bank. WWF (2001), ‘Climate Change and the Policy of the Russian Government, Reference Information’, www.wwf.ru/climate/kyoto, 20 November. Yomiuri Shimbun [Daily Yomiury] (2002), ‘Russia may Drag Feet on Kyoto’, 28 March, available at http://www.yomiuri.co.jp/.

Index Agreement on Subsidies and Countervailing Measures (SCM) 82 Agreement on Technical Barriers to Trade (TBT) 81–2, 84, 85, 86–7, 90 Agreement on Trade-Related Intellectual Property Rights (TRIPs) 89 agriculture and EU enlargement 149–50, 151, 154 and invasive alien species (IAS) 72–4 Poland 158, 161, 162, 163, 164, 195 Albrecht, J.A. 116 Auer, M.R. 182–3, 186, 190 Barrett, S. 114 base-weighted targets, problems with 22 behaviour, and incentives 44–5 Bhagwati, J.N. 68 Bradford, R.L. 114, 117, 126 brownfields revitalization 196–9, 200, 201–2 Bulgaria and Kyoto Protocol 210, 213 nuclear energy, reliance on 229 Bush, President G.W. 17–18, 38, 43 business as usual (BAU) emissions trajectories 22–4, 39–40, 51–2 capital mobility 65 carbon tax 30–32, 50, 300 Carter, F. 227 Central and Eastern Europe (CEE), see Central and Eastern Europe (CEE), energy and sustainability; Central and Eastern Europe (CEE), environmental cleanup; entries for individual countries; European Union (EU)

enlargement, eastern; Kyoto Protocol, and economies in transition (EITs); Kyoto Protocol, and Russia; Russia, climate policy, new framework for; Russia, environmental policy, reorganization of Central and Eastern Europe (CEE), energy and sustainability 227–9, 260–61 carbon intensities 228, 230 electricity demand trends 247–9 electricity industry reform 241–3 energy efficiency, progress towards 256–60 energy intensities 228, 230, 231–5, 238–9, 246–7, 249–60 energy transition, first decade of 240–49 GDP trends and demand for primary energy 245–7, 248–9 legacies of centrally planned economies 233–7, 239–40 policy agenda for energy market transition 237–40, 256–60 pollution levels 227–8, 230, 231 position at fall of communism 229–33 price reform 238, 243–4, 249, 257 see also Russia Central and Eastern Europe (CEE), environmental cleanup 182–4, 202–3 brownfields revitalization 196–9, 200, 201–2 external public financial sources 198, 199–202, 203 foreign direct investment (FDI) 184–90 managing environmental liability risks 188–90, 199 past pollution, cleanup 198–9 339

340

Index

subregions, description of problems in 190–96 centrally planned regimes inefficiency of 233–5, 239 and pollution 227 positive legacies 235–7, 239–40 Chernobyl disaster 227 China, greenhouse gas emissions 20 coal-fired power plants 39 comparative advantage, and EU enlargement 151, 152 compensation mechanisms, and trade regime 60–61 competitiveness, see regulation and international competitiveness Copeland, B.R. 66, 67 corruption 29, 234–5 Russia 29, 268, 277, 287, 318 cost–benefit analysis 39 Croatia, and Kyoto Protocol 210, 213, 219 Czech Republic data reliability 252, 253 electricity demand trends 247–8, 249 electricity industry 241–2 emission levels 147, 191–2, 213, 230 and emissions trading 211 energy efficiency, progress towards 256–60 energy intensity 230, 231, 232, 250, 251, 253–4, 257–8 energy prices 243–4, 249 EU accession 146–7 foreign direct investment (FDI) in 184, 185, 186, 189 GDP trends and demand for primary energy 245–7, 248, 249 and Kyoto Protocol 210, 213, 221 natural gas 230 subregions, social and environmental problems in 191–2, 193 developing countries and eco-labelling 90–91 foreign direct investment (FDI) in 184 and Kyoto Protocol 21–2, 23–4, 43, 47–8, 51–2, 332 persistent poverty, reasons for 202

and USA 43 and WTO 86, 94, 95 discount rates 217–18 eco-duties 82 eco-labelling 83–4, 90–91 economic development 22, 23 economic growth 61–2 and climate policy, Russia 295–6, 297–306, 316–18, 321, 324–5, 326–7 and foreign direct investment (FDI) 188 and trade liberalization 144, 145, 151 economists 44–5 emission scenarios 299 Russia 298–306, 324, 325 emissions targets 21–6, 39–41, 51–2, 216 economies in transition (EITs) 207–8 flexibility 45–8 emissions trading 24, 25, 26–30, 46–7, 208–9, 330 and Clean Development Mechanism (CDM) 47–8 and cost reductions 48, 49 data management and reporting 215 and EU 28–9, 42–3, 211 prices 28, 50–51, 208 and projections of emissions 216 revenue from 212, 218–20 Russia 284–5, 300, 303, 328, 334 USA and EU, views on 42–3 see also Kyoto Protocol, and economies in transition (EITs); regulation and international competitiveness energy sector, Central and Eastern Europe (CEE), see Central and Eastern Europe (CEE), energy and sustainability energy taxes 31, 40–41, 42, 50 environment and trade, linkages between 60–65, 107–8 environmental policy, as surrogate for trade policy 66–7, 76 environmental protection, possible instruments 168

Index environmental standards, see European Union (EU) enlargement, emission standards and foreign direct investment (FDI); regulation and international competitiveness; standards Estonia and Kyoto Protocol 210, 213, 221 subregions, social and environmental problems in 194–5 European Bank for Reconstruction and Development (EBRD) 200–202 European Court of Justice (ECJ) 96, 98–9, 100, 102, 103 European Union (EU) 1–2 domestic standards, maintenance of 96–7 and emissions trading 28–9, 211 energy taxation 31 extra-jurisdictional activity 97–9 financial institutions 200–202 harmonization, environmental policy/standards 67, 68–70, 72–3, 74, 76–7, 83, 96–8, 102, 104–6 and invasive alien species (IAS) measures 72–3, 74, 75 and Kyoto Protocol 2, 22–3, 42–3, 328 and protectionism 82 rule making and implementation 99–102, 103–4, 105–6, 107 subsidiarity 68–70 subsidies 82, 150 and USA 42–3 and WTO 95 European Union (EU) enlargement, eastern 67, 163–4, 167–8 economic effects 157–9, 162 and emissions trading 211 and environmental cleanup 198, 200–202 environmental effects 159–62 and Kyoto Protocol 219 regional disparities 162 southern enlargement, comparisons with 145–7 and standards 101, 102, 105–6

341

European Union (EU) enlargement, emission standards and foreign direct investment (FDI) 167–9, 178–9 benchmark model 169–72 comparative statics 172–4 free entry and exit of FDI 175–8 European Union (EU) enlargement, southern 143, 163–4 eastern enlargement, comparisons with 145–7 economic effects 148–53, 156–7 environmental effects 153–6 regional disparities 156–7 trade liberalization, environmental impact of 144–5 transition periods 148 externalities 63, 70 internalization of 60–61, 63–4 foot and mouth disease (FMD) 72–4, 75–6 foreign direct investment (FDI) 168–9 Central and Eastern Europe (CEE) costs and benefits 188 and environmental cleanup 182–4 managing environmental liability risks 188–90 patterns of 184–7 Poland 157, 162, 184, 185, 186–7, 188–90 Russia 318 costs and benefits 187–8 and environmental standards 68 and EU enlargement, southern 151–3 see also European Union (EU) enlargement, emission standards and foreign direct investment (FDI) free-rider problem 19, 68 General Agreement on Tariffs and Trade (GATT) 63, 64, 66–7, 103, 104 domestic standards, maintenance of 85–7 extra-jurisdictional activity 89–90 import bans 81 and invasive alien species (IAS) 72

342

Index

genetic engineering 33 Global Environment Facility (GEF) 64, 287, 329 Global Environment Organization (GEO) 63–4 global warming and cost–benefit analysis 39 future effects of 32–3 Intergovernmental Panel on Climate Change (IPCC) assessments 17 Kyoto Protocol, effect of full implementation 21 structure of problem 19–20 technological responses to 33–4 globalization, and Russia 290 Gokturk, S.S. 169 Grachev, V. 331 Greece, and EU enlargement 146–7 agriculture 149, 150, 151 economic effects 148, 149, 150, 151–2, 153, 156–7 environmental effects 153–4, 155–6 Grossman, G. 144 Hagem, C. 208 Hardes, H.-D. 146 harmonization, environmental policy/standards 59–60, 67–70, 72–3, 74–7, 83, 96–8, 102, 104–6 Hausmann, R. 202 heating networks 236, 238 Holtsmark, B. 208 housing 236–7 Hudec, R.E. 68 Hungary data reliability 252, 253 electricity demand trends 247–8, 249 electricity industry 241–2 emission levels 147, 213, 228, 230 energy efficiency, progress towards 256–60 energy intensity 230, 231, 232, 250, 251, 253–4, 255, 257–8 energy prices 243, 244, 245, 249 EU accession 146–7 foreign direct investment (FDI) in 184, 185, 186, 189 GDP trends and demand for primary energy 245–7, 248, 249

inefficiency in 234–5 and Kyoto Protocol 210, 213 natural gas 230 nuclear energy, reliance on 229 subregions, social and environmental problems in 193–4 import bans 81 innovation and regulation, see regulation and international competitiveness Instrument for Structural Policies for Pre-accession (ISPA) 201–2 Intergovernmental Panel on Climate Change (IPCC) 17 internal market (EU) 145 International Bank for Reconstruction and Development (IBRD) 200, 286, 287 International Finance Corporation (IFC) 199–200 International Monetary Fund (IMF), carbon tax monitoring 31 invasive alien species (IAS) 70–76 investment 216–18, 301; see also foreign direct investment (FDI) Jaffe, A.B. 114 Krueger, A. 144 Kyoto Protocol 1, 18 and developing countries 21–2, 23–4, 43, 47–8, 51–2, 332 and emissions trading 26–30 enforcement 50 evaluation of 20–26 mechanisms 207, 208–10 ratification 208, 210, 293, 326, 327–35 time horizons 40 Kyoto Protocol, and economies in transition (EITs) 2, 207–8, 221–2 benefits 211–14, 296–7, 334 carbon intensities 212–13, 214 domestic implementation, successful 214–18, 310–13 international negotiations 218–20 mechanisms, post-Marrakesh 208–11, 329–30 participation 220–21

Index Kyoto Protocol, and Russia 28, 29, 47, 208, 210, 213, 219, 220 commitments, meeting 300 and economic growth 298–9 ratification 293, 326, 327–35 Kyoto Protocol, and USA 17–18, 21, 29, 37–8, 208, 334 cost estimates 48–50 flexibility mechanisms 45–50 political chasms 41–5 targets and timetables 39–41 treaty design 50–52 Lahiri, S. 169 Large Plant Combustion Directive 70 Latvia foreign direct investment (FDI) in 185–6 and Kyoto Protocol 210, 213, 221 Levinson, A. 169 liability, environmental, see Central and Eastern Europe (CEE), environmental cleanup Linde, C. van der 117 Lithuania and Kyoto Protocol 210, 213, 221 nuclear energy, reliance on 229 location decisions, firms 65–6 Long Range Transboundary Air Pollution (LRTAP) Convention 70 marine environment, international agreements 91, 272 Markusen, J.R. 168–9 methane, and taxation 31 monitoring 29, 31, 50, 215, 315–16, 328–9 Most Favoured Nation (MFN) status 86 multilateral environmental agreements (MEAs) 63–4, 91–3 multinational corporations (MNCs) 68, 187–8 natural gas Central and Eastern Europe (CEE), use in 229–31 Russia 230, 287, 320, 325–6, 334

343

North American Free Trade Agreement (NAFTA) 64 Nutter, G.W. 252–3 Oates, W.E. 116 Objective 1 funds 201–2 Ono, Y. 169 packaging 237 Palmer, K.P. 117, 126 Poland coal, reliance on 229, 255 data reliability 252, 253 electricity demand trends 247–9 electricity industry 241–2 emission levels 147, 159–61, 162, 213, 220, 228, 230, 231 energy efficiency, progress towards 256–60 energy intensity 230, 231, 232, 236, 237, 250, 251, 253–6, 257–8 energy prices 243, 244, 249 foreign direct investment (FDI) in 157, 162, 184, 185, 186–7, 188–90 fuel structure 255 GDP trends and demand for primary energy 245–7, 248–9 heating networks 236 and Kyoto Protocol 210, 213, 220–21 subregions, social and environmental problems in 195–6 Poland, EU accession 146–7, 163–4 economic effects 157–9, 162 environmental effects 159–62 regional disparities 162 politicians, time horizons 40 polluter pays principle 82 Popov, A. 331 population based emissions targets 25 Porter, M.A. 114, 116, 117–18, 126, 131, 132 Portugal, and EU enlargement 146–7 economic effects 148–9, 150–53, 156–7 environmental effects 154, 155–6 precautionary principle 84–5, 87, 88 privatization and energy sector, Central and

344

Index

Eastern Europe (CEE) 239, 241–2, 249, 255–6, 257 and environmental cleanup, Central and Eastern Europe (CEE) 189, 198–9 Russia 319 production methods, and trade liberalization 145 property rights 310–11, 316, 319–20 proportionality 86, 100, 103, 107 protectionism 66–7 eco-labelling 83–4 invasive alien species (IAS) measures 72 regulation as 65, 81–2, 83 see also Agreement on Technical Barriers to Trade (TBT) public goods 68, 70, 73 vaccinations as 75–6 public transport 235–6, 240, 253–4 quality assurance 84 Rauscher, M. 169 regulation, see standards regulation and international competitiveness 113–16, 131–2 conventional school 116–17 model 118–31, 132, 135–40 revisionist school 117–18 risk assessment 87–8, 106 risk pooling 74–5 Romania and Kyoto Protocol 210, 213 natural gas 230 Runge, C.F. 64 Russia 2–3 corruption 29, 268, 277, 287, 318 data reliability 252–3, 306 electricity demand trends 247 electricity industry 241–3 emission levels 213, 230, 270–73, 279, 326, 332 emission scenarios 298–306, 324, 325 energy efficiency, progress towards 256–60, 321–4 energy exports 229–30 energy intensity 230, 231–2, 250–53, 256, 257–8, 301, 304, 305, 320, 325

energy prices 243, 244, 252, 320, 322, 323, 325–6 energy sector, emission forecasts 303–4 GDP trends and demand for primary energy 245–7 natural gas 230, 287, 320, 325–6, 334 see also Kyoto Protocol, and Russia Russia, climate policy, new framework for anti-bureaucratic laws 318 climate policy law 308–9 Committee of Environmental Protection (CEP) project 311–13, 315 Development Strategy 317–18, 321, 324–6 economic growth 295–6, 297–306, 316–18, 321, 324–5, 326–7 emission trends and economic growth 298–306 energy sector modernization 320–24 evolution of climate policy, 1990s to 2000s 293–8 Federal Target Program on Climate Change 309–10 future configuration of institutions 310–16 institutions, domestic 295, 296, 297, 306–16, 318–20 Interdepartmental Commission on Climate Change (ICC) 295, 296, 297, 306–8, 314 Kyoto Protocol, ratification of 293, 326, 327–35 Ministry of Fuel and Energy project 313–16 property rights 310–11, 316, 319–20 public opinion 294, 296–7, 333 regions 313–14 tax reform 318–19 Russia, environmental policy, reorganization of 265–6 administrative reorganization 273–5 barriers to new policy implementation 268–9 decentralization of environmental management 275–8 economic activity, effect of 270–73

Index environmental funds 281–2, 284 environmental situation 269–73 financing environmental protection 282–8 foreign assistance, role of 285–8 future prospects 288–90 implementation effectiveness 269–73 institutional framework for environmental management, innovations in 273–8 major features of, 1990s 266–7 pollution charges 278–81 Sanitary and Phytosanitary Agreement (SPS) 63, 66–7, 72, 81, 85, 87–8 Simpson, R.D. 114, 117, 126 Single European Act (SEA) 100 Slovak Republic emission levels 147 and emissions trading 211 EU accession 146–7 foreign direct investment (FDI) in 186 and Kyoto Protocol 210, 213, 221 nuclear energy, reliance on 229 subregions, social and environmental problems in 192–3 Slovenia foreign direct investment (FDI) in 186 and Kyoto Protocol 210, 211, 213, 221 Spain, and EU enlargement 146–7 economic effects 149–51, 152, 153, 156–7 environmental effects 154, 155–6 standards compliance with, trading partners 107 and cost differentials 81 and eco-duties 82 and EU 67, 68–70, 72–3, 74, 76–7, 83, 96–9, 100–102, 103–4, 105–6 and GATT/WTO 85–8, 102–5 harmonization of 59–60, 67–70, 72–3, 74–7, 83, 96–8, 102, 104–6 production process or methods standards (PPMs) 83–4, 89–90, 94, 97–8, 104 and protectionism 65, 81–2, 83

345

and quality 84 and relocation of activities 65–6 types of 83 see also European Union (EU) enlargement, emission standards and foreign direct investment (FDI); regulation and international competitiveness Stupp, S. 146 subsidiarity 68–70 subsidies 82, 150, 238, 244, 257 Task Force on the Environment and the Internal Market 145 taxation 30–32, 40–41, 42, 50, 82–3 Russia 300, 318–19 technology 33–4, 43–5, 154–6, 162 and emission scenarios 300, 301, 302 transfer 214 trade agreements, and relocation of activities 65–6 trade and environment, linkages between 60–65, 107–8 trade–environment debate 1 trade liberalization 61–3, 103–4, 144–5, 151 trade unions, Russia 320 Ukraine and Kyoto Protocol 28, 29, 47, 208, 210, 212, 213, 220 natural gas 230 Urban Waste Water Treatment (UWWT) Directive 69 USA and developing countries 43 and EU 42–3 public opinion 42 social and environmental problems, pockets of 190 and WTO 95 see also Kyoto Protocol, and USA Victor, D.G. 29–30 Vienna Convention for the Protection of the Ozone Layer 286–7 Whalley, J. 64 Wheeler, D. 66

346

Index

World Environment Organization (WEO) 63–4 World Trade Organization (WTO) 63–4, 68 domestic standards, maintenance of 85–8 extra-jurisdictional activity 89–93

rule making and implementation 93–5, 102–5, 107 and taxation 82 Xepapadeas, A. 116 Zeeuw, A. de 116 Zissimos, B. 64