Experience with the Use of Economic Instruments in Europe

Mr Blokland, Ladies and gentlemen,

I would like to start by offering you two quick facts.

The average new passenger car in Europe consumes about 6.5 litres of fuel per 100 kilometres. The average passenger car in the United States uses over 40% more over the same distance.

Why is this the case?

Wholesale prices for car fuel are roughly the same in the European Union as in the USA. But it is the prices at the pump in Europe which are different. Here these include taxes in the range of 60-75%, compared with only 20-25% in the USA.

Is there a connection between higher fuel prices and better fuel economy in cars? Of course, there is!

Is there a cultural difference that makes Americans adore big cars more than Europeans do? Maybe there is, but Europeans are also buying Sports Utility Vehicles. The crucial point is that Europeans – just as Americans - are encouraged to buy SUVs if the tax reduction conditions provide them incentives to do so.

A basis for motor fuel taxation was laid down with the European Energy Tax Directive of 2003. Such taxation is of course what environmental policy-makers usually refer to as a market-based instrument (or MBI). But it is not always recognised as such, because energy taxation, which was already widespread when environmental policy making made its way up the political agenda, never actually had environmental protection as its raison d’être.  Its main purpose was to raise funds for government spending. But it has worked to protect the environment as well.

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The European Environment Agency – which set up office in Copenhagen in 1994 - has played a key role in analysing economic instruments from its earliest days. We needed to do this in order to fulfil our task of providing timely, targeted, relevant and reliable information and assessments that inform policy and debate.

The five-yearly State of the Environment and Outlook report, which we published in November 2005 provided a comprehensive assessment of the state of Europe’s environment. It analysed key developments and their main driving forces. One of the main conclusions was that reform has at last begun in sectors like agriculture, transport and energy provision. But a great deal remains to be done if these sectors – which impact so heavily upon the environment - are to perform sustainably.

The Agency’s main strategic contribution to sustainability is to raise awareness about environmental problems amongst consumers, producers, politicians and other policy makers.

Regulations can of course help internalise environmental costs, but market-based instruments provide a continuing and dynamic incentive to reduce pollution and for economic activities to become more resource efficient.

So today I would like to draw on our experience and illustrate some of the lessons that have been learnt from the application of market based instruments in Europe in recent decades[1].

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Water Pollution

Let me start with water pollution.

It is estimated that the costs of water pollution control from households and industries have been about 50 per cent of total environmental investments in the EU over the last three decades. In fact, it is generally accepted that the 1991 Urban Waste Water Treatment Directive is the single most investment-intensive directive in the Union’s environmental acquis.

A recent EEA study looked at the experiences of six Member States in implementing the directive – Denmark, France, the Netherlands, Spain, Poland and Estonia.

Each case study reveals interesting experiences in its own right, but it is the comparison between the policy measures adopted in the Netherlands and Denmark that brings out the clearest lessons about how MBIs can be useful in both applying the polluter pays principle and  in achieving  reduction of pollution at source.

Already from the 1970s – so before the introduction of the directive - the Netherlands adopted both full cost user fees, for access to water treatment plants, and realistic levies on discharges of pollution to open water, based on the polluter pays principle.

The revenues were then used to construct water treatment plants and crucially also to provide technical and financial support to help the most polluting industries to install cleaner technologies – for example the food, chemicals and paper industries. Together with the substantial pollution levies, this helped them to reduce their discharges of polluted water, which then in turn required less treatment plant to be constructed.

By contrast, Denmark mainly invested in end-of-pipe public water treatment plants until around the mid-1990s when they introduced pollution levies and clean technology support programmes.By then, however, most treatment plants were already constructed, and had begun to generate additional operating and maintenance costs.

The most important reasons for the different experiences of these two Member states were the early use in the Netherlands of full cost recovery user fees and realistically high levies on pollution combined with the targeted application of their recycled revenues – in other words “hypothecation” - to support eco-efficiency measures.

In the minds of people then, it was clear that by using less they would pay less.

If we look at industrial air pollution and wastes, we can see a similar pattern with the nitrogen oxide charge in Sweden, the Landfill Tax in the United Kingdom and other such taxes elsewhere.

A key design feature of a successful MBI is steadily rising and pre-announced tax rates on units of pollution or environmental pressure. These provide both increased  incentives to innovate and help to maintain tax revenues.

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Energy and CO2

The European Council meeting here in Brussels two weeks ago confirmed that energy and CO2 emissions are at the very top of the political agenda.

Two significant economic instruments are in use to address energy consumption and CO2 emissions: energy taxation and the EU Emissions Trading System (ETS).

These differ substantially in structure and functioning, but they are basically two sides of the same coin – that is, putting a price on emitting CO2. Taxes do it through a price on the fuel, while the trading system creates scarcity by limiting the total CO2 emissions. Taxes have a known price and an uncertain outcome; ETS has a known outcome but an uncertain price.

So which is better? The answer is provided not by theory but by real-world conditions. Actual conditions and context influence which of the two approaches – or, which combination of the two approaches - should be preferred. Where there is an agreed absolute policy target, as in the case of the EU climate change policy, then the ETS is a logical choice for point sources. At the same time, energy product taxes are optimal for addressing the environmental performance of diffuse sources.

The emissions trading system, which is the first of its kind in the world, has alerted financial directors in 11,000 installations in Europe as to the impact on costs of a price for their CO2 emissions. In most member states, these had previously cost them nothing. Overnight, the externality of climate change has been made transparent and brought directly into the bottom line of companies.

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Transport

I started my speech today on fuel taxation but let me now return to the subject of transport more generally.

The environmental externalities of transport are much larger than those in the energy production sector, amounting to some 650 billion Euros. Thankfully, at least some of these costs are being internalised through a variety of taxes and charges ranging from fuel taxes and fuel tax differentiation, distance based charges and congestion charging.

But there are of course limitations to internalising transport externalities via fuel taxes in one country when the transport is international. Germany has experienced the limitations of taxing transport fuel in one country. After five years of steadily increasing taxes, “fuel tank tourism” - as it is known - undermined the efforts of the authorities.

The fuel tax differentiation on leaded and unleaded petrol in many countries in the 1980s, in combination with other measures, eliminated sales of leaded gasoline much more quickly than expected.

Distance based charges for heavy goods vehicles - which are generally a more efficient way to internalise transport externalities than fuel taxes - are being used in Switzerland, Austria and Germany. These will be extended across Europe through an improved Eurovignette Directive over the next few years.

There are also plans in the EU to diversify annual road taxes according to environmental characteristics of the car, and gradually abolish the registration tax applied in most EU Member States. The aim of this is of course to charge for the use of the car rather than the ownership.

Congestion charging is another instrument that has been successfully introduced in central London where the steadily rising revenues are being recycled into improving public transport.

It therefore makes sense to use a balanced policy mix – as well as co-ordinating the use of instruments across Europe - to address the ever-growing environmental impact of traffic.

This is particularly true with regard to subsidies.

One of the main requirements for long term success in the use of MBIs is the need to remove environmentally perverse subsidies. 

In a technical report that the Agency is launching today on transport subsidies, we estimate that nearly 300 billion Euros of subsidies are being provided every year across the four transport modes of road, rail, water and air.  These subsidies clearly need further investigation if we are to understand properly their environmental impacts.

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Ladies and gentlemen,

This short overview of the use of market based instruments in Europe shows that there is already a lot of experience out there to learn from.

But that does not mean that there is universal acceptance. The introduction of MBIs is often opposed by three main arguments, all of which can be rebutted:

• First, the counter-argument that “the disadvantaged will suffer most”. It is of course true that poor people often pay proportionately more for energy, transport and housing. But this can be offset by smart policy design and the use of exemptions or tax free thresholds.
• Second, there is the counter-argument that “competitiveness will be damaged”. But OECD evidence and other studies have shown that this is rarely the case at the macro-economic level: it is often companies with already uncompetitive products and cost-bases that have difficulty absorbing their external pollution costs. In any case, short term effects on the competitiveness of particular sectors can be offset by long introduction periods; temporary compensatory measures; border tax adjustments etc.
• Third, critics say that ‘environmental tax revenues will shrink’ as the taxes encourage the reduction of pollution and increase eco-efficiency. However, the tax per unit of pollution, or of inefficient energy use, can increase as eco-efficiency improves, thus maintaining both the incentive to do better and the tax revenue.

Long term trends in labour, energy and resource productivity illustrate the scope for shifting the focus of innovation from labour to nature. Between 1960 and 2000 labour productivity in the EU 15 rose by 270 % whilst materials productivity only rose 100% but energy productivity  rose by only 20%.

So we need tax reform to realign a European economy that is still characterised by an insufficient use of labour resources and an excessive use of natural resources.

Europe has shown that it is prepared to take the lead in the fight against climate change. What is needed now is greater leadership by the EU on the roll-out of taxation reform and other market based instruments to embed sustainable development.

Let me leave you with one closing thought.

Progress in the wider use of market based instruments for environmental protection and environmental tax reform depends to a great extent on how societies see the role of taxes.

As Franklin D Roosevelt pointed out when he introduced comprehensive income tax for the first time in the 1930s: “taxes are the price of a civilised society”.

Thank you for your attention.

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