COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE EUROPEAN PARLIAMENT - Bringing our needs and responsibilities together- Integrating environmental issues with economic policy

1. introduction

The Amsterdam Treaty requires the integration of environmental protection into Community policies in order to achieve sustainable development [1]. At its June 1998 meeting in Cardiff, the European Council invited all relevant formations of the Council, starting with the Transport, Energy and Agriculture Councils, to establish their own strategies for giving effect to environmental integration and sustainable development within their respective policy areas. In Cologne in June 1999 the European Council called upon the Council to report to it in 2000 on the integration of environmental issues and sustainable development in the policy areas of General Affairs, Economic and Financial Questions, and Fisheries.

[1] "Environmental protection requirements must be integrated into the definition and implementation of the Community policies and activities referred to in Article 3, in particular with a view to promoting sustainable development." Article 6 of the consolidated version of the Treaty establishing the European Community; OJ C 340 of 10th November 1997

This Communication follows the presentation of strategies for integrating the environmental dimension into the Agriculture, Transport and Energy sectors; the Development, General Affairs (in particular for trade issues), Industry and Internal Market Councils are working on strategies for their policy areas. Building on the Commission's 1994 Communication on economic growth and the environment [2], it contributes towards the definition of a Community strategy to improve integration of the environmental and economic dimensions of sustainable development [3]. In line with the conclusions of the Lisbon European Council, the strategy proposes no new process, but rather the use of existing instruments to achieve gradual but credible progress in integration. These include Member States' annual reports on structural reforms and the Broad Economic Policy Guidelines. The Broad Economic Policy Guidelines should ensure that consistent policies for integration are proposed across different sectors of the economy. The ECOFIN Council when preparing the Broad Economic Policy Guidelines taking account of contributions from other Council formations should ensure such consistency. The Council's decisions concerning energy and environmental taxes are also relevant to the integration between environmental and economic policy measures.

[2] "Economic Growth and the Environment: Some Implications for Economic Policy Making"; COM(94)465 of 3 November 1994

[3] At Helsinki in December 1999 the European Council asked the Council to submit to it in June 2001 comprehensive strategies for these sectors. The Commission was also invited to present to the June 2001 European Council a proposal for a long term strategy dovetailing policies for economically, socially and ecologically sustainable development. Annex 1 contains a more detailed discussion of issues relating to the integration of economic and environmental concepts of sustainability.

The Communication argues that there is no inherent contradiction between economic growth and the maintenance of an acceptable level of environmental quality. Indeed, economic growth typically enables societies to provide their members with a cleaner, healthier environment: cholera and dysentery due to water pollution are not problems faced by developed societies, even when confronted with natural disasters. Accordingly, the issue should not be seen as one of economic growth versus the environment, but rather of how improvements in living standards can be accompanied by the safeguarding and improvement of the quality of the environment. Moreover, improving integration should be beneficial for both environmental and economic policy. "Greening" fiscal policy, by removing subsidies to environmentally harmful activities for example, should enhance economic efficiency. The use of economic instruments, such as taxes, subsidies or other incentive payments, or tradable emission permits, will frequently offer a more effective means of achieving environmental policy objectives than traditional environmental policy instruments such as direct regulation of polluting activities. Measures to enhance integration will be simultaneously beneficial for the economy and the environment.

The European Environment Agency has argued that "improved environmental quality . . . will have to come mostly from changes in economic activity and socio-economic policies" [4]. To the extent that our current use and allocation of resources is not consistent with this goal, moving our economies onto trajectories which will allow us to meet this objective entails changes in resource use and allocation. There are essentially two ways of doing this. Either the goods and services that we consume now must be produced using fewer natural resources, or we must produce and consume goods and services which use these resources less intensively. Both of these scenarios imply change. This change is an essential part of achieving the Lisbon European Council's goal of making the Community the world's most competitive and dynamic knowledge-based economy.

[4] "Europe's Environment: The Second Assessment"; European Environment Agency, 1998

2. why integration is inadequate and what can be done about it

One of the reasons why environmental considerations are insufficiently incorporated in economic policy formulation is that economic policy is - correctly - essentially concerned with macroeconomic stability and the functioning of markets. But many environmental problems arise precisely because there are no markets in environmental goods and services. As well as damaging the environment, these missing markets give rise to an important source of economic inefficiencies, or "externalities".

Externalities lead to a mismatch between private and social costs. But economic efficiency requires that private and social costs be equal at the margin: if resources are to be used efficiently, the costs to an individual of using those resources must be the same as the costs society incurs from the use of the same resources. If economic agents do not take account of pollution in their production costs, then they will allocate too many resources to producing goods and services which cause pollution; if economic agents are not paid for environmentally beneficial actions, they will undertake too few of them. In both cases, society as a whole loses. So measures to improve the integration of environmental issues into economic decisions should result in less pollution and improve the functioning of the economy.

Because markets for many environmental goods and services are either missing or incomplete, producers and consumers receive misleading price signals. "Getting the prices right" - action to improve the working of such markets where they exist, or to create such markets when they do not - should therefore form part of an effective integration strategy. Several instruments which might be used to improve integration of environmental and economic policies by creating markets in environmental goods and services or improving the functioning of these markets are outlined below. Additional details are in Annex 2.

The functioning of a market for any good or service requires that property rights in that good or service are well-defined, enforceable, and tradable. In the case of many environmental products, property rights are not explicitly defined, so markets for them cannot develop. Accordingly, one option for resolving externalities which will be effective in certain well-defined circumstances is to create and assign tradable property rights in those environmental goods and services.

By placing a price on pollution through the imposition of pollution taxes or charges, governments can reduce or eliminate the gap between the private costs of the activity which generates the pollution and the costs to society.

In contrast to pollution charges, which fix a price for pollution but leave the quantity uncertain, tradable emission permits determine the quantity of pollution and allow market forces to set its price.

Deposit-refund schemes are among the instruments which may be used to encourage recycling.

Support to undertake activities or provide goods and services which generate positive environmental effects may be offered by subsidies, or other positive incentive payments.

Negotiated agreements between industry and public authorities are a hybrid between market-based instruments and formal regulation. They typically entail members of an industrial association committing themselves to targets such as phasing out use of harmful substances, or reductions in their use of energy per unit of output over a certain time period, in return for promises by government to refrain from direct regulation or taxation of the sectors concerned.

Although not strictly an economic instrument, clear and reliable information can substantially improve the effectiveness of economic instruments as a means of integrating environmental concerns with economic policy. Better information about the environmental characteristics of goods and services can play an important part in encouraging and enabling producers and consumers to make choices which are environmentally sound and reflect the economic costs to society of their actions.

3. market-based instruments versus "traditional" regulation

In contrast to more traditional forms of regulation, economic instruments use markets to tackle pollution. Whether by influencing prices, or absolute quantities, or quantities per unit of output, market-based instruments implicitly acknowledge that firms are different and provide a flexibility that can substantially reduce the costs of environmental improvements. They are typically superior to more rigid regulatory instruments in both the short and long run. In the short run, they enable emission reductions to take place where they are cheapest. Each firm knows the "value" of its own pollution: faced with a charge per unit of emissions, a firm will reduce its emissions as long as the cost of doing so is less than the level of the charge. In the long run, market-based approaches to pollution control give companies incentives to find cost-effective ways to reduce pollution by devising new, cleaner production techniques. By reducing the cost of pollution abatement, this may allow societies to achieve greater environmental improvements than would otherwise have been considered economically feasible.

This may be relevant for enlargement of the Community to Central and Eastern Europe. Market-based instruments offer additional possibilities to the candidate countries to effectively implement EU environmental law in practice. They could thereby facilitate the achievement of Community environmental standards in a cost effective way. Moreover, market-based instruments may require fewer administrative resources to implement. This is an important consideration, given that public administrations in CEECs are under considerable stress as they adapt to the rules of a market economy and the requirements of Community membership. The Community's development policy should also support the introduction of market-based instruments, in particular through its assistance to structural adjustment and sectoral reform programmes in partner countries.

Conventionally, environmental regulation has created rights to pollute by, for example, setting limit values which define the maximum amount of pollution allowed per emitter. Firms have no incentives to outperform whatever standard is set for them. Increasingly, such regulation has adopted standards differentiated according to the type of production technology. However, even the most sophisticated regulations have limited scope to take account of differences in the ability of individual sources to reduce their emissions. It is extremely difficult to legislate for the wide variety of firms that exist and the different costs they may face in switching to cleaner production techniques. By its nature, a regulatory approach to integrating environmental values in the decisions of individual economic actors largely ignores market forces. Attempts to integrate environmental and economic policy objectives are likely to be more successful if they instead acknowledge that market forces are powerful - they are implicated in many environmental problems - and seek to harness them to achieve environmental policy aims.

The uncertainty which is a recurring problem for environmental policy-makers offers another reason to use economic instruments to integrate environmental policy in economic decision-making. Markets can reveal important information which would otherwise remain inaccessible. Environmental policy targets should in principle be set so that the benefit of the environmental improvement at least matches the costs of achieving it. However, it is often difficult for a regulator to place a value on a specific environmental amenity or the damage caused by a particular pollutant, or to find out the exact costs of pollution abatement. The use of economic instruments makes the costs of environmental improvements explicit. Regulation also imposes costs, but they remain hidden, or implicit.

Clearly, economic instruments do not eliminate uncertainties. When introducing taxes or charges, the quantity of emission reduction that will result is generally unknown. Equivalently, it is difficult to determine the charge or tax rate which will ensure an efficient allocation of resources. Similarly, if a ceiling is put on emission volumes, the cost of sticking to this ceiling under an emissions trading scheme will not be known in advance. Moreover, to be effective these instruments require well-functioning and competitive markets which are responsive to price signals. The current focus on structural reforms of the Community economy should further increase the attractiveness of market-based instruments. The more markets are competitive, and the more responsive are supply and demand to changes in relative prices of goods and services, the more effective will be market-based solutions to environmental problems. However, uncertainty about prices or quantities should not become an excuse for inertia. The direction of the desired policy response is clear, even if its precise size is unknown.

While market-based instruments offer substantial advantages compared to more traditional options, the choice of policy instrument should be tailored to the precise environmental problem to be addressed. This may entail using market-based measures, regulation, negotiated agreements, either separately or in combination. Site-specific or regional problems require site-specific or regional responses. Regulatory instruments are likely to remain particularly suitable to prevent and combat major hazards in the living and working environment. Irrespective of the exact form of the policy intervention, care must be taken that the political process leading to its implementation does not lead to the measure deviating from its stated objective, whether by accident or design. For example, regulation which imposes tighter emission standards on new installations than on existing plants may stifle market entry and hamper competition; negotiated agreements may achieve little more than "business as usual" outcomes, or may provide opportunities for anti-competitive behaviour; market-based instruments such as taxes may serve mainly as revenue-raising devices and have little or no environmental effect. Whatever approach is adopted, environmental problems should not be tackled in a way which creates or exacerbates other difficulties. Moreover, the impact of any policy depends on its effective enforcement.

4. environmental integration, growth, competitiveness and social stability

4.1. Growth and the environment

The relationship between economic growth and the environment is not straightforward. Many environmental problems faced by poorer countries result from too little economic growth. Growth enhances willingness and ability to pay for a cleaner environment. In contrast, at low income levels, societies do not have the resources to provide for even basic needs such as sanitation. The World Bank has estimated that water pollution in developing countries is responsible for over 2 million deaths each year [5]. Moreover, this pollution acts to constrain economic development by, for example, damaging fishing grounds. Pollution levels in urban areas are several times higher in poorer than in richer countries. On the other hand, in the absence of targeted policy measures, quantities of household waste and emissions of greenhouse gases tend to rise with per capita income: on current trends the Community will not meet its commitments to abate greenhouse gas emissions under the Kyoto Protocol to the UN Framework Convention on Climate Change [6].

[5] "Growth and the Environment" (World Development Report 1992); World Bank; 1992

[6] The Commission's Green Paper on greenhouse gas emissions trading (COM(2000)87 of 8th March 2000) discusses how a system of tradable emission permits could help the Community achieve its target.

Nevertheless - at least in the short-term - economic growth, whether in the developed or the developing countries will likely require increased use of natural resources, and will lead to more pollution. Bringing economies onto a higher growth path should therefore be accompanied by improved integration of environmental factors in decisions and behaviour at corporate and at individual level. While the Community and other developed countries have made progress in decoupling economic growth from the use of natural resources, much more needs to be done. For example, the scientific consensus is that emissions of greenhouse gases must be at least halved from their current levels if potentially dangerous human-induced climate change is to be averted. But rising levels of greenhouse gas emissions or of waste are not inevitable. They are not preordained consequences of economic growth. Rather, they reflect inadequate integration of environmental considerations in the decisions of individual consumers and producers. As a result, developed countries now face substantial costs in repairing past environmental degradation. This is due to a failure to value the environment and the services it provides.

In the view of the Commission, creating competitive markets for environmental goods and services will frequently be the most effective way of ensuring that we, as producers or consumers, value the environment appropriately and integrate it in our everyday decisions.

4.2. Competitiveness and environment- the international dimension

Environmental policies do not intrinsically result in higher aggregate costs. Rather, and in particular if implemented using economic instruments, they make costs more apparent. Incorporating the Polluter Pays Principle as an element of the integration of environmental issues with economic policy alters the burden of costs between producers and consumers: polluters have to recover the costs of abatement efforts through higher prices. This contrasts with a situation in which the costs are not made explicit but nevertheless fall on society through, for example, higher health-care expenditures.

Both traditional "command and control" environmental regulations and economic instruments shift costs to enterprises and consumers for pollution abatement which would otherwise have been borne by others. In addition, they can entail substantial transfers of funds for emissions that remain unabated. For certain sectors a large sudden increase in costs could pose substantial problems notably vis-à-vis foreign competitors. These problems are not insurmountable. There are a number of ways to address them.

Instruments such as business impact assessment systems can help to establish the implications for the sectors and enterprises concerned, and ensure that decision makers are better informed. Though some environmental problems may require urgent action, there are others where a more gradual approach to integration is possible. The economy cannot be put on an environmentally sound path overnight. The risk in taking an incremental, long-term approach is that the policy goal may be expressed in such general terms or set so far in the future as to lack credibility. This can be remedied by setting intermediate milestones against which progress to the ultimate well-defined policy objectives can be assessed. Provided that it is credible, a gradual approach to integration should be consistent with the need to achieve a better environment while avoiding a "step-change" in the conditions in which companies operate. Adopting a high level of environmental protection as a policy objective should not mean creating large quantities of "stranded assets" or making large numbers of workers unemployed. A gradual approach will give firms time to adapt and to develop innovative approaches to pollution abatement.

A gradual approach to the internalisation of external costs in which all sectors are treated equally seems preferable to more accelerated implementation if the latter is accompanied by tax exemptions or rebates for some sectors. This can result in environmental taxes having perverse effects. Typically, it is the most energy-intensive or polluting sectors which receive derogations or exemptions. Since these sectors are frequently also intensive users of capital rather than labour, the outcome may be bad both for the environment and for employment. Nonetheless, countries which have introduced emissions taxes have very often accompanied them with these types of exemptions because of fears that the affected sectors face technical constraints which would not allow them to adapt quickly to price changes, and that they as a consequence would lose international competitiveness leading to widespread job losses.

Such concerns should be less important if a coordinated long-term approach to the environment is undertaken at Community level or even globally. Indeed, in the absence of coordinated international action, efforts by the Community to safeguard the environment cannot be fully successful in the longer term. Global challenges such as climate change and ozone depletion can only ultimately be conquered by global action. International environmental problems such as transboundary water and air pollution can best be tackled by coordinated international efforts. The Community's development policy could assist partner countries to use market-based instruments such as Joint Implementation and the Clean Development Mechanism of the Kyoto Protocol. This should improve their overall economic and environmental performance and be a cost-effective way for the Community to contribute to global environmental objectives.

The overwhelming majority of the goods and services produced in the Community are also consumed in the Community. Exports to and imports from third countries are each equivalent to less than one-tenth of Community GDP. A large part of this trade is with countries in Central and Eastern Europe which have applied to join the Community, or with countries which are members of the European Economic Area. These countries are committed to implementing Community Single Market legislation in the short- to medium-term. Steady progress by the Community towards improved environmental quality in the framework of the Internal Market should not therefore have major negative implications for international competitiveness versus these countries.

A still wider group of countries - including all the major industrialised economies - is also taking steps towards protecting the global environment by limiting their greenhouse gas emissions. Although comprehensive common and co-ordinated action at the global level or at least at the level of the industrialised countries would be the optimal solution to tackling global environmental problems, lack of such co-operation should not trigger a major relocation of economic activities. Indeed, suggestions that higher levels of environmental protection would cause large parts of production to relocate outside the Community (and the developed world in general) take inadequate account of the many benefits of location in the Community. These include guaranteed access to the single market, generally well-developed infrastructure, and macroeconomic, political and institutional stability.

Furthermore, substantial differences in tax structures and levels already exist both within the Community and between the Community and other industrialised countries. This suggests that differences in tax structures are not the only relevant factor for international investment decisions and accordingly, that the preservation and improvement of international competitiveness does not have as a pre-requisite identical structures and levels of taxation or environmental standards across countries or groups of countries.

For all of these reasons, fears that the pursuit of a high level of environmental protection will inevitably lead to a deterioration of the Community's international competitiveness may be exaggerated. It is nevertheless beyond question that international cooperation on the widest possible scale will facilitate the introduction of policies promoting environmental sustainability and in some respects is a necessary condition for their success. In the absence of such co-ordination, the Community could examine the feasibility of making border tax adjustments in a way which would be environmentally and economically sound and consistent with international trading rules.

4.3. Environmental integration, the distribution of resources and social stability

There are more fundamental reasons why arguments that well-designed environmental policy will lead to a loss of international competitiveness are misplaced. In fact, such arguments are frequently not about macroeconomic competitiveness, but about the distribution of resources across the economy.

Indeed, tightening environmental regulation and withdrawing or charging for the use of explicitly or implicitly assigned rights with respect to natural resources and the environment has distributional implications, as has the initial allocation of property rights. Here a balance has to be found between the interests of the incumbent polluter and those suffering from this pollution and society as a whole.

As already argued, improved integration of environmental factors in economic policy will enhance economic efficiency. Some sectors currently receive hidden subsidies through not paying for the environmental degradation or damage to public health linked to their activities. Some polluting sectors benefit from explicit subsidies which may have been introduced for short-term social policy reasons. If these subsidies contribute to additional environmental degradation they are clearly not consistent with the objective of environmental integration.

The improvement in economic efficiency can be accentuated if resources raised by environmentally-motivated taxes and charges and saved by the removal of environmentally-damaging subsidies are returned to the economy through cuts in other, inefficient taxes. A more efficient economy will be more competitive internationally, not less.

Over time, placing more value on the environment is likely to mean changes in the goods and services we produce and consume and how we produce them. Some sectors will decline and others will expand. Overall, we will benefit by living and working in healthier societies and more efficient economies. Environmental policies can have a positive effect on employment, where the supply of environmental goods and services is more labour-intensive than the economic activities being replaced [7].

[7] cf. "Environmental Policies and Employment", OECD, 1997

Economy-wide measures to improve the skills and adaptability of the labour force, as recommended by the Employment Guidelines and the Lisbon European Council, will facilitate the changes induced by improved integration of environmental and economic policies. Nevertheless, the possibility of negative repercussions in some sectors and regions cannot be ruled out. For this reason, any comprehensive integration strategy must contain objective assessment of its full implications. To alleviate potential difficulties the strategy must include appropriate structural measures including retraining and other support for the workers in the affected industries, if moves to improved environmental integration are to remain socially and politically acceptable.

5. measuring integration: devising indicators

5.1. Introduction

The integration strategies under development by other Council formations have already identified several indicators which have both sectoral and general interest. Indicators such as energy intensity, and emissions of greenhouse gases and other pollutants, both in absolute terms and per unit of GDP should be part of any comprehensive assessment . Rather than duplicating the work of other Council formations, this section focuses on identifying additional indicators of horizontal economic policy relevance. The Commission will intensify its efforts to devise a detailed set of indicators of integration of environmental and economic policies which will support the structural indicators requested by the Lisbon European Council. This should help to ensure that environmental factors are an integral part of structural reforms of the Community economy.

5.2. Indicators on the use and effectiveness of economic instruments

Section 0 above suggested that creating and improving the functioning of markets for environmental goods and services offers an effective way to improve integration of environmental and economic policies. This naturally suggests that indicators about the use of economic instruments may assist in assessing progress in integration.

The use of economic instruments has traditionally focussed on influencing prices through fees and user charges or taxes. Perhaps the simplest and most readily available indicator of this type is the amount of revenue generated by environmental taxes.

These indicators based on taxation should, if possible, be complemented by analogous data on the use of fees and charges relating to, for example, water use and waste collection. Intensified cooperation between environmental, statistical and fiscal authorities at Member State and Community level will facilitate comparisons between Member States. This will in turn help to spread information about effective integration strategies.

Indicators on the use of tradable emission permits and negotiated agreements should also be established, to provide a more comprehensive picture of the use of economic instruments as a means of integrating environmental and economic policies.

Quantitative information on the use of market-based instruments must be complemented by analysis of their environmental and economic effects. The Commission has undertaken such analysis [8], and will continue to do so. This would help spread information about best practices in Member States and identify successful and less successful attempts to use markets to integrate environmental and economic policies.

[8] See for example "Evaluation of environmental effects of environmental taxes", European Commission, 1998; an updated version of this study will be available shortly

Box 1: Indicators on the use of environmental taxes

An environmental tax may be defined as "a tax whose tax base is a physical unit (or a proxy of it) that has a proven specific negative impact on the environment". This definition stresses the potential impact of a tax on environmentally-harmful activities, rather than the name given to the tax or its announced purpose. Starting from this definition Commission Services (Eurostat and the Taxation and Customs Union Directorate-General), in co-operation with other international organisations, has devised a classification of environmental taxes under four headings. These cover energy taxes (mainly taxes on transport fuels), transport taxes, and pollution and natural resource taxes.

As a percentage of total government revenues from tax and social security contributions, these taxes have barely increased in importance over the last twenty years, representing a little under 7% of such revenues. Almost all of this is generated by "traditional" taxes such as those on energy and transport.

However, this gives an overly negative impression. These figures do not show attempts to differentiate taxes on environmental grounds. For example, while the overall levels of revenues from fuel excise duties may not have changed much, differentiation between leaded and unleaded petrol has been successful in persuading motorists to use cleaner fuels. Also, the amount of revenue raised is a poor guide to environmental impact: an effective environmental tax will discourage activities which damage the environment. Accordingly, it will reduce its own tax base, and possibly raise little revenue.

On the other hand, in order to remain environmentally effective over time, these taxes need to be adjusted regularly to compensate for overall inflation, income growth and fluctuations in the pre-tax price of the commodity. Indeed, if one really intends to curb or slow the demand for a polluting commodity or activity its price after taxes should rise faster than income and overall inflation.

This requires politically difficult discretionary tax changes, unless the tax formula includes an automatic adjustor.

Accordingly, breaking down the headline revenue data according to the number of taxes, the products and pollutants taxed, the rates at which they are taxed and the real price after taxes helps to make the aggregate figure more policy-relevant. Presented as a time series alongside figures for the volumes of the taxed products and emissions, this will provide further information about progress in integrating environmental issues with fiscal policy, and will show if increased fiscal efforts have been associated with cuts in pollution.

5.3. Indicators on environmentally-harmful policies and measures

Developing a comprehensive integration strategy also requires indicators relating to policies which intentionally or unintentionally encourage activities which are environmentally harmful.

Progress in reforming environmentally damaging policies appears to be blocked in part by a lack of comprehensive information on the extent of these counter-productive measures. A recent OECD report which sought to identify the scope for improving the environment by reducing subsidies found that, with some exceptions, internationally comparable data on support levels was either scarce or almost non-existent [9]. Developing agreed indicators on the extent and impact of these policies could accordingly remove an important obstacle to improving integration.

[9] "Improving the Environment through Reducing Subsidies; Part I: Summary and Policy Conclusions"; Organisation for Economic Co-operation and Development, 1998

5.4. Indicators about the value of the environment

Although Gross Domestic Product is the most readily available (and therefore widely used) indicator of economic well-being, it is strictly speaking a measure of production. From the perspective of environmental integration, GDP data have two major weaknesses. They do not provide information about potential scarcities of natural resources which could threaten future economic activity, and they neglect degradation of environmental quality which could have negative impacts on human health and well-being. To fill these gaps, considerable effort has been made to develop "satellite" national accounts and indicators such as measures of savings and wealth which attempt to capture the impact of depletion and degradation of natural resources. These aim to complement conventional economic statistics and extend the range of information available to public authorities. By identifying the depletion and degradation of environmental resources associated with different economic activities they can help policy-makers to take account of the value to society of these resources. Improved information about the value of environmental resources - including the value of positive environmental effects generated by some economic activity - can enhance the consistency and transparency of policy-making by making explicit the valuations which are implicit in any environmental policy measure.

5.5. Indicators about "environmental" industries

The process of improving integration of the environment into economic policies entails changing the focus of policy from environmental problems to the causes of those problems. This suggests that a classification of environmental activities into two main sub-categories, one covering pollution prevention and abatement (integrated technologies and processes), the other relating to repairing pollution damage and providing environmental services would be useful for monitoring progress with integration. Information derived from the second sub-category in particular could be useful in resolving some of the uncertainties in valuing environmental resources. The amount of money spent on repairing damage and providing environmental services may serve as a guide to the value placed on the environment. However, the data which would allow such a classification remain to be developed at Community level. Accordingly, it will not be possible to produce these indicators in the short- to medium-term.

6. conclusions

The Helsinki European Council requested the Council to submit comprehensive strategies for environmental integration and sustainable development to the European Council in June 2001. It will be important to ensure that these comprehensive strategies propose consistent policies across different sectors. The contributions from various Council formations to the preparation of the Broad Economic Policy Guidelines should help to guarantee that a coherent, systematic approach is taken.

Environmental protection based on increased use of market-based instruments should be taken into consideration in the preparation of the Broad Economic Policy Guidelines and recommendations concerning the quality and sustainability of public finances. Making better use of environmental taxes and charges than is now the case would contribute to economic efficiency and broaden the tax base. This would help Member States continue fiscal consolidation while improving the quality and sustainability of public finances, in line with the Lisbon European Council conclusions. At the same time, markets to which these instruments are applied should be made more competitive and more responsive to price signals.

Integration of environmental and economic policies will also be improved by removing environmentally-damaging subsidies. While there is widespread agreement that such subsidies exist and are a potentially significant source of environmental damage, little firm information about their extent and incidence appears to be available. Using as a model the approach used to identify cases of harmful tax competition between Member States, the Commission proposes that the Council should examine the positive and negative environmental impacts of national taxation systems, taking account of work already being done within the Community. This review should be as comprehensive as possible, and include direct and indirect, explicit and implicit, intended and unintended effects of subsidies, taxes, tax differentiation and tax exemptions or reliefs. The results would enable Member States to share information about "best practice" in national fiscal policies, and identify those elements of national systems which have especially strong environmental effects, both good and bad. This would help in setting priorities for environmentally sound fiscal reforms.

The increased use of market-based instruments should be reflected in reports on economic reforms of product and capital markets. As recommended in the 2000 Broad Economic Policy Guidelines, the Ecofin Council could demonstrate its own credentials as an agent of environmental integration by rapidly adopting the Commission's energy tax proposal in a form which does not compromise its environmental effectiveness.

A coordinated approach within the Community to implementing the polluter pays principle - whether by taxation or other market-based instruments - will help to address issues which are commonly grouped under the heading of "competitiveness", even if - as suggested in section 0 above - this is a misnomer, since macroeconomic competitiveness should be enhanced by moves towards better integration of environmental concerns. Where taxes or charges are the appropriate means of improving integration, they should start at low rates and be progressively increased, allowing firms to adapt to the new set of prices and find innovative solutions to pollution abatement and control. This contrasts with current practice in individual Member States, which tend to start with relatively high tax rates but grant lengthy exemptions or rebates for the larger polluters. Apart from the fact that this may turn out to be environmentally irrational, it also risks damaging the Single Market and falling foul of Community State Aid legislation. Again, a coordinated approach at Community level may help to enhance the credibility of introducing effective pollution taxes gradually. Establishing a minimum Community framework could also help those Member States which wish to move faster in integrating environmental concerns but fear that autonomous action would lead to a loss of competitiveness. The Commission's proposal to the Intergovernmental Conference that qualified majority voting be used for environmental taxation is aimed at easing the creation of such a framework [10].

[10] "Supplementary contribution of the Commission to the Intergovernmental Conference on institutional reforms: qualified majority voting for Single Market aspects in the taxation and social security fields", COM(2000) 114 final of 14 March 2000

Based on the above, the Commission suggests that the following should form the essential elements of a Community strategy for improving the integration of environmental issues with economic policy:

* the Community should adopt a transparent, gradual, credible approach to environmental integration, based on efficient target setting, derived from a comprehensive analysis of the available scientific and technical data, the environmental conditions in the various regions of the Community, and the potential costs and benefits of action or lack of action

* integration of environmental issues with economic policy must be consistent with the strategy for sustainable development which the European Council intends to adopt in June 2001

* examination of the environmental impacts of economic activity and regulation should be integrated into the process of multilateral surveillance of structural reform, as should be the way environmental policies impact on the economic reform process (level of regulation, functioning of markets)

* the Broad Economic Policy Guidelines should fully incorporate the objectives of environmental integration, making use of a reliable set of indicators to be developed

* reviews of the quality and sustainability of public finances should take particular account of the contribution of taxation and expenditure polices to environmental integration and should contain an assessment of the efficiency of economic instruments in achieving their environmental objectives

* improved integration of environmental issues into economic policy should make increased use of an appropriate mix of market-based instruments and regulation; this should include the removal of subsidies which are harmful to the environment and should take account of analyses by the Commission and other bodies of the environmental and economic effectiveness of market-based instruments.

This approach should help to ensure that the Community achieves growth which is economically and environmentally sustainable.

Annex 1 Concepts of Sustainability

The words "sustainable development" mean different things to different people. A macroeconomist may see the concept in terms of the relationship between the rate of increase in Gross Domestic Product, the inflation rate, the fiscal accounts, and the balance of payments. This is essentially a short- to medium-term definition of sustainability. It neglects broader considerations. These include the long-term viability of the ecological systems on which much economic activity depends, and whether the distribution of the growth in income is giving rise to inequalities between rich and poor which threaten social cohesion.

An environmental activist will in contrast regard sustainable development as being about issues such as global warming and the preservation of biodiversity. Economic or social side effects of environmental policies may receive little consideration. Definitions of environmental sustainability are often expressed in quite general terms. This may make it difficult to translate them directly into workable policy prescriptions.

Perhaps the most often cited and widely accepted definition of sustainable development comes from the World Commission on Environment and Development (the "Brundtland Commission") [11]. It defined sustainable development as development which "meets the needs of the present without compromising the ability of future generations to meet their own needs". This definition needs to be given substance to make it useful for policy makers.

[11] "Our Common Future"; World Commission on Environment and Development; 1987

While we cannot know the needs of future generations, it seems unreasonable to assume that they should be any less than our current needs. That is, as a minimum we should aim at ensuring that in meeting our needs, we do not prevent future generations from enjoying at least the same "standard of living" as we do. What are the implications of this objective-

Each generation meets its needs by making use of the resources available to it to produce goods and services which it can consume. In addition, some of the available resources may be used to create new resources which will be available to produce goods and services for consumption in the future. This provides a first criterion which may be applied when assessing the sustainability of economic policy: is the supply of resources which we are leaving to future generations sufficient to enable them to meet their needs- To put the same question in slightly different terms, what constraints does this sustainability criterion place on how we use the resources available to us-

Three different types of resources are the inputs for producing goods and services: human capital, natural capital and physical capital. Some goods and services may be produced using a variety of techniques. That is, the proportions of human, natural or physical capital used in their production may vary. However, the observation that different categories of resources may be substituted for one another when using them to produce goods and services needs to be qualified. Natural and physical resources are not perfect substitutes. That is, natural resources generate some services which simply cannot be produced by other means, and without which we could not survive. Two implications follow from the observation that natural and physical resources are substitutes, but not perfect substitutes.

The fact that there is some room for substitution between natural and physical resources implies that sustainability gives some degree of freedom to the current generation as regards the use it makes of the natural and physical resources available to it. It is not necessary that we pass on to our successors exactly the same quantity and quality of each type of natural and physical resources which were available to us. Rather it requires that the aggregate of these resources available for use by future generations, together with their human resources, be able to generate goods and services which will enable future generations to meet their needs at least as well as the current generation.

As well as substituting between resources, societies may also substitute goods and services for one another - they may choose to consume different types of goods and services in different quantities. Thus, sustainability does not require that the same distribution of goods and services be available to future generations. What matters is that the range of goods and services be such as to enable future generations to achieve the same level of well being as the current generation.

This concept of sustainability closely corresponds to a definition which is often referred to as the "weak sustainability" criterion. In such a framework, a policy aiming at sustainability would have to strike the right balance between the accumulation and depletion of economic, social and environmental assets. Alternative definitions of sustainability include:

- "Strong sustainability": this stresses the importance of natural capital, on the grounds that it provides services which cannot be replaced or provided by other means;

- "Environmental sustainability": this requires preserving the physical flows of goods and services from natural resources.

The differences between these and other concepts of sustainability essentially relate to the degree to which natural and physical capital can be regarded as substitutes for each other. However, these differences should not distract from the large degree of overlap which exists between competing concepts of sustainability. All agree that our use of natural resources cannot be unlimited. The environment has a finite capacity to absorb the waste by-products of economic activity. Development of Community policy towards sustainability should not be delayed by arcane discussions about what exactly the limits are.

Sustainability as a practical policy principle

Consider the construction of a hydroelectric power station. This entails replacing natural resources with physical resources, and changes the type of services available for society. Instead of the services generated by the "original" landscape, which may have included fishing, or tourism services, society now has the use of the electricity generated by the power station. These services may or may not be adequate to compensate for the services they replace. It is impossible to say what relative value society will place on these sets of services in every case. Yet this determines whether building the power station is consistent with the concept of sustainable development. If the electricity is more valuable, then the power station is consistent with sustainability; otherwise it is not. The important point is that replacing natural by physical capital may be consistent with sustainability.

In contrast, climate change is an issue where consideration of the sustainability criterion does give a clear direction to policy. There is widespread scientific consensus that increased atmospheric concentrations of greenhouse gases as a result of human activity - mainly carbon dioxide from burning fossil fuels - risk changing the earth's climate in unpredictable but potentially highly disruptive ways. In other words, our current levels of use of fossil fuels and of the atmosphere as a dumping ground for the carbon dioxide they produce are unsustainable. That is, our current behaviour risks compromising the ability of future generations to meet their needs. Accordingly, under the terms of the Kyoto Protocol to the United Nations Framework Convention on Climate Change, the industrialised nations have agreed to start reducing their emissions of greenhouse gases in order to move towards a sustainable development path.

The risks that climate change will seriously damage the welfare of the current generation are generally agreed to be quite small: a cost-benefit analysis which only took account of benefits directly received by the current generation would almost certainly conclude that action to prevent climate change was not justified. The fact that progress is nonetheless being made towards addressing the issue is a practical example of the integration of environmental considerations with economic policy making, and shows that the sustainability criterion can have real-world policy implications.

Integrating environmental considerations with economic policy making via the sustainability criterion may or may not yield workable policy prescriptions in every case. We may be unable to arrive at a satisfactory operational definition of sustainability which will determine decision-making always and everywhere. Frequently, the decision whether a particular development is or is not consistent with sustainability will be a matter of judgement. However, incorporation of the sustainability criterion into decision-making provides the outline of an analytic framework in which these judgements can be made, in awareness of the consequences of decisions taken now for the welfare of future generations.

Annex 2 Economic Instruments for Environmental Integration

On the basis that a key reason environmental issues are insufficiently integrated with economic policy is because markets for many environmental goods and services are either missing or incomplete, section 0 of this Communication identified a number of market-based instruments with the potential to improve integration of environmental and economic policies. This Annex provides some additional detail.

Property rights

Environmental externalities arise because of inadequate or missing markets for environmental goods and services. The definition and allocation of tradable property rights creates a market, thereby internalising the externality. This ensures that social and private costs are equalised, and leads to an economically efficient outcome.

The question of whether polluters or victims receive the property rights has some important implications for equity - for the question of who owns society's resources. If the polluters receive the property rights, they are paid to reduce their pollution; if the members of society get the rights, then the polluters pay them for the right to pollute. Integrating environmental issues into economic policy by application of the Polluter Pays principle will have profound implications. Not only is the Polluter Pays principle a sound basis for environmental policy, it can also lead to efficient and equitable economic policy, and contribute to social cohesion.

Although assigning property rights to an environmental asset - either to the victims of pollution or to the polluters - may be all that governments need to do to enable environmental problems to be resolved in an economically efficient manner, many environmental questions are not amenable to such a "pure" market solution.

Many forms of air pollution, for example, are caused by thousands of sources and affect millions of people. In such circumstances, it is impossible for any individual to precisely identify the source of the pollution that affects him or her. It is also unlikely that it is in the interest of any one individual to take action against any source of pollution, because this pollution will also affect many others: the costs of taking action will be borne by the individual, but the benefits will be felt by several. In these circumstances, each person has an incentive to "free-ride" on the efforts of others. Thus, assigning property rights will not on its own be sufficient to lead to an economically efficient outcome. If a right to pollute is assigned to firms, individuals are unlikely to be able to organise themselves to collectively pay firms to reduce pollution; if a right to clean air is assigned to citizens, firms will find it prohibitively expensive to purchase part of this right from its individual owners.

Faced with this situation, a government which does nothing implicitly subsidises polluting activities and places no constraint on the level of pollution. On the other hand, assigning property rights explicitly to either the polluters or the victims of pollution will be equally ineffective. However, given that the pollution is environmentally undesirable and economically inefficient some form of public intervention is needed to protect society's interests. To put the issue in the context of an integrated approach to sustainable development, the challenge is how the environmental objective of reduced pollution can best be integrated with economic policy objectives of maintaining levels of output and employment which will enable the needs of the population to be met, consistent with the goal of social sustainability.

Charges, tradable permits, subsidies and other incentive payments

When governments cannot create functioning markets by attributing property rights, they can nevertheless use market forces to improve or maintain environmental quality by levying charges or offering payments. These put a price on environmental resources. They thereby make progress towards internalising the environmental externality by bringing private and social costs closer together. The fact that it will almost always be impossible to determine precisely the cost of the damage caused by pollution or the benefit provided by an environmental service in any particular case does not invalidate the economic and environmental arguments in favour of making polluters pay and of compensating service providers.

Tradable emission permits offer a potentially attractive market-based means of implementing environmental objectives when an absolute quantity of pollution is the policy target [12]. However, they will not be a suitable instrument in every such case. If the pollutant in question gives rise to environmental "hot spots", then other forms of pollution reduction should be pursued. If the cost of measuring emissions from individual sources is expensive relative to the cost of pollution abatement, and if it is not possible to monitor the use of some input which is closely correlated with emissions, then tradable emission permits will not offer a cost-effective approach.

[12] For this reason, the Commission has recently suggested that tradable emission permits could "form part of a coherent framework of common and co-ordinated policies and measures for reducing greenhouse gas emissions and implementing the Kyoto commitments" (Green Paper on greenhouse gas emissions trading within the European Union ; COM(2000)87 of 8 March 2000).

In terms of the impact on the environment, it makes little difference in competitive markets whether the permits are sold ("auctioned") or given away ("grandfathered") - in either case, the quantity of permits is known and limited, and it is this which provides the environmental benefit. Both, grandfathering the permits and auctioning achieve internalisation of external costs - a necessary condition for economic efficiency. However, auctioning has the advantage that the revenue raised from the sale of tradable emission permits can - and should - be used by governments to reduce distortionary taxes elsewhere in the economy, thereby giving a further boost to overall efficiency.

From an economic perspective, subsidies or other incentive payments to "clean" activities or for switching to such technologies are in principle equal to charges or taxes on "dirty" activities as a means of achieving environmental policy objectives as both remove or reduce the difference between private and social costs of the polluting activity. However, this indifference holds only if raising the revenues to finance these payments does not introduce an additional distortion somewhere else in the economy..

Paying for a reduction in negative externalities rather than charging for negative externalities raises questions of income distribution in general, and more specific the issue of the distortion of competition in the Single Market [13]. From an environmental policy perspective, such payments do not respect the Polluter Pays principle. Nonetheless, they can help to stimulate the diffusion of new environmentally-benign technologies or activities, in particular when it is impossible or difficult to apply the Polluter Pays principle. The risk in such a "second best" approach is that recipients of the subsidies may become dependent on them, making it difficult to remove them even when they have no environmental or economic justification.

[13] The "Community guidelines on state aid for environmental protection" (OJ C72 of 10 March 1994) give guidance as to the types of aid which may be compatible with Single Market rules

Negotiated agreements

In its 1996 Communication on Environmental Agreements [14], the Commission observed these agreements "can bring about effective measures in advance of legislation and thus reduce the volume of regulatory and administrative actions".

[14] Communication from the Commission to the Council and the European Parliament on Environmental Agreements; COM(96)561 of 27 November 1996

Compared with legislation which may prescribe uniform standards or use of a particular technology, negotiated agreements leave industry with greater flexibility in reaching the agreed environmental targets. This encourages innovation to reduce compliance costs. To be successful these agreements must set well-defined, quantified objectives which can be monitored. Publication of agreements helps to ensure their credibility and transparency, and should avoid negotiations which do little more than validate "business as usual" scenarios.

The environmental effectiveness of negotiated agreements in achieving reductions in pollution over and above those which would have occurred is difficult to assess since industry knows more about its activities than the regulator.

Realistically, such agreements can only be negotiated with sectors where there is a strong industry association which represents all or almost all the firms in the sector and is authorised to negotiate on their behalf. Moreover, a sectoral approach may lead to inconsistent treatment of similar problems, thereby introducing additional distortions into the economy. This may lead to a situation in which the burden of pollution reduction falls unduly on smaller enterprises in developing sectors, and households.

In some situations negotiated environmental agreements may be a more effective means of reducing pollution than direct regulation. Depending on the circumstances negotiated environmental agreements could be a useful complement to market-based instruments.

Information

The role of information in enabling the efficient functioning of markets is easily overlooked. Too often, information available to consumers and producers about the environmental impacts of different goods and services is either missing or incomplete, or is presented in a form which does not facilitate informed choices. For example, low-energy light bulbs, while costing more to buy than conventional incandescent bulbs, have considerably lower running costs to deliver the same amount of light and last much longer. Without knowing how much of their electricity bill is due to lighting, how are consumers to decide if buying low-energy lighting is a good deal- Similarly, energy labelling of domestic appliances which only identifies differences in energy consumption does not readily allow consumers to judge whether the higher purchase price of an appliance with lower running costs is justified in comparison with one which is cheaper to buy but dearer to run.

The effectiveness of clear, reliable information can be enhanced when it is combined with price signals which incorporate the environmental costs and benefits of different goods and services. Indeed, such price signals can lessen the need for regulations obliging the provision of consumer information. In the wake of the first oil price shock, fuel consumption performance became an important selling point for car manufacturers. While many of the figures claimed were unlikely to be widely replicated by actual driving conditions, the spontaneous emergence of such material shows the role that price signals can play in improving consumer information. The prominence given to information about fuel consumption in the 1970s and 1980s, when fuel prices were relatively high, contrasts with the situation in the late 1990s, when low fuel prices led the Council and European Parliament to adopt a directive requiring the display of fuel consumption data [15]. Because fuel had become a less important part of the total costs of car ownership, it had less influence on consumers' choices.

[15] Directive 1999/94/EC of the European Parliament and of the Council of 13 December 1999 relating to the availability of consumer information on fuel economy and CO2 emissions in respect of the marketing of new passenger cars; OJ L12 of 18 January 2000

Better information can also help firms - particularly SMEs - to choose less polluting methods of production. Farmers may benefit from better information about how to achieve acceptable crop yields while using less nitrogenous fertilisers. Energy audits, for example, may enable firms to improve their competitiveness by reducing their energy use per unit of output produced, while simultaneously reducing emissions of greenhouse gases and other pollutants.