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Subsidies to the Use of Natural Resources

Environmental Economics Research Paper No.2
This report was prepared by a consultant,
the National Institute of Economic an Industry Research (NIEIR),
for the Department of the Environment, Sport and Territories.
Commonwealth of Australia, 1996
ISBN 0 642 24864 8

Introduction

1.1 Study scope

As a result of increasing population and economic activity, human impacts on the environment are increasing. Financial and environmental subsidies may promote environmental impacts. The purpose of this report is to identify and quantify these subsidies as they relate to a selection of economic activities.

1.1.1 Definitions

Economic processes generally involve the combination of inputs to produce valued outputs. These outputs may be valued either as further inputs to production or as goods or services which can be directly consumed.

Environmental resource inputs refer to naturally occuring stocks and flows. Stocks of minerals, fish, old growth forests and similar assets may be permanently depleted or destroyed through their incorporation into production processes. Again flows of renewable natural resources may be incorporated into products, or (more commonly) may be adversely affected by the process of production. In both cases a cost is incurred, in that destroyed stocks are no longer available for future generations, and flows are not available for other purposes.

In commercial production, the owners of inputs are paid from the proceeds of sale of the outputs. If revenues from sales fail to cover costs, the productive entity makes a loss, which if sustained will normally entail closure of the productive entity.

Many, but not all, environmental inputs are public property, which means that payments for their use are due to governments as representatives of the public. It has been usual for governments to impose charges for access to minerals and forests, and sometimes for water, but rarely for air. It has been unusual for charges for using natural resources to cover all financial and environmental costs.

As the term is used here, a financial subsidy arises when a government deliberately adds to the revenue or relaxes the financial performance criteria of a productive entity to enable it to sell its outputs at less than the real costs incurred in producing those outputs. The subsidy may be disguised, for example as provision of capital at less than market rates, or the purchase of part of the output at greater than cost. In this paper these subsidies are termed ‘financial subsidies’.

Financial subsidies may be provided through the failure of government owned entities to achieve normal rates of return, direct subsidies, rebates, etc., special tax allowances, and the non-recovery of public agency costs for services provided to resource industries, for example by not being required to earn normal rates of return,or to recover some costs of their operations.

Governments may also subsidise production by not enforcing payment for costs imposed on other parties by producing entities. In economic terms these costs are termed external costs and where they impact on the environment are known as environmental externalities. In this paper such subsidies are termed ‘environmental subsidies’ since they are costs which are not reflected in prices. Environmental subsidies may be removed by imposing charges for use of the resource, or alternatively by negotiation, regulation or information programs to reduce environmental impacts.

When production is organised within the public sector and is wholly paid for out of taxes, it is not generally regarded as subsidised. Thus it is rarely claimed that the defence or police forces are subsidised. A further condition for a subsidy to be identified, therefore, is that the output must be at least potentially saleable. This means that individual purchasers must be identifiable, and the output must be denominated in units on which a sale price can be placed.

An output is sold at a price if the following conditions apply:

1. The output is divided into units.

2. Units are saleable; they may be appropriated by individuals.

3. Purchasers are charged according to the number of units they appropriate. The more the units, the greater the total payment.

4. Purchasers have the option of varying the number of units they appropriate, provided they make the requisite payments.

5. The amount charged per unit is related to the cost of producing that unit.

Revenues gained under these conditions are termed user charges; revenue which is raised to defray the cost of particular government services but which does not meet these conditions can be termed a ‘hypothecated levy’, that is, revenues from it are hypothecated to production of specific services. Water and sewerage rates charged in property values are such a levy.

These conditions are the minimum required to present purchasers with financial incentives to minimise costs. They are not sufficient to guarantee the attainment of economically efficient or optimal levels of production, but at least make a contribution in that direction.

Debate often takes place as to whether particular items of revenue are a user charge. An example might be a compulsory municipal garbage charge, which fails to meet conditions 3 and 4 above. Imposts which meet several but not all of the conditions can be termed ‘quasiuser charges’.

This report identifies a number of economic activities which involve significant inputs of environmental resources, and where the resultant outputs are considered potentially saleable. Financial and environmental subsidies are then assessed using the above definitions. By definition, there is no subsidy if revenue from user charges covers all input costs, including external natural resource costs. Where environmental costs are incurred, this requires that there be a revenue flow to the government proportional to environmental costs, in addition to the revenue required to meet other input costs.

Where either a financial or environmental subsidy is incurred, but either quasi user charges or hypothecated levies are applied which fully cover the costs of production, it will be pointed out that the resource using activity is subsidised from these sources rather than from general taxation. This is significant, in that there is likely to be less public objection to moving from a hypothecated levy or quasi user charge to a genuine user charge than there would be when user charges are imposed for goods or services which have hitherto been financed from tax revenue or from uncompensated environmental subsidies.

The study provides aggregate estimates of subsidies. Where one group of customers or clients of an activity such as water distribution pay less than another group for the same service a cross-subsidy is said to be paid. Cross-subsidy situations are frequently found among resource activities. The estimation the cross-subsidies was not required in the study brief but the presence of cross-subsidies is noted, for example in the electricity and water sectors.

1.1.2 Significance of subsidies

Financial or environmental subsidies may allow producers to operate at relatively low price levels or to fail to minimise other types of cost. Subsidies tend to encourage relatively high production levels and low operational efficiency. In economic terms significant resource misallocation could occur in the subsidised and related activities.

The interplay of financial and environmental subsidies often magnifies environmental disruption as both sets of subsidies tend to encourage higher output levels of environmentally disruptive activities. A priori there is a clear case for removing financial subsidies and for imposing charges for environmental costs so as to place these activities on a basis more related to their real financial and environmental costs of production. In an imperfect (second, third, etc. best) world this a priori conclusion needs to be thoroughly checked as application of these principles only to more obviously subsidised activities could result in further misallocation of resources.

In many of the areas under study there is often a view that governments have “community service obligations” to provide low cost and ready access to natural resources and services based on these resources. Similarly, it is often argued that subsidy removal would seriously affect some groups such as farmers and forestry workers. This traditional view is now being critically assessed in many areas because of increasing evidence (analytical and observed) that this policy stance leads to misallocation of resources. The misallocation of resources results from the resource user charges being below the real cost of using the resource. That is, appropriate price signals are lacking. Where deemed necessary, community service and other perceived obligations can be met through offsetting measures such as income tax adjustments for low income earners, targeted concessions and structural adjustment programs. Subsidies to resource use are a blunt and ineffective instrument for meeting social objectives.

No economic system can be made to function in a theoretically optimal manner even if agreement could be reached on how optimality could be defined. Various pressures on the political milieu overseeing the system prevent optimality being achieved. However, a careful analysis of each situation can lead to decisions which improve resource allocation.

The resource activities analysed in the study are:

The main resource activity not covered in the study is mining (except coal); this activity was not included because of the work already done on this activity and because the complexity of mining issues would require a substantial addition to the scope of the study. For similar reasons agriculture was not comprehensively examined.

This type of study is in keeping with the goal, core objectives and guiding principles of the National Strategy for Ecologically Sustainable Development 1992 and the consensus reached in the Intergovernmental Agreement on the Environment (IGAE) to which the Commonwealth, State/Territory and local governments are party. Pricing, regulation and information programs to address subsidies to the use of natural resources are likely to become important in the context of the national agenda for microeconomic reform.

1.2 Study approach


The first step in the study was a review of available literature on financial and environmental subsidies to the resource uses listed above.

From the literature review, NIEIR’s knowledge of these activities, and from detailed analysis of these resource uses, the financial and environmental subsidies associated with each resource use were identified. A summary of the subsidies identified is included in Table ES1 in the executive summary of the report.

Estimates of the values of the subsidies were then identified and developed using the approaches set out below.

(i) Financial subsidies. Estimates were developed, where feasible, of financial subsidies to economic entities engaged in activities affecting the depletion and/or degradation of natural resources. Activity subsidies arising from the non-recovery of public agency costs from resource activity entities were estimated from a review of budget documents and departmental reports. Cost estimates included a normal business rate of return on capital investments and resource information and management costs. Revenue from user charges was offset against costs, and if revenue failed to achieve a normal rate of return a subsidy was inferred.

The financial subsidy estimates developed should be regarded as broad indicators of the value of financial subsidies and not precise magnitudes, primarily because most of the data is extracted from publications which were not designed to measure financial subsidies to environmentally depleting and degrading activities.

A special comment is required on the estimates which relied on federal and State government budget papers and departmental reports. In view of factors such as:

(i) the immense amount of information presented in budget papers and reports;
(ii) management and programs are often shared by agencies;
(iii) federal state financial arrangements are complex; and
(iv) data is not formatted to highlight financial subsidies to environmental degrading activities,

it is not possible to state that all financial subsidies have been identified.

These factors tend to lead to underestimation of the value of financial subsidies. On the other hand, the possibility of double counting the value of financial subsidies is ever present in the Australian federal system. This arises because of the over lapping sources of finance and responsibilities in the different tiers of governments. Here, in developing financial estimates considerable effort was expended in reviewing budget papers and departmental reports to ensure double counting was eliminated but some probably remains.

The different approaches adopted by various State governments in presenting information on government expenditure in budget papers were also recognised as a limitation on expenditure estimates. While most areas of expenditure identified in budget papers cover all funding sources this does not occur in all States or every area of expenditure. There is also the possibility of some double counting within the States’ own expenditure estimates. A further problem is that departmental corporate overheads are seldom allocated to specific activities. With the general improvement in the quality of State Budget Papers and departmental reports over the past decade this measurement problem is unlikely to be of great significance. Nevertheless , it should be recognised that the limitations placed by the States on their own estimates of expenditure are relevant when evaluating the reliability of the estimates of the value of subsidies to environmental depletion and degradation included in this report.

Despite all the difficulties, it is believed that the estimates of financial subsidies in this report provide a reasonable approximation of the magnitude of subsidies. Further refinement of these estimates would require detailed analysis of budget papers and departmental/agency annual reports in all States, consultative research with all State Governments and considerable resources. In future public management agencies could systematically report on subsidies to the use of natural resources.

(ii) Environmental subsidies. Available Australian and overseas studies were critically reviewed to:
  • assess their methodologies;
  • assess the applicability of their findings to this study; and
  • extract suitable data from them.

Data from these studies were, where necessary and feasible, supplemented by NIEIR estimates for data deficiencies. Details of the environmental subsidy estimates , and the caveats associated with them, are provided in each resource activity chapter. The use of budget and other government agency data for the estimation of environmental subsidies is subject to similar limitations as those described above for financial subsidies.

The identification of subsidies was often a complex exercise as several activities and their environmental effects are often interrelated, for example the use of fertilisers and irrigation water, and overall farm practices. It was often difficult to estimate the values of the financial and environmental subsidies associated with each activity due to data gaps and uncertainties. Those subsidies that were not amenable to even order of magnitude estimates due to lack of data etc. were delineated along with comments on the estimation problems.

Alternative policy instruments to remove financial and environmental subsidies were listed and briefly discussed in each of the resource activity areas.(see note below) A fuller review and assessment was not required in the study terms of reference.

NOTE A comprehensive study of environmental policy instruments has been undertaken for DEST. See James, D., Using economic instruments for meeting environmental objectives: Australia’s experience, Environmental Economics Research paper No. 1, DEST, 1993. Another discussion, focusing on greenhouse issues,is found in Policy Instruments for Responses to Environmental Concerns, NIEIR, for the Electricity Supply Association of Australia,March 1994.

Finally, on the basis of the subsidy estimates, estimates were made, wherever possible, of the revenue implications of removing the subsidies.

The revenue implications of removing particular financial and environmental subsidies can be estimated from the values determined for them, subject to all the above caveats. A further problem arises, however, because charging the cost to users of the activities under examination will change market demands for them and thus impact on the revenue base. The net revenue estimates are based on a ceteris paribus assumption, i.e. that the present pattern of production and consumption prevails. This assumption provides a reasonable picture of short term revenue impacts and points the way to estimation of the longer term impacts. Beyond this, a further study could estimate the expenditure which might be required to address environmental disruption.

Difficulties were encountered in deciding on an analysis period for the study. Firm fiscal data for resource entities is often only available for periods prior to 1993–94; on the other hand, as indicated above, subsidy situations have changed (and continue to change) significantly since the early 1990s. Therefore, using early 1990s data can significantly misrepresent the current and likely future subsidy situation for each resource activity. On considering the conceptual and data problems, the approach taken was to use the most recent data available and, where necessary, extrapolate available 1990s data to 1994–95 and use this year as the analysis period for the study. Estimates of financial and environmental subsidies are expressed in 1994 dollars.

Revenues from removal of financial subsidies would mainly depend on the extent to which public agency costs were recovered, the rate of return sought and the tax situation of the entities involved. For environmental subsidies revenues would mainly depend on the charges levied and the extent to which resource users and polluters reduced their emissions, etc. when charges were imposed and/or regulations tightened.

1.3 Conceptual issues


1.3.1 Introduction

Recently there has been considerable work on financial subsidies to resource activities, particularly in the energy and water industries. In Australia these studies include those undertaken by the Industry Commission and a number of other agencies and groups. Internationally, the OECD Environment Directorate is undertaking work to assess the environmental consequences of government support to the energy sector.

For both financial and environmental subsidies to the activities covered under the current study, quantitative estimates of subsidies are sparse and by no means comprehensive. This appears to be true of both Australia and other countries. Among the activities most work has been and is being undertaken on energy sector activities, mainly because of the importance of energy activities on greenhouse gas (GHG) emissions and the more apparent environmental impacts, for example air pollution from transport, of these activities in urban areas.

1.3.2 Costs for the assessment of financial subsidies

Subsidies, as defined above, arise when costs of production are not fully covered by user charges. In this section we expand on the definition of costs. Valuation approaches are discussed in Section 1.3.4 of this chapter.

Financial subsidies were defined above as arising when user charges do not cover the costs of production of a good or service, apart from the costs of environmental inputs. Input costs other than environmental costs are generally treated as having first claim on user charges; i.e. it is common for a business entity in either the public or private sector to cover its financial costs but not to cover its environmental costs, and so receive no financial subsidies but extensive environmental subsidies.

The most important of the financial costs for consideration in this study are discussed below.

Capital costs

Failure to achieve normal rates of return represents a major source of financial subsidies to several resource activities in Australia,particularly in the water sector. A normal rate of return may be defined as the opportunity cost of capital use in the community. It is the minimum rate of return on investment required to adequately cover opportunities foregone from alternative investments.

For public sector activities a normal rate of return should reflect the cost to the community of using public assets. This cost may be assessed in several ways.

  1. It is arguable that the rate of return should reflect the current long term bond rate, since this is the marginal cost of public funds. A problem with this approach is that long term bond rates have been subject to considerable fluctuation. From a normal level of around 2 per cent a year in the early part of this century, the ten year bond rate averaged around 5 per cent in the 1960s; rose from 7 to 10 per cent during the 1970s and reached 13.3 per cent in 1989–90, from which height it fell to 7.3 per cent in 1993–94, recently recovering to 8.8 per cent.
  2. Given that the assets of government businesses are likely to rise in value with inflation, it is arguable that the true cost of capital to such businesses is the long term bond rate adjusted for inflation. Real long term bond rates fluctuate both with the nominal rate and the inflation rate, but over the first half of the twentieth century and into the 1960s they averaged around 1 per cent. They were negative for a number of years during the 1970s, but rebounded to unprecedented heights during the 1980s, and for the period 1989–94 averaged 6.6 per cent.
  3. Some would further argue that productive activities are risky, and should bear a rate of return greater than the long term real bond rate. Reflecting this view, a rate of 8 per cent has been adopted as a benchmark in the present study.
  4. An alternative would be to set the rate of return with respect to private sector activities. The question then is which private sector rate of return should be considered. Though rates of return in corporate business average above the long term bond rate, the aggregate returns of the Australian corporate sector had to be adjusted downwards by 20 billion dollars due to business failures in the early part of this decade. Again, returns in small business to which there is ease of entry notoriously fail to yield any surplus over financing costs. However, the choice of 8 per cent is reasonably defensible from this point of view, at current rates of return.
  5. A different perspective is that derived from calculations of the rate at which nonrenewable resources should be depleted. At current rates of interest it makes very little sense to defer exploitation of nonrenewable resources, since postponed benefits count for very little the further they are postponed and the higher the discount rate. Those who wish to emphasise provision for the future accordingly wish to use much lower discount rates. If low rates should be used in calculations of the rate of exploitation of nonrenewable resources, it is arguable that they should also be extended to other environmental assessments.
  6. Finally, as already pointed out, real interest rates are currently at very high levels, by historical standards. It has been argued that these high rates reflect the stress at present being placed on monetary policy as an instrument of economic control, and are likely to be temporary in nature. If this is the case, it is arguable that public sector returns should continue to be judged by historically normal long term interest rates plus a risk margin. This yields a rate of 3 or 4 per cent.

Points 5 and 6 above provide caveats to the choice of 8 per cent as the cost of capital for purposes of calculating subsidisation. In general, where capital returns are in question in this report, the achieved rate will be reported. Readers who prefer a rate lower than 8 per cent may use this information to adjust the reported financial subsidies downwards if they choose.

In both the financial and environmental subsidy areas there are important intergenerational considerations. Removal of resource use subsidies would contribute to the lowering of government debt and/or enable higher expenditure on priority areas including those with long term benefits. These changes would tend to increase benefits to future generations, as would moves towards the sustainability of economic activities. In dealing with intergenerational and other future value issues it is necessary to consider what discount rate should be applied to these values.

Discount rates link the future value of money to the present by specifying at what rate the value of a future dollar should be reduced. Or, put another way, the discount rate is the amount by which a unit of monetary value available in a future year is discounted or reduced for comparison with present economic values.

As discussed in section 1.3.2 above, for some public policy purposes, such as a choice among alternative development investment projects from a limited budget, high real discount rates may be appropriate. However, such rates quickly turn future values into negligible amounts. Discounting at 10 per cent, $100 received 200 years in the future is worth only $5.3 x 10-7 today (i.e. a small fraction of a cent); about $0.005 discounting at 5 per cent; and about $2 if the discount rate is 2 per cent. Although some greater valuation of the present over the future is appropriate, the extreme tradeoffs suggested by the 5 per cent and 10 per cent rates seem implausible. Some analysts such as Mishan (see note 1 below) suggest that, for intergenerational analysis, there should be no discounting at all because the unborn generation might value extra income just as highly as the present generation. Similarly, Sen (see note 2 below) has argued that environmental degradation may “oppress” the future generation even if it is wealthier.

Tax concessions

Financial subsidies to enterprises in both the public and private sectors can be disguised in the form of tax concessions. However, detailed analysis of tax treatment of the resource activities is beyond the scope of the study and discussion is limited to areas where tax subsidies may arise, e.g. in electricity. With microeconomic reform the major utilities, for example in the electricity industry, now pay or make provision for “surrogate” corporate tax.

Public management costs

The apportionment of the cost of public agencies for resource management activities remains an important issue. The trend is to the more extensive use of levies and charges for the services provided by the agencies to the specific resource industries involved. It appears, however, that more critical analysis of the benefit and cost apportionment is required, particularly of claimed benefits to the community at large, that is, the public goods aspects of the agencies’ functions. Costs of these public goods aspects should be raised from consolidated revenues rather than being raised from industry levies, charges, etc. An arbitrary allocation of public agency costs could be made; for example 50 per cent to direct resource users and 50 per cent to public goods (indirect user) functions of the agencies. However, such an allocation of costs may under or overestimate each agency function and each situation requires specific analyses. Ultimately policy makers must decide on the appropriate allocation of costs in each case; to attempt to do so is beyond the scope of this study.

NOTE 1 Mishan, E.J., Cost Benefit Analysis: An Informal Introduction, Allen and Unwin, London, U.K., 1975.
NOTE 2 Sen,A.K., Approaches to the choice of discount rates for social benefit cost analysis, in Lind. R. (Ed.), Discounting for Finite Risk in Energy Policy, Resources for the Future, Washington, D.C., USA,1982.

User charges

An important resource use issue is that even where costs are fully recovered and normal returns to capital achieved, this may be by means of hypothecated levies rather than a system of cost related user charges which give appropriate price signals to users of the resource. Thus, in the water and solid waste sectors, cost recovery has historically been through municipal property taxes and water rates, which are unrelated to actual resource or service use. Similarly, in the road sector it is often claimed that costs are recovered, more or less, through various taxes (such as sales tax on vehicles and fuel excises) which are to some degree related to road use. However, as will be discussed below, the relationship of these charges to the costs occasioned by each road user is tenuous, and in respect of the financial costs of road provision they do not meet the definition of a user charge set out above.

The requirement that user charges be cost related involves analysis of the costs of service provision. Sometimes this analysis reveals a cost structure which demands a two-part tariff, as for example in electricity. A fixed charge covers the cost of providing access to the service while a variable charge based on use of the service (e.g. kWh or kilolitres of water used) is also imposed. Charges of this type meet the test of cost relatedness in a way that flat rate compulsory charges, such as garbage charges levied at a flat rate per household, do not.

Charging and pricing systems are changing towards user charges, particularly in the water sector but only very slowly in the road sector.

1.3.3 Valuation of environmental subsidies

Environmental subsidies were defined above as arising when the costs of environmental impacts are not recovered from the entity disrupting the environment. Where the environmental effects of the polluting entity are abated (fully or partly) by the affected entities and/or government agencies there is in effect a financial subsidy to the polluting entity paid (in market values) by the community at large. Where the environmental damage is not abated the damage cost is not paid in explicit dollar terms but is borne by the community at large in terms not explicitly priced, for example in health effects or loss of biodiversity. Alternative methods for valuation of environmental subsidies is a major issue and is discussed in Section 1.3.4 below. Environmental costs may be offset by user charges which compensate the public purse for the deterioration of public resources. Such funds may be applied to mitigate the environmental damage, but a public choice may be made to accept the environmental cost and use the revenue elsewhere.

Where the disrupting entities can be identified negotiation or regulation may be used to resolve the subsidy issue. Where clear identification is not possible with current techniques or where for other reasons the entities are not required to control the damages, the costs of these damages are borne by the community at large or particular segments of the community.

Some environmental disruption is mitigated by public agencies and private firms that have not caused the disruption. The environmental costs mitigated are internalised by the economic system but, as indicated above, represent subsidies to the entities causing the disruption.

Where mitigation of the environmental disruption is not undertaken (e.g. reduction of algal blooms in streams), damages are incurred by particular groups (e.g. affected water users) or the community at large (e.g. biodiversity reduction) because the disruption and its ensuing damages have not been mitigated. In these situations environmental subsidies have not as yet been internalised by the economic system though they may have economic effects such as increased health costs. This group of environmental subsidies which are not directly priced by the economic system presents particularly difficult valuation problems.

Some externality studies have included the costs of rising unemployment from economic decisions. These costs, we consider, are not true environmental costs but are costs associated with the distributional or transitional impact of economic decisions. This study considers only externalities arising from the utilisation of environmental resources as inputs.

Environmental subsidies or externalities may be estimated by reference to valuation studies using several approaches. The strengths and weaknesses of these approaches and examples of their use in this study are briefly summarised below. More comprehensive and thorough discussion of these techniques and of the issues surrounding the valuation of environmental externalities and resources is found in Pearce, D., Markandya, A., and Barbier, E.B., Blueprint for a Green Economy Earthscan, London, 1989, Chapter 2 and also in Techniques to Value Environmental Resources: An Introductory Handbook, Department of Sport and Territories, Department of Finance and the Resource Assessment Commission, 1995.

(a) Direct damage costing

In principle this is the soundest approach as it attempts to directly measure the resource cost of negative externalities. That is, it is based on valuing damages caused by external effects. The main problem with this approach is the frequent lack of accurate information on damage costs. The damage caused may have no market value, for example reduction in biodiversity. Also, the damage may be of such a magnitude that it affects market prices of goods and services associated with the external effect, and it is often difficult to separate out the impact of the external effect on market prices.

Further, it may be difficult or incorrect to extrapolate from one damage situation, e.g. in a particular location, to a larger geographic entity.

One approach to the damage cost evaluation problem is to attempt evaluation of the loss in economic activity which the subsidy or externality causes, i.e. evaluation of the opportunities foregone.

The problems of directly measuring the damage cost of negative externalities have led to the use of the other valuation approaches briefly discussed below.

An example of the use of direct damage costing in this study is the damage caused by forestry operations to yields of water. Detailed damage costs have been prepared for particular Victorian catchments. In this case the problem with these (and several other) estimates is that of extrapolating them to the whole of Australia.

(b) Control costing

Because of difficulties with quantifying the impacts of external effects it is sometimes suggested that another approach might be to estimate the cost of mitigating the external effect. However, as control costs are generally unrelated to damage costs, they cannot be seen as providing shadow prices for damage costs. On the other hand, as control will remove or reduce damage cost, control costs give an indication of what society has to pay to prevent or reduce the damage. Where society has given an indication, even of a general nature, that it is willing to pay the cost of avoiding or controlling an environmental problem, the control cost approach provides a minimum figure for the damage cost which society perceives.

The use of control costs is generally based on controlling the external effect to some standard level. This level may be considered too high (reduction of an emission below the damage concern point) or too low (control to a level which leaves emissions causing damage of concern). Standards are generally set by consultation between the affected parties, experts and the regulating body. It must be recognised that standards, even those set by consensus, involve value judgments. A further problem with control costs is that available data may be based on control approaches which may be expensive compared with other control options.

In this study estimates of costs to control environmental disruption by waste water systems in the Sydney region are used to estimate the waste water externality for the whole of Australia. Here it is judged that extrapolation was reasonable because the Sydney region is a substantial portion of the Australian whole. This extrapolation has its limitations, however, because it is very difficult to judge how other regions’ waste water problems and the costs of controlling them compare with those in the high population concentration Sydney area.

(c) Contingent valuation

Surveys on the willingness-to-pay (WTP) for reduction of damage or to accept compensation (WTAC) for damage caused by an external effect have been suggested as contingent valuation approaches to external effects. These approaches requires those surveyed to value contingencies and are dependent on persons being willing and able to value non-marketed goods and services.

The main problem with these approaches is that people surveyed may strategise in their response rather than give a real appraisal of their willingness to pay. Thus they may overstate their willingness to pay because they feel it very unlikely they will ever have to pay for the damage; understatement may result from a feeling that they may be a prime target for payment. Further, respondents may not be able to isolate the effect they are being asked to evaluate from other related effects.

In this study estimates of the difference between willingness to pay for entry to natural attractions and the fees actually charged are used to estimate financial subsidies to direct users of these areas.

(d) Hedonic pricing

This approach is based on the concept that the satisfaction derived from the purchase of goods with many similar but some dissimilar attributes will show up as price differences caused by the dissimilarities.

In the environmental field the hedonic pricing approach has been used to value external effects, particularly as they affect property values. For example, the price difference between a house next to a power line and a house of similar size, age, condition, etc. might be used to value the external effects associated with the power line.

But many attributes affect the price of fairly similar goods and services, and it is generally very difficult to separate out/collect sufficient data to enable reasonably accurate separation of the impact on prices of each attribute difference.

Although the hedonic approach is not used in this study, a reference is made to its possible use in valuing odour externalities from sewerage treatment plants.

(e) Other approaches

Where data from the above valuation approaches is not directly available attempts are made to estimate environmental subsidy costs from secondary data sources, for example from data on production impacts, and from extrapolation of limited control cost data to the total activity population. In the study where no satisfactory costing approach was possible the effects are noted but not valued.

A recent report(see note 3 below) on techniques to value environmental resources examined a range of valuation approaches and how they might be applied. In covering the broad approaches discussed above, the report used a more detailed classification system. Resource valuation issues and estimates are also the subject of a recent Australian Bureau of Statistics (ABS) paper(see note 4 below) which focusses, however, on commercial (market) value of resources.

NOTE 3 See Techniques to Value Environmental Resources: An Introductory Handbook, op. cit.
NOTE 4 ABS Occasional Paper, National Balance Sheets for Australia: Issues and Experimental Estimates, 1989–1992, ABS Catalogue No. 5241.0, AGPS, 1995.

(f) Valuation example 96 liquid wastes

The problems of evaluating environmental external effect may be illustrated by reference to the liquid wastes treatment. The drainage of liquid wastes from sewerage plants and other sources into streams causes serious reductions in stream water quality around Australia . These water quality reductions affect wildlife and humans. Odours from sewerage plants may also cause reductions in property values and business and aesthetic damage.

The valuation of the external effects on wildlife might be carried out by attempting to value the damage to wildlife (fish,crustaceans, birds) associated with the streams. This damage cost approach would be difficult as the species affected are, in the main, not marketed.

For humans damage to health might be valued by reference to impacts on longevity and earning power; this raises difficult issues of relating specific water borne toxicants to health and the valuation of health impacts.

The possibilities of preventing wastes entering drainage systems, of treatment of wastes entering the drainage system and of other stream cleanup techniques suggests that a control cost approach might be used. As many waste sources are dispersed and are not readily identified they are therefore difficult to quantify. In this situation prevention costing would be incomplete or inaccurate. Also, as many drainage points are dispersed comprehensive treatment is often impossible; and in estimating treatment costs post-treatment water standards must be specified. These standards depend on what damage is to be prevented which leads us back to the damage cost and assessment problems.

A contingent analysis approach could be attempted by asking a carefully designed sample of persons what they would be prepared to pay for preventing the damage caused by the liquid wastes entering the streams or what amount they would be prepared to accept for the damages caused. This sample cost estimate could then be extrapolated to the whole population. Problems with this approach include: the exact nature of the damage is often difficult to specify in a survey, sampled persons may not understand the damage implications and sampled persons may overestimate or underestimate the damage depending on whether they think charges or compensation would be based on their valuations.

Application of the hedonic approach would attempt to value similar properties affected and unaffected by the liquid waste disposal effects.For example, odours from sewerage plants contribute to property devaluation and perhaps the forced relocation of some activities. The contribution of the externality (e.g. odours) to property values and relocation decision is, however, difficult to determine.

This example illustrates the problems of externality valuation which apply, to varying degrees, to all the resource activities under study. Overall control cost estimates are more readily developed for most activities but some damage, contingency and hedonic analysis costings are available. It must be reiterated, however, that control costs do not provide an estimate of societal valuation of environmental resources. In all cases substantial caveats apply to the values developed because of the difficulties outlined above.

1.3.4 Effects of reducing subsidies

Financial subsidies encourage increased use of environmental resources compared with an unsubsidised situation. For example, a subsidy to farmers for the use of pesticides will tend to increase the usage of pesticides and, in turn, increase the total negative externalities from pesticides.

Conversely decreasing the subsidy will tend to decrease the use of pesticides and decrease the total negative externalities but will increase net pest damage/control costs to farmers if suitable alternatives to the use of the pesticides are not available at similar or lower cost. Note that evidence from the Netherlands shows that an increase in the price leads to more careful use of the input and the development and implementation of alternatives, a result which can lead to lower input costs.

Reducing environmental subsidies and imposing externality charges will raise costs of the entities causing environmental disruption.

The cost increases will tend to reduce the level of activities and the negative environmental externalities. Also, government revenues will tend to be increased, the net effect depending mainly on the subsidy reduction effects on the operations of the negative externality producing activity, on the values of the subsidy and the externalities, and on the tax position of the activity.

The increase in costs to subsidised entities will generally lead to increased prices for their products and services. Over time the cost and price increases will lead to the development and application of improved resource use technologies and other cost reducing techniques.

From the environmental viewpoint the aim of the subsidy removal is to improve price signals to the subsidised entities and their customers in a way that results in resource reallocation that achieves less environmental disruption.

Whether the subsidy removal achieves the desired level of environmental improvement depends on the strength of the price signal given and the response of the affected economic entities to the modified price signal. If the environmental improvement response is judged inadequate additional levies and/or other initiatives such as tradable emission permits or direct regulation of the environmental impacts may be required. Information programs and finance for research and development may also have an important role in influencing economic behaviour.

Where prices charged by government do not cover the full cost to government of a resources’ use, that is where the charges do not fully reflect the resource values and public management costs, the revenue short fall must come from other revenue sources. Thus, apart from improving resource allocation in the economy, the removal of subsidies to natural resource use would tend to improve the fiscal position of governments. A proportion of increased revenues from higher user charges, additional levies, etc., could be used for control of environmental disruption. Environmental regulations might reduce current government revenues, for example from high conservation value forests, unless this revenue loss is offset by other impacts of the regulations, for example increased revenue from tourism in forest areas.

The study did not attempt to quantify the extent to which subsidy removal would result in environmental improvements for this or future generations. Although a major aim of subsidy removal would be to reduce environmental disruption the extent of the reduction, this issue was not includes in the terms of reference for this study.

1.4 Subsidy policy developments


Currently there are some significant moves towards removal of financial subsidies and internalisation of environmental externalities (subsidies). Financial subsidies are tending to be removed by, for example, competition policy (“Hilmer”) reforms, the Council of Australian Government’s (COAG) agenda for water reform, moves towards requiring a normal rate of return on publicly owned assets, requirements for tax equivalent payments to be made by public corporations and agencies, and through the privatisation of some assets.

Policy developments are continuing and a range of instruments are under consideration. For example, financial subsidies may be removed by competitive neutrality policies, that is policies designed to place public sector activities on a similar basis to accepted commercial norms such as charging user fees based on resource, management and other production costs. Or the subsidies might be neutralised by levies on the subsidised activity. Environmental subsidies may be internalised by imposing a charge estimated to be the value of the external cost, by regulation (standards, etc.), tradable permits or a combination of policy instruments.

In the environmental subsidies area regulations designed to reduce environmental disruption of resource activities are forcing internalisation of some externalities by the entity causing the environmental disruption. The regulations reduce environmental subsidies but may not remove them depending on the stringency of the regulations.

Over time environmental regulations have generally been tightened, particularly for newer facilities. In this situation initiatives (e.g. charges,etc.) which are applied similarly to all facilities will tend to impose higher costs on older plants, equipment, etc. On the other hand, if less stringent initiatives are applied to those facilities that are more environmentally disruptive higher production at those facilities will tend to be encouraged.

The National Environmental Protection Council (NEPC) formed through the IGAE, is to develop consistent national measures for environmental protection and has the potential to improve communication among governments on environmental issues. All states are introducing legislation mirroring that of the NEPC Act. Once established, the NEPC will have the power to pass nationally applicable environment protection measures (NEPMS) covering ambient air and water quality, noise relating to amenity, site contamination, hazardous wastes, motor vehicle emissions, reuse and recycling. The measures will harmonise environmental standards in Australia and are likely to advance the internalisation process. It should be noted that the NEPC will not prescribe how the standards are to be met. The required legislation should be in place by the end of 1995.

The above discussion indicates that policies designed to improve environmental performance, i.e. to reduce negative environmental effects, require very careful analysis, development and implementation. The complex set of factors which have led to existing financial and environmental subsidies must be carefully studied before changes are introduced. For example in the case of resources which are internationally traded, financial subsidies and environmental regulations often reflect practices in competing countries. Changing existing market arrangements and rules can lead to loss of some competitiveness; such loss must be weighed against the improvement in environmental performance. On the other hand, changes to achieve environmental objectives can lead to efficiency improvements which enhance both competitiveness and environmental performance.

Another fiscal issue sometimes raised in connection with resource activities is that increases in charges, taxes, etc., on these activities would contribute to balancing the revenue base of government which is currently weighted heavily on capital (corporate tax) and labour (personal income and payroll taxes). Factors to be taken into account on this question include decisions on tax levels and competitiveness effects of such a tax change.


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