The Political Economy of Water Effluent Charges in ...

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The Political Economy of Water Effluent Charges in France: Why Are Rates kept Low? Matthieu Glachant

Soumis à The European Journal of Law and Economics 2001 The financial support of the Agence de l’Eau Seine Normandie is gratefully acknowledged. I am also grateful to Ekko van Ierland, Gary Libecap and Joel Ruet for their comments on earlier versions of the paper.

The Political Economy of Water Effluent Charges in France: Why Are Rates kept Low?

Matthieu Glachant

Abs tra c t

A key prescription of the economic profession towards environmental and water policy makers is to expand the domain of use of environmental taxes. In France this prescription was seemingly followed when a water effluent charge was set up thirty years ago. However, this water charge differs significantly with the theoretical solution envisaged in the textbooks. In particular, various studies have shown that the tax rate is too low to significantly affect the polluters’ behaviour. Its main role is thus one of fund raising. This feature is socially very damaging. If it is not capable of influencing the polluters’ behaviour, it is a precondition for the tax to bring social benefits in terms of abatement cost savings or innovation incentives that is not being met. The paper is a case study of the French water effluent charge and aims to understand why rates are low. It consists of a careful political economy analysis of the institutional setting through which the water effluent charge is implemented using both historical evidence and simple modelling. The fact that the charge is combined with regulation plays a crucial role in explaining its rate.

Key words: environmental taxes, water policy, political economy

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1 . In tr o d u c ti o n

A key prescription of the economic profession towards environmental and water policy makers is to expand the domain of use of environmental taxes. The main arguments are that they help to save pollution abatement costs and provide higher incentives to innovate in abatement technology than the traditional Command and Control approach based on direct regulation. If regulation remains by far the dominant approach in environmental policy, the use of charges is now developing quickly. More than 300 existing environmental taxes exist in OECD countries (OECD, 1995). However, existing taxes and charges differ significantly with the theoretical solution envisaged in the textbooks. Paraphrasing the title of a famous paper by Hahn (1991), the patients do not exactly follow the doctor's orders. In practice, pollution charges are not Pigovian taxes set at a level where the marginal environmental damage is equal to the marginal abatement cost. Several studies suggest how “real” taxes work (Hahn, 1989, OECD, 1995, EEA, 1997). First of all, earmarking is prevalent, that is pollution tax revenues are earmarked to finance pollution abatement projects through grants and subsidised loans in the domain where they were collected.1 Secondly, environmental taxes usually coexist with regulations. In fact when taxes are introduced, they do not substitute but are combined with the pre-existing regulatory system. Lastly, tax rates are said to be too low. This means that rates are below the level at which marginal damage is equal to marginal abatement cost. But they are usually even too low to have a significant incentive effect on polluters' behaviour as well. Their main role is thus one of fund raising.2 The now thirty years old French water effluent charge exemplifies these features. Charge revenues are earmarked for promoting water pollution abatement (in particular, to build wastewater treatment plants). A permitting system imposing emission standards on water polluters is implemented in parallel. Finally, the price signal is too low to have a significant influence on polluters’ behaviour according to different evaluation and econometric studies

1

In the recent years, earmarking tends to be less favoured with the current so-called Ecological tax Reform going on in several EU countries. The general principle of this reform is to use environmental tax revenues to cut labour taxes thus allowing for a "double dividend" in terms of employment and environment. However, to date, the vast majority of environmental charges remain earmarked. 2 The universal validity of this statement may be a bit more fragile than the others. Claiming that charge rates do not influence polluters’ behaviours require careful econometric studies. As a matter of fact, reviews by the European Environmental Agency (1997) and OECD (1997) recently argued that quantitative evaluation of tax effectiveness were in fact very scarce. However, based on qualitative evidence, it is quite universally made (Hahn, 1989, OECD, 1995, Pearson, 1995….).

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(CGP, 1998; Castay and Point, 1999). The latter is probably the more socially damaging feature for an environmental charge. If it is not capable of influencing the polluters’ behaviour, it is a precondition for a tax to bring benefits in terms of abatement cost savings or innovation incentives that is not being met. This paper is a case study of the French water effluent charges aims to understand why rates are low. It consists of a careful political economy analysis of the institutional setting through which the water effluent charge is implemented using both historical evidence and simple modelling. The water effluent charge is run by six basin-wide institutions: the Water Agencies (Agences de l’Eau) which are jointly controlled by the central government and municipalities. In this institutional setting, the Agencies’ charge rate is viewed in the following as the outcome of an institutional game involving three players: the Ministry for the Environment maximising polluters’ compliance with water regulations, the Ministry for Finance minimising Agencies’ budget, and municipalities maximising the pollution abatement subsidy in order to reduce regulatory cost. The fact that the charge is combined with regulation plays a crucial role in explaining the players’ pay off. The political economy literature on environmental taxes is now developing quickly. Most contributions focus on the question of the instrument choice (see Djikstraa, 1999 for a recent survey). This branch of the literature aims at understanding why regulation remains the preferred option over economic instruments in practice. Dealing with the design of real environmental charges, and thus closer to our questions, a few papers focus on earmarking. For instance, Bret and Keen (2000) propose a model where earmarking is shown as possibly efficient by limiting the negative impacts of electoral cycles and of political uncertainty. Also, in an incomplete contract setting, Hansen (1999) develops a model where earmarking is seen as a way to overcome industrial lobbying against tax schemes in line with the classical BuchananTullock’s argument (1975). A contribution by Fredriksson (1997) addresses a question very close to ours since it explores the relationship between lobby membership, product price, tax rate and abatement subsidy rate. But his analysis does not bring any insights which could explain why tax rates are low. To our knowledge, no political economy contributions address therefore our question. In contrast with the theoretical political economy literature that we have just briefly reviewed, this paper is more empirical. Basically it is a case study of a French policy. However, some of the key drivers arising in this particular case may in fact apply in other contexts. They may thus lead to similar impacts on environmental charges in other countries. The structure of the paper is straightforward. A second section presents the basic features of French water pollution policy. The third section describes the history of Water Agencies

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policies, characterised by many conflicts since their creation in 1964. Since a political economy analysis of the Water Agencies policies require a deep understanding of the main issues at stake in the institutional game, a simple model of the French water policy mix is developed in the fourth section. The fifth section analyses the institutional game of which Agencies’ charge rate is the outcome. A final section includes concluding remarks.

2 . De s c r i p t i o n o f th e Wa t e r A g e n c i e s ’ c h a r g e s a nd subs i di e s

Like many western European countries, France has no major problem with the quantitative availability of water resources due to favourable climatic conditions. Hence, the priority of French water management policy restson water pollution. Throughout the paper we restrict our attention to this qualitative aspect, even though the general argument of the paper also applies for quantitative issues in water management. At the level of river basins, the key water policy institutions consist of six agencies, which run a system of effluent charges and subsidies. Firstly implemented in 1969, this system is an early example of the use of economic instrument in water policy, inspired from seminal work by Kneese (1967) on water quality management. The polluters (industrialists and individuals3) pay the effluent charge proportional to the quantity of pollution they discharge. The charge covers a wide variety of pollutants, including suspended solids, biological oxygen demand (BOD), chemical oxygen demand (COD), toxic substances, phosphorus, nitrates and several heavy metals. 1.1 billion Euros are levied each year by the six Agencies. Collected funds are earmarked to promote water management activities and investments through grants and subsidised loans. Revenues are thus almost totally redistributed to those undertaking pollution abatement (industrialists or municipalities responsible for treating household effluents), according to investment costs, and not pollution performance. Investments are subsidised by up to 30-50 percent of capital expenditure depending on the nature of the investment. The overall incentives brought by the Water Agencies’ financial scheme stems from the joint effect of effluent charges and investment subsidies. In parallel, at the central government level, the Ministry for the Environment is in charge of a

3

Agricultural polluters are exempted from paying the charge for political reasons that will not be studied in the paper even though it constitutes a major and environmentally significant question. As a matter of fact, this results from a continuous macro political choice in France where for social reasons farmers are systematically protected from stringent regulations.

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permitting system which places regulatory constraints on the type and quantity of effluents a polluter may discharge according to water emission standards. These permits are required for sources discharging more than a specified quantity of effluent. Since the early 1990s several legal articles have dramatically reinforced water quality standards. In particular, a very ambitious European Directive on effluent discharges from household sources was enacted on 21 May 1991. This Directive includes a complete set of emission standards (dealing with many pollutants and including very ambitious targets on nitrates and phosphorus) and sets the obligation for every municipality with a population over 2,000 inhabitants to collect and treat domestic waste water by 2005. An implementation norm (Arrêté Ministériel) issued on 1 March 1993 also made effluent standards for industrial polluters more stringent. Water regulation, and the Agencies’ charges and subsidies, concern the same pollutants and the same pollution sources. A question is how they interact at the level of the individual polluter. There is a wide consensus among observers and concerned parties that charge and subsidy rates are in fact too low to provide polluters with incentives to go beyond the regulatory constraints (see, for instance CGP, 1998). Stated differently, the shadow price of the regulation is higher than the overall price signal of the charge and subsidy scheme and the regulatory constraint is binding for individual polluters. For a long time, no hard evidence was available to support this statement but Castay and Point (1999) have recently carried out an econometric study which confirms it as far as industrial water pollution is concerned. For domestic pollution, a preliminary simulation by Valiron (1998) is available and shows that the charge rate would have to be multiplied by a factor ranging between 1.8 and 3 to provide sufficient incentives to build waste water treatment plants. While the tax and subsidy scheme does not push polluters to abate beyond the regulatory constraints, it should not be assumed that the scheme has no impacts at all on polluters’ behaviour. This is because regulatory enforcement suffers from big weaknesses. Water regulation has always been imperfectly enforced due to a lack of administrative resources and to the dispersion of enforcement responsibilities in different administrative branches. In this context, the fiscal scheme plays a role in promoting regulatory compliance. In particular, Agencies' cost subsidies de facto reduce regulatory compliance cost. The economic instrument plays a role in regulatory enforcement incentive. This function of the charge and subsidy scheme will be systematically explored in section 4. The poor effectiveness of the French effluent charge is not new (see for instance Bower et al., 1981). Given that the problem has remained unsolved for years, one cannot adopt a naive approach where policy choice is seen as driven by the search for efficiency. Instead, one need to consider a political economy approach in order to understand how the institutional game

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allowed for this thirty-year-old inefficient lock-in. In this regard, Water Agencies are original institutions in which water users are centrally involved in the decision making process. In particular, municipalities, industrialists and farmers represent about eighty percent of the seats in so-called Basin Committees, sometimes referred to as the “water basin parliaments”. These committees elaborate and agree on a comprehensive five-year policy programme that sets the main parameters of Agencies' policy, and in particular the charge rate. The Agencies are also under the control of the central government that enjoys a veto over the five-year policy programme. Instead of promoting co-operation, this peculiar status has generated a continuous conflict between the State and the water users represented in Basin Committees over charge rates and related issues. We shall now turn to this story in detail.

3 . T h i r t y y e a r s o f c o n f l i c t o n th e r o l e o f Wa t e r A g e n c i e s

1 9 6 4 : A n o n expected institutional innovation i n t h e W a t e r A c t The system is based on the 1964 Water Act. In fact, the creation of decentralised Water Agencies responsible for levying effluent and water charges was not an institutional innovation planned from the outset, but rather the product of a late amendment by the Senate (Loriferne, 1987). It is noteworthy that the amendment was included despite vigorous opposition by the governmental administration that fought against the weight given to municipalities and industrialists in these institutions, which would inevitably reduce government’s influence in water policy. The ultimate argument overcoming this opposition was that the participation of the taxpayers (municipalities, industrial and agricultural polluters) in the Agencies' management was the only way to make the new charge acceptable. 1969-1974: T h e conflict w i t h municipalities The Agencies and the charge and subsidy scheme were firmly in place by 1969. In the first Agencies’ Programmes (1969-1971), charge rates were very low but were expected to rise progressively to reach the incentive level. But the newly created Agencies immediately faced a large-scale conflict with the municipalities represented by the Association of French Mayors (Association des Maires de France). To understand the conflict, it is necessary to point out the central role municipalities play in water management in France. They are responsible for domestic water supply and are liable for waste water discharged by individuals. Therefore they are in charge of collecting and treating domestic wastewater. Given that, the 1964 Water Act made the municipalities liable for paying the effluent charge based on the residual pollution discharged by municipal waste water treatment plants.

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But the Association of French Mayors asked its members to refuse to pay the charges for household-based water pollution, their argument being that responsibility for pollution lay with individuals who should thus be charged directly. After five years of debate, the municipalities won. A new law was adopted in 1975 modifying the charge system for domestic pollution. The adopted system, still in force today, is quite complex. The effluent charge is paid by individuals in their water bills. Municipalities receive a ‘purifying bonus’ (prime d’épuration) which basically constitutes a subsidy proportional to the abatement by the municipalities-run water purifying plants. This subsidy may be viewed as a negative effluent charge, since it covers the same pollutants at the same rate. Furthermore, municipalities benefit from grants and other subsidised loans when investing in wastewater treatment. In the end, the effect of this complex solution is to transfer the financial burden from municipalities to individuals, while keeping the same incentive effect on pollution abatement by municipalities through the purifying bonus. This episode suggests the existence of political motives behind municipalities’ behaviour. The explanation is the following. Citizens are both voters and customers of the municipalities for water supply and waste water treatment. Voters are not perfectly informed about the water institutional system (which is rather subtle indeed!). In particular, they are not aware of the influence of municipalities in Agencies’ decisions and do not attribute the responsibility for agencies’ charge increases to municipalities. In this context, municipalities clearly have an interest in rising charges: they are not punished by the voter for whereas it leads to increase the amount of money they receive through subsidies. This is politically rewarding since subsidies reduce the net pollution abatement cost perfectly visible on water bills paid by the voters. 1974-1979: T h e conflict w i t h t h e n e w l y created Ministry f o r t h e Environment Having reached agreement with municipalities, the Agencies’ budget progressively increased through an increase in charge rates and the inclusion in 1974 of toxic substances pollution charges (cf. figure 2). In the meantime, the Ministry for the Environment was created in 1974 and made responsible for the regulatory aspect of water policy. It rapidly became irritated by the influence of the Agencies on regulatory issues. In particular, Agencies were held responsible for co-ordinating regulatory activities at the regional level, and were also in charge of implementing the so-called ‘quality objectives policy’ (politique d’objectifs qualité). Launched by the 1964 Water Act, this policy consisted of defining ambient quality standards for surface waters at a local level. Then the regulator was obliged to fix regulatory requirements of individual permits in conformity with these standards. This gave Agencies a key influence over permitting since, in effect, they were controlling the stringency of the regulatory constraints on polluters. By the end of the seventies, the Ministry for the Environment had obtained the transfer of these two responsibilities back to the central government (Académie de l'Eau, 1998).

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1979-1987: T h e State vetoes t h e increase i n charge rates A new crisis started in 1979 when the State vetoed the proposal by the Basin Committees in the fourth Programme (1979-1984) to continue to raise charge rates and thus the Agencies’ budget. The rationale for this was to fight the inflationary pressures observed in the French economy at the end of the seventies and the beginning of the eighties. This conflict between the Finance Ministry and the Basin Committees lasted until 1987. As a consequence, the effluent charges remained stable for ten years (see figure 2). Figure 2: Volume of effluent charges in the Agence de l’Eau Seine Normandie between 1969 and 1999 (in 1994 million francs, source AESN) 4000 3000 2000 1000 0 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99

1987-1996: Charges growth resumes after t h e increasing stringency o f regulatory obligations Due to the slow down of inflation around 1985, tax rates and budget began to slightly rise again in the fifth Programme (1987-1991). But the turning point was the sixth Programme (19921996). Effluent charges were nearly multiplied by a factor of three in four years. This followed the adoption of the EU Directive on water pollution in 1991 which dramatically reinforced regulatory requirements. The increase in charges was clearly motivated by the need to support compliance with these new regulatory obligations. 1997-2002: T h e v e t o i s b a c k a n d earmarking i s debated Once again, charge rates proposed in the seventh Programme (1997-2002) were vetoed by the State. Its motive was the need to cut public deficit in order to respect the European criteria imposed by the Single Currency process. Consequently, charges remained stable (see figure 2). At the moment, the political debate on Water Agencies is very heated. In July 1998, the Government announced a major reform of the French environmental fiscal system with the creation of the Tax Générale sur les Activités Polluantes (general tax on polluting activities) which inter alia concerns Water Agencies. The idea was to partly withdraw the earmarking principle. Part of the charges’ revenue would have no longer been used to subsidise water management improvements, but rather, they would have been transferred to the State budget to

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reduce payroll taxes. The key rationale for this reform was to disconnect water charges from subsidies, hence allowing for charge increases and subsidy reduction. It would have switched incentives from remedial activities to pollution prevention. Of course, Water Agencies and Basin Committees were extremely hostile towards this reform since it would have transferred to outside the system funds they had previously benefited from. At present this aspect of the reform has been withdrawn due to these strong political oppositions. What are the lessons of this history? Firstly, the conflict over the charge for household-based pollution provides us with an interesting arena in which to identify municipalities’motivations. It clearly suggests that they give the highest priority to maximising political support; in this perspective, one key aspect of the Agencies's financial scheme is that it reduces the net pollution abatement costs perfectly visible on the voters' water bills thanks to abatement subsidies. Secondly, the conflict over the Agencies' influence on the regulatory policy in the seventies is also telling in the way it characterisesthe behavioural pattern of the Ministry for the Environment. The strong opposition from the newly created Ministry suggests its willingness to keep direct control over water regulation. Finally, and most importantly, the charge rate has been kept below the incentive level despite the continuous willingness of Basin Committees to raise it. In this regard, the Ministry for Finance played a key role in preventing any significant increase. When an increase occurred as illustrated by the sixth Programme, the motivation was not to reach the incentive level but to follow regulatory change. In the end, the key lesson is that what is today the pending problem - the modest impacts of the charge/subsidy scheme on behaviours due to low rates - has constantly been on the agenda for thirty years and has been a continuous subject of conflict between the State and the Basin Committees. Why has this conflict never been solved? Why has this inefficient equilibrium been sustained during thirty years?

4 . A s i m p l e m o d e l of th e w a t e r po l i c y m i x

Prior to answer the question, a preliminary step is to characterise the issue at stake: the tax rate. To do so, our premise must be that the charge cannot be understood in isolation. As explained above, it is part of a policy mix including abatement subsidy and regulation as well. A further feature is that the regulation is imperfectly enforced. This section uses simple economic reasoning for two purposes: (i) to characterise the impact on pollution abatement of the water charge in such a policy mix and (ii) to clarify the relationship between the tax rate and the subsidy rate. The latter is justified by the fact that the municipalities appear very concerned by subsidy as suggested in the preceding section.

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T h e assumptions For sake of simplicity, we consider in the following a representative polluter facing a pollution abatement cost C(q) where q is the quantity of pollution abatement. We make the usual assumptions C > 0, C’ > 0 and C’’> 0, implying the existence of decreasing returns to pollution abatement. Without charge or standard, we assume that the polluter discharges a quantity of pollution, q°. The polluter is facing a flat rate tax T to be paid on each unit of pollution discharged. When he decides to abate beyond q°, its initial level of pollution, he receives a subsidy corresponding to a fixed proportion s of its abatement cost. Hence s ∈ [0, 1]. The earmarking constraint is given by: s C(q) = T(q°-q)

(1)

We assume that an emission standard prescribes the polluter to abate a minimal quantity of pollution qR. The regulation is imperfectly enforced. In case of non-compliance the polluter pays a lump sum fine F (F>0) with a probability p given by the frequency of inspection. In this context, the polluter decides à la Becker (1968) whether to comply by comparing the total cost of compliance with the expected cost of sanction. In the end, compliance depends on the sign of ∆R, the cost difference between compliance and non-compliance: ∆R = C(qR) – pF To account for imperfect enforcement, we assume that ∆R < 0, that is C(qR) < pF. Hence, the response of the polluter is non-compliance in the absence of tax and subsidy. T h e polluter's response t o t h e s o l e fiscal system We firstly consider the polluter facing only the tax and the subsidy. He solves the following optimisation problem: Min [C (q) – s.C (q) + T(q°- q)] leading to the first order condition: C'(q) = T / (1-s)

(2)

A crucial point is that (2) does not define alone the polluter's reaction function because of the existence of the earmarking constraint (1) which links q, T and s. In particular, it is not possible to infer from (2) that T increases in q. Let us clarify this point. When T increases, it has a positive impact on q given (2). But at the same time it reduces (q° -q) that is the base on which the tax is perceived. The question is whether the tax revenue increases in T ultimately depends

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on a trade-off between the variations of the tax rate and of the tax base. Tax revenues can perfectly well diminish and, if it is the case, the subsidy rate necessarily decreases because of the earmarking constraint. In the end, what will be the effect on q? In fact, we have: Proposition 1. Proof.

q is strictly increasing in T.

Combining (1) and (2) yields: T=

C ' (q )C (q ) C (q ) + (q ° − q )C ' (q )

(3)

Hence

∂ T C ( q ) 2 C ' ( q ) 2 + ( q ° − q ).C ( q ) C ' ( q ) 2 + C " ( q ) C ( q ) 2 = ∂q [C ( q ) + ( q ° − q )C ' ( q ) ]2

(4)

that is strictly positive because q°>q, and that C(q), C'(q) and C"(q) are strictly positive for any q. In the following, we note q*(T) the corresponding polluter's reaction function which is strictly increasing in T. It is worthwhile to note that the sign of ∂T/∂s is ambiguous. We have: ∂T ∂T ∂q = . ∂s ∂q ∂s

Since ∂T/∂q>0, it is sufficient to look at ∂s/∂q. (1) and (2) yields: s =1−

C (q ) C ( q ) + ( q ° − q ).C ' ( q )

(5)

and thus:

∂ s ( q ° − q ).C ( q ) C ' ( q ) − C ' ( q ) C ( q ) − ( q ° − q ) C ' ( q ) 2 = ∂q [C ( q ) + ( q ° − q )C ' ( q ) ]2

(6)

The sign of the numerator of (6) is ambiguous. ∂T/∂s can thus be either positive or negative depending on the value taken q° and of C(q), C'(q), and C"(q). Raising the tax rate does not necessarily lead to an increase in subsidy rate. This is a contingent version of the Laffer curve. T h e polluter's response t o t h e policy m i x We consider now that the polluter is facing the policy mix. The joint effect of the tax, the cost subsidy, and the imperfectly enforced standard on its behaviour will depend on the relative level of q*(T) and qR, In the following we note TR the tax rate for which q*(T) = qR.

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Case 1: T > TR q*(T) is binding and the polluter abates until q*(T). In this context, the standard does not have any incentive effect and the environmental outcome is fully determined by the charge/subsidy system. Case 2: T < TR If the regulation was perfectly enforced, the polluter would abate until qR and the tax/subsidy scheme would have absolutely no impact on the polluter’s behaviour. But enforcement is imperfect and compliance depends on the sign of ∆ given by: ∆ (T, s, qR) = (1-s)[C(q*) - C(qR)] + T.[qR- q*] + pF

(7)

∆(T) = 0 determines a particular value for T that we will note T E. This leads to the second useful proposition: Proposition 2. Proof.

0 < TE < TR

When T = TR, qR = q*(T) and hence ∆ = pF>0. Moreover, when T=0, s=0 and ∆ = pF

- C(qR) which is strictly positive. Moreover, ∂∆/∂T is strictly positive. In effect, plugging (1) and (2) in (7) yields: ∆ (T, s, qR) = C(q*) - C(qR) + pF that is strictly invcreasing in T. Hence 0 < TE < TS. We thus need to consider two sub cases dependent on whether exceeds TE. Sub-case: T