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Environmental Policy and International Competitiveness

Environmental Economics Seminar Series
Department of the Environment, Sport and Territories, 1996
ISBN 0 642 24879 6

International competitiveness and environmental regulation: distinguishing fact from fiction

C D Jubb
Aquatech Pty Ltd and
the Bureau of Industry Economics

Introduction

Pressures for new, different or more extensive forms of environmental regulation has, almost inevitably, led to the assertion that international competitiveness is a relevant issue to be addressed when considering changes to management of the environment. Frequently, views are expressed that a particular course of action cannot be taken or should not be taken to protect or preserve the environment, because this will harm Australia's international competitiveness. This is stated to be especially important at a time when Australia is believed, at least in some quarters, to have a problem with the balance of payments. Although environmental regulation has not caused the balance of payments problem, or it could not be sensibly argued that it is the cause, nonetheless, it is often asserted that new regulations will exacerbate the problem. These propositions are seldom if ever supported by evidence of any kind, be it evidence relating to Australia's performance or the performance of any other country.

The discussion in this paper is structured as follows. In the next section, the purpose of environmental regulation and the implications for efficient regulation are briefly outlined. Then the relationship between environmental policies and the balance of payments, the implied importance of producing for export rather than domestic consumption, and whether it is appropriate to make a distinction between regulation for global commons problems and regulation for domestic commons problems, are considered. This is followed by a discussion of opposing points of view on the relationship between environmental regulation and international competitiveness. The penultimate section is concerned with the idea that implicit subsidies might flow from weak environmental regulations. Section 6 concludes the paper with a summary of what are considered to be facts and what are considered to be fictions.

The purpose of environmental regulation and efficient environmental regulation

The purpose of environmental regulation seems obvious: it is to promote the economically efficient use of environmental goods and services within the relevant institutional constraints. What is meant by economically efficient? Either the costs are outweighed by the benefits or, the environmental objective having been defined based upon the best available scientific evidence and/or community preferences, the regulation achieves that objective at least cost. In the former case, all costs and benefits are explicitly evaluated whereas in the latter case it is assumed that a cost -effective outcome will mean the costs are outweighed by the benefits.

An essential part of the regulatory regime is that environmental regulation respects both individual property rights and public property rights. These attributes all seem to be non-contentious. Regulations should promote the efficient use of goods and services, and part of that promotion is the delineation, definition and enforcement of property rights.

Where, in the equation does international competitiveness appear? The Australian Manufacturing Council constructed a system for best practice environmental regulation (BPER) that had international competitiveness as one of its attributes. The relationship between past practice and best practice turns on the addition of international competitiveness to the dimensions of BPER. What international competitiveness purports to mean in this context is not entirely obvious. There is no doubt that studying the regulatory practice of other countries and the economic efficiency of those practices can provide valuable insights for Australia. But, if, in the past, this learning process was not undertaken, it means that the regulatory process and regulatory outcomes either were not economically efficient or were constrained by information deficiencies.

Best Practice Environmental Regulation image: best practice environmrntal regulation

Environmental policies, producing for export and the balance of payments

There are two possible interpretations of international competitiveness in the environment debate. The first interpretation implies that for some reason the traded goods sector should be subject to less stringent regulation that the non-traded goods sector. That is, for some reason (in our case, a perceived balance of payments constraint) a premium should be attached to exports. Much was made of this during the controversy surrounding regulation of the proposed pulp mill at Wesley Vale.

This argument tends to confuse the decision on the viability of a particular project with whether a country with balance of payments problems should attach a premium to exports. There is only a tenuous link between such a balance of payments problem and the viability of any particular export project. Any linkage of the issues should be approached in two stages in order to make explicit the reasoning that is involved, and to enable its logic to be analysed.

The first stage is concerned with the economic viability of the project. This is determined by an evaluation of all benefits and costs inclusive of environmental costs under the desired regime of environmental regulations. In undertaking the analysis, the regime of environmental regulations that is ultimately chosen is not necessarily exogenous. For example, scientific evidence might be used to determine a range of environmental damage outcomes. Various regulatory methods are then chosen that can be used to achieve each of the outcomes. The regulation that is ultimately applied is then determined endogenously based on a trade-off between the costs and benefits of each of the regulatory outcomes. International competitiveness, per se, is not relevant to the evaluation. That is, the evaluation method should be independent of whether the affected firm is operating in the traded or non-traded goods sector. It is, however, possible that the second stage may be related to the first on the following basis. If, because of a balance of payments constraint, a decision is taken to attach a premium to exports, then it might be decided that the environmental rules applicable to an export project should be relaxed. That is, not all environmental costs should be borne by the project but a proportion should be borne by the community. The result is that a subsidy flows from the community to the project.

However, the incidence of the subsidy cost will fall unevenly as it will be paid by part only of the community; namely, those in the area where the environmental regulations have been relaxed. In general, such an indirect and inequitable means of delivering a subsidy would not be favoured.

Essentially the above analysis evaluates the project by testing its viability taking all external factors as given and fixed. If the project is found to be viable, the next step is to shadow price environmental costs under the desired regime of environmental regulation. If the project is non-viable with the higher environmental costs, the final step is to shadow price the output attaching a premium to exports and perform the evaluation again with the shadow priced environmental costs. A result indicating the project is viable may lead to a decision not to impose the stricter environmental regulations and, therefore, the project will proceed. What this means is that the benefits of increased exports are considered to outweigh the environmental costs arising from less strict regulation. In this way, international competitiveness governs the determination of environmental regulation.

As already pointed out, this seems to be a highly inefficient method of delivering a subsidy to exports. Furthermore, it ignores the fact that the traded and non-traded goods sectors interact. One sector cannot be insulated from the other.

The alternative construction of international competitiveness is that when a decision is made to impose environmental regulation, Australia should carefully analyse the available forms of regulation and learn from the experiences of other countries. That is, the regulation has nothing whatever to do with the international competitiveness of a particular firm or sector. Merely that the regulation chosen is economically efficient.

What view should be favoured? Expressed in simple terms, a dollar is a dollar wherever it is earned. A dollar earned from exports does not disclose an intrinsically nobler disposition on the part of the producer than a dollar earned from domestic production and consumption. The domestic producer is not some treacherous villain who so lacks a sense of patriotism that he/she satisfies demands within the domestic market. There is one reason and only one reason why exports would be valued more highly than production for domestic consumption and that is if Australia had a balance of payments crisis. If that were the case, it seems naive in the extreme to suggest that such a crisis can be dealt with through environmental policies that encourage exports by failing to price environmental goods and services correctly. Better macro-economic management, whatever that means, would seem to be the appropriate policy area for addressing current account problems.

Regulation should be economically efficient and should not be conditional upon whether it is the traded or non-traded goods sector which is being regulated. If there is a balance of payments constraint, a range of policy actions should be considered only one of which might be the stringency of environmental regulation. However, as Rauscher's (1994) work demonstrates, such a policy could be the worst of all possible policies in that it could lead to a deterioration in the terms of trade and thereby exacerbate any balance of payments problems.

The impact of environmental regulation on international competitiveness

This is an issue that is replete with controversy and the potential for conflict, especially within the GATT context. There are two opposing views of the impact of environmental regulation on international competitiveness. One view suggests that strict environmental regulation can be used as an instrument of industry policy to force industry to become more efficient and more competitive. Implicitly, there are first-mover advantages associated with industry devising means of operating under strict environmental regulation, particularly in the area of research and development and technological innovation. The opposite view is that strict environmental regulation harms the international competitiveness of domestic firms and they lose out to other countries which become pollution havens.

These issues have recently been considered in the United States by Palmer and Simpson (1993). They describe the conventional view as: 'If the United States adopts environmental standards stricter than those of its foreign industrial rivals, US firms would experience increasing costs, declining production, reduced employment, and decreased profits. Thus the United States may end up importing products it now makes domestically and 'exporting' jobs, profits, and environmental degradation to countries with laxer environmental standards (p. 17).'

The revisionist view, characterised as such by Palmer and Simpson: 'suggests that, rather than placing the United States at a disadvantage relative to its industrial rivals in Europe and in Asia, the tightening of US environmental standards will stimulate US growth.' They refer to one of the most noted proponents of the revisionist view, Professor Michael Porter, and comment that: 'Porter suggested that, rather than stifling productivity, environmental protection enhances competitiveness in the long-run. Tough environmental standards will lead firms to make better products by less costly methods. US firms will become world leaders in their industries, and they will be in a position to export or license their new-found technologies abroad (p. 17).'

Palmer and Simpson considered three potential justifications for using environmental policies. These were:

They admitted that their analysis of the justifications was based on anecdotal evidence and, unsurprisingly, in their conclusions they are highly sceptical of the value of using environmental policy as industry policy. They make the point that government is probably no better able to determine inefficiencies in markets than are the market participants; that spillover effects from subsidisation of environmental technologies are unlikely to be able to be confined within national boundaries; and that strategic trade policy founded upon environmental regulation is both complex, and relies upon assumptions that are unlikely to be realised. Specifically, the advantage conferred by investment in innovation would be quickly dissipated if rivals also invested in innovation. Palmer and Simpson conclude that: 'Good environmental policies will confer net benefits, but even a good policy will create winners and losers relative to the status quo. Even if - especially if - society benefits from strict environmental policies, more meaningful progress toward the realization of improved environmental quality would be made by concentrating on how to share fairly the burden of cleaning up pollution than by making dubious assertions that solutions will be painless (p.21).'

Arguably, the revisionist view of environmental policy as strategic industrial policy, is independent of economic efficiency. What then of the conventional view outlined above and the application more generally of the conventional view; that is, that strict environmental regulation is a recipe for economic doom within the international trading system? Cropper and Oates (1992) reflect on this issue and the large number of studies that have been undertaken to examine the effect environmental regulation has had on international trade. They conclude that: 'In short, domestic environmental policies, at least to this point in time, do not appear to have had significant effects on patterns of international trade. From an environmental perspective, this is a comforting finding, for it means that there is little force to the argument that we need to relax environmental policies to preserve international competitiveness (p.699).' This is reinforced by Tobey (1991).

Recent work by the OECD lends further support to the conclusion of Cropper and Oates. Stevens (1993) states that: 'The relative stringency or laxity of environmental standards has little or no impact on the general competitiveness of countries or on their trade balances. This conclusion has emerged from countless empirical studies of the relationship between the costs of compliance with environmental regulations and international trade patterns (p.22).'

Stevens notes, however, that: 'In particular sectors and for individual firms, nonetheless, some clear environmental winners and losers start to emerge. Environmental compliance costs are far higher than the average in some pollution-intensive and natural-resource sectors, such as chemicals, minerals, oil-refining and pulp and paper. Environmental regulations can also have adverse impacts at the margin for sectors or firms that have competitive weaknesses because of, say, higher labour costs, poor availability or laggardly technology development. In these instances, domestic firms complying with stringent environmental standards may suffer competitive disadvantages in relation to firms in countries that allow lower standards (p.22).'

It should come as no surprise that some activities face higher input costs as a consequence of environmental regulation. It is those industries that use environmental goods and services more intensively that are most affected, especially, initially. This should be self evident. If an industry is using an input that is underpriced, when that input is correctly priced or movement takes place in the direction of correct pricing, all other things equal, the competitiveness of that firm will be diminished relative to what it was under the prior set of parameters. Stevens (1993) observes that: 'environmental regulations can also enhance the competitiveness of firms, sectors and countries. Environmental legislation can spur the use of cleaner and fewer inputs, cleaner and more efficient technologies, and waste minimisation and recycling. Firms and sectors which invest early in environmental technologies can realise advantages in efficiency and productivity and put themselves in a position of a comparative advantage in meeting future regulations. Many enterprises in the OECD countries are starting to profit from the technical and marketing advantages of earlier investments in 'going green' (p.23).'

Environmental regulation and implicit subsidy

The possibility (or inevitability) that environmental regulations will ultimately lead to clashes within the context of the GATT is an issue that needs to be considered. This stems from the prospect of, on the one hand, weak environmental regulations being used as a means of delivering an implicit subsidy to exports and, on the other hand, strict environmental regulation in one country being used as an excuse for trade mediation, as protection is euphemistically termed in the US, in respect of imports from another country - protectionism in the guise of environmental regulation.

There are three possible responses of policy makers:

  1. Environmental regulations are weakened such that they tend towards the lowest common denominator and or/there is a recognised implicit environmental subsidy delivered to a particular industry;
  2. Strict environmental regulations are maintained and those industries that cannot compete exit from the market, and Australia takes advantage of the environmental policies of other countries; or
  3. Strict environmental regulations are maintained and countervailing measures are taken against imports from countries with weaker environmental regulations.

The first possibility, namely, the idea of implicit subsidy through weak environmental regulations, has already been criticised in the discussion of the relevance of international competitiveness to the process of determining the impact of environmental regulations. The issue is, however, more complex when the full range of factors are taken into account.

First, assume that international competitiveness is relevant to environmental regulation. That is, weaker environmental regulations apply to traded goods industries than apply to non-traded goods industries. The question that arises is, what is the benchmark? Is it the country involved in the international trading system that has the lowest level of environmental protection, the country with the highest, or somewhere in between? Or is it the country that has the lowest level of environmental degradation, or the highest? Consider a polar case where there is only one international competitor, that this competitor has a very low level of environmental protection, and the environmental degradation arising from its activities is irreversible.

If international competitiveness is relevant, environmental regulation in Australia will mirror the low level of protection of the competitor, and Australia will accept the irreversible environmental degradation. If it is true, however, that a low level of environmental regulation delivers an implicit subsidy to exports, then the point will be reached where the cost of the subsidy is too high and it becomes unsustainable. Australia, therefore, should not emulate the competitor, but should import the competitor's output to take advantage of the subsidy for as long as it persists. The second policy response listed above. The same argument has been used previously in analyses of dumping. That is, the desire of other countries to subsidise our purchases should be welcomed and encouraged. They will find it unaffordable in the long-run, at which point Australia can commence production and export at the price that reflects the cost of all inputs.

This leads to the third point referred to above, and the one at which clashes within the GATT are most likely to result. Assume that Australia neither wishes to emulate the low level of environmental regulation of a competitor country, nor does it wish to avoid the activity that causes environmental harm. What it does is to implement economically efficient regulation to protect its environment which puts it at a cost disadvantage. Does it seek to have the environmental subsidy recognised within the GATT so that it can restrict imports from the competitor country, or does it impose rules relating to the origin of, or production processes to be used for, imports? Irrespective of the mechanism chosen, Australia would be imposing its valuation of the environment on other, frequently less affluent, countries.

Where there is a global commons problem, for example, greenhouse, such an imposition might be acceptable. Otherwise, it is a particularly contentious issue. Fri (1993) comments that: 'A few cynics have argued that the environment-development debate is little more than a new and especially large tent under which to rehash special interest agendas. Some believe that, under the banner of sustainable development, the industrialised countries will continue to strive for political and commercial advantage over international competitors. Others see the debate as an opportunity for social reformers to pursue their elitist views on everything from lifestyle to family size (p. 17).'

The answers are not yet readily at hand, and these issues are likely to be debated in various states of excitement in future years.

Conclusion

Where does this leave international competitiveness? It is a fact that environmental regulation does increase the price of factor inputs, namely, environmental goods and services factors. Further, it is a fact that producers who use these factors inefficiently or cannot compete at the new factor prices will go out of business. It is a fiction to suggest that the perceived balance of payments problems can be rectified by including in the definition of efficient environmental regulation, something called international competitiveness. It is a fiction to attempt to deliver a subsidy from the underpricing of environmental goods and services under the guise of something called international competitiveness. This is an inefficient and uneven method of delivering subsidies. Further, Tobey's (1991) modelling of patterns of trade based on tests of the extent to which environmental regulations influence patterns of world trade, cast serious doubt on the balance of trade argument against environmental control.

If, however, the interpretation of international competitiveness is that Australia should learn from the impact of regulatory regimes used by other countries, with a view to ensuring that our regimes are economically efficient, there is no problem with international competitiveness. Essentially, environmental regulation should be economically efficient with the attributes of simplicity, flexibility and, where possible, certainty. The latter applies to certainty of enforcement as well as certainty as to the requirements of the regulation.

Certainty in respect of content is, in an uncertain world, unlikely to be achievable. Nonetheless, the cost can be minimised by avoiding capricious, arbitrary or party political regulatory actions or reactions. To conclude, it is possible that lobbyists for weaker environmental regulations are misleading themselves. Rauscher (1994) in his recent paper on ecological dumping observed that: 'It is a truism (but not always the truth) that a producer will benefit from relaxed pollution abatement requirements applied to the production processes she uses. But this conjecture, wrong as it may be, provides incentives to lobby for lower emission tax rates. If the exporters' lobbies are more influential than other lobbies, then this may explain ecological dumping' (p.838).

References

Australian Manufacturing Council (1992), The Environmental Challenge: Best Practice Environmental Management

Australian Manufacturing Council (1993), The Environmental Challenge: Best Practice Environmental Regulation

Bureau of Industry Economics (1990), Environmental Assessment - Impact on major projects, Research Report 35, AGPS, Canberra

Cropper, M. L. and Oates, W. E. (1992), 'Environmental Economics: A Survey', Journal of Economic Literature, Vol.XXX, pp. 675-740

Fri R. W. (1993), 'Environment and Development: The Next Step', Resources, Winter, No. 110, pp.16-18

Jubb, C. and Underhill, B. (1990), Economics and Environmental Impact Assessment, Working Paper No. 63, Bureau of Industry Economics

Palmer, K. L. and Simpson (1993), 'Environmental Policy as Industrial Policy', Resources, Summer, No. 112, pp.17-21

Rauscher, M. (1994), 'On Ecological Dumping ', Oxford Economic Papers 46, pp. 822- 840

Stevens, C. (1993), 'Do Environmental Policies Affect Competitiveness?', The OECD Observer, No. 183, pp.22-25

Tobey, J. (1991), 'The effects of Domestic Environmental Policies on Patterns of World Trade: An Empirical Test', Kyklos, Vol.43, Fasc. 2, 191-209.

Note: The views expressed in this paper are those of the author and not those of the Bureau of Industry Economics or Aquatech Pty Ltd.


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