Chancellor in tricky waters over water pollution charges

A decision in principle on whether the Government intends to proceed with any water pollution taxes or charges is expected in the March Budget. But responses to last year's consultation paper on the topic indicate that the Chancellor would be ill-advised to treat the matter as a simplistic test of his environmental credentials. Enthusiasm for charges on point sources is limited, and virtually absent for tradable permit schemes. Environmental interests are keen to see taxes imposed on pesticides and fertilisers - but the farming and agrochemical industries have raised important questions about their environmental effectiveness. One issue on which most interests agree is that at least some of the revenues from pollution charges must be used for environmental ends.

In his pre-Budget statement last November, the Chancellor announced that a consultation paper on water pollution charges was being published by the Department of the Environment, Transport and the Regions (DETR) "with a view to making proposals in the Budget." The Budget is on 17 March - but key players' responses to the consultation suggest that the Government would be misguided to proceed at full steam ahead.

The consultation paper canvassed views on a number of economic instruments. The candidates were charges for both direct and indirect discharges to water; tradable permits for direct discharges in selected locations such as major estuaries, or to help achieve national targets for reducing discharges of hazardous substances; and product charges on fertilisers, pesticides and, as an afterthought, detergents. The paper was silent on how much money these measures might raise - ENDS estimated that it could exceed £500 million per year if the charge rates were set high enough to deliver environmental improvements - and on how the revenues might be used (ENDS Report 274, pp 17-20 ).

None of the 15 or so responses obtained by ENDS favours replacement of the current system of water quality regulation with economic instruments - immediately posing the question whether their theoretical benefits could ever be realised in a marriage with regulation.

At best, some respondents are keen to see economic instruments used to buttress or fill gaps in the regulatory system, especially to deal with diffuse sources of pollution. But the interest groups in these gaps - the farming, fertiliser and pesticides industries - have all voiced forceful opposition to the idea of product taxes, and have challenged the Government to make a better case for them than it has done to date.

Most respondents have also urged the Government to be much clearer about the environmental objectives of any water pollution charges. Experience with the landfill tax has heightened scepticism about the environmental merits of economic instruments and done little to discourage perceptions that the Treasury regards them simply as a new means of raising revenue. There is limited evidence that the landfill tax has promoted waste minimisation or recovery, but it has diverted large quantities of waste to poorly regulated outlets (ENDS Report 276, pp 20-23 ). Legitimate concerns that water pollution instruments may deliver little environmental benefit are coupled with worries that, unless carefully designed, they may give rise to similar perverse effects.

Taxes on agrochemicals
The simplest of the various instruments to implement would be taxes on agrochemicals, and for that reason they are prime candidates for early introduction if the Chancellor does signal the go-ahead in March. However, it is also on this issue that opinions are most sharply polarised.

Almost the only question on which the various interests are agreed is that demand for agrochemicals is inelastic to price changes. The Fertiliser Manufacturers Association (FMA), for instance, points out that nitrogen fertiliser prices have varied by 30% in recent years without any identifiable impact on use. It estimates that a doubling of price would affect the economic optimum application rate by less than 10% - so a "punitive" tax would be needed to have much effect on consumption.

The FMA and National Farmers' Union (NFU) also make the point that environmental disbenefits might result if a tax did succeed in curbing fertiliser usage. Farmers may respond by making more use of organic wastes such as livestock manure or sewage sludge which could increase nitrate leaching. A switch to nitrogen-fixing crops such as peas and beans as part of rotations would also release flushes of nitrate when ploughed.

Industry groups also contend that taxes on agrochemicals would bring little water quality benefit even if they did succeed in reducing farm inputs. The British Agrochemicals Association (BAA) puts this most strongly, asserting that "no harm is arising directly from approved pesticide usage." And the FMA maintains that there has been no general reduction in nitrate concentrations in water since the mid-1980s despite the 15% reduction in nitrogen use since then. The only improvements, it says, have occurred in Nitrate Sensitive Areas as a result of compensated changes in land use.

These arguments disregard some important problem areas. For instance, a series of officially-sponsored studies have shown that pesticide run-off can damage aquatic life in headwater streams (ENDS Report 265, pp 8-9 ). And the NFU's claim that excessive use of phosphate fertilisers is "not an issue" stands up badly against recent studies which have shown that some arable soils have become so enriched with the nutrient that it is leaching into watercourses and contributing to eutrophication problems (ENDS Report 263, p 10 ).

Bringing in biodiversity
But environmental groups have mounted a more fundamental challenge to the farming and agrochemical industries' arguments. They maintain that any product taxes should be based on an integrated perspective of their disbenefits rather than be aimed solely at water quality improvements.

According to the Royal Society for the Protection of Birds (RSPB), pesticides are a major cause of the decline of the grey partridge, and there is now "strong circumstantial evidence" that they have contributed to substantial declines in a dozen other farmland bird species by reducing populations of food insects (ENDS Report 268, pp 11-12 ).

Fertilisers are also having significant impacts on terrestrial biodiversity, the RSPB says. On grassland, they reduce the diversity of plant species directly and, by enabling pastures to be grazed more intensively, lead indirectly to further losses of biodiversity. These losses of plant life have knock-on effects on insect populations and on the wider food web, and are believed to be responsible for the decline of at least one common bird species, the cirl bunting.

On arable land, says the RSPB, increased use of nitrogen fertiliser increases the susceptibility of crops to pests and diseases, enhances "lodging" and often promotes weed growth. As a result, crops require more applications of insecticides, fungicides, growth regulators and herbicides, with adverse consequences for biodiversity.

Environmental groups have highlighted other problems associated with agrochemicals. Eutrophication is affecting 79 aquatic Sites of Special Scientific Interest, according to a survey carried out two years ago (ENDS Report 252, pp 3-5 ) - although in lowland Britain the dominant source of phosphate is discharges from sewage works.

The need to remove pesticides from drinking water is another costly problem. Again, though, the picture is complicated because non-agricultural uses of herbicides are a common cause of drinking water contamination, and because the £1 billion investment in pesticide removal plants during the 1990s has served other purposes - notably the removal of substances causing taste and odour problems in tap water.

The elasticity problem
The conclusion drawn by environmental groups is that taxes on pesticides and fertilisers should reflect their full environmental costs, and not just those associated with water quality problems. But they have not offered views on what those costs may be or how they would translate into a particular tax rate, contenting themselves with a general demand for measures which would reduce the adverse effects of agrochemicals. Friends of the Earth (FoE), perhaps influenced by experience with the landfill tax, has gone further by urging the Government to set a pesticide use reduction target 5-10 years ahead and let this drive its taxation policy.

But here the low price elasticity of demand for agrochemicals comes into play. All interest groups agree that the one thing the Government should not do is to pretend that a modest tax on pesticides or fertilisers will do anything on its own to solve environmental problems. The NFU rubs the point home by disputing the DETR's suggestion that a small fertiliser tax would reduce "surplus" usage. This, it says, is based on the questionable assumption that economically irrational farmers will suddenly respond rationally to a modest price increase.

Higher taxes would obviously stand a better chance of curbing the use of agrochemicals - but could also damage the competitveness of British agriculture and its suppliers, the industries warn. Indeed, the NFU and FMA argue that such taxes should only be applied at EC level. Pesticide taxes are in fact being considered in a wide-ranging European Commission review of EC pesticides policy. But deferring action at UK level pending a possible EC proposal would at best be a guarantee of a lengthy delay.

The solution to the elasticity of demand problem offered by most environmental interests is to recycle at least part of the revenues from agrochemicals taxes into training and advice to farmers on less intensive forms of agriculture, and incentives for conversion to organic farming or arable systems which enhance biodiversity. Such measures could be targeted to problem areas in a way that a simple product tax could not.

The BAA and NFU will have none of this. However, the FMA says that a modest fertiliser tax would be acceptable on condition that the revenues were used to pay for measures to promote improved fertiliser practice. UK manufacturers currently support such schemes, but overseas producers, who account for about one-third of UK fertiliser sales, make little contribution. The FMA sees a revenue recycling arrangement as a means of redressing the balance.

Some other interests are keen to get their slice of the cake. In a joint response, the Water Services Association and Water Companies Association (WSA/WCA) say they would support hypothecation of the revenue from a pesticides tax to fund the costs of removing pesticides from drinking water.

Avoiding perverse effects
Other key issues are how perverse effects can be avoided or leakages out of the tax system of the kind experienced with the landfill tax minimised. On the latter point, the FMA and BAA warn that farmers may attempt to avoid a sales tax on agrochemicals by means of own-use "parallel imports". The BAA notes that parallel imports of pesticides are already on the increase as a result of the strong pound.

For pesticides, the basis of a tax will be particularly important. Those respondents who comment on the options do not favour an ad valorem or a weight-based tax on environmental grounds. Most support a tax based on the recommended dose per hectare of product, though some also favour differentiation between products. The WSA/WCA, for instance, suggest that a tax could be weighted to discourage use of pesticides known to cause water pollution.

Taxes on pesticides and fertilisers clearly pose difficult design issues. Respondents' views also indicate that the Government would have a serious credibility problem if it failed to use at least some of the revenues to pay for other measures to support the limited incentive effects of a tax. Working out a package which would bring genuine environmental benefits is likely to take some time beyond the March Budget.

Backing for regulation
However, the difficulties of designing effective agrochemicals taxes pale into insignificance alongside the complexity of possible charging regimes for point sources.

On one point at least all respondents are agreed. The theory of pollution charges is that they offer the most cost-effective means of achieving a desired overall water quality goal. But none of the responses seen by ENDS is prepared to see Britain's system of local water quality objectives sacrificed on the altar of national cost-effectiveness - and the majority make it explicit that the present regulatory system must be retained.

Indeed, the existing regime receives glowing tributes from some possibly unexpected sources. According to the WSA/WCA, it is "efficient in achieving environmental goals; transparent and well understood; equitable and easy to administer. It is difficult to see how economic instruments could improve on it for point sources."

Most industry bodies appear to have had some difficulty in getting to grips with the DETR's paper, often criticising it as excessively abstract and limiting their comments to a few general principles.

For instance, the Engineering Employers' Federation says that there is a dearth of evidence to judge whether pollution charges would result in improved water quality at a reduced or neutral cost to industry. If a charging scheme is introduced, it wants the Government to signal trends in charge rates in advance to allow dischargers time to plan their response. And it wants the scheme to be fiscally neutral, with the revenues used to cut other taxes such as employers' national insurance contributions, introduce capital allowances for investments in cleaner technologies or effluent treatment, or pay for dissemination of environmental best practice to business.

Some sectors dislike the idea of pollution charges altogether. The Food and Drink Federation - whose members are possibly the largest sectoral source of discharges to sewer - opposes them on the grounds that they would fall inequitably on sectors or firms, and "could be so high for some companies that they would be politically unacceptable." It proposes instead that the Government should promote environmental improvements by means of tax incentives to industry.

But industry interests are not alone in opposing pollution charges. Though in favour of taxes on agrochemicals, the Scottish Environment Protection Agency (SEPA) otherwise dismisses the consultation paper as "not relevant to the issues facing the Scottish environment." Possibly taking things a little far by claiming that discharges are already consented so as to cause "no environmental harm", SEPA says that its main preoccupations are urban run-off, minewater discharges and specific hazardous substances such as endocrine disruptors which the DETR's proposals do not address.

Agency calls for strategy
SEPA's approach is somewhat at odds with that of the Environment Agency, whose response is the most considered of those seen by ENDS. This may come as no surprise to those, such as the CBI, who feel that the Agency is after extra sources of revenue to finance new ventures and offset possible future reductions in its grant-in-aid.

The Agency's response begins with an implicit criticism of the consultation paper. What is needed, it says, is an overall strategy to "co-ordinate the development of economic instruments and to integrate them into all of the other environmental management tools. Thus whilst it would be possible to develop a range of economic instruments in an ad hoc manner, responding to opportunities as they arose, the Agency is concerned that such an approach could create unnecessary problems."

The desirability of a strategic approach is evident in the challenge posed by eutrophication. The WSA/WCA believe that future investments in phosphate stripping at sewage works will not be enough on their own to improve the trophic status of waters, and argue that it will be "essential" to control agricultural inputs of phosphate as well.

But the converse also applies. The main driving force for investments in phsophate stripping is the 1991 EC Directive on urban wastewater treatment. However, this does not apply to small sewage works, yet these are often a major factor in eutrophication of aquatic wildlife sites. Because of economies of scale, the RSPB estimates that pollution charges for such works may have to be up to 20 times higher than for large sewage works before they encourage water companies to install phosphate removal plant. It suggests that conventional regulation - setting phosphate limits in consents - would be a more appropriate means of control than pollution charges.

The Environment Agency chips in with another consideration, pointing out that high-phosphate animal feed concentrates are an increasingly important source of phosphate in watercourses resulting from over-application of livestock manures to land. A product charge on these feeds, it suggests, could be included in an overall package to control eutrophication in the longer term.

The complexity of the phosphate issue illustrates why a strategic approach to economic instruments and their relationship with other controls is so desirable - and why the DETR's paper has been criticised for being too detached from the real world.

Charges and regulation
If anything, charges on discharges raise these questions even more strongly because regulatory controls are so much more entrenched than they are for diffuse sources - though again the consultation paper skimmed over the implications. The important issues include:

  • Cross-media transfers: The environment agencies and several industry groups point out that charges on liquid discharges might simply encourage businesses to dispose of wastes to other environmental media to avoid paying the charge. SEPA, for instance, suggests that charges may result in more pre-treatment of effluents, generating more sludges for disposal to land, or promote incineration of wastes, with knock-on effects on air quality.

    These consequences would not necessarily be undesirable, as some respondents suggest. What would be undesirable is adverse environmental impacts caused unwittingly by cross-media transfers of waste as the result of a failure to make a considered appraisal of the overall environmental costs and benefits associated with water pollution charges.

  • IPC/IPPC: Processes regulated under integrated pollution control are required to employ the "best available techniques not entailing excessive cost", in part to achieve the "best practicable environmental option". Water pollution charges might alter the balance between media in BPEO decisions for the reasons noted above, and most respondents dislike it on that ground alone.

    Such complaints are not on the surest possible ground. BPEO decisions are already influenced by factors such as the landfill tax and by the economic impacts of regulatory controls on disposal outlets such as landfills, incinerators and discharges to sewer, which are scarcely fixed quantities themselves. Where the Government would be open to criticism is, again, if it introduced water pollution charges without thinking through the objectives it wants for other media from the IPC regime.

    The Chemical Industries Association (CIA) takes the debate a step further by arguing that all processes subject to IPC - and, from next year, to its EC variant, IPPC - should be exempted from charges because operators are already required by law to minimise and render all releases harmless. A tax on the residual authorised discharges would "go beyond a reasonable interpretation of the `polluter pays' principle," it says, since operators are already paying to meet society's requirements for water quality. In this respect, however, it could be argued that IPC processes are no different from other discharges, whatever the detail of the regimes under which they are authorised.

  • Water quality objectives: Theory has it that economic instruments could help to achieve national water quality targets more cheaply than regulatory controls. Relying on them alone, however, would mean that some local stretches of river might have to be allowed to become more polluted, or at least might not be improved as planned, in the wider interest of national cost-effectiveness.

    No respondents are prepared to countenance this scenario. All prefer the relative certainty of the current regulatory system, based on local quality objectives, and point to public resistance to the idea that local waters should be sacrificed to the general interest. Moreover, the DETR is widely held not to have made a case that charges could in practice deliver on the theoretical promise of cost benefits when run in tandem with regulatory controls.

    However, an equally telling point made by the Environment Agency is that the proposed EC Directive on water resources, if approved in its current form, would leave the UK no choice over future water quality objectives, since most waters would have to be upgraded to "good" quality within a decade or so.

    Environmental groups, while backing the present regulatory system, want to see it strengthened. FoE argues that "as a matter of priority a comprehensive network of localised water quality objectives needs to be completed that are always set at aspirational levels rather than reflecting the status quo as they often do." And the RSPB wants the Government to announce its intentions for statutory water quality objectives - provided for in law at the time of water privatisation, but still not introduced on a single stretch of river.

  • Existing commitments: Early introduction of a pollution charging scheme would coincide with the improvements needed to comply with the EC Directives on urban wastewater treatment, nitrate from agriculture and IPPC, and a little later with the draft Directive on water resources. Legislation will therefore remain the key driver for water quality improvements for some years ahead, and many industry groups concur with the CBI's concern that "economic instruments will simply impose additional costs on industry while not adding any significant value to achieving the UK's overall environmental improvement targets."

    The water industry, which would bear the brunt of a pollution charging scheme, also points out it would have little opportunity for some time to respond creatively. Major investments required by the urban wastewater Directive must be completed by 2005, leaving little time for "significant development and installation of novel processes," according to the WSA/WCA. "Economic instruments are therefore unlikely to result in anything substantially different or innovative in sewage treatment" over this period at least.

    Filling the gaps
    Most respondents agree that these considerations leave limited room for economic instruments on point sources. Suggestions include:

  • Faster improvement: The Environment Agency and some environmental groups believe that pollution charges could be used to overcome the lack of incentive in the regulatory system for dischargers to clean up their effluent much below consent limits, or to meet tighter consent limits ahead of time.

    However, it remains far from clear whether the costs of a scheme to meet this fairly limited goal would be justified by the benefits. SEPA, for one, is far less convinced than its southern counterpart that charges would be worth the candle. There are, it says, "significant dangers" that they would create "unacceptable burdens on the environment agencies, either by encouraging dischargers to seek continual reviews of their consents which may require increased monitoring efforts or by increasing the level of monitoring required."

    Local permit trading: Respondents generally see few opportunities for tradable permit schemes in the water pollution field. Some are opposed to them outright - including SEPA, which wants them dropped from the agenda altogether. SEPA believes that current models of estuaries, in which trading was mooted by the DETR, are not sufficiently developed to guarantee the prevention of pollution hot spots, and doubts whether there would be sufficient "depth" in trading markets on estuaries to deliver cost reductions.

    However, the CIA goes along with the Environment Agency in suggesting that there may be some stretches of river where there are enough dischargers to allow permit trading to deliver an environmental objective more cost-effectively than regulation. It also sees scope for trading among dischargers to sewer where the receiving sewage works is under pressure to meet tighter consent limits on its own discharge of a particular substance. However, both the CIA and the Agency want trading to be tested in pilot studies.

  • National targets: The CIA and the Agency also believe that trading schemes could help to meet national targets for reducing inputs of particular hazardous substances set by North Sea agreements, as suggested by the DETR.

    However, the Agency goes on to suggest that the scope for trading in this area is more theoretical than real. Many of the existing targets, it points out, have already been met. Substances still short of the targets - notably zinc, nutrients and some pesticides - arise mainly from diffuse sources, which would pose additional complexities for trading.

  • Paying for historic pollution: Another suggestion by the Agency is that pollution charges could be used to raise revenues to pay for cleaning up historic pollution from sources such as contaminated land and abandoned mines. Business groups would no doubt bridle at the suggestion that current dischargers should pay for the sins of the past.

    Spending the revenues
    Some respondents, though, have forceful views on how the revenues from pollution charges should - and should not - be used. The CIA says it would support the introduction of incentives to reduce environmental damage, on condition that there were compensating changes in other taxes. But it would be "extremely concerned" if pollution charges were used "solely as an electorally safe way of raising general revenue."

    The CIA also takes issue with the DETR's suggestion that economic instruments on their own embody the "polluter pays" principle. Discharges can, it concedes, impose costs on society. But society in this context means downstream users who incur costs or lose potential benefits. "For the `polluter pays' principle to be seen to work in this situation the revenue from any form of emissions charges should be used to compensate those downstream interests," the CIA says; "otherwise it is simply an additional tax on economic development."

    The CIA does not develop the theme any further. But it appears to be at one with the Environment Agency, which contends that "the revenue raised from the exploitation and (inevitably, to some extent) damage of a valued resource should in some way be used to repair the damage to that resource....It is extremely unlikely that...the public would wish none of that income to be used to repair the water environment."

    The Agency does not offer detailed proposals on how charge revenues might be spent. But it does suggest that they should be used either to ease the transition away from polluting practices or to manage aquatic resources. It also appears keen to see any charging regime based on its existing cost-recovery system - which some may interpret as a wheeze to get its hands on the loot.

    Other proposals for use of revenues have come from the RSPB. Its priorities are funding for rehabilitation of wetlands, which have suffered severe degradation in recent decades, and for projects to enhance aquatic biodiversity. An alternative modelled on the landfill tax would be to allow dischargers to allocate part of their tax liabilities to independent trusts which would implement biodiversity and other projects approved by the environment agencies.

    The DETR's paper also canvassed views on a host of detailed design issues for pollution charges. Responses on many of these - such as the merit of using abatement costs as a basis for charges, the feasibility of developing "standard pollution units" to achieve some equivalence between effluent components, and the desirability of volume credits - are fairly polarised, suggesting that much further work needs to be done before the Government could hope for a measure of consensus.

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