Journal Issue

Development Finance and the Environment

International Monetary Fund. External Relations Dept.
Published Date:
September 1970
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Michael L. Hoffman

FINANCIAL INSTITUTIONS are not noted for their concern about “the balance of nature.” It is unlikely that members of the boards of directors of most financial institutions would even be able to attach any very precise meaning to the phrase. But a new term for essentially the same concept has appeared on the scene, almost surreptitiously, and has suddenly blossomed into prominence—the human environment. And one message not difficult to read in the tea leaves, when looking into the 1970’s, is that financial institutions, public and private, will ignore at their peril the consequences of their operations on the human environment.

The World Bank Group Alerted

The World Bank Group, as part of the United Nations family of organizations, has been alerted by the Secretary-General to the growing world concern with environmental problems. In response to a Resolution unanimously approved by the General Assembly on December 3, 1968, he has announced his intention to convene a “Conference on the Human Environment” in June 1972. It is entirely appropriate that this conference will be held in Stockholm, in which city, in 1969, a gathering of scientists, including most living recipients of the Nobel Prize for scientific achievement, examined the consequences to humanity of the applications of modern scientific knowledge, and found reason for great apprehension and, in some areas, alarm. The World Bank is not listed in the General Assembly Resolution among those international agencies already doing “important work on some problems of the human environment.” By the time the Stockholm conference assembles, I believe that the Bank will deserve at least passing mention in this context. Indeed, the President of the World Bank has already instructed his staff to evaluate the ecological consequences of Bank-financed projects, and has initiated organizational changes to ensure that this will be done.

The environmental problem can be rather simply stated in broad terms. But this does not mean that it is easy to decide how a development finance institution operating on the world scale should attempt to meet the problem, or to determine just what its responsibilities ought to be in such matters. We are now fully aware that the growth of an industrial society damages man’s natural environment in many ways, and that today’s advanced industrial nations have not ensured against these damages in any effective manner. The newspapers are full of examples; threats to the human environment are now deemed newsworthy although they were not only a short time ago. Perhaps the classic example, so far, is the pollution of the Great Lakes of North America, vast bodies of fresh water that earlier generations have taken for granted as being inexhaustible depositories for sewerage, industrial waste, and trash from the surrounding areas. Suddenly it has been discovered that the Great Lakes are not inexhaustible. Indeed, some of them are very nearly “biologically dead” because of the effects of pollution. Here a grave crisis of the environment has been recognized and is now beginning to be dealt with.

“External Diseconomies”

The environmental impact of the industrial process includes everything from the effects of withdrawing the inputs for industry from nature, through the effects of transforming the inputs into salable products, the effects of using the products, and the effects of disposing of what remains after the product no longer has an economic use. The heart of the problem is that almost none of these impacts of industrial processes can readily be costed. An individual enterprise, whether it be a private chemical company or a municipal corporation, cannot justify to its shareholders (or taxpayers) an allocation of revenue for the purpose of offsetting the consequences of its operation on the general environment, unless it is compelled to do so as part of some general program. Alfred Marshall, probably mainly to give symmetry to his theory of the costs of production, introduced the concept of “external diseconomies” of production in his Principles of Economics (first edition 1890). In technical terms, he suggested that a cost curve for an industry relating output to unit costs might differ from the curve that could be derived by adding up the cost curves of individual enterprises in the industry because the expansion of the industry could create conditions that imposed costs on each enterprise, whether that enterprise expanded its output or not. For half a century this concept of external diseconomies remained buried in the literature of economic theory. Nobody could think of many real cases to which it applied. When I studied Marshall in the late 1930’s under the great theorist Jacob Viner, the only example he could think of—and it was still largely hypothetical—was that of a highway used by many private truck operations. As the highway got more congested the costs for each operator would rise irrespective of the scale of his own operations. This is still perhaps the most obvious, and certainly no longer a purely hypothetical, example. But we now see that external diseconomies must be taken into account in connection with major investments in nearly every sector of the economy. And the essential difficulty remains—taken into account by whom? Marshall’s concept related diseconomies only to the output and costs of an “industry.” We now realize that costs external to an enterprise in industry A (e.g., steel) may become costs internal to enterprises or “industries” quite unrelated to A (e.g., tourism). The costs imposed on the economy by carrying out this or that industrial or agricultural project are not fully reflected in, nor easily attributable to, the costs of the enterprises, whether public or private, that are responsible for the project. This is not a matter of goodwill or bad will on the part of the responsible managers of the enterprise concerned. One may be able to devise an equitable system of sharing the costs of reversing the process of pollution of the Great Lakes of North America among private industry, public industry, and the governmental units concerned. But one cannot say that the enterprises and local governments have acted irrationally or without a sense of their social responsibilities, when, as has been the case up to now, the external diseconomies of industrial and urban expansion around the Great Lakes have never been costed.

It was perfectly clear to Alfred Marshall, and it should be equally clear to us today, that cost benefit analysis that confines itself to the returns to the enterprise (or to one out of several governmental units in an ecological region) cannot provide an adequate measure of the economic desirability of an investment. It seems equally clear that most external diseconomies can be costed and accounted for only by government. And governments have been very slow to recognize their responsibilities in this respect.

Sometimes, indeed, government policies can frustrate natural corrective forces working through the market. While the price system is not very good at registering the true cost of external diseconomies, it does occasionally, if not prevented by government controls, encourage the recycling into the economic system of what would otherwise be polluting trash. Recently, for instance, the price of steel scrap in the United States has risen to the point at which it becomes profitable to recover and process some of the discarded automobiles that clutter the North American landscape. The principal influence on the demand side is coming from the booming steel industry of Japan. But efforts have been made by American steel producers, who would like to keep the price of scrap low, to have export controls applied to throttle the market and break the price. In this example, free market and ecological principles would be reinforcing rather than conflicting, and government intervention to prevent a price increase would be repugnant to both.

Ecological Effects of Development Projects

The problem facing development finance institutions, including the World Bank, is whether and how we can help today’s underdeveloped countries to avoid some of the undesirable consequences on the human environment of industrial and general economic development that are now identified in the advanced industrial societies. That these costs are tremendous can no longer be doubted. In example after example it can be shown that the cost of prevention (e.g., of river pollution) would have been a small fraction of curing the disease once it has taken hold. But the trouble is that these costs are not normally the responsibility of anybody in particular and they are not easy to calculate in advance. The ecologists can tell us a great deal about unfortunate consequences on the environment of this or that industrial, agricultural, or power project after it has been carried out. Unfortunately, they do not seem to be able, so far, to help us very much in predicting such consequences, or in suggesting alternative means of carrying out projects. The Bank, and other development finance agencies, are right, it seems to me, to ask the ecologists to move from generalizations about possible disasters to more specific advice about what the ecological effects of major development projects are likely to be, and as to how adverse consequences can be guarded against. The World Bank seeks help from ecologists, not just general warnings about possible impending disasters.

One thing that the ecologists have made all responsible organizations, including the World Bank, conscious of is the fact that some changes in the environment which man is now capable of bringing about are irreversible. It may be that rivers or lakes that have been polluted to the point of becoming sewers can be cleaned up, at a cost. But man has no way of restoring a species of bird, fish, or other form of life that he has once destroyed. Other effects of changes in the balance of nature, while perhaps not absolutely irreversible, seem to be extremely difficult to cope with, such as the steady increase in the percentage of carbon dioxide in the earth’s atmosphere. How far should a development finance agency go, for instance, in promoting projects that use natural gas or petroleum as a source of energy, knowing that the combustion of these fossil fuels adds steadily to the carbon dioxide in the atmosphere? Could this be offset, at a cost, by increasing the forest area of countries, such as South Korea, that have been practically denuded of trees, nature’s means of reducing C02; and, if so, how would one justify to a board of directors an investment in growing forests in one country to offset atmospheric pollution by C02 originating largely in other parts of the world? We might be able to establish a benefit, in the cost-benefit calculus, but it would be a benefit which would not accrue mainly to the borrower responsible for carrying out the reforestation projects. We may as well admit that we have no answers to such questions today. But at least they are beginning to be asked.

A Formulation of the Problem

A formulation of the environmental problem that seems to me to provide valuable insights into the way we might tackle questions of the kind that concern ecologists, and that are hardly more than hinted at in this brief article, has been provided by Max Nicholson, the British zoologist, in his recent book The Environmental Revolution (London, Hodder and Stoughton, 1970). The quotations are taken from extracts from Mr. Nicholson’s book published in The Times (London, January 3, 1970). He contrasts the “biosphere” to the “technosphere,” the term for the whole of the “flows of energy through manmade structures, devices, and economic or social channels.” The striking difference between the two spheres, he writes, is “that while the biosphere is a complete, self-contained, permanently balanced system organized to provide all its own needs and to break down, disseminate and re-use its waste materials through subtle processes of dissolution and decay, the technosphere is dependent on the biosphere not only for much of its input, but also for important outlets at the far end of the production chain. Many of its demands are made on the biosphere in crude and reckless disregard of the requirements of sustained yield, while many of its unutilized or discarded elements are irresponsibly tossed out into a biosphere entirely unequipped to deal with them, at any rate in such quantity and at such a pace.”

As geologists and cosmologists would be quick to point out, the biosphere is not exactly “permanently balanced” in any ordinary sense of that term. It can be thrown severely off balance for very long periods of time, in human terms, by movements in the earth’s crust or by whatever it is that causes occasional Ice Ages. Also, nuclear physicists might point out that as far as energy is concerned we are on the verge of an epoch in which vast quantities of energy will be available to man with ecologically insignificant inputs from the biosphere. Nevertheless, Nicholson’s formulation is an interesting one, and can point the way, it seems to me, to a much better understanding of what we are up against in dealing with problems of the environment. For instance, it is entirely possible to make the technosphere less dependent on inputs from the biosphere and less productive of pollutants—again, let us remind ourselves, at a cost. The recycling of waste materials is perhaps the most promising means of proceeding immediately in this direction. As this is written, I have before me a Reuter’s dispatch from Tokyo describing a machine that makes building blocks by compacting garbage. Good technical brains are at work on methods for reprocessing the minerals now accumulating in urban dumps. The time will come when these and other techniques of conserving and protecting the biosphere will become practical possibilities, and the World Bank will not be indifferent to these developments in planning its investments.

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