ANNEX 1

STRENGTHS AND LIMITATIONS OF ENVIRONMENTAL FUNDS¹

1. Potential Strengths of Environmental Funds

The emergence of environmental funds represents a major new trend in financing environment and natural resources management. When designed with care, environmental funds have a series of attributes that make them attractive as a financial mechanism. Some of the elements below apply to both private and public types of funds, others more to public (national) environmental funds:

STABLE FINANCING: Environmental funds have the potential for providing long-term stable financing necessary for the effective implementation of conservation and sustainable development. They can lessen the dependence on the vagaries of cyclical infusions of donor assistance and fluctuating government budgets.

DEMONSTRATION EFFECT: Environmental funds can provide a catalytic effect on the growing interest by the marketplace, entrepreneurs and NGOs in combining social issues with profit maximization objectives.

DEVELOPMENTAL IMPACT: Environmental funds can contribute to the creation of jobs and GDP in rural areas of LAC. Such growth will be balanced with environmental sustainability.

DIVERSITY OF FUNDING SOURCES: Environmental funds can have a variety of financial resources, both national and international. Diversity encourages stability, growth, self-reliance, and independence.

ABSORPTIVE CAPACITY: Environmental funds provide an institutional mechanism for disbursing appropriately sized funds which have to be used within the capacities of the different beneficiary institutions to absorb them effectively. They can accommodate the needs to move large sums of money with relatively low overhead cost for international agencies.

IMPROVED DONOR COORDINATION: As long as donors continue to operate in the existing mode —picking and choosing among projects to fund according to their varying criteria— then donor coordination will continue to be sporadic and limited in its effect. However, in environmental funds the donors have a mechanism to pool their resources to fund jointly priority activities identified in national environmental plans and strategies.

COUNTRY-DRIVEN EFFORT: The environmental funds have responsibility for, and control of decisions about the management and allocation of funds. They contribute to the national capacity building and relieve the international agencies from analyzing small individual projects with high administrative costs for such agencies.

SUPPORT TO NATIONAL PLANNING FRAMEWORKS: Environmental funds may help implement national environmental planning and priorities rather than simply being prerequisites for donor assistance. They do this by putting the environmental action plans on a stable financial footing and ensuring that selected priorities represent a consensus of the relevant players.

PARTICIPATION AND TRANSPARENCY: Environmental funds encourage the participation of a wide range of interested parties (government agencies, non-governmental and business sectors, and other relevant interest groups) through representation on the boards of directors, technical review committees, general assemblies, etc., thus providing necessary checks and balances. They may provide a stable platform for cooperation among government and civil society. Decision-making in environmental funds should be made transparent and subject to public review and critique. In addition, by contributing to the financial strengths of local environmental NGOs, environmental funds can help ensure their continued survival and influence as important instruments of sustainable development.

2. Potential Limitations of Environmental Funds

While there is plenty of potential for environmental funds, their successes may be limited by several factors:

EXCESSIVE PROJECT FOCUS: The existence of an environmental fund can reinforce the impression that environmental problems can be addressed by funding a series of projects, while in truth, resolving environmental problems generally requires a variety of ingredients such as policy reform, fiscal incentives, increased enforcement of existing regulations, and political will. One has to keep in mind that a fund is merely a mechanism for financing, while policy reforms, adjustments in enforcement mechanisms, etc., have to be resolved through other means.

OVERLY SECTORAL APPROACH: The very name environmental fund may suggest to some people that the environment can be dealt with as an isolated sector. The key lesson from past experience is that the approaches to conservation must be integrated with development activity in different sectors (agriculture, finance, mining, etc.)

DISPLACEMENT OF GOVERNMENT BUDGETS: The existence of a national environmental fund may tempt government officials to reduce or eliminate budgets for government ministries or departments that address nature conservation and natural resource management.

FINANCIAL RETURNS: Typically, investments seek high potential returns, which are not necessarily provided by environmental activities. There may be trade-offs between financial and non-financial results of funding, thereby offsetting the potential downside of low financial profitability for investments with sizable public benefits.

FUND MANAGEMENT: Most environmental funds are sponsored by NGOs, which typically have not had a tradition of asset management and financial transactions.

WEAK POLICY FRAMEWORK: Weaknesses in the environmental policy and poor enforcement of environmental requirements due to inadequate capacity of government entities may restrict a successful application of funds.

LACK OF LOCAL COUNTERPART FINANCING: Frequent neglect of environmental issues in the political decision-making may limit the availability of budget funds for local counterpart financing. Changing fiscal systems may result in uncertain revenue raising and allocation of government counterpart funds. On the other hand, financial constraints of private firms may restrict the use of own resources for projects to be financed by environmental funds.

INADEQUATE BANKING SYSTEM AND CAPITAL MARKETS: In some countries insufficiencies of the banking systems, which create credit shortage and rationing and underdeveloped capital markets, may constrain the use of advanced financing instruments.

INADEQUATE INFORMATION: Lack of knowledge of the extent and social costs of environmental damage, and poor understanding of cost-effective solutions, may make decision-making suboptimal for the allocation of the resources of environmental funds.

3. Financing Issues

One key issue of environmental funds relates to the financing mechanism used by the fund. The financial structure needs to be considered. The basic options are an endowment, a revolving fund, or a sinking fund.

International resources for the environmental funds still come largely from bilateral assistance agencies (cash donations and debt restructuring), multilateral development banks, and the Global Environment Facility. It should also be noted that grant financing has not been limited to public funds, since in some cases it has been used to cover operating costs in enterprise funds and/or to finance technical assistance. In the current funding climate, virtually all international donors are under increasing pressure to show concrete results and developmental impacts from their investments. Therefore, it is increasingly important for environmental funds to participate in national policy processes that will affirm their central role as channelers of funding toward sustainable resource management, to maintain the support of national governments, and to conduct monitoring programs that will show progress toward short- to medium-term benchmarks even in programs whose impacts occur over the long term.

It is very important to diversify funding sources and avoid dependence on a single or a few sources. Fund managers agree that they must develop innovative resource mobilization strategies. They include: resources from the application of the “polluter pays” principle, entrance fees, other user and concession fees, sales of services, and resources from privatization of state-owned enterprises. Other sources include environmental taxes, consumption input and product charges or taxes, and penalties and fines.

None of the sources identified above may be alone sufficient to cover the long-term recurrent costs of the activities supported by environmental funds. There is a great challenge to find combinations of financial sources to support over the long-term organizations involved in the complex processes of community involvement and locally based sustainable development.

An important decision related to the sustainability of environmental funds is whether they should provide mainly loans and/or equity and thus increase financial responsibility of the recipients. This decision affects profoundly their relationship with the private banking sector.