7. chapter 4 application of economic instruments

Economic and Financial

Instruments for IWRM

Application of economic

instruments

Goal and objectives of the session

To discuss evaluative criteria for economic

instruments

To understand specific economic

instruments and their application

Outline

Understanding the various criteria for

efficiency: technical, allocative, equity,

environmental, administrative, political.

Exploring water tariffs and subsidies.

Other economic instruments.

Introduction

Economic instruments can be used to promote a higher level

of efficiency in the allocation of water among multiple users

and sectors. Pricing is often used as a mechanism for

achieving efficiency in water allocation and to avoid

wastage. If water provision is priced below its economic cost

there is no incentive to conserve water.

The ways in which economic instruments work will be seen

throughout this chapter.

Efficiency criteria

There are two basic notions of efficiency used in economic theory:

technical and allocative efficiency. Both together are known as

economic efficiency.

Technical efficiency is traditionally related to production and refers

to firms getting a maximum output per unit of input, or use minimum

input for a given target output. The concept, however, can also be

applied to consumers if we define “output” as the utility coming from

input use.

Allocative efficiency, refers to the use of inputs in a way that

maximizes total net revenues for firms or consumer surpluses. This

implies using inputs in way that follows the signals of relative input

prices, equalizing marginal revenues to marginal costs.

Technical efficiency

water

production

a

b

c

c>a>b

Production fn.

Allocative efficiency in a water system with two activities

$

y2 y1

P1*z1´(y1)

y* y**

v1

v2

v3

P2*z2´(y2)

The allocative efficient point is y** in which marginal product of both activities are equal. In y*, too much water is assigned to the low value Z2 activity, and “society” can gain from reallocating water from Z2 to Z1 (you can understand this intuitively looking at the marginal product of Z2 in the diagram, if you allocate more water than y** to Z2, any additional unit of water produces less income than allocating that unit to Z1, and viceversa, thus the maximum efficiency occurs in y**).

Equity criteria

Equity in water: a particularly acute equity

problem is when poorest groups pay more per unit

of water than other social groups (urban sites with

partial coverage of potable water).

Adverse consequences for equity may derive from

efficiency driven water reallocations. However,

seldom there are clear and fair rules for

compensation, and most legal and institutional

systems are not prepared to deal with complex

water reallocations and its hypothetical required

compensation.

Environmental criteria

In an institutional context where environmental

objectives are given no real expression either within

institutions or among decision makers, the water

sector will tend to reflect this situation and is very

unlikely to produce positive environmental effects.

For example, if the overall effect of economic policies

is to favour rapid economic growth with intensive use

of contaminating processes, the water sector will only

amplify this, since water will be allocated to the

activities favoured by these policies.

Example: Use of economic tools for dealing with environmental

externalities: groundwater or pollution taxes

Cost with

externality

Private

cost

demand

quantity

Cost of

extraction

With

extraction tax

No tax

Other important criteria

Administrative feasibility: It is senseless to adopt economic instruments which are difficult to implement. For instance, water tariffs based on marginal cost pricing, which charges on the basis of each additional unit consumed, is administratively unfeasible in the absence of metering.

Political acceptability: Gains from well chosen economic instruments are compromised if there is adverse public reaction to it. For example, the utilization of user fees is a sensitive matter for most governments which want to control the rate of price inflation, and fear the political repercussions of price increases for basic services.

What are water tariffs?

If there is a regulated monopoly for well controlled and metered

water (potable), both a regulator and the monopoly will fix a

price, demand for water exists and changes in it will build

pressures on “administered” or “regulated” prices. The price

scheme can have blocks to control demand and cross-subsidy.

If water is not controllable to a minimum degree (like most

existing irrigation systems, i.e. 80% of water consumption), there

is no such thing like a supply or demand for water in a market

sense. In this case, water tariffs are not really prices, are devices

to cover (or recover) fixed costs for water administrations. The

concept of elasticity of demand for these irrigation systems does

not makes sense.

Diagram 2: Main types of water tariffs

Water use

Tariff

Fixed and variable

Variable

Variable blocks

Fixed

Fixed with

variable blocks

Types of water tariffs:

Water tariffs, taxes and subsidies

t*

t*+ tax

t*- subsidy

Subsidies (1): Definitions

Water subsidies should be used to promote

social equity, growth, employment and

increase incomes in particular economic

sectors.

A case for subsidization and social equity

occurs where the water service primarily

benefits the individual user.

Subsidies (2): Justification

Subsidies to water users are management tools that can be justified on the grounds that:

Many users are poor and could not afford cost-recovering tariffs;

The use of safe water sources and basic household hygiene should be promoted since they improve public health;

Subsidies can be used to accelerate the uptake of water-saving, or pollution-reducing, measures by both firms and households.

Subsidies (3): Good practices

Smart subsidies are targeted, transparent and tapering:

Targeted to population groups, or to purposes, that are specifically intended to

benefit, rather than scattered across the population at large.

Transparent so that they are accountable to citizens, users and taxpayers.

Tapering – where the aim is to diminish subsidies over time, and eventually

eliminate them.

There will be countries and circumstances where full financial cost recovery is a

more distant goal. Various kinds of cross-supports are possible, e.g. from

richer to poorer, larger to smaller consumers, from urban to rural, industrial to

household, etc. In economic terms cross-subsidies are second-best solutions

since they produce distortions in consumption. But they are widely resorted to

as pragmatic solutions.

Other economic instruments

Water fees, when water permits are issued, like a license linked to a permit regime. Or fees are also used for charging access to water related aesthetical and recreational sites, or considered as connection charges.

Water abstraction charges, similar to water tariffs but charged at the source of water withdrawals from multiple users.

Discharge charges are applied to activities which discharge effluents into water bodies. These charges are increasingly used to control and reduce water pollution.

Tradable water rights

In some countries there are well developed water markets

(California, Colorado, parts of Spain, Australia). In others, markets

are allowed but not very active (Mexico, Chile)

Tradable water rights promote allocations of water to higher value

uses, an important issue for IWRM

Problems with equity impacts, management of externalities and

transaction costs.

Economic instruments and other water situations

Operation and expansion of water

infrastructure;

Management of water quality and

environmental goods;

Provision of water management services which

are public goods (IWRM);

Pressures for increasing supply or reallocation

of water services

Think about it

Which economic

instruments are applied

in your country? Are they

achieving the goals and

objectives of facilitating

IWRM implementation?

End

Economic instruments are not neutral interventions. They have pros and cons, and their application will largely depend and affect differently each local context. Thus, as IWRM, they should be assessed locally and by means of a participatory approach.

Chapter 5 enters financial instruments more in depth.