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Working Paper 17

Payments for Environmental Services: A Review of Global Experiences and Recommendations for Their Application in the Lower Mekong Basin

Consultancy Report prepared by

Petrina Rowcroft

Vientiane, December 2005

MRC-GTZ Cooperation Programme Agriculture, Irrigation and Forestry Programme

Watershed Management Project (WSMP)

The opinions and interpretations expressed in this report are those of the author, and do not necessarily reflect the views of the Mekong River Commission and/or GTZ and/or the Watershed Management Project. The version presented is the unedited original as

submitted by the author, which has not been screened for factual or other errors.

Summary

The potential for PWES is highly variable from one watershed to the next. In some watersheds the opportunities do not yet exist or are extremely limited. This is especially true in remote, very large, or sparsely settled watersheds and in countries with poorly defined or ineffective legal and regulatory frameworks. In other places the opportunity is there but its development is hindered by a lack of information about the source of the ecosystem service and who exactly benefits from it. Even where this is known, the beneficiaries of the service may have little interest in paying for a service they now believe they are getting for free. This evidence suggests that MRC-AIFP-WSMP should consider very carefully whether it should fully engage in such activities. While the high costs and low success rates of large scale (or basin-wide) initiatives are discouraging, there are considerable opportunities for it to contribute to the development of more successful and sustainable PWES systems by conducting (and making available) relevant research, by supporting local level institutions and organisations and by encouraging the emergence of a more favourable institutional setting for the sustainable operation of such systems.

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Table of Contents Summary..................................................................................................................i

Table of Contents .................................................................................................... ii

Acronyms and Abbreviations.................................................................................. iii

List of Figures......................................................................................................... iv

List of Boxes............................................................................................................v

1. Background and Introduction .......................................................................... 1

1.1 Objectives ..................................................................................................... 2

1.2 Focus ............................................................................................................ 2

2. Payments for Environmental Services: The Principles.................................... 3

2.1 The shift to market-based mechanisms ........................................................ 3

2.2 The principles ............................................................................................... 4

2.3 Payments...................................................................................................... 6

2.4 Environmental services................................................................................. 8

2.5 PES schemes ............................................................................................... 8

3. Payments for Watershed Environmental Services – The Global Experience 10

3.1 The potential of PWES for watershed management ................................... 11

3.2 PWES in practice........................................................................................ 13

3.3 PES and PWES in Asia .............................................................................. 14

3.4 Features of existing PWES systems........................................................... 15

3.5 Effectiveness .............................................................................................. 17

4. Key findings and issues in the implementation of PES ................................. 18

5. Recommendations ........................................................................................ 29

6. References.................................................................................................... 34

Appendix 1: Glossary of Terms ............................................................................ 39

Appendix 2: Source of Funds for PES.................................................................. 41

Appendix 3: PES and Poverty Alleviation............................................................. 42

Appendix 4: Payments for Watershed Environmental Services – Summary ........ 44

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Acronyms and Abbreviations AIFP Agriculture, Irrigation and Forestry Programme (of the MRC) GTZ Deutsche Gesellschaft für Technische Zusammenarbeit ICRAF World Agroforestry Center IUCN International Union for the Conservation of Nature LMB Lower Mekong Basin MES Markets for Environmental Services MRC Mekong River Commission OECD Organisation for Economic Cooperation and Development PES Payments for Environmental Services PWES Payments for Watershed Environmental Services RUPES Rewarding the Upland Poor for Environmental Services WSMP Watershed Management Programme (of the AIFP) WWF World Wildlife Fund

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List of Figures

Figure 1: The simple logic behind PES (Source: Pagiola and Platais, 2002) 7

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List of Boxes

Box 1: PES explained - the economic theory ......................................................... 4

Box 2: Types of PES schemes............................................................................... 9

Box 3: PES – different things to different people .................................................. 10

Box 4: Cost-savings through watershed management ......................................... 12

Box 5: How governments are using PWES to help protect watershed areas ....... 12

Box 6: PWES in practice ...................................................................................... 14

Box 7: PWES in Viet Nam .................................................................................... 14

Box 8: WWF and PES .......................................................................................... 30

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Payments for Environmental Services: A Review of Global Experiences and Recommendations for Their Application in the

Lower Mekong Basin

1. Background and Introduction Upstream – downstream relationships are of ecological, economic and social nature. The behaviour and decision-making of upstream populations influence downstream opportunities. Land users, however, typically to not receive any compensation for providing environmental services. As a result, they usually ignore them in making their land use decisions. Often, this can lead to land use decisions that are socially sub-optimal. The response to this problem has often tended to rely either on remedial measures, such as repairing the damage caused by flooding or the construction of civil works aimed at protecting downstream communities from flooding, or on regulation which attempts to dictate particular patterns of land use. Neither of these approaches has proved effective. Remedial measures are often imperfect and expensive - often far more expensive than preventive measures. And regulatory approaches are extremely difficult to enforce and may impose high costs on poor land users. Among the most important factors explaining this phenomenon are the failures to properly value environmental services; to assure the appropriate allocation of property rights; and to design systems to compensate stewards, who will usually be drawn from the rural poor, to maintain those environmental services. Market mechanisms often can be used to achieve these goals. There are many examples in both developed and developing countries that suggest that poverty and sustainability may be addressed through such approaches. The economic opportunities (including costs) behind these relationships could therefore play a vital role in managing future developments. Systems of payments for environmental services (including the provision of incentives) between upstream and downstream users are finding application in a number of countries around the world as a strategy for both conservation and development. This is because of their potential to generate a sustained flow of funding that will also act as an economic incentive for engaging in appropriate land use practices. They are also regarded as potentially more equitable than regulatory approaches that have typically excluded local communities from access to resources that have traditionally supported their livelihoods without any form of compensation. It is largely in recognition of this potential that the MRC-AIFP-WSMP identified the need for a state-of-the-art overview of these experiences as well as relevant recommendations for how MRC-AIFP-WSMP could be (if at all) involved in this issue.

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1.1 Objectives The purpose of this document is to present an overview of the global experience in developing and implementing systems of payments for environmental services (PES) with a view to identifying an appropriate role for the MRC-AIFP-WSMP in developing and applying such systems in the Mekong River Basin. Conducted over a short period of time, this study does not seek to replicate existing reviews (e.g. Landell-Mills and Porras, 2002; Pagiola and Platais, 2002; Rojas and Aylward, 2003) – which are both extensive and comprehensive - but rather draws out the key findings from these, as well as from more recent experiences and issues raised by PES practitioners such as the Katoomba Group1 (a collection of international experts engaged in developing markets for environmental services) and Flows Online2, a regular electronic newsletter. A closely related purpose of this report is to present a broad range of information in a way that is relevant and useful for decision-making in terms of: • the main issues at stake when developing PES mechanisms; • the advantages and constraints, successes and failures of these mechanisms; • the conditions, especially institutional and policy conditions, for the successful

implementation or replication of these mechanisms The report should thus provide a starting point for MRC-AIFP-WSMP to evaluate opportunities and to have a better appreciation of what may be required in practice.

1.2 Focus Payments for environmental services have generally been applied to four types of environmental services: • Carbon sequestration and storage; • Biodiversity protection (.e.g. conservation donors paying local people for setting

aside or naturally restoring areas to create a biological corridor); • Watershed protection (e.g. downstream water users paying upstream farmers

for adopting land uses that limit deforestation, soil erosion, flooding risks, etc); and

• Landscape beauty (e.g. a tourism operator paying a local community not to hunt in a forest being used for tourists’ wildlife viewing).

The review has necessarily been limited to the following: • A focus on watershed protection. • A definition of environmental services where payments are made directly or

indirectly to environmental stewards or service providers. This excludes a broader area of environmental financing which seeks – at a more macro level – to transfer resources from wealthier to poorer communities (OECD, 2005).

1 See www.katoombagroup.org 2 See www.flowsonline.net

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• A focus on developing countries. PES has been widely tested in developed countries but is a relatively new phenomenon in developing countries, particularly in SE Asia.

• A focus on the issues around the practical implementation of the concept rather than on issues associated with particular designs.

• Schemes that aim directly at providing rewards, either financially or non-financially.

2. Payments for Environmental Services: The Principles There has been much interest in the development and application of PES systems over the few years and consequently there is a large and growing body of literature on the topic. In reviewing some of this literature, it became apparent that the term PES means different things to different people. In some cases it is used interchangeably with markets for environmental services (MES) while in others there is a clear distinction between the two. This section does not dwell on definitional nuances but focuses instead on providing a general introduction to the concept in its broadest sense and describing some of the mechanisms through which such systems operate. Box 3 at the end of this section describes some of the definitional differences.

2.1 The shift to market-based mechanisms The emergence of direct economic incentives for the conservation of environmental services indicates a shift from the predominant use of command-and-control mechanisms (such as park establishment, logging bans and land use regulations) to more flexible, financially sustainable and efficient approaches to delivering high quality water and other environmental services (Landell-Mills and Porras 2002; Perot-Maitre and Davis, 2001, Jenkins et al, 2004). Experience with market-based instruments in other sectors has shown that such mechanisms, if carefully designed and implemented, can achieve environmental goals at significantly less cost than conventional ‘command-and-control’ approaches, while creating positive incentives for continual improvement (Jenkins et al, 2004). Of equal merit are the potential local benefits that PES could provide to people who protect threatened environmental services. Recent studies, for example, have identified markets for environmental services as a tool for environmental protection that could also contribute to poverty alleviation (Landell-Mills and Porras 2002; Pagiola and Platais 2002; Pagiola et al. 2005; Grieg-Gran et al. in press; Hartmann and Petersen, 2004). For upstream poor communities potential benefits include increased income, improved diversity of forest-linked livelihoods, and stronger cooperative institutions (Gouyon, 2003, Rosa et al, 2003). In downstream poor communities, benefits might include new mechanisms to ensure improved and sustainable water supplies (Gouyon, 2003). Apart from the financial benefits from the sale of ecosystem services, Jenkins (2004) also identifies the benefits of improved human capital through associated training and education. The potential of PES in this regard, is discussed in significant detail in Scherr et al (2004a and b)

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Landell-Mills and Porras (2002) and Gouyon (2003). Some of their arguments are presented in Appendix 3. Such markets thus provide both a necessary and fundamental opportunity to provide creative solutions for the management of watersheds and sustainable livelihoods. In the Mekong region, where poverty alleviation and developmental goals are as much part of the national imperative as the sustainable and “profitable” utilisation of natural resources, markets for environmental services would seem to make good sense (economically and socially), provided the supporting mechanisms are clearly defined and carefully established. Box 1: PES explained - the economic theory Market failure in the provision of environmental services is particularly severe in many tropical countries and especially in areas with high levels of poverty. Important environmental benefits are often provided by land where tenure and access rights are unclear or where institutions and regulatory frameworks are weak. The opportunity costs to poor people of maintaining a land cover that is optimal for the environment may be very high. These problems are most severe in the areas of lower agricultural potential where many poor people live (Tomich et al, 2004). In most parts of the world, forest environmental services such as watershed protection, carbon sequestration and biodiversity conservation cannot be bought and sold and markets fail to ensure adequate supply. There are several reasons markets fail to emerge. One of the most important is that many environmental services provided by forests fall into the category of positive externalities or public goods (Cornes and Sandler, 1996). A positive externality is any uncompensated benefit. Positive externalities associated with forest protection include, for example, erosion control, reduced risk of flooding downstream and water quality maintenance. Markets typically fail to compensate those who produce positive externalities due to the absence of property rights or other legal means to require payment for services rendered. Forest environmental services can also be characterised as public goods. These are a special class of externalities distinguished by their non-excludability and non-rivalry. Non-excludability means that consumers cannot be prevented from enjoying the good or service in question, even if they do not pay for the privilege. Where goods are non-rival the consumption of a good or service by one individual does not reduce the amount available to others. In this situation there is no competition in consumption since an infinite number of consumers can use the given quantity supplied. Where non-excludability and non-rivalry exist they undermine the formation of markets since beneficiaries of the good or service have no incentive to pay suppliers. As long as an individual cannot be excluded from using a good they have little reason to pay for access. Similarly, where goods are non-rival, consumers know that where someone else pays, they will benefit. In both cases beneficiaries plan to “free-ride” based on others’ payments. However, where everyone adopts free-riding strategies, willingness to pay for public goods will be zero and the product will not be supplied (Landell-Mills and Porras, 2002).

2.2 The principles PES should not be regarded as a single, rigid approach, but rather a group of related approaches based on the central principle that those who provide environmental services should be compensated for doing so and that those

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who receive the services should pay for their provision. Where the collection of this revenue is linked to a fee on the use of the ecosystem service – for example a fee on water use – this can also create incentives for the more efficient use of resources. Payments for watershed environmental services (PWES) schemes usually involve the implementation of market mechanisms to compensate upstream landowners in order to maintain or modify a particular land use which is affecting the availability and/or quality of the downstream water resource. Usually this compensation is generated from payments made by downstream water users (FAO, 2003). Wunder (2005) and Wunder and Robertson (2005) argue that payments also need to be fully contingent on the continuous provision of the defined service (Wunder, 2005) for the system to be effective. Service buyers need to be able to withdraw from a PES contract if they do not get what they paid for. Conversely, service providers may also desire flexible contracts that allow them to modify the terms of a PES scheme, or withdraw altogether, if changing conditions induce them to do so. It is conflicting interests that provide the raison d’être for PES (Wunder and Robertson, 2005). In fact, one of the major drivers for cooperation amongst downstream beneficiaries is that their watershed services are threatened by changes in land use upstream. Beneficiaries must cover upstream landowners’ opportunity costs associated with forgone revenue from alternative land uses (e.g. intensive agriculture) to ensure continued protection. Pagiola et al (2002) in a review of 12 case studies of market-based initiatives for forest conservation adopt two basic criteria to examine their effectiveness in promoting conservation: the extent to which they attract participants and influence their behaviour, and the extent and nature of the forests that are ultimately conserved. The authors conclude that most of the initiatives have been successful in attracting participants. They stress, however, that the extent to which a specific mechanism provides incentives to forest managers to undertake conservation depends not only on the amount and form of payments but also on the opportunity cost of conservation. The cases that have been most effective are in relatively remote areas with limited alternative land uses where opportunity costs are low. In these circumstances, the payments do not have to be very high to bring a clear net benefit for the sellers of environmental services. The concept is intuitively appealing: by offering payments to landowners, the public can change the financial rationale behind land use decisions that are generally based only on private costs and benefits, and induce landowners to produce more positive externalities or avoid negative ones by making environmental management a financially attractive alternative to degradation and deforestation. For such systems to work, real land-use choices must exist, what is being bought and/or sold needs to be well defined (i.e. directly measurable) and cause-effect relationships (i.e. the scientific basis of the scheme) well understood. These issues are explored in more depth in a later section.

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2.3 Payments Payments (or incentives) are simply specific inducements designed and implemented to influence or motivate people to act in a certain way. In the context of nature conservation, economic incentives make it more worthwhile in financial and livelihood terms for communities to maintain, rather than to degrade, natural resources in the course of their economic activity. They aim to: • set in place economic inducements, or positive incentives, for nature

conservation; • discourage nature degradation through the use of penalties and disincentives3;

and • overcome the broader economic forces, or perverse incentives, which underlie

biodiversity degradation (Emerton, 2001). Payments may be monetary or in-kind, may involve private sector or government financing, and can be made at local, national, and global levels. There are numerous examples of PES in practice. Lower watershed users may pay upper watershed communities for land management (the focus of this paper). Governments may give tax breaks to people setting aside land for conservation. And companies may pay in other countries for activities that provide global environmental benefits such as carbon sequestration or biodiversity conservation. Some authors (notably Emerton, 2001 and the RUPES programme) prefer to use the terms ‘rewards’ or ‘incentives’ rather than ‘payments’. While in practice, the nomenclature usually amounts to the same thing, this preference is usually to acknowledge that ‘payments’ do not necessarily have to take the form of direct cash transfers. Upland communities collaborating in the implementation of watershed management projects could be compensated in terms of wages for services rendered, provision of free planting materials, conduct of skills-training, technical assistance, and tenure security, among others (Francisco, 2002). The rewards can be classified into three groups (Gouyon, 2002): • Financial rewards: this is the case in which farmers receive subsidies or tax

abatements in the exchange of environmental services such as not farming in a particular sensitive area. Financial rewards include subsidies, tax abatements, tradable permits, subsidized credit rates, higher prices for products and lower prices for inputs.

• Rewards in kind: this is the case in which farmers receive free planting material, infrastructure or other services. The provision of such rewards is the strategy used in integrated conservation and development projects in which farmers are rewarded in the form of community development project.

• Rewards in the form of improved access to resources and markets: they are given through the provision of better land tenure, conditional access to credit, or preferred access to public or private markets.

3 Here disincentives and/or penalties refer to cases where payments are withheld when agreed service levels (quantity, quality, etc) are not met. This is different from cases where polluters are asked to pay for any negative externalities. For the purposes of this paper, the polluter pays principle is not considered a PES.

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The value of these “rewards” must be perceived to be at least as high as the value that would otherwise have been obtained from the land before PES were introduced (i.e. payments should cover the opportunity costs). Figure 1 below illustrates this logic. Some of the most environmentally-beneficial land use practices are less rewarding financially than alternative land uses, at least in the short run. When this is the case, farmers are likely to shift to less environmentally beneficial practices as soon as they are able to. Communities often prove unwilling, and economically unable, to support conservation unless they are provided with tangible, cash benefits at the individual or household level, which directly offset the financial costs and losses associated with limiting natural resource use or switching to other activities (Scherr et al, 2004a).

As the figure shows, land users receive benefits from forest conservation – often, less than the benefits they would receive from alternative land uses, such as conversion to cropland. But deforestation can impose costs on downstream populations, who no longer receive benefits of ecological services such as water filtration. A payment by the downstream beneficiaries can help make conservation the more attractive option for land

Figure 1: The simple logic behind PES (Source: Pagiola and Platais, 2002)

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2.4 Environmental services Simply put, the term ‘environmental services’ can be taken to refer to the overall concept of natural systems providing a continuous flow of valuable goods and services to society (Landell-Mills and Porras, 2002). It was noted earlier that four major types of environmental services are identified in the PES literature. These functions are usually non-marketed, financially un-rewarded and only indirectly connected to economic activities. Although PES mechanisms may be set up with only a particular type of environmental service in mind, it should, however, be noted that: • The provision of watershed services, biodiversity maintenance, and

carbon sequestration are essentially joint products (Francisco, 2002; Gouyon, 2003; Landell-Mills and Porras, 2002). It is very rare that these services can be separated in practice (Gouyon, 2002). For example, afforestation to enhance watershed services usually results in higher biodiversity and greater carbon storage. This is because watershed protection normally requires the conservation of a dense vegetation cover in key areas of the watershed, such as along rivers, terraces, or field contours. The vegetation usually supports other local natural flora and fauna. They will also act as carbon sinks, removing carbon from the atmosphere during their growth period, or avoiding carbon releases if they are mainly protected (Gouyon, 2003). But as will be explained later, service definition and differentiation is critical to the establishment of well-functioning markets. Buyers have different needs and are often not willing to pay for a ‘package’ of services when they are really only interested in one particular service.

• Nearly all of the PES literature focuses on forests as the source of environmental services. But in the same way that forests provide a number of environmental services, these services may be produced by a number of land uses. Forests are not the only provider. While the perception that forests contribute to the delivery of these services is widespread, there is often little supporting scientific evidence. The level of scientific uncertainty surrounding forest-water linkages has been described in some depth by Lambin et al (2001). Relatively few studies have considered services provided by trees within more complex landscapes, i.e. where forestry is one of a number of land management techniques used to improve downstream hydrology and conserve soil. When considering forests’ role, it is important to consider how forests fit into a broader land use context.

2.5 PES schemes PES schemes differ according to the number and type of participants involved, the payment mechanisms employed, the degree of competition and their level of maturity. They also often have very different impacts for local and global welfare. These variations reflect local socio-economic and environmental factors, drivers and ultimately local variations in the process of market development. See Box 2 for examples of scheme differentiation.

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Box 2: Types of PES schemes The FAO (2003) distinguishes between two types of PES schemes. The first type – related to services at the global or the broad geographical scale – has the purpose of using market instruments to pay for services whose users are not limited to the local level, e.g. biodiversity conservation, scenic beauty, carbon sequestration and others. The second type of PES schemes is designed to compensate providers by means of a local market, in which generally users are better defined and limited to a particular geographical area, which is close to the location where providers carry out their productive activities. Since users and providers are geographically close to each other, the operation of the PES scheme should be facilitated since transaction costs are reduced and the information flow becomes easier among the economic agents (FAO, 2003). PES systems for water services in watersheds, which are the focus of the present report, belong to the latter category. This category can be further broken down to distinguish between direct and indirect beneficiaries (Gouyon, 2003) where: • Direct beneficaries are represented by a limited, well-defined number of

stakeholders benefiting directly from the service. This often occurs in watershed conservation: a bottled mineral company reaps direct benefits from watershed conservation services resulting from agroforestry practices in the upward part of the river basin. Similar examples are found when agro-industrial companies make benefits from genetic resources collected in the upland rice systems of poor farmers, where genetic intra-species diversity is still high. In such cases, the environmental services is rendered to a private individual party, and designing a compensation system seems relatively simple.

• Indirect beneficiaries are a more loosely-defined group of stakeholders, who may benefit in varying degrees and in a non-obvious way from environmental services. For example, if rural poor refrain from clearing steep slopes for cultivation, all the population and industries in the downstream part of the basin are likely to benefit from the resulting conservation of water flow and quality. However, we are already in a case of public goods or services, whereas in the previous case, there were well-identified individual beneficiaries of the service.

There are a number of different financial incentive mechanisms that can be used to “process” environmental payments. Mechanisms used to provide financial incentives for the provision of ecosystem services are essentially an institutional arrangement among stakeholders, that determines how services are paid for – i.e., who is paid to take particular actions, who pays for it, and how it is implemented. These range from informal, community-based initiatives to more formal contracts among private parties, and various combinations of market-based, regulatory and policy incentives required at larger scales, when threats are beyond the control of affected communities. Typologies of these mechanisms are usually separated by the degree of government intervention in their administration and include self-organized private deals, trading schemes, and public payment schemes. In reality, of course, there is continuum of mechanisms involving public and private actors, and many cases involve a combination of different mechanisms (see Scherr et al, 2004; Tognetti, date unknown for a detailed description of the types of systems commonly used). The sources of funds to support PES may include user fees, taxes and donations. The choice of instrument depends upon the context in which the PES system is

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being developed. Some of these market-based instruments and their most common applications are described in Appendix 2. Box 3: PES – different things to different people Payment for environmental services is a relatively new approach, and there is not yet a settled definition of the term. It can be used very broadly to include, for example, pollution charges. In this paper, the term is used more narrowly to focus on mechanisms under which those who provide positive externalities are compensated for doing so, usually through payments from the beneficiaries. Pollution charges are in a sense the mirror image of this approach; they make those responsible for negative externalities pay for the damage they cause. There are also a number of different approaches to PES, some of which are transactions between private companies or individuals while others have more government involvement. While the term markets for environmental service (MES) is applied by some - for example, Landell-Mills and Porras (2002) - to all of these approaches, others - for example Pagiola et al. (2002) and Wunder (2005) - prefer to restrict the use of this term to schemes with the following key characteristics: • Buyers and sellers come together on a voluntary basis; and • Prices are set through the interaction of supply and demand. Some schemes may have various characteristics of markets in that they allow suppliers of environmental services to respond to financial incentives and decide how much of the service they want to supply in response to the payment offered. But in some schemes the transaction from the buyer side may not be voluntary. That is the case, for instance, when a municipality increases the price of water supply to users in order to pay landowners to conserve forests. The payment may also be administratively determined, as when a government agency sets the price. These types of initiatives can be considered partially market-based but not markets in a strict sense and are therefore often referred to as PES. The distinction between PES and MES can be rather blurred particularly where markets are imperfectly competitive, involving only one or a few players on either the buying or supplying side, or where governments are involved as the seller or buyer of environmental services (Grieg-Gran and Bann in Gutman, 2003). There is also a certain degree of overlap between the term PES and the term private sector–community partnership. Not all such partnerships relate to the financing of natural resource management, but when they do they can often be considered a type of payment for environmental products or services. This is because they often involve a community providing access to land or wildlife or refraining from activities that detract from conservation or landscape beauty in exchange for a variety of inputs from the private sector, both financial and non-financial. Direct negotiation is the most common approach for developing such partnerships and much of the research on them has focused on how to improve this aspect, rather than the broader market issues (Grieg-Gran and Bann, in Gutman 2003).

3. Payments for Watershed Environmental Services – The Global Experience

The logic behind payments for environmental services is not new. For decades farm subsidies, notably the agri-environmental schemes at the core of the EU Common Agricultural Policy have been justified by real or perceived environmental benefits from agriculture. Development agencies have provided subsidies to farmers for afforestation or similar projects based on presumed income losses and the costs of implementation. Interest in payment schemes for environmental services in developing countries is more recent and regionally focused on Latin America and the Caribbean. A

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number of practical applications are testing the potential for managing water resources at the level of watersheds through the introduction of market mechanisms for the compensation of upstream landowners to maintain or modify a particular land use (Hartmann and Petersen, 2004). In the tropics, the most prominent PES system has been developed over almost a decade in Costa Rica. Their potential has only recently begun to be explored in other regions, particularly in Asia, where high population densities and strong economic development are raising the value of environmental services in many regions.

3.1 The potential of PWES for watershed management The potential for increased demand and increased payment for watershed services is significant for at least five reasons: Globally, water demand is projected to double, if not triple, over the next 50 years, and much of this growth will be in developing countries (Scherr et al, 2004b). Over the past 30 years the population of the Lower Mekong Basin has doubled. An estimated population increase of another 30 to 50 per cent by the year 2025 will bring the basin population to over 100 million (MRC, 2003). Pressure on natural resources will increase dramatically, as will the demand for additional land, food, water and energy. Downstream users are learning that investments in watershed protection are often substantially cheaper than investments in new water supply and treatment facilities (See Box 5 for examples). For example, it is often cheaper and more efficient from society’s standpoint to protect a service from the ecosystem, such as water purification or flood control, than building and maintaining artificial structures such as purification plants and flood control structures. The majority of the world’s population lives downstream of forested watersheds, making them all susceptible to the costs of watershed degradation. These downstream populations, and their interest in reducing vulnerability, flooding and degradation are likely to grow with education and spending power. This is equally true for the LMB. There is growing recognition that traditional watershed management projects, which rely either on regulatory approaches or subsidies to encourage the adoption of soil conservation techniques on private lands, have generally not proved effective (Kaimowitz 2000; Lestrelin et al, 2005). Typically, funds for watershed management and protected areas (which are often justified in part based on their water benefits) come from government general revenues and are not based on the value of water that these areas provide. This represents a form of market failure (see Box 1). This approach has been effective in some places, but there are also serious limitations. One problem is that many governments have serious revenue shortfalls caused by ineffective tax systems or depressed economies (Johnson et al, 2002). Increasingly, public

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authorities require those who most obviously benefit from ecosystem services to provide financing (see Box 6 for examples).

Box 4: Cost-savings through watershed management By investing approximately US$1 billion in land protection and conservation practices, New York City has avoided spending US$4–6 billion on filtration and treatment plants (Scherr et al, 2004b; Echavarria & Lochman 1999; Hawn, date unknown). In South Africa, removing thirsty alien tree species in Cape Town’s watershed and restoring native vegetation produces water at a fraction of the cost of water delivered through diversion or reservoir projects (Gelderblom & van Wilgen 2000).

Box 5: How governments are using PWES to help protect watershed areas This is the case in Colombia, for example, where hydroelectric and water utilities are required by law to allocate a fixed percentage of revenues to an ecosystem fund. The fund pays private landowners for watershed management and purchases hydrologically sensitive lands for management by government agencies. In addition to direct-investment approaches of this nature, some governments are experimenting with new fiscal approaches. In Brazil, a number of states have pioneered a new tax allocation system under which a percentage of state tax goes directly to municipalities that actively protect watershed areas (Scherr et al, 2004b). The World Bank together with the OECD and other development agencies, has examined the potential for Environmental Fiscal Reform (EFR) – a wide range of taxation and pricing instruments, including taxation on the exploitation, consumption and pollution of natural resources, and the reform of water or energy subsidies to encourage sustainable natural resource use (IBRD, 2005). However, EFR does not necessarily imply any form of transfer to ES providers and for the purposes of this paper is therefore not considered as a form of PES.

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3.2 PWES in practice At a global scale, several recent reviews indicate that these activities are nascent and still limited in scope and scale, but that they may have potential to be scaled up to regional, river basin or national levels with further development. In May 2002, the International Institute for Environment and Development (IIED) published a review with 61 examples of environmental service markets for watershed protection (see Appendix 4 for summary details). New initiatives have arisen since then and are in proposal stages; they are being considered as a new opportunity for the watershed development. Most of the trials of such schemes to date have been in developed countries, where biophysical science tends to be stronger and legal frameworks and institutions exist that permit the development of more sophisticated markets.

“Watersheds cover almost half of the developing world land mass and provide services of decreasing quality and quantity despite increasing demand. They are potentially the world’s largest asset class after real estate, if markets can be developed around them” (IIED Project Document, 2003).

The value of watershed services is realised through: • Provision of freshwater for consumptive and non-consumptive purposes • Flow regulation and filtration • Erosion and sedimentation control • Salinisation control • Recreational, tourism and cultural uses • maintenance of aquatic habitats (e.g. maintaining water temperature, shading

rivers/streams, ensuring adequate woody debris in water). Over the last few years, there has been considerable effort devoted to moving payments for watershed services from theory to practice. There have also been more efforts focused around the evaluation of these initiatives as they are implemented, through "action learning" and "action-research" approaches. These are approaches designed to provide feedback needed to allow the concept of payments to be adopted for local conditions and to support learning by doing. Many of the lessons learned from the implementation of longer-standing initiatives such as those in Costa Rica (see Box 4) have already led to adjustments needed to make them more equitable and inclusive. They have also led towards an emphasis on pilot initiatives at small scales, where land and water relationships can be better linked to management practices, and that make it possible to more directly engage stakeholders.

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Box 6: PWES in practice • One of the most often cited examples in the PES literature is that of Lake Arenal in

Costa Rica where landholders in critical watershed areas are paid between US$30 and US$50 per hectare per year. A private utility company voluntarily pays into a fund that provides money for private upstream landholders to increase forest cover. This reduces sedimentation, thus providing sufficient water flow for hydroelectricity generation (Scherr et al, 2004b).

• In Karnataka State, India, farmers have formed a fund with the assistance of an

NGO, the Government of India and the Swiss Agency for Development Cooperation to help other local farmers with watershed protection activities such as regenerating forest and maintaining fallow land.

3.3 PES and PWES in Asia In Southeast Asia initial work on developing environmental service markets seems to have gained impetus through research at The World Agroforestry Centre (ICRAF). ICRAF has contributed significantly through building a consortium among international and national research centres, government and non-government organizations and other interested parties to conduct action research for rewarding the upland poor in Asia for environmental services they provide (RUPES). The overall goal of the project is enhanced livelihood and resource security for poor upland communities in Asia. Improved livelihoods in this context refer to: improved food security, income and welfare of poor households and communities in upland areas; improved nutritional status; greater access to and control over the use of resources. Appropriate methods for transfer payments to upland communities will be tested and monitored through action research (Sayanto et al, 2005). Markets for watershed protection services do not formally exist in any of the Lower Mekong countries although their potential has been explored in Viet Nam (see Box 7) and numerous research initiatives and practical projects address the issue in an indirect way. China also has made progress in establishing the rules and framework for setting up mechanisms for environmental services payment. Forest Law 1998 introduced the Forest Ecological Benefit Compensation fund as a responsible institution that channels the money from beneficiaries to providers. The implementation on the ground, however, is still limited (Wenming et al 2002).

Box 7: PWES in Viet Nam Forest land use in upland Vietnam (above 600 metres) has been governed by the government’s “people’s forestry” initiative since 1994. The initiative involves the transfer of forest management from the state to households and individuals. Forest land may be forested or barren, and different rules apply to land transfer arrangements under each category. Forest land without forest cover may be “allocated”, while forest land with forest cover is “contracted”. In parallel with efforts to increase private participation in forestry, the government has implemented a critical shift in its policies towards forests. Whereas before the 1990s forests were thought to offer an abundant source of tangible products, emphasis has shifted to their importance as suppliers of environmental services. Forests’ watershed services are singled out for their role in controlling dam sedimentation.

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While upland forests are valued for their environmental services, these services have not traditionally generated payments that reward upland communities. The lack of compensation has been compounded by restrictive government land use regulations. A logging ban was introduced in all natural forests in 2000. Moreover, because forest resources are state-owned, local households have not shared in benefits from the revenue earned. State Forestry Enterprises have traditionally been responsible for forest use and have tended to employ lowland people rather than locals. With little incentive to protect forests, natural forest cover is estimated to have declined from 43% in 1943 to 26% in 1993. Protected areas have not been immune. While 6.5 million hectares are classified as protected for watershed management, only 3.1 million hectares are under forest cover. To tackle this problem, under the new “peoples’ forestry” initiative, the state has begun to allocate barren forestland to households through Land Tenure Certificates and contracts for protection. Financing for household forest protection is provided through a “National Programme to Create and Protect Watershed Protection and Special Use Forests”, which has an annual budget of US$60 million. Funds are channelled to State Forest Enterprises, communes and districts to contract households and individuals to undertake protection and regeneration activities. Payments of up to VND 50,000/hectare/year (US$3.34/hectare/year) are made. Payments are channelled to households through “Forest Protection Units” which monitor implementation. By the end of 1996, about 6 million hectares of forestland was allocated for protection (about 5% of total forest land). Source: Morrison and Dubois (1998), GTZ (1996), Sikor (2000) in Landell-Mills and Porras, 2002.

3.4 Features of existing PWES systems In summary, some of the key features common to PWES systems in developing countries are as follows: Purpose - Generally, PES systems in watersheds have been restricted to one of the two following purposes: a) to improve the availability and quality of water for human consumption, mainly in urban areas, and b) to improve the availability and quality of water used in hydroelectric generation. Beneficiaries - The main groups of beneficiaries include hydroelectric power generators, municipal water supply systems, irrigation systems, industrial users, and populations in floodprone areas (Pagiola et al. 2002; Scherr et al, 2004) who are directly and significantly impacted by upstream land-use. Drivers of PWES - Landell-Mills and Porras (2002) found that in their 62 cases of watershed protection markets in 22 countries (24 cases in eleven tropical countries), the private sector accounted for 65% of sellers and 60% of buyers of watershed services. Private investors included companies for whom watershed properties are a key input to their production capabilities, companies who are required to offset their water pollution, and private home-owners who use water for everyday functions. For a number of reasons (described in Section 4) governments are still the most influential buyers of watershed services. Agencies such as water boards and electricity suppliers have the most defined interest in maintaining water flow and quality. As a major landowner in critical watershed

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areas, the government also has a role to play in maintaining supplies. The government’s role in Vietnam’s emerging watershed market is described in Box 7 (Landell-Mills and Porras, 2002). Financing - show a high degree of variability due to differences in locale characteristics, both institutional and geographical but transfer payments from downstream water users to upstream stakeholders for ecosystem conservation are the most common approach and account for the largest current source of financing (Landell-Mills and Porras, 2002). These systems do not involve the direct buying and selling of services per se, but rather the ‘selling’ of land-uses that generate those services. A range of watershed service commodities has developed, depending on the type of service demanded. Those interested in maintaining water quality purchase this service, in some schemes, through best management practice contracts with watershed landholders, and in others, through water quality credits. Water table regulation is being commoditized in a number of ways including salinity credits, transpiration credits, and stream flow reduction licenses. Payment mechanisms - Of the various types of watershed payment mechanisms, Landell-Mills and Porras (2002) found that intermediary-based transactions are most common, accounting for 44% of all mechanisms employed among the 62 cases. Intermediaries either have significant local knowledge or are established specifically to manage the transaction process and include NGOs, government agencies and communities. Intermediary-based transactions are used as a way of pooling demand and for risksharing and fundraising. Scale - PES systems in watersheds have been applied at very different stages and for various objectives in Latin America, from the micro-watershed level – focusing on a very specific service – and usually managed by an NGO, to national programmes controlled by the State. Of the cases studied by Landell-Mills and Porras (2002), 68% involved local markets while only 11% were national and 3% were international. In larger markets, downstream beneficiaries of watershed properties are less willing to pay for upstream water protection (often due to significant uncertainties regarding the cause-effect relationships between land use and the services) and, where watersheds cross political boundaries, other types of risks may prevent payments from occurring. Legal basis - A few countries have specific legal frameworks for PES at the national or regional level; however, most schemes operate without a specific legal basis. Overall, there is no blueprint that fits all situations: mechanisms tend to be site and user-specific, depending on the nature of the ecosystem services, the number and diversity of stakeholders and the legal and regulatory framework in place. The desirability and potential for financial incentive mechanisms for watershed management varies widely from place to place. Differences in the nature of the service provided, who supplies it, who receives it, how economically important it is, and what legal and regulatory systems are in place are just a few of the factors that shape payment schemes.

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3.5 Effectiveness - Past reviews have found that relatively little is known regarding the actual effectiveness of PES systems. While there are a significant number of examples for the application of PES schemes for water-related services, particularly in Latin America, most of these cases have not yet been comprehensively inventoried and there are few studies on the socio-economic and environmental impacts of these systems. Many of the payment systems reviewed by Landell-Mills and Porras (2002) and others had only recently been proposed or were in initial phases and therefore could not be fully evaluated in terms of actual service delivery. While the principles are clear, designing and implementing a system of payments for environmental services in practice is often difficult. Some of the most notable challenges include: • Identifying willing buyers of watershed services, • Identifying and implementing land management practices that ensure the

service is provided, and • Developing cost effective ways of linking buyers and suppliers of watershed

services. Based on these and other reviews of literature and case studies (UN FAO 2002; Johnson, White et al. 2001; Perrot-Maître and Davis 2001; Tognetti 2001; Aylward 2002 and Pagiola, Landell-Mills et al. 2002), much has also been said about the general advantages and limitations associated with PWES schemes. Some of these are summarised below (see Section 4 for a more detailed discussion of the issues): Advantages /Opportunities Innovative financing mechanisms Cheaper and more adaptive (compared to command-and-control measures) once

functional Improve the efficiency in the allocation of natural, social and economic resources. Generate new sources of funding to conserve, restore and value natural resources. Direct benefits from watershed protection (e.g. more efficient hydropower and water

supply systems) Positive spin-offs for forestry, agriculture, fishing and recreational activities Have the potential to transfer resources to socially and economically vulnerable

sectors who provide environmental services Create indicators of the relative importance of natural resources Difficulties / Limitations Generally not suited to large-scale applications Poorly tested in developing countries Expensive to implement and thus have tended to depend largely on external financial

resources when implemented in developing countries Often not the most cost-effective method to attain the goals established because of

the transaction costs of introducing and managing payment mechanisms Poor knowledge about the dynamics of ES supply (how to transfer payments

between, often remote, poor communities Do not work well where property rights are not well established Often based on generalizations, which have not been proven by empirical studies

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Difficulties / Limitations about the relation between land use and water-related service. Many ES beneficiaries are thus unwilling to pay.

Service providers, users and the service itself are often not properly identified Frequently implemented without a mechanism for follow-up or control. Opportunity costs associated with foregone land uses may be high (higher than the

level of payments being offered) May conflict with land-use plans The model and costs of the service are politically imposed and do not correspond to

studies on demand and economic valuation of the resource. They may offer perverse incentives to land users where legal actors engage in illegal

activities in order to qualify for payments

4. Key findings and issues in the implementation of PES While much has been written about the potential of environmental service payments to provide incentives for upland dwellers to adopt land management practices that enhance the flow of environmental benefits to downstream communities, in practice operational schemes seem to be difficult to sustain. The results of existing analyses point to a variety of conceptual as well as practical questions. The major problems appear to be both the difficulty of measuring and valuing the services and of assessing the cost incurred by rural people in providing them. The basic requirements for a market in environmental services are rarely present. Furthermore, “…policy-makers’ enthusiasm is not matched by practical understanding…” (Landell-Mills and Porras, 2002) when it comes to the difficulties of creating markets and their impacts for poor landowners and land users. Replacing the pitfalls of command-and-control measures for effective and efficient environmental management raises a variety of challenges including property rights, clearly defined environmental services, organisational capacity and sources of funding (Hartmann and Petersen, 2004). This section focuses particularly on the findings and issues considered most pertinent to the Mekong context and which have implications for possible MRC involvement in developing and applying PES systems. 1) Technical – For systems of payments for environmental services to work, the environmental goods and services must be clearly defined and their values to both providers (upstream communities) and beneficiaries (downstream dwellers) relatively well known. Communities’ willingness-to-pay for environmental benefits needs to be assessed and appropriate payment mechanisms identified and agreed. There is a lack of scientific clarity regarding the relationships between land and water and this has allowed a number of initiatives to develop on the basis of myths, half-truths on assumptions about land use impacts on water resource. Some of the implications of this may be that:

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• Demand could be affected - if expected services are not delivered, payments will be abandoned. To establish and maintain a willingness to pay on the side of the beneficiaries, a broadly shared and accurate understanding of the cause–effect relations is required (Tomich et al, 2004; Landell-Mills and Porras, 2002).

• In some cases, these ‘myths’ gain significant influence on policies and natural-resource management practices that may lead to partial or inappropriate solutions, which not only fail to solve problems of watershed degradation but may actually exacerbate them (Kaimowitz 2001, 2004; FAO 2003; Tomich et al, 2004). They may also result in scapegoating of marginal groups in remote upper watershed areas (Lestrelin et al, 2005).

• It is difficult for suppliers to specify how they will alter service delivery or for beneficiaries to be persuaded that their payments will make a difference.

Verifying these linkages is often difficult because: • The relationship between forest cover and the production of ecosystem

services is complex, variable and in general not very well understood due to the large number of variables and their complex relation. The high variability of geographical and climatic conditions in watersheds especially makes it difficult to attain generalizations about land use and its impact on water resources which are universally applicable. This is particularly true in SE Asia where a mosaic of landscape conditions makes it difficult to (a) generalise about these linkages, and (b) identify the individuals to whom payments should be directed.

• To scientifically prove the linkage between a certain preferred land use and the additional provision of a water-related service can sometimes be more expensive than the alleged value of the service itself. Even where the linkages are clear, it is possible that the payment made is insufficient to compensate for the opportunity costs involved. As this becomes clear to the suppliers of services, they may lose interest. This is more likely to happen where the payment level is determined administratively or as a result of political negotiation, rather than on the basis of cost-benefit analysis.

Some argue that markets may nevertheless evolve with limited data concerning these linkages, as long as the upstream land management practices are perceived as providing services, and that the beneficiaries hold a positive willingness to pay. It has also been found, however, that even when these links can be established in small-scale initiatives, it has sometimes been found difficult to demonstrate that specific watershed benefits have sufficient economic significance to justify payments that outweigh opportunity costs (Aylward, 2004; Johnson & Baltodano, 2004). There is a lack of a clear definition of the service for which the payment system has been established is a common problem in many schemes. A complicating factor is that a given watershed may have many different users of water, each with their own requirements in terms of hydrological services. Domestic water supply, irrigation, hydropower, navigation, fisheries and ecosystem maintenance are just a

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few of these uses, each with its own requirements in terms of water quantity and water quality. The implications of this are that: • Each of these objectives requires different strategies of land use management

in the watershed (Rojas and Aylward, 2003). Given the mosaic of land uses in the Mekong Basin it becomes potentially quite difficult (and expensive) to satisfy the requirements of all downstream beneficiaries. Rather, some trade-offs seem likely.

• It may result in serious deficiencies in the system, since it reduces the users’ willingness to pay. Likewise, in some cases, not all relevant users or providers participate actively in the system, causing reluctance on the part of the users who do pay – they consider it is unfair to pay for the service while others benefit for free – and conflicts within providers, since those who do not participate feel excluded from the benefits granted for the services they are providing (FAO, 2003). To generate willingness to pay for specific environmental services, it is critical that beneficiaries recognise the value of environmental services for their welfare. Impacts may be direct, e.g. the provision of clean drinking water, or they may be indirect, e.g. the reduction of sedimentation and improved hydropower efficiency leading to cheaper and more regular electricity supplies. Conversely, to create appropriate incentives in order to effectively maintain or enhance environmental services, rewards must be properly directed toward those providing services.

Willingness to Pay (WTP) is a prerequisite for demand. Two key reasons for a lack of willingness to pay are highlighted in the literature: Resistance of stakeholders that are used to receiving watershed protection services for free. Lack of finance, especially where the government is the buyer. In Vietnam, for instance, government payments for watershed protection are often too low to attract the necessary landowner participation (Sikor, 2000). Similarly in an example in Costa Rica where the opportunity costs of land and alternative economic activities, such as dairy farming, export-oriented agriculture, and urbanisation, is high. Some landowners would like forest conservation to be their main activity but they believe the payments from the programme would be insufficient to cover the opportunity cost of land (Miranda et al, 2003). The willingness to pay of a given group of beneficiaries will depend on the specific service they receive, on the value of that service to them (compared with the cost of alternatives), and on the size of the group. Once the beneficiaries of a service are known, a means must be devised to capture part of their willingness to pay. This is obviously easiest when the beneficiaries are easily identifiable and are already organized, making it relatively simple to negotiate with them and to collect payments. For example, an additional fee can easily be added to water bills paid by municipal and industrial water users. In contrast, populations in floodprone areas are not organized as such, although they may be included in other

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beneficiary groups, and there is no pre-existing mechanism for collecting payments from them (Pagiola and Platais, 2002). In more developed countries, new government regulations for improved water quality have been the major force behind payments for watershed protection. Also, improved understanding of the benefits provided by watersheds and the growing threats that they are facing have increased beneficiaries’ willingness to pay for watershed conservation (Landell-Mills and Porras, 2002). Perverse incentives are an inherent risk to any market mechanism applied to attain environmental goals. In the case of PES schemes, such incentives may include accelerated land clearing (which would not have occurred in the absence of the scheme) on the part of the providers in order to benefit from higher payments offered under the scheme to restore deforested lands, as compared to conservation of existing forest. Perverse incentives can be avoided only by considering them in the scheme design and through a detailed assessment of the scheme’s implementation. Monitoring systems must be capable of detecting “secondary” or “unintended” effects of the PES scheme (FAO, 2003). There is one argument presented in the literature (Hobley et al. 1998 in The et al, 2004) that the money paid for protection is in itself acting as a perverse incentive in some cases. It encourages households to protect forests for money from government rather than for the flow of benefits from the forest. This encourages dependency on government subsidy particularly in poorer areas and may lead to the situation where removal of subsidy leads to farmers ending protection of the forest and then unsustainably using the forest. The need to move from an objective of sole protection to protection through production is one means of trying to remove dependency on subsidy and to increase the link between sustainable use of the forest and development of sustainable rural livelihoods.

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2) Institutional and Governance issues - Designing and implementing systems of payments for environmental services may require changes in the legislative and regulatory framework. Weak governance and a lack of clearly defined property rights are threats to the success of any such system and are important constraints facing the application of PES in the Lower Mekong Basin. (a) Appropriate forms of property rights or tenure security play a key role in both economic incentives and payment arrangements because they control access to benefits and also define responsibilities for actions needed to insure their provision. Thus they determine who has access to particular resources, and whether those who pay the costs of management practices have access to any of the benefits, and therefore have an incentive for conservation. Difficulties with insecure tenure include: • People may become dispossessed and social problems may result. Rural

populations in developing countries mostly earn their living directly from subsistence agriculture or extraction of natural resources. Informal landowners whose land claims are widely recognised and respected can be efficient ES providers since they can control access; someone whose tenure is perceived as insecure and weak cannot, since external agents can occupy the land or harvest resources (Wunder, 2005) when land dedicated to conservation results in direct payments. Even if the local people become the direct beneficiaries of conservation-related payments, large numbers of people may become unemployed. This is likely to lead to social disruption, and many of the people are likely to continue their previous activities (Kiss, 2002).

• Without clear land title, upper watershed land users often lack the authority to

enter into contractual agreements and are therefore unable to benefit from payments (Tognetti et al, date unknown; FAO, 2003; Landell-Mills and Porras, 2002; Pagiola et al, 2002). They may also risk eviction as values are placed on services to which they lack recognized rights (Landell-Mills and Porras 2002). In some cases, upstream land users may be blamed unfairly for impacts to which their contribution may be insignificant, and displaced without any form of compensation, as values rise (Tognetti et al, date unknown).

Property rights may take different forms, ranging from informal rights or norms recognized by users, to various forms of formally recognized public and private ownership by individuals, groups or government entities (Tognetti et al, date unknown; Landell-Mills and Porras, 2002). Some PES cases show, however, that this is not an unsurmountable obstacle to establish compensations to the users providing the desired environmental services, at least temporarily, since this type of system can be considered as the beginning of a legal recognition process of their land use (FAO, 2003). (b) PES programs require a supporting institutional infrastructure. Market participants must have access to information on the value and volume of the services being exchanged. Participants must have opportunities to negotiate payments. Property rights to service commodities need to be clearly defined, and

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ownership has to be assigned. Monitoring and enforcement mechanisms are required. A network of supporting regulatory and institutional arrangements may be necessary if markets are to function effectively. In many cases, there is a need for new institutions, ranging from private sector contracts to public entities, to facilitate payment for services. For example, a “contractual culture” may not be sufficiently developed. Markets also require structures for financing, verification, monitoring, accounting and certification. Other necessary structures include business advisory services, planning devices and consultants, independent environmental advisory groups and capacity building. Establishing such market infrastructure is not easy and is rarely cheap (Pagiola and Platais, 2002). Without strong and effective institutional support, the success of PWES systems may be compromised for the following reasons: • WTP depends on stakeholder confidence in the effectiveness of proposed

management actions needed to insure that the service is delivered and that they will have access to future benefits. For example, Schilling and Osha (2003) found that in some cases, drop-out rates of participants reach 30% or more between the first and second payment, and incentive mechanisms had to be fine-tuned by asking for guarantees. This was found to be especially true where payments were “frontloaded” (paid out during the first years of a contract period) presenting few possibilities to enforce contractual obligations over longer periods of time. Value thus depends as much on effective governance and institutional development as on determining supply and demand (Tognetti et al, date unknown).

• Some of the parties involved may not be educated and may be distrustful of

authorities. They also may have been the objects of discrimination in the past. Thus, effective community institutions are essential to form a common position for negotiations on one or both sides. Communication and trust must be established between participants, and agreements need to be monitored and enforced (Shilling and Osha, 2003). The MRC could help build and strengthen these structures.

• Many of the suppliers of environmental services are likely to be the poor who

are particularly susceptible to manipulation by special interest groups. There is every reason to believe that PES will be subject to the same kind of political pressures. The credibility of the instrument can be seriously harmed if it is not insulated against such processes. Interest group pressure may result in the allocation of payments to those who are not the main providers, to non-priority regions, to non-priority target groups (for example, larger farmers), and in excessive levels of payments from which only the well-informed and well-connected will benefit.

A synthesis of environmental governance case study findings in mainland Southeast Asia by Dupar and Badenoch (2002) indicates there are still many questions about the appropriate scope of powers located at different levels of governance hierarchies, as well as about incentives, accountability processes and

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fiscal arrangements of intermediate-to-local level institutions appropriate for managing natural resources (Tomich et al, 2004). Developing a new market instrument for a particular service involves a unique set of stakeholders and governance structures. It also must correspond to that local ecosystem. Most markets, with its unique regulatory, fiscal, and legal context, will require substantial creativity, political leadership and willingness by stakeholders to consider new approaches. As knowledge develops in many cases, continued adaptation will also be needed. (c) There are likely to be significant costs (including transaction costs) involved in designing and maintaining such a scheme even though the basic economics of a strategy to use financial mechanisms in watershed management may be good and there are willing buyers and sellers. As the case studies by Perrot-Maître and Davis (2001) illustrate, stakeholder participation, negotiation, and institution building are fundamental to creating any new mechanism and can be expensive. Transaction costs arise through: • The research needed in many areas to define and trace the flow of ecosystem

services • Monitoring and enforcement, conflict management, and making necessary

changes in legal and regulatory frameworks • Mobilising and maintaining effective stakeholder engagement. Deals arranged

between upstream and downstream communities in watersheds frequently involve large number of participants. Hydrological threshold effects mean contracts must cover a minimum area of the watershed, often involving large numbers of landowners. Moreover, to avoid “free-riding” in consumption, and to convince beneficiaries to pay, broad participation is often essential. The result is a complex process of negotiation involving a range of upstream and downstream players, often with differing interests. Magrath et al (1997) attempted to calculate the costs of participation in Ghana and found that it accounted for 66% of project costs and 80% of the project officials’ time.

The complexity and expense required to address these issues will vary tremendously from watershed to watershed. For example, transaction costs are likely to be higher in a watershed, such as the Mekong, with many small forest landowners than in a watershed with a few large owners. Working with many small, dispersed farmers imposes high transaction costs, and special efforts are needed to ensure that the poor have access to the new opportunities created by PES programs. In Costa Rica a system of collective contracting has been developed through which groups of small farmers can join the PES program collectively rather than individually (Pagiola and Platais, 2002). Such costs need to be recognized when assessing the potential for a particular strategy as it is not always clear that PWES schemes are more cost-effective than other courses of action. Transaction costs can be reduced if the institutions

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involved in the implementation of the scheme know the local situation comprehensively and if the scheme is part of a broader programme on natural resource management (FAO, 2003). However, in evaluating transaction costs, it should be kept in mind that over time, history suggests that they may be reduced through improvements in technology and institutional arrangements (North and Thomas 1973, in Landell-Mills and Porras, 2002). (d) Governance is critical for emerging markets. Good governance, transparency and public participation in decision-making play a central role in the successful design and implementation of development policy. This is particularly important in relation to the management and exploitation of natural resources, where the scope for corruption, rent-seeking and political patronage is significant (OECD, 2005). 3) Sustainability - For systems of environmental service payments to survive, they must have secure sources of financing. This is especially important if payments are to be on-going as is usually necessary if land users are to have a continuing incentive to maintain the environmental services. As noted above, this entails identifying not only the beneficiaries but also the specific services they receive. Some important questions in this regard are: • Under what conditions land managers will be able to adopt and sustain

new land uses? This mainly depends on how long it takes the new land use to become competitive or to break even compared to the traditional or next best use of the land. In most Latin American contexts, it is thought unlikely that substantial levels of PES can be maintained from public budgets or that local financing mechanisms will be firmly established after some years. Unless land management in support of environmental service provision is economically beneficial, land managers are likely to revert to previous (i.e. ex ante) land uses. In the Mekong context, the potential service providers would need to be carefully identified before payment systems can be established. Much of the agriculture in the upper reaches of the LMB is still practised on a subsistence basis but is intensifying with population growth and land use regulations (e.g. eradication of shifting cultivation). In order to ensure that intensification does not result in negative downstream externalities, any payment scheme would have to consider the implications for subsistence. Conversely, the profits from logging are high and thus payments to discourage such practices would have to be extremely high.

• What are the appropriate vehicles for ensuring that payments actually

reach the environmental stewards? It has been extremely difficult to put into place operational schemes that allow payments to be made in a sustainable way. The major problems appear to be both the difficulty of measuring and valuing the services and of assessing the cost incurred by rural people in providing them. The basic requirements for a market in environmental services are rarely present. Incentive measures seldom provide a permanent or absolute means of achieving nature conservation and community livelihood improvement goals. The status and integrity of natural systems and community

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livelihoods, as well as the exogenous forces, which impact on natural systems, change over time. The continuous review and re-examination and, where and when necessary, redesign of the incentive measures is critical for ensuring their long-term viability and effectiveness (Emerton, 1999).

4) Political economy - The political economy issues deal with how to set up a process whereby (usually wealthier) resource users downstream are gradually/eventually convinced of paying for environmental services provided by (usually poorer) resource users upstream. Ecosystem service markets pose profound equity implications, as new rules may fundamentally change the distribution of rights and responsibilities for essential ecosystem services. Forest producers and civil society need to ensure that rules support the public interest and create development opportunities. The benefits of investments in ecosystem services will be maximised over the long term if markets reward local participation and utilise local knowledge. Studies of indigenous timber enterprises show that, on average, local communities invest as much in conservation as is available from outside donors or investors. Ecosystem service payments and markets should be designed so that they strategically channel financial payments to rural communities to enable conservation-oriented management to remain, or become, economically viable (Jenkins et al, 2004). Part of the problem resides in the genuine difficulty that exists in communicating a complex subject that many in the real world still consider an "economist's toy" (Tomich et al, 2004). While it may be impossible to put a precise dollar value on an ecosystem service, it is important to demonstrate its economic importance to generate support for financing the service. Because of the complexity and difficulty in determining the real economic value of the service in most cases, these values are usually devised according to rough estimates. This can be done in a variety of ways. One way is to value the cost of replacing the service, as the New York watershed case illustrates. Another way is to value the economic activities that depend directly on the service, as in the case of Energia Global’s hydroelectric facilities in Costa Rica. 5) Scale – Payment for watershed environmental services are generally considered to be most feasible as small-scale local level initiatives and located within national boundaries. In large-scale operations, where there is a greater diversity of environmental and socioeconomic conditions and interests, it is harder to establish links between causes and effects of watershed degradation. Cross-boundary deals pose larger risks since they fall under separate jurisdictions. There is also a tendency for small-scale pilot initiatives to be constrained by conflicting macro economic incentives and lack of a supporting policy and institutional context. In smaller catchments, in which there are community ties between upstream and downstream areas, and where stakeholders can directly see the effects of upstream land use practices, understanding these effects may be a sufficient

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incentive for them to diminish or halt land degradation, provided that there are economically viable alternatives. The situation becomes more complex at larger scales, in which more formal institutional arrangements are required to ensure enforcement and compliance. In large-scale operations, where there is a greater diversity of environmental and socioeconomic conditions and interests, the following issues become apparent: • It is harder to establish links between causes and effects of watershed

degradation. The link between suppliers and recipients of water-related ecosystem services becomes increasingly tenuous with distance since many other activities and conditions along the way can “dilute” the contributions made by a forest owner far upstream.

• The cost of collective action grows as more actors are involved. Agreements

need to be more standardized and require more regulatory infrastructure but do have the advantage of a larger pool of buyers and sellers (Rose 2002).

Payment for watershed environmental services (PWES) are thus generally considered to be most feasible as small-scale local level initiatives (Tognetti et al, 2005; Landell-Mills and Porras, 2002; Pagiola and Platais, 2002; Aylward, 2004; Johnson et al, 2004) where: • Transaction and administration costs are usually lower • There is a better information flow among providers and users • The service can be defined more clearly; and • The institutions involved may have a greater adaptation capacity. There is, however, also a tendency for small-scale pilot initiatives to be constrained by conflicting macro-economic incentives and lack of a supporting policy and institutional context. This suggests that there is thus perhaps significant scope for considering the benefits of PWES as one of the multiple objectives in an Integrated River Basin Management (IRBM) strategy that can be used to justify specific actions, by demonstrating their relative value for achieving objectives, and that has been developed in collaboration with stakeholders on a basin-wide scale. Effective coordination in watershed management between adjacent states could strengthen international deals (Landell-Mills and Porras, 2002). In terms of contractual arrangements: • As a general rule, contractual arrangements among private parties tend to

be more effective at smaller scales where the causes and effects of land management decisions are more certain, benefits are more tangible, stakeholders are more identifiable, and agreements can be better tailored to unique local circumstances.

• At larger scales, there is a greater role for government and other

intermediary organizations (Forest Trends – Watershed services) to facilitate transactions among more numerous and diverse stakeholders and to establish priorities. Lower levels of government in general have better information about

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farmer activities and incur lower costs to monitor them. They may also know more about the environmental benefits of these activities if the benefits are local. However, local government may not give adequate attention to services that are global or regional and to the program costs if the central government finances the conservation payments (Babcock, 2001).

6) Impact and effectiveness - While the promotion of payments for watershed protection has been gaining impetus over recent years, IIED and others raise the concern that little attention has been devoted to critically assessing the effectiveness of such systems. In some cases, PES schemes have been found not to be the most cost-effective method to attain watershed management objectives, since there may be other more efficient management mechanisms to guarantee delivery of the environmental service. “The literature fails to convince us that markets offer the optimal way of achieving improved watersheds” (Landell-Mills and Porras, 2002). Questions need to be asked as to whether markets provide a preferable mechanism for delivering watershed services to tried and tested regulatory systems. For the most part, studies offer superficial reviews of economic, social and environmental benefits with virtually no assessment of costs. Moreover, the benefits claimed tend to be associated with watershed protection itself, not with the introduction of markets (Grieg-Gran and Bann in Gutman, 2003). Market tools require certain social conditions in order to function approp