Feb 10, 2004 - Paper presented at a Water Policy Workshop convened by the Australian ..... Water effluent trading, such as the Hunter River Salinity Trading ...
Addressing water-related externalities: Issues for consideration Martin van Bueren Darla Hatton MacDonald
Abstract The environmental impacts of water supply and use — both in rural and urban areas — are currently the subject of intense scrutiny. In 1998 the Council of Australian Governments (CoAG) agreed to the principle of full-cost pricing for water, which includes externality costs as one of the items that should be recovered when setting administered prices. CoAG also agreed that water should be set aside specifically for environmental purposes to maintain the ecological health of river systems. As part of the National Competition Policy (NCP) assessment process, the progress of State governments to implement full cost pricing for urban water and irrigation water is coming under review. Formulating policies to manage externalities is proving to be a difficult task owing to misunderstandings about the nature of externalities, uncertainty about environmental impacts, differences of opinion about impacter versus beneficiary pays and inconsistent/unrealistic policy objectives. This paper reviews the current issues, summarises the different policy approaches and highlights some of the practical issues that need to be considered in addressing externalities.
Paper presented at a Water Policy Workshop convened by the Australian Agricultural and Resource Economics Society, 10th February 2004, Melbourne. Martin van Bueren, Senior Economist, Centre for International Economics, Canberra. Darla Hatton MacDonald, Economist, Policy and Economic Research Unit, CSIRO Land & Water, Adelaide
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Introduction Water reforms over the past decade, namely those initiated by the Council of Australian Governments (CoAG), have made significant progress in restructuring water charges so that they capture the so-called financial costs of water supply. These include the operation, maintenance, depreciation and capital costs of water supply infrastructure. However, the third party impacts on other users, including the environment, are rarely or only summarily addressed through administered prices. In the current round of National Competition Policy assessment process, States are obligated to demonstrate progress against the CoAG objectives of full cost pricing which is to include the cost to the environment, or externalities, for urban water 2003-04 and irrigation water in 2004-05. To date, efforts to meet environmental goals have focused mainly on direct allocation of water to environmental flows, which effectively assigns a property right to the environment. This approach is being complemented with non-price demand management strategies — for example, mandatory water restrictions, subsidies to encourage the uptake of water-saving technology and ‘waterwise’ education programs. State governments are currently faced with the challenge of determining appropriate policies for addressing a wide range of environmental externalities. This involves determining efficient levels of environmental quality and cost-effective, equitable mechanisms to deliver the improvements. Externality charges are being considered as a mechanism for recovering resource management costs, which include ‘defensive expenditures’ for maintaining/improving environmental quality. Charges are also viewed as a possible instrument for demand management. However, there are a number of potentially conflicting objectives inherent to most pricing policies and the implications of each objective need to be thought through carefully. Balancing often quite legitimate objectives will lead to "second-best" policy. Other tools will be required to augment these diluted price signals. This paper There is a range of issues that arise when considering policies for addressing environmental externalities. Formulating policies to manage externalities is proving to be a difficult task owing to misunderstandings about the nature of externalities, uncertainty about environmental impacts, differences of opinion about who should pay, and inconsistent or unrealistic policy objectives. To summarise, the main issues confronting policy makers are as follows:
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Many environmental relationships are poorly understood and as a result, the full nature of externalities is poorly understood.
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Water quality issues are intertwined with community demands for increased quantity of environmental flows. The scientific evidence suggests that water quality will only be partially addressed through increased flows.
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Meeting environmental goals can involve both infrastructure upgrading and reduced extraction of water.
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Baselines for measuring changes in environmental quality are often ill-defined and this can lead to unrealistic policy targets.
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Who pays for environmental restoration or improvements in environmental quality is still an issue.
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Developing water property rights that are resilient in the face of highly variable flow regimes, evolving scientific understanding and State borders is proving to be difficult.
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Principles for allocating costs between water users and government are still under development.
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Environmental standards and targets are seldom based on a cost-benefit approach that examines community willingness to pay for higher standards and the opportunity costs of diverting water to the environment.
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Processes to ensure cost-effective delivery of environmental standards are not always present.
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There is confusion about the role of administered prices — and the capacity of pricing to ‘internalise’ externalities.
The purpose of this paper is to provide an economic perspective on these issues. The paper also provides commentary on what progress is being made in overcoming conceptual and practical difficulties in addressing externalities.
Nature of water externalities A variety of externalities arise from the extraction, storage, distribution, use and the ultimate disposal of water. An externality is any impact caused by an activity that can be traced back to a human activity such as water consumption whose costs (or benefits) are not factored into the decisions of the economic agents involved in the transactions. Externalities are not confined to negative impacts — some impacts may provide positive benefits. For example, catchment management activities for the purpose of supplying potable water can result in some positive spillover benefits. For instance, development controls on the type of activities that can take place in a catchment in order to protect water quality provide spillover benefits such as improved biodiversity, recreation opportunities, visual amenity and reduced water pollution. Untangling the externalities The nature of externalities varies depending on the point along the supply chain at which the environmental impact is generated. Table 1 illustrates some examples of externalities associated with the extraction, storage, distribution, use and disposal of the water. Naturally, the type of externalities can be quite different in different locations and contexts, so table 1 is meant only to be indicative of the types of the types of impacts that may occur. Generally speaking, externalities are either related to the volume of water used or are independent of volume. For example, flow-related externalities depend crucially on the amount, quality, quantity, timing, duration and frequency of river flows. But the installation of fish ladders at dam sites to overcome barriers to fish migration are clearly unrelated to the volume of water used. Therefore, to mitigate the damaging effects of water supply activities it is often necessary to increase the quantity of flows, modify existing infrastructure to facilitate the delivery of effective flows and potentially change land-use in the catchment. For instance, current level of extraction and storages from the River Murray has reduced the low and medium sized flood events which in turn results in a loss of spawning cues for native fish populations and decreased recruitment of floodplain vegetation. It is useful to view extractive activities as having direct impacts on the physical characteristics or attributes of the environment which, in turn, generate indirect benefits or costs. The value of these impacts are either reflected by the economic surpluses generated by nature-based activities for which markets exist (such as eco-tourism) or peoples’ willingness to pay for non-market environmental services such as recreation, visual amenity and biodiversity.
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Table 1 Types of water-related externalities Catchment management activities Extraction Storage stage
Use Distribution and inter-storage transfers Disposal stage
Direct impacts on People and Ecosytems Biodiversity protection (+) Reduced pollution (+)
Indirect impacts Improved recreation in catchment (+) Visual amenity (+)
Reduced flushing of floodplains (-) Creation of sulfidic materials (-) Flood mitigation (+) Reduced downstream flows resulting in degraded streambank vegetation, aquatic weeds and potentially higher salinity (-) Barriers to fish (-) Habitat disturbance at dam site (-) Salinity induced through rising ground water tables (-) Disease transfer (-) Flow-related damage (-) Temperature pollution (-)
Reduced amenity (-) Lost biodiversity (-) Dam site recreation (+) Heritage value of dams (+) Boating on the dam (+) Decreased amenity values (-) Reduced fishing opportunities downstream of dam (-)
Algal blooms (-) Degraded streambank vegetation (-) Damage to seagrass (-)
Reduced recreation (-) Reduced recreational and commercial fishing (-) Reduced amenity (-)
Agricultural yield loss and infrastructure damage (-) Threat to local populations of fish (-)
Environmental damage functions are poorly understood Developing policies for addressing externalities calls for a sound knowledge of the cause-effect relationships between water supply activities and ecosystem damage. Estimates of the type, scale and rate of change are required for the purposes of making sensible, efficient policy decisions. At present there is considerable region specific quantitative information. Biophysical scientists are not generally able to provide damage functions mapped in the correct dimensional space for use by economists or natural resource managers. Further, monitoring programs often have not been in place long enough or maintained over large enough geographic areas to provide more than cautious advice. In some cases, the science has not been targeted to answering policy relevant questions. For example, a recent report by the NSW Auditor-General concluded that: There are significant gaps in the monitoring and evaluation of water quality. Based on the information currently available, it is not possible for anyone to gauge in a comprehensive way the health of NSW rivers; the main risks to those rivers and the sources of risk; and the strategies to manage those risks (NSW Auditor General 2003).
To date, many of the terms used to describe the outcomes of alternative management strategies are subjective — for example, healthy ecosystem and deteriorating quality, where quality is not adequately defined in objective terms. In many cases, the modelling that has been done focuses on the ‘micro’ level and produces predictions, for water quality factors such as salinity, chlorophyll-a, nitrogen and phosphorous concentrations. Little research has been done to understand what these changes might mean at a macro level, with implications for the health of ecosystems or landscapes.
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The prediction and measurement of impacts is confounded by the fact that the benefits arising from changed environmental flows are temporal. Some environmental impacts will be quickly identifiable while most will not be evident for a considerable length of time. Furthermore, it is difficult to disentangle the impacts caused by water users (flow-related impacts) and other activities — such as pollution from point and non-point sources. Efforts to improve our knowledge of environmental relationships are under way, but in the meantime the lack of basic information about environmental response is impeding policy development.
Baselines for measuring environmental change In order to develop environmental targets that are realistic and that can be ‘plugged in’ to a policy process, it is necessary to establish a baseline against which to measure changes in environmental quality. Returning the environment to pristine conditions is generally not realistic but principles of stewardship require the development of strategies to manage the serious threats and irreversible outcomes to riverine and groundwater systems. Often a pragmatic choice is to draw a line at some point in the past or to use the current level of environmental quality as a baseline against which to examine past and future changes — as shown in Figure 2. For most river systems, bio-physical scientists believe that environmental quality will continue to degrade under current levels and patterns of extraction (Wentworth Group, 2003) Figure 2
Measurement of environmental change
Environmental quality
Legacy impacts
Pristine environment
Restoration option
Current quality
Maintenance option Contemporary impacts
Year of dam construction
1997
Current flows
2020
The NSW Independent Pricing and Regulatory Tribunal (IPART), which oversees bulk water pricing in NSW, have drawn a ‘line in the sand’ and taken the environmental conditions and standards that existed in 1997 to be a baseline for the purposes of examining past and future externality costs (IPART 2001). Using this approach, it has defined two different types of costs: !
Legacy costs are equivalent to the damage caused by water supply activities undertaken prior to 1997. The future costs involved in restoring environmental quality back to levels that existed pre 1997 are defined as legacy costs. IPART is vague on what process should be used to determine the appropriate level of restoration, except to say that legacy costs should be limited to those actions that are necessary to meet community standards that prevailed in 1997.
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Contemporary costs are those that arise from damage caused by current and future water supply activities, as measured relative to the 1997 baseline level of environmental quality. Again, IPART is silent on whether it is indeed efficient to maintain quality at 1997 levels. It
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abstracts itself from passing judgement on these matters and makes the implicit assumption that community standards and values will dictate environmental targets.
First-best and second-best solutions The goal of managing externalities is not to eliminate them but to take account of the spillovers when making resource allocation. This can be done either by using economic instruments that aim to ‘internalise’ the externality into water users’ decision making (for example, property rights, taxes or subsidies) or by using regulatory and education approaches. The Draft Guidelines for Managing Externalities prepared for the High Level Steering Group on Water (June 2000) drew attention to four signalling mechanisms — property rights, charging, grant and fee rebates and standards. Governments have generally opted for environmental standards, quantity-based targets and administered reallocation of water to the environment to address externalities rather than price-based mechanisms. Property right approaches are beginning to emerge but are not widespread or well recognised. For instance, the concept of water utilities being able to sell water savings achieved through better transmission efficiencies (eg reduced evaporation losses) is relatively new has not been embraced by all States. A first-best solution would require water to be priced to include externality impacts, which may involve ‘tagging’ the water as to when and where the water was extracted and when and where the water was used and finally disposed of in the environment. This approach would send clear signals about the impact each kilolitre of water has along the water cycle. Despite the elegancy of this solution, it is doomed to failure due to the intensive information requirements and administrative logistics. Operationally, a better strategy is to use a suite of pricing, regulatory and other mechanisms that collectively result in the efficient management of externalities. First best solutions are often not achievable because the conditions required to achieve these results do not exist in the real world. We are often left in the world of second best, which is described in the literature as an optimal departure from the first best situation (Lipsey and Lancaster, 1956). For example, irrigators in New South Wales, Victoria and South Australia extract water from the River Murray. There are a series of unintended impacts that occur as a result of the extractions. Toxic algal blooms are linked to the presence of nutrients, decreased flows and regulation of the river. Decreased flows have resulted in closure of the mouth of the Murray and without regular flushing, the fragile ecosystems of the Coorong have been affected. These externalities would be internalised in the decision making of irrigators if a perfectly designed externality charge was put in place. This is known as a Pigovian tax. The tax would reflect the costs imposed by upstream users upon downstream users including the needs of the downstream ecosystems. A Pigovian tax would tag the water according to where it was extracted, where it was used and how it was returned to the environment. Pigovian taxes might result in some very different patterns of extraction. Even though a perfectly designed Pigovian tax is probably not achievable, does this mean we are left in the realm of second best solutions? The answer is yes but good second best policy can yield results that leave society better off. There are a number of potential solutions available including externality charges which will approximate a Pigovian tax as well as other market based incentives mechanisms. The first step is to establish a level of environmental quality that is efficient from society’s perspective.
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Establishing efficient costs (or targets) Environmental targets are often developed without paying due regard to the cost of achieving the targets or the likely benefits that will ensue. Costs include direct implementation costs and, in the case of environmental flows, the opportunity costs of reallocating water to the environment. The estimation of these costs is relatively straightforward but quantifying the benefits is difficult owing to the fact that many environmental ‘goods’ are not traded in markets. Various survey techniques have been developed for estimating these non-market benefits and the techniques continue to be refined. Choice Modelling is one such technique that has been applied to valuing river quality improvements (recent studies are van Bueren and Bennett 2002, Bennett and Morrison 2002, and Loch, Rolfe and Bennett 2002). Figure 3 illustrates the steps that are required for valuing environmental impacts using the Choice Modelling method. Increased environmental flows are used as an example. Moving from left to right, the first step is to define the quantum change in flows and various aspects of flow management which have an influence on environmental outcomes. Second, the potential impacts of the new flow regime need to be specified — both in ‘micro’ scientific terms and in terms of changes to environmental attributes that have relevance to people, which are usually at a more macro level — such as recreation opportunities, visual amenity and wildlife populations. The third step is to value these attribute changes using the Choice Modelling technique and aggregate the household value estimates to the appropriate population (ie those affected by the changes). This process not only establishes an estimate of what the community is willing to pay for improved environmental quality, but also teases out how people value specific attributes — which enables the policy maker to package up policies that deliver the greatest benefits per unit of expenditure. Figure 3 Process for valuing environmental benefits Environmental flow regime
Quantity of increased flows ! GL per annum ! relative to current allocation
Other management variables ! duration ! timing ! frequency
Modelling and expert opinion
Value of externalities
Choice model $ per unit change in attribute Biophysical changes ! outcomes ! processes
X
! ! ! !
Attribute changes recreation quality amenity waterbirds etc.
Scale of change X Number of h/holds affected
Environmental benefit ! $ impact per GL increase in environmental flows.
Cost effective delivery of environmental targets Another plank of the CoAG water reforms of 1994 is the requirement that services are delivered in a cost-effective manner. The reforms require that ‘water and wastewater service providers have a commercial focus, that services are delivered as efficiently as possible and that service providers seek to achieve international best practice’ (NCC, 2003). This same principle should apply to the delivery of
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environmental targets. State governments have made progress in ensuring that service provision is contestable, particularly the sourcing of input services for operating water supply schemes. Often there is more than one option for achieving the same environmental target. For instance, waterway pollutants (salt, nutrients, sediment etc) can be reduced in a number of ways. One option is to dilute the concentration of pollutant by flushing the system with additional flows. Alternatively, polluters could be regulated to reduce their discharges into the river. A third option is to treat the water to remove the pollutant (an engineering solution). The choice of option or options should be based on cost-effectiveness of achieving the mitigation target. Water effluent trading, such as the Hunter River Salinity Trading Program, allows the market to select the most efficient option or package of abatement methods. While trading programs can be an efficient mechanism for delivering an environmental target, the transaction costs associated with defining, verifying and enforcing abatement credits can outweigh the potential efficiency gains. Directly addressing the cause of the externality is often the most effective policy response — as opposed to treating the symptoms. This requires identifying the source of the externality and determining the most effective mechanism to reduce the impacts. For example, loss of water quality associated with turbidity or nutrient discharge could be better managed through taxing soil or nutrient run-off rather than through increased water charges.
Who pays? An important question that needs to be sorted out in any discussion of environmental impacts is "Who should pay?" We summarise and extend the arguments of Cope (2002). Under an impacter pays approach, it must be possible to identify which water users are causing the environmental damage, the amount of damage that they cause and a mechanism to transfer the cost to encourage a reduction in the damaging activities. This principle, when applied in practice, relies on establishing the appropriate points for measuring incremental damage, as information often does not exist for precise measures. Under a beneficiary pays approach, the groups that benefit from damage mitigation fund the remedial activities. Under this approach, water users pay for any private benefits received from improving the environment and the community, through its taxes, pays for the broader public benefits. Arguments for beneficiary pays are often presented for costs which are difficult to assign to any particular user or damages that occur before the nature of the environmental problems is understood. Extending this line of argument in terms of where rights reside or perceived to reside, if one takes the view that water and environmental services are a State-owned resource, then water users should pay the externality costs - the ‘impacter pays’ model. On the other hand, if the view is taken that the rights belong to water users, then the public should pay — the ‘beneficiary pays’ model. IPART has developed guidelines on how externality costs should be allocated between water users and the greater community. summarises IPART’s approach. Once it has been decided what level of environmental quality is deemed efficient from a social perspective, the next step is to disentangle legacy costs from contemporary costs. It is IPART’s view that legacy costs should be met entirely by government, principally because current and future water users should not be required to meet the expenditure necessitated by the activities of past users. The South Australian government has taken a similar stance as it has agreed to cover the costs of salinity management schemes caused by pre-1988 irrigation development. The salinity costs of all post-
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1988 irrigation development are the responsibility of irrigators (RMCWMB 2003). While not spelt out in IPART’s guidelines, we assume that other examples of legacy costs would be the need to build fish ladders to allow fish to migrate past dam walls and modifications to infrastructure to facilitate the effective delivery of environmental flows. The tribunal is less definitive on how contemporary costs (due to current and future extractions) should be allocated. The basic principle is that costs should allocated in proportion to the contribution each stakeholder (water users and government) makes to creating the costs or the need to incur the costs. Thus, the government would be responsible for funding any quality improvements due to changing community values post 1997. For example, public demand for increased environmental flows would fall into this category. Bulk water users would be required to pay for that component of contemporary costs that arise due to ‘the need for bulk water to be delivered from assets which might otherwise be decommissioned rather than upgraded to meet contemporary standards’ (p.32 IPART 2001). Examples of these costs could include ongoing river monitoring and water resource planning. But it is evident from current debate on cost allocation that the issue of who owns the rights to environmental services is still unclear. Figure 4 IPART approach to allocating externality costs Assess efficient costs ! operational ! capital ! opportunity costs Legacy costs ! damage caused pre 1997 ! fully allocated to government
Contemporary costs ! damage caused by current and future activities ! costs to be shared
! Costs allocated to impactor or beneficiary in proportion to the contribution their actions have on the need to incur the cost.
In the case of water quality, it is often difficult to establish whether water users are responsible for the environmental problem or whether some other production activity is the prime cause. Consider stream salinity. The concentration of salts is influenced by the amount of salt entering the watercourse — possibly from dryland farms — and the amount of environmental flows that are flushing the system. Stream salinity is exacerbated by ‘excessive’ water use but it is not the root cause of the problem. In these circumstances equity becomes an issue with respect to which parties should be required to bear the costs of addressing the problem.
The role for administered prices Environmental groups frequently advocate that water is too cheap and that consumers would use water more carefully and efficiently if they were required to pay more. Broad-brush statements of this type overlook the fact that administered pricing could have a number of roles and it is important to be clear about the rationale for raising charges. The potential roles for water charging include:
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! recovery of commercial water supply costs — putting aside environmental concerns; ! recovery of environmental compliance costs arising from standards; ! a demand-management instrument for signalling to users the cost of environmental impacts (or externalities) which may be additional to those accounted for by the environmental standards; ! a charge to signal resource opportunity costs to users in situations where water is scarce and water trading is inhibited. The goal here is to improve the efficient allocation of water among consumptive users; ! recovering a community return (or resource rent) on a State-owned resource; ! attempting to address regional equity issues; and ! targeting charges to market segments with the ability to pay. The challenge for policy makers is to determine which of the above objectives are being sought and then to develop a pricing policy accordingly. These objectives may seem reasonable individually but are unlikely to be achieved simultaneously. Financial cost recovery It is well known that economic efficiency can be achieved by maximising the net value of water use to society. The net value would be based on the value customers receive minus the marginal cost of supply. This is often described as the marginal cost pricing rule where the optimal quantity to be supplied is where the marginal cost equals the marginal willingness to pay (McNeil and Tate, 1991). There is a short run and a long run interpretation to this rule. In the short run, capital cannot be easily altered and as a result, marginal cost is based on the factors are variable in the short run. As long as there is capacity in the system, this pricing rule will result in an economically efficient solution. In the long run, however, expansions and replacements of infrastructure are required and planned for and as a result, capital is said to be variable. In the long run, a pricing rule where long run marginal costs equals willingness to pay will result in an economically efficient solution over the long run. However, a water utility or an irrigation company may not generate sufficient revenue to cover all its costs as there are often significant fixed costs. Pricing at long run marginal costs will be economically efficient but not financially viable if average costs exceed marginal costs. In the long run, forcing a firm with a decreasing marginal cost function to price at marginal cost will force it out of business. A solution to this is to use what is commonly referred to as a two-part price (Call and Holahahn, 1983) that fulfils the cost recovery objective while still retaining efficiency aspects. The two-part price consists of a fixed charge and a volumetric charge based on the marginal cost of supplying water. This is a strategy employed by a number of water utilities in Australia and in other industrialised nations (OECD, 1999). Issues of regional equity and ability to pay are often at odds with economic efficiency. One price across regions will not reflect different supply costs as a result of differential distribution costs or costs to the environment. Using ability to pay may result in profitable businesses (while in a position to pay considerably higher rates), cutting production and employing less people and this may correspond to a net social loss to society. Demand management versus recovery of environmental compliance costs Pricing water for the purposes of demand management can take many forms. Demand management may be employed to reach a particular target level of consumption in order to avoid large infrastructure costs or to avert building a dam. If used blindly to achieve a goal of
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conservation, there may be unintended reductions in economic activity as well as hampering future opportunities for economic growth (that is, the demand management objective must pass the public benefit test). The effectiveness of using price as a tool for demand management or ‘freeing up’ water for the environment is dependent on water users’ price elasticity of demand. For activities in which water constitutes a small proportion of total input costs, increasing charges is unlikely to be effective. Many irrigation enterprises fall into this category and have relatively inelastic demand at low water prices. Thus, externality charging can sometimes be a blunt instrument in addressing environmental problems because it is difficult to determine how water users will respond to higher prices. Depending on how the charge is structured, lower demand for water can also result in reduced revenues for water supply utilities. This conflicts with the objective of raising revenue to recover the infrastructure and operating costs of meeting higher environmental standards. If costrecovery is the main policy goal, it will be necessary for users to have an inelastic demand function. In this sense, administered pricing cannot be used simultaneously as a tool for both demand management and cost recovery. Scarcity pricing Often there are institutional impediments that stand in the way of efficient water use. Administered pricing to reflect water scarcity values may be necessary when water markets are not operating efficiently. The purpose of a scarcity charge is to signal resource opportunity costs to users in situations where water is scarce and water trading is inhibited. However, in the absence trading, it is often difficult to estimate what scarcity rents exist in the system. Setting an inappropriate charge rate could exacerbate rather than improve inefficiencies. The first-best solution is to remove the impediments to water trade. What pricing cannot address While perhaps obvious, it worth stating that externality charges are unsuitable where the externality has severe and irreversible consequences on other water users or environments. Externality charges are not a substitute for smart regulation and monitoring programs. Where the externality is less severe but has significant threshold effects, quantity-based market-based instruments are more suitable.
A Pragmatic Second Best Approach In the absence of a series of Pigovian taxes for erosion, turbidity, salinity, decreased flows, etc., a series of market-based instruments, including a couple of second best externality charges may well serve the purpose. In a pragmatic approach, the current two-part price structure might be adapted to deal with the quantity related externalities. Where an externality can be adequately traced back to the extractor and user, there is an opportunity to introduce a quantity-based charge. Where water quality related externalities are to be mitigated by modifying or building new infrastructure, there would be a series of new fixed costs. This is similar to how the cost of new infrastructure to address regulations would be passed on. The two-part price approach to allow for cost recovery of the fixed externality costs but the volumetric charge retains the marginal properties in order to send signals to users. For instance, one-time costs to adapt the existing infrastructure to mitigate the quantity-unrelated externalities
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would be included in fixed charges. Quantity related externalities such as inadequate environmental flows would be included in the volumetric charge. Figure 5 describes the components of an externality charge that might be incorporated into a conventional two-part price. The externality costs have been separated into a quantity and a quantity-unrelated component. The quantity related externalities are directly related to each kilolitre of water extracted from the river and stored. Quantity-unrelated externalities might include the environmental impacts due to the existence of the infrastructure to regulate and store quantities of water. This is a pragmatic approach for incorporating externalities charges in the administered price of water. This approach allows for principles of economic efficiency to be retained as well as cost recovery. In the case of externalities directly related to quantity, the cost relates only to the incremental damage to third party and does not include any modifications to infrastructure. In practice this will be an approximation. Modifications to infrastructure are actions by the firm or utility to comply with increasing environmental standards would enter the fixed charge. For example, modifications to a dam for variable off-takes to allow for warm water releases would enter short run fixed costs. There is an important difference between an externality charge and cost recovery. The volumetric externality charge is designed to send signals to users to change behaviour and the fixed charge is designed to cover costs. Figure 5 A Two-Part Price involving Externalities SR Fixed Costs largely unrelated to quantity of water
Externality Costs unrelated to Quantity
SR Variable Costs Costs that depend on the quantity of water supplied
Externality Costs directly related to Quantity
Research Monitoring, Enforcement
Some maintenance
Scheduled Maintenance
Treatment Costs
Capital Costs
Operating Costs
expansions, new pumping stations, etc.
Some labour, pumping, etc.
Implications of two-part pricing There are important implications of two-part pricing that need to be acknowledged. Large fixed cost charges do not encourage consumers and businesses to change behaviour and take account of their choices, as the fixed charges are often unescapable. However, there are ways to encourage conservation in general or encourage conservation in specific locations by allowing for rebates of fixed charges if particular targets are met. This is where it is important to look at the mix of market-based instruments. Wherever possible, volumetric charges should be explored - not placed in the "too hard basket" out of hand. Volumetric charges encourage some of the changes in resource use that may well
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need to occur. Pursuing engineering or infrastructure solutions will increase fixed costs and may well re-enforce current patterns of use. An example is the choice between volumetric sewage charges or upgrading sewage treatment plants. A volumetric sewage charge could address seagrass dieback by reducing the volumes of sewage reaching the end of the outfall. Volumetric sewage charges would result in some opportunities for other technologies and solutions. Currently the economics of wastewater recycling is impractical without public subsidies given the large fixed cost of current infrastructure.
Environmental flows in the Murray — a case study As we consider specific examples of catchments or river basins, it becomes apparent that policies and approaches cannot be considered in isolation. With the lower connected River Murray, it becomes apparent that the specifics of water pricing, externality charges and layers of environmental policies need to be considered as a whole. Scientists have expressed concern about the reduced flows in the Murray (Wentworth Group, 2003). The level of water diversions has significantly reduced small and medium level flood events in the lower reaches of the River Murray, particularly during winter periods. As a result, the lower reaches of the River Murray are experiencing drought-like conditions in over 60 per cent of years in comparison to what would have happened under a natural flow regime. Environmental flows are determined at present by agreements between State and Territory governments in the Murray-Darling Basin. The recent agreement by CoAG to acquire 500 GL of water entitlement for environmental flows represents an important example. The 500 GL may only be a first step and governments, responding to community pressure, may agree at some future date to increase this allocation. Figure 6 summarises what might happen in a market for water if externality charges and an entitlement for the environment were introduced. If the Commonwealth and State governments opt to enter the market and buy water entitlement on a permanent basis for the environment, there will be a series of market reactions. First we can anticipate an immediate announcement premium that is related strictly to expectations of the irrigators for government funds to chase up the price. It can be expected that the announcement of a programme to relocate water from users to the environment will result in markets assessing the information and an increase in the Figure 6
Components of water price after the allocation for the environment Future
Summary
Now
Water Quality Externalities Externalities
Externalities Related unrelated to quantity imposed to Quantity dissipate with ↑ Allocation for on environment and others the Environment
Remain
Scarcity Rent Scarcity Rent intertwined with externalities related to
(Not Charged at present)
quantity
Externalities related to quantity imposed on environment and others
Financial Variable Costs
Trading Price of Water ↑
excluding externalities
excluding externalities
Financial Fixed Cost
Financial Variable Costs
Current
Financial Fixed Cost
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price of permanent water rights can be expected. Marsden Jacob has indicated that increase of 20% can reasonably be expected. (Young et al, 2001) Irrigators may also view their water rights as more secure in the sense that a move to improve environmental flows has been in the public forum for a number of years. As water is bought up and used for environmental flows, there will be a series of price increases as water rights become increasingly scarce (inward shift of the supply curve). It is anticipated that water will be released from the most willing sellers first, followed by uses with relatively low gross margins and then by increasingly higher value uses. Thus we are suggesting that supply is somewhat elastic (i.e. price responsive). It is difficult to anticipate what sort of technological innovation and water saving technologies will occur. Irrigators have demonstrated their ability to adapt in the past. However, these changes will not come without social cost. Some irrigation systems may be driven out of business because there will be so little water left in the system to deliver. The result may be stranded assets and communities having to face the prospect of an eroding economic base. The externalities relating to inadequate flows will decrease as the environmental flows increase. As the allocation to the environment shifts, scarcity rents will increase significantly. Scarcity rents are the premium that a scarce factor of production can attract. The value of water entitlements in the lower connected Murray River represents a scarce factor of production. Scarcity rents are a forward-looking concept that should anticipate future increases in demand and changes in costs of extracting the resource according to Tietenberg (1992). Thus, the scarcity rent and externality costs will be intertwined throughout the period of adjustment. A summary of the changes that would is illustrated in Figure 6. As water for the environment is acquired over time, the trading price of water will provide a clear signal of the scarcity rents that are attributable to water. A volumetric externality charge could be introduced once a commitment has been made to return larger volumes of water to the environment recognising that as water is returned, the externality charge will become a scarcity charge over time. The fixed cost charge related to adapting and upgrading infrastructure will ensure that these costs are recovered.
Conclusion The key message from this paper is that there is still some way to go in developing sound guidelines and policies for addressing water-related externalities. Some significant progress has been made in conceptualising the problem and establishing pricing principles — such as those contained in IPART (2001) and the Victorian Government’s Green Paper (DSE 2003). However, more attention needs to be paid to:
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clarifying property rights in water and the provision of environmental services — which is important for determining who should bear the cost of environmental improvements and lowering the costs of meeting targets;
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establishing a robust set of ‘cause and effect’ relationships to assist policy makers in assessing the environmental impact of alternative water management options; and
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greater scrutiny needs to be applied to the cost-benefit of environmental targets, which will involve techniques such as threshold analysis (the minimum size of environmental benefit required to offset the cost of delivering the target — including full implementation and opportunity costs).
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DSE [Victorian Department of Sustainability and Environment] (2003). Securing our Water Future, Green Paper for Discussion. August 2003. IPART [Independent Pricing and Regulatory Tribunal, NSW] (2001). Department of Land and Water Conservation Bulk Water Prices, Determination No. 3, December 2001. Lipsey, R and Lancaster, K. (1956). The General Theory of Second Best (1956). Review of Economic Studies 24: 11-32 McNeill, R and Tate, D. (1991). Guidelines for Municipal Water Pricing, Social Science Series No. 25, Environment Canada, Ottawa, Canada. MDMC [Murray-Darling Basin Commission] (1996). Setting the Cap, Report of the Independent Audit Group, Canberra, ACT, Executive Summary.
MDBMC. [Murray-Darling Basin Ministerial Council] (2002). The living Murray – A discussion paper on restoring the health of the River Murray. www.thelivingmurray.mdbc.gov.au NCC [National Competition Council] (2003). National Competition Policy Water Reform Assessment Framework 2004, December 2003. NSW Auditor-General (2003). Protecting our rivers performance audit (in brief), Report, Sydney, http://www.audit.nsw.gov.au, Accessed 12 May 2003. OECD, (1999). The Price of Water: Trends in OECD Countries, OECD Environment & Sustainable Development, 1999: 5, 1-170. Rolfe, J., Loch, A. and Bennett, J. (2002). Tests of Benefit Transfer Across Sites and Population in the Fitzroy Basin, Valuing Floodplain Development in the Fitzroy Basin Research Report no. 4, Central Queensland University, Emerald. RMCWMB [River Murray Catchment Water Management Board]. (2003). Understanding the Water Allocation Plan for the River Murray. Government of South Australia. Tietenberg, T., (1992). Environmental and Natural Resource Economics, 3rd ed., HarperCollins Publishers, U.
van Bueren, M. and Bennett, J. (2002) Australians and Natural Resource Management 2002, in NLWRA (National Land and Water Resources Audit) 2002, National Heritage Trust, Canberra, pp. 128-34. Wentworth Group, (2002). Blueprint For a Living Continent: a Way Forward From the Wentworth Group of Concerned Scientists, WWF Australia, Sydney, NSW. Young, M., Young, D., Hamilton, A., Bright, M. (2002). A Preliminary Assessment of the Economic and Social Implications of Environmental Flow Scenarios for the Murray River System, Project Report, CSIRO, Adelaide, South Australia.
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