Executive summary
Economic instruments have been described as promising tools for advancing sustainable development in New Zealand (Sinner and Salmon, 2003). Sometimes described as "market-based instruments", these instruments seek to bring market opportunities and processes into areas that have been traditionally controlled by direct regulation, information and motivational processes.
In the area of water quality, economic instruments hold potential to speed adjustment towards optimal outcomes and stretch available resources. But there is devil in the detail. To be effective they must be well designed and, in particular, there must be adequate investment in science and in the administrative arrangements necessary to make them work.
Often these instruments need also to be supported by the development of standards, regulation and other instruments. Economic instruments are rarely a substitute for regulatory and other approaches. They just make it possible to achieve desired environmental outcomes at less cost. They do this by creating incentives for firms and households to act in the interests of society. For those who have an impact on water resources - whether industries, farmers or households - economic instruments allow choice and may result in cost savings when compared with strict prescriptive solutions.
Types of instrument
This report focuses on opportunities. At the end, it recommends the introduction of a range of pilot projects which, by trialling the use of economic instruments, would develop expertise and experience in New Zealand. This approach would also reduce the risk of failure.
The report offers a framework for the assessment of alternative instruments that will assist decision makers to identify which instruments can most appropriately be applied to a particular water quality problem. Sometimes, instruments are most appropriately used in concert with one another. Movement from theory to practice requires being able to identify the prerequisite conditions necessary for their application.
Economic instruments work either by changing prices or by limiting the quantity of an environmental resource that may be used. Thus, the suite of instruments available can be classified easily as:
- Price-based instruments and
- Quantity-based instruments.
To facilitate the work undertaken in this report and ensure that the report focused on opportunities relevant to New Zealand, a particular set of instruments were selected by the Steering Committee for consideration in this report:
- Price-based
- environmental charges
- tendering
- compensated covenants
- land leasing
- Quantity-based
- transferable permits
- environmental offsets.
A short description of each of these instruments is provided in the second section of the report. The emphasis is on instruments that are currently not widely used in New Zealand. New Zealand has developed some innovative approaches with respect to covenants and has important experience that could be extended to other countries.
Instrument choice
Choosing the most appropriate instrument (or mix of instruments) is difficult and often context specific. The third section of the report provides a framework designed to simplify this process. It focuses on the attributes and conditions needed for an instrument to work. An efficient screening process is offered. Environmental processes of concern, monitoring technology, market conditions and administrative arrangements all have to be considered. The range of values held by different cultural groups is also an important factor to consider. When, for example, these groups have different risk profiles, they can be expected to respond to the introduction of the same instrument in a different manner.
The screening process offered provides a sufficient base of information to answer these key questions:
- Which of the variants of economic instruments are feasible in the existing institutional settings?
- What is the potential of different economic instruments to ensure environmental quality goals are met?
- What is the potential of different economic instruments to reduce the cost of meeting environmental policy objectives?
The result of applying this screening process may not be a definitive identification of "the" economic instrument for a given problem. Rather, for any particular water quality problem, use of this screening process should result in:
- Identification of the types of instruments that are feasible given the current institutional setting, and the range of institutional changes that might be required;
- Identification of the environmental process, institutional setting, market characteristics, technology and policy design attributes that favour or impede reliable and cost-effective realisation of natural resource management (NRM) policy goals.
Sometimes, new administrative processes or new regulations must be introduced before a market-based instrument can be introduced.
Non-market valuation
The Terms of Reference for this report also required a review of the role of non-market valuation in the use of economic instruments. Essentially, non-market valuation offers a way to understand the degree to which market instruments should be used. It can also assist with the preparation of cost-benefit analyses designed to advise whether or not the benefits from using an instrument are likely to be greater than the costs of doing so.
Application to New Zealand
Finally to place these instruments in a New Zealand context, two case studies are presented. The first focuses on diffuse source nutrient pollution associated with agricultural drainage into groundwater which then discharges into freshwater lakes. The second focuses on stream and estuary sedimentation as a result of surface runoff from urban development and forestry.
The case studies provide a focus for the development of recommendations for implementation. It is inevitable that there will be some political aversion to new policies like higher environmental standards, differentiated charge rates based on outcome or input use levels, and additional development restrictions. Such aversion does not have to stifle change. Standards that limit how property can be used have been introduced in the past and are now widely accepted. For example, the right to sell farm products are typically conditional on meeting certain food safety and trade related restrictions on production.
The case studies lead to the conclusion that:
- Tendering could be used to deliver more efficient incentive payments. This would involve soliciting bids to take actions to reduce nitrate or sediment loading and choosing among bids based on levels of measurable factors correlated with the outcome of interest (e.g. prioritisation of bids to reforest based on slope and proximity to vulnerable water bodies).
- Offset approaches could be implemented by setting limits that preclude future conversion of land to pasture to control nitrate loading or setting limits on logging or urban development to control sediment loading. Then some level of actions such as livestock farming intensification, urban development or forestry could be allowed where compensating mitigation is provided based on formulas that would guarantee a "net" decrease in nitrate or sediment load.
- Tradeable permits could be applied to either nitrate or sediment loading by placing a cap on the level of nitrate or sediment load allowed from each source. Alternatively, a cap could be placed on levels of allowable input use for some input correlated with nitrate or sediment load. Those able to reduce loading or input use below their cap level would be able to sell permits.
Successful introduction of change can be facilitated with several strategies. One useful approach involves a transition to higher standards with an initial period of reduced compliance burden, followed by a period of gradually increasing standards and penalties for non-compliance. The approach can reduce the perceived threat of changes by allowing individuals to gain some degree of comfort with the production modification required before there are serious sanctions for non-compliance.
Issues around the development of institutional arrangements, such as standards, were identified as a factor that limits the use of economic instruments. Several mechanisms could be used to create more effective standards that could then be used to limit activities that are the source of diffuse source water quality externalities. For example:
- Discharges from diffuse sources could in principle be regulated by local councils under the resource consents process of the Resource Management Act (RMA) through requirements for mitigation under defined conditions.
- Development of catchment-based water plans could be required that provide standards for environmental outcomes and best-practice performance. This approach was intended in the original RMA enabling legislation but has only been pursued by three councils.
- Either of these above listed approaches could in turn be augmented by offset or tradeable permit approaches for agricultural and forestry diffuse source water quality issues.
- More fundamentally, changes in standards relating to activities influencing water quality are possible at the national government level under section 43 of the RMA. New Zealand is currently in the process of developing standards for air quality and landfill gas under these provisions and it would be possible to develop standards for water quality in a similar way.
- Another fundamental change in the RMA worth considering would involve clarifying the ambiguity between provisions for continued land use and intensity at current levels (provisions 10 and 20a) and provisions prohibiting discharges with demonstrably significant adverse effects. This could enable development of more effective standards and support economic instrument development.
- In peri-urban settings where sediment loading from development is an issue, existing development laws generally allow for the development of controls that limit activities impacting sediment loading. In such settings, further development of such controls could represent an effective standard on which quantity-based economic instruments of the offset type can be built.
This report outlined how a number of attributes of biophysical processes and markets can limit potential for cost saving and/or environmental reliability of economic instruments. One key finding was that the difficulty in measuring actual outcomes of interest for diffuse source water quality issues has made application of economic instruments particularly challenging. There are essentially three ways to overcome the "monitoring problem":
- focus on practices that are correlated with the outcome of interest
- focus on an input which is correlated with the outcome of interest - rather than the outcome of interest per se or
- setting standards or charges, or incentive payments on some easily measurable input or practice, and then using zones and other locational arrangements to correlate them with the outcome of interest.
Focusing on practices is not recommended for New Zealand. While the approach has often been chosen elsewhere for ease of implementation and environmental reliability, it has often failed to produce the anticipated cost savings because the flexibility of the landowners or developers is often curtailed.
An additional strategy worth considering in New Zealand is implementation of a series of trial or pilot projects designed to test feasibility and build administrative experience. Typically, such trials would be of limited duration and limited geographic extent. Experience in Australia suggests that the approach could represent an effective, and politically feasible way to gain an understanding of economic instrument design and how implementation influences environmental and cost effectiveness. An advantage is that best practice for New Zealand can be developed using pilots before new policies are implemented on a larger scale.
