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Economic Instruments for Managing Water Quality in New Zealand

Executive summary

Acknowledgements

1 Introduction

2 Overview

3 Developing a framework for evaluating economic instruments

4 The role for non-market valuation

5 Economic instruments for diffuse source water quality issues in New Zealand

6 Summary and conclusions

References

3 Developing a framework for evaluating economic instruments

A goal of this report is to provide a framework for identifying which economic instruments might be most attractive to deal with the particular water quality issues faced by New Zealand. The framework proposed is a qualitative approach based on identifying key advantages and constraints from Connor and Bright (2003) and Lockwood, Morrison and MacKay (2003). The core of the framework is a stepwise screening approach.

Each step gathers information about the environmental processes, institutional settings, potential adopters and technologies that may influence the performance of an economic instrument. Ultimately information is obtained 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?
• What is the risk profile of the groups being targeted by the policies and instruments? How will these groups react to the policies and instruments?

The result of applying this screening process may not be a definitive identification of "the" economic instrument for a given problem. Rather, applying the framework 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 NRM policy goals;
• Identification of the likely mix of instruments both market and regulatory approaches required to achieve NRM goals.

It is likely that even after applying the screening process some questions will remain unanswered. For example, the framework identifies the mitigation response as a key determinant of the effectiveness of an environmental charge. This type of information may not exist. The framework may well provide an indication of future research priorities - research that may be required before good judgements can be made about the potential for some economic instruments.

3.1 Screening institutional determinants of feasibility

Once a decision is made to explore the potential of market-based tools, decision makers are confronted with numerous examples of instruments that can be used and the practical question becomes "which instrument"? Figure 1 shows the first step or the initial screening process where the class of economic instruments (refer to the categorisation of Text Box 1) is identified given the institutional rules that are already in place.

The feasibility of price-based instruments is influenced by a key set of institutional rules - rules about who is held responsible to pay the costs of mitigating adverse environmental impacts. These rules are often less formally institutionalised than property rights and often set on a once-off basis in specific legislation. Nonetheless, precedent is often an important basis for institutional rules. So environmental charges are much more likely to be politically acceptable where there is some tradition of making the polluter pay. Likewise, incentive payments and tendering approaches are more likely to be politically acceptable where there has been a tradition of charging the general public for provision of public environmental goods.

Quantity-based economic instruments are only feasible if some type of overall cap or standard that limits emissions is in place. Tradeable permits require a very specific type of property right that is usually associated with water use or discharges to air or water - a performance standard that assigns a specific amount that is allowable for use or discharge for each individual and allows trading in the right to use or discharge. Offsets, in contrast, can be implemented with a range of standards, development restrictions or other rules limiting activities with adverse environmental consequences. In essence, once a standard has been established, offsets can be used to allow the standard to be relaxed at one site, if this is compensated for by providing environmental improvement elsewhere.

Ultimately, institutions change over time. The absence of an institutional prerequisite, identified through the screening process, does not mean that the economic instrument remains forever infeasible. Rather, it indicates where effort in institutional development would be required before the economic instruments could be implemented. In addition, there are sometimes opportunities to overcome institutional impediments with clever policy design. Such possibilities will be discussed in the application of the framework to analysis of economic instruments for water quality that follows.

3.2 Screening determinants of potential to reduce cost of achieving environmental outcomes

Table 1 is the second step in the screening process from Connor and Bright (2003) for ascertaining the extent to which attributes of the environmental process, available monitoring technology, markets and the details of instrument design favour or impede cost effective realisation of NRM goals.

Table 1: Determinants of environmental policy instrument cost effectiveness

View determinants of environmental policy instrument cost effectiveness (large table)

The screening process identifies large variations in the cost of mitigation as a factor influencing the potential cost effectiveness for both quantity-based and price-based economic instruments. Tradeable permits, offsets, environmental charges and tendering all give those with the lowest cost of reducing impact the incentive to provide higher levels of mitigation than those with higher cost. Market-based approaches set the right incentives for private parties acting in their own interest either to internalise the cost of pollution or provide more pollution reduction from least cost mitigation sources and less from higher cost sources. The result can be significantly lower cost of achieving an emissions goal where there is significant variation in cost of mitigation.

An additional determinant of when efficiency gains to quantity-based economic instruments are possible is the technical feasibility and the cost of monitoring environmental performance. Economic instruments have generally been more effective where emissions are from a point source such as a pipe, or smoke stack discharging from an industrial facility than when emissions are from diffuse sources such as farms. One of the main reasons is the difference in the feasibility and cost of monitoring in point source versus diffuse source emissions settings. In point source settings, direct monitoring of emissions performance (at the end of a pipe or smokestack) is generally possible at a cost that is reasonable compared to the benefit. Thus in point source settings, it is usually possible to base permit trading or offsetting on actual performance (levels of discharge).

In diffuse source emissions situations, in contrast, it is often necessary to specify best available technology (BAT) or best management practice standards (BMPs) as a proxy to a performance standard. Text Box 7 presents an example of scheme that allows point sources to trade with diffuse sources by allowing point sources to buy permits from diffuse sources (farms) for implementing best management practices. It also highlights the potential for associations representing a small group of polluters to take more responsibility for developing and implementing best management approaches. Small numbers need not present an insurmountable problem.

Other determinants of cost effective implementation of economic instruments are listed in Table 1. In the absence of highly localised environmental impact "hot spots", both theory and experience suggests that the way discharges disperse in the environment influences the capacity of permit trading schemes to achieve environmental goals. Trading schemes are easier to implement when emissions are "global" in that they disperse uniformly across large areas (i.e. SO2 and global green house gases) and there is little difference in damage per unit emission across locations. For instance, when impacts are global, trades with simple one-for-one exchange rules are possible over large areas with many market participants.

When the diffusion is localised, the impact of emissions can be quite different from location to location. So for example, less dilution flow at some points in a river can result in more damage per unit emissions. One-for-one permit trade in such a setting can result in net damages rather than improvements. This would be the case in instances where permits were traded from a high dilution to a low dilution river reach. Consequently, if localised adverse environmental impacts are to be avoided, the approaches typically have to be implemented with restrictions on locations where emissions can be traded.

Overall, economic instruments are likely to be more successful for emissions with global impacts compared with localised impacts. Simple one-for-one exchange rules are possible over larger areas with more market participants and less restrictive trade rules. Less complex trade rules generally increase willingness to supply permits because the cost of seeking out trading partners, evaluating trades and other transactions costs are lower.

3.3 Screening the segments of society that will be targeted

The range of attitudes and behaviours within the community towards water quality and the adoption of best practices suggest that there are different 'market segments' in relation to sustainable land management. For instance, there may be five segments within the 'sustainable land management policy market':

• Segment 1: Potential adopters, financial capacity to invest in best practice
• Segment 2: Potential adopters, no financial capacity to invest in best practice
• Segment 3: Non-adopters, risk averse
• Segment 4: Non-adopters, respond to peer group norms
• Segment 5: Non-adopters, exclusive focus on farm products.

In marketing strategy, the existence of different segments typically induces firms to develop a range of products. For example, in the automotive market, there are many different kinds of vehicles to cater for the wealth and tastes of different consumers. People in different segments would also be expected to respond differently to different policy instruments and this is a facet of policy development that can easily be overlooked. Ideally, a mix of instruments could be devised that will result in behavioural changes in each market segment. Policy makers need to select instruments that are likely to be most effective for each segment.

If Segment 1 is the majority of the population, there is a case for using economic instruments. If most people come from Segment 2, economic instruments may work, but the incentives will need to be sizeable. Segment 3 may respond to incentives that are designed to deal with risk, and Segment 4 may respond to promotional campaigns that seek to encourage a general change in attitude in the agricultural sector towards water quality. Segments 3 to 5, however, may require strategies that do not involve financial incentives, because of their general unwillingness to undertake conservation management.

The appropriateness of different instruments to different market segments is considered in Table 2. Most instruments are suitable for creating behavioural changes amongst people in Segment 1. There are also many instruments suited to people in Segment 2, provided that the issue of limited finances is dealt with. For the remaining segments, there are fewer suitable instruments and regulation is most likely to be one of the few tools for addressing water quality with segment 5.

The relative size of these different market segments may be influenced by the presence of different ethnic groups within a catchment. Especially if these groups hold values or have attitudes to risk that are different to other groups. From a New Zealand perspective, recognition of these considerations could result in the selection of different instruments in catchments where a significant proportion of a catchment is managed or used by Maori people.

We have put forward a hypothetical example of market segments in Table 2 to illustrate the importance of targeting policies to particular groups within the community. The existence of market segments may partly explain why some economic instruments have not worked in some cases, despite their apparent suitability for a given context. Although work has been done on understanding some of the social, psychological and economic attributes of rural communities, these data do not yet enable the derivation of policy-relevant market segments.

Table 2: Hypothetical classification of the suitability of policy instruments for different market segments

View hypothetical classification of the suitability of policy instruments for different market segments (large table)

3.4 Determinants of potential to ensure environmental quality goals

Existing institutional settings, market conditions, size of market segments and details of policy design can all influence the likelihood of actually achieving desired environmental outcomes with an economic instrument as outlined in Table 3. Existing institutional settings are a significant determinant of the environmental effectiveness of any economic instrument. In the absence of well-defined standards, tradeable permit or offset approaches simply cannot be expected to meet environmental goals. Likewise, incentive payment approaches will not achieve desired environmental goals if they are not adequately funded. Environmental charges will not achieve desired goals if institutional constraints limit charges to rates that motivate little environmental mitigation.

One of the major challenges of instrument design is the need to reduce uncertainty for all parties, including uncertainty about the capacity of economic instruments to ensure desired environmental outcomes. Essentially there are three sources of this uncertainty concerning:

• responses to the incentives that the instrument approaches offer,
• how mitigation actions relate to environmental outcomes,
• how the institutional environment will evolve.

As a general rule, when supply response to price is poorly understood, and damages are a steeply increasing function of price, quantity-based instruments are more desirable. This is because if price responsiveness is underestimated, the price-based instrument will result in significantly more expensive damage than anticipated. Even when, supply response is reasonably well understood and is found to be quite elastic (i.e. very responsive to price changes) the argument may still be applicable, because supply response can change relatively quickly with factors such as technology.

In many instances, there is considerable uncertainty about the damage function because the biophysical processes that relate actions to environmental impact are incompletely understood. In such cases, ensuring that desired environmental outcomes are met through the use of quantity-based instruments requires definition of property rights in a way that allows updating as improved information about environmental processes becomes available (Smith, 2002). One approach can be to define the standards that underpin the quantity-based instrument for limited temporal duration. It is important if this approach is taken to define the uncertain conditions that will lead to revisions of standards, and to allow standards once set to remain in place long enough to allow some certainty about costs of compliance over that period (i.e. updating on five-year or longer intervals).

Young and Hatton MacDonald (2003) identified that transparent processes about how rules will change over time in water rights will reduce the uncertainty for firms and individuals contemplating investments. If there is uncertainty about how transferable permits might be renewed, it is easy to see how risk adverse firms might not adopt new technology.

Table 3: Determinants of potential to ensure environmental quality goals

View determinants of potential to ensure environmental quality goals (large table)