Keywords

1.1 Background

Economic Policy Instruments (EPIs) are incentives designed and implemented with the purpose of adapting individual decisions to collectively agreed goals. They include incentive pricing, trading schemes, cooperation (e.g. payments for environmental services), and risk management schemes. EPIs can significantly improve an existing policy framework by incentivising, rather than commanding, behavioural changes that may lead to environmental improvement. They can have a number of additional benefits, such as creating a permanent incentive for technological innovation, stimulating the efficient allocation of water resources, raising revenues to maintain and improve the provision of water services, promoting water use efficiency, etc.

EPIs have received widespread attention over the last three decades, and have increasingly been implemented not just to raise revenue but also, most importantly, to achieve environmental policy objectives. However, whereas EPIs have been successfully applied in some policy domains (such as climate, energy and air quality), their application to tackle environmental issues such as droughts/water scarcity, floods and water quality control are beset by many practical difficulties. In recent years, however, an increasing number of local, national and international EPI experiences in water management have appeared, and key legislative and policy documents, including the EU Water Framework Directive 2000Footnote 1 (WFD) and the recent EU communication Blueprint to Safeguard Europe’s WatersFootnote 2 (2012), now support their wider use.

Following prior policy oriented references (NCEE 2001; Stavins 2001; Kraemer et al. 2003; UNEP 2004; PRI 2005; ONEMA 2009; OECD 2011; EEA 2013), EPIs for sustainable water management are consequently designed and implemented both to induce some desired changes in the behaviour of all water users in the economy (being individuals, firms or collective stakeholders) and to make a real contribution to water policy objectives, in particular reaching the broad environmental objectives of water policy (e.g. EU Water Framework Directive or US Clean Water ActFootnote 3), at least cost for society.

Three ideas are crucial when thinking of EPIs: incentives, motivation, and voluntary choice. Rather than prescribing a particular type of behaviour that the user should comply with, EPIs create or harness economic incentives to encourage or discourage certain behaviour, but finally leave it to the user to devise his/her way of dealing with those incentives based on individual motivations. An EPI must result in voluntary changes (i.e. of practices, technology, etc.) that contribute to improving the status of ecosystems and meeting relevant environmental objectives. In saying so, not all economic instruments may induce changes that contribute to meeting environmental objectives. For instance, an increase in water tariffs to recover the cost of drinking water supply might not necessarily result in reducing water use. To be environmentally effective, tariffs should be designed by taking into account how users may respond to the price signal.

Four main forms of EPIs can be broadly distinguished: pricing, trading, cooperation, and risk management schemes:

  • In pricing mechanisms, incentives are usually introduced via tariffs, charges or fees, taxes or subsidies;

  • Trading relies on the exchange of rights or entitlements for abstracting or using water, or polluting the water environment;

  • Cooperative mechanisms are based on the voluntary adoption of new practices leading to reduced pressure on the water environment. They can either be self-motivated – without monetary incentives – or accompanied with some form of payments (e.g. subsidies);

  • Risk-based mechanisms rely on the influence of differential insurance premiums and compensation levels.

Table 1.1 presents in more detail the main characteristics of the four main types of EPIs and introduces the opportunities they can bring in for water policy.

Table 1.1 Revised typology of EPIs relevant to water management
Full size table

Besides influencing the behaviour of water users to reach environmental objectives, Each type of EPI can have a number of additional benefits (OECD 2001, 2010, 2012), notably by:

  • Increasing the economic efficiency of governmental action. EPIs allow water users to meet environmental targets by adopting practices and/or technologies at least cost. Water users with lower marginal abatement costs will find an incentive to reduce pollution first, so the overall aggregate costs of meeting environmental targets are lower than if all water users are targeted indiscriminately. Finally, EPIs may maximise overall benefits by allocating water resources to most valuable uses;

  • Generating financial resources to maintain and improve the delivery of water services. EPIs may help recover capital and operational costs, as well as so-called environmental and resource costs (as required by the EU WFD);

  • Creating permanent incentives for continued technological innovation, as opposed to regulatory instruments that may only provide incentives to innovate until compliance is achieved;

  • Flexibility and the capacity to adjust to shifting conditions with minimal transaction costs (e.g. option value that informs infrastructure design and investment).

1.2 Review of Application

The use of EPIs in water management clearly faces several challenges, notably due to lack of information and misconceptions on their “real” costs and benefits, and limited interest or, in some cases, political resistance. While the theoretical literature argues that EPIs are more “adaptable” and easier to reform than other instruments, adjusting EPIs can in reality face similar rent-seeking practices and constraints to other policy instruments. As with any other policy instruments, the choice, design and implementation of EPIs must be complemented by a careful analysis of the environmental, social and economic context, and embedded in critical debate on their relevance, limitations, and their potential synergies and conflicts with other forms of governmental action.

In practice, a wide range of EPIs have been applied at different spatial scales (e.g. national, regional, river basin, etc.) and on in different sectors (e.g. water utilities, industry, agriculture, tourism, hydropower generation, etc.). Tariffs, taxes and charges are by far the most recurrent EPIs, followed by subsidies and cooperative schemes. While trading schemes on water quantity have been limited to a few cases in Europe (e.g. Spain, England and Wales), they have been more popular elsewhere, notably in Australia, the semiarid Western states of the USA, or Chile.

However, the actual use of economic instrument differs among countries and among policy areas. Notwithstanding well-established theoretical foundation, the implementation of EPI lacks follow-through. Whereas positive experience abound in other areas of environmental management (notably air quality and recently climate governance), the application of EPI in the context of water (particularly demand) management is relatively recent (PRI 2005; Cantin et al. 2005).

In the context of Europe, a survey by the European Commission on the use of economic instruments in the WFD first river basin management plans shows that a minority of actions have been taken by individual Member States to comply with the requirements of Article 9 on cost recovery for environmental and resource costs through water pricing of the WFD. Further, the details of the actions often referred to water pricing, were unclear and did not provide any details on what was effectively proposed to adapt existing water pricing policies. Where economic instruments are mentioned, mostly it referred to subsidies for eco-system services (where the sources of funding mostly come from the EU Rural development program) and water and waste water charges or taxes.

With the programmes of measures for the achievement of the objectives of the EC WFD being developed and then finalised, Member States in Europe have shown increasing interest in economic instruments. The very high costs of the proposed programmes of measures have raised the issues of (cost-)effectiveness of proposed measures and of financing and revenue raising. In practice and policy terms, although the application of economic instruments are often justified on economic efficiency grounds, attention is mostly given to the financing dimension of economic instruments, i.e. how they contribute to collecting new revenue that feeds into the central government budget or can support “good practice” in water use and management.

The examples in the interest in the application of EPIs to tackle water management issues abound in Europe; Sweden has started to investigate new pollution permit-fee schemes that include the potential for water pollution permit trading in the medium term; with Denmark and Norway showing similar interest in the application of the same EPI. And there are signs of renewed interest in France for water markets, following the publication of a report that concluded that water markets established in Australia and California could be considered as applicable in France (Barthélémy et al. 2008). In the Netherlands, a review of existing economic instruments applied to water management in Europe (Mattheiß et al. 2009) was launched with the objective of identifying new opportunities for economic instruments that would support the implementation of the WFD and in particular measures dealing with hydromorphology, ecology and biodiversity. Most experiences and policy discussions on tradable permits and water markets in Europe are from Spain. See for example: Calatrava and Garrido 2005; Gómez-Limón and Martínez 2006.

Very interestingly, the review for the Dutch Government has stressed the very wide range of economic instruments already implemented in individual Member States such as: innovative water tariffs structure to limit water demand; electricity premium to hydropower for good hydromorphological practices/restoration; tradable permits for both quantity and quality; subsidies for the construction of green roofs aimed at improving rainwater management/reducing excess water; voluntary agreements for restoring flood plains and shifting practices to good environmental practices (both in urban areas and for agriculture), etc. The review also emphasised:

  • The importance of extending the policy focus of economic instruments to be investigated and proposed, from economic instruments separated between “water quantity” and “water quality” to economic instruments targeting: (i) water scarcity and drought, (ii) excess water (floods), (iii) pollution management and (iv) ecology/biodiversity.

  • The limited knowledge available on (i) the functioning/implementation and (ii) the performance of these economic instruments, stressing the need for more rigorous assessments of the innovative approaches developed by individual Member States.

There are several key reasons why EPI are not more widely used in water management, or why implementation in Europe has been focused mainly on water tariffs, environmental charges and taxes and dedicated subsidies (mainly agriculture-related):

  • Uncertainty – Not enough is known about the effectiveness of many instruments in contributing to the achievement of environmental goals, that is whether economic instruments will spur the change needed in the given time frame and without unintended drawbacks. This applies to economic instruments that require the development of “new markets” (such as tradable permits or payments for environmental services). It also applies to many innovative instruments already in place in selected countries for which no knowledge is available. It also applies to “traditional” water tariffs and environmental charges for which expected changes in water demand or pollution discharged is rarely translated into environmental and ecological status of aquatic ecosystems. The same holds true for the actual implementation/transaction costs and their distribution. When uncertainties abound about what can be delivered by the EPI and whether predetermined policy objectives will be met, the policy makers are inclined to make use of prescriptive regulatory instruments (such as environmental standards and best available technologies).

  • Path dependency – EU countries already have a set of fairly sophisticated regulations for the management of water quality and water quantity issues. Changing these systems to incorporate EPIs might offer (uncertain) efficiency gains in the longer term, but will inevitably require additional efforts (and hence costs) by regulators and regulatees during the adaptation process. Hence, we are more likely to see EPI applied in fields that were hitherto unregulated, or in areas where a significant regulatory reform is necessary anyway (for instance, where competencies are re-organised within a federal governance structure).

  • Transaction costs – It is often assumed that the supposedly superior efficiency of economic instruments stands against the higher transaction costs associated with EPI. For instance, tradable permit systems require a regular allocation of permits, ongoing monitoring, reporting and verification, and of course the trade itself. All of these activities impose additional efforts onto the regulatee, which need to be balanced against the expected efficiency gains. In most cases, however, there is no information on transaction costs that such new instruments would imply, the transaction cost argument being used on a rather emotional basis. Furthermore, command and control mechanisms have also their own transaction costs that are rarely analysed nor quantified.

  • Heterogeneity of impacts – the efficiency of EPI is maximised if the unit to which they are applied is completely homogeneous across space and time, i.e. if 1 kg of nitrogen released or 1 l of groundwater abstracted has the same marginal impact anytime, anywhere. While this condition is satisfied e.g. for greenhouse gas emissions, it is typically not the case for water management issues. There are options to account for this heterogeneity of marginal impacts, but they will necessarily drive up transaction costs for regulatees and regulator alike.

Although arguments in favour of using EPIs to make water decisions more flexible and adaptable have been put forward, it is expected that such arguments in favour or against an extended adoption of EPIs have to be based on proven facts and testable empirical evidence. At this moment, there is a gap in the literature about the evaluation of performance of water EPIs that this book aims to fill in. In this context, this book sets to shed light into assessing the effectiveness and the efficiency of implemented EPIs in achieving water policy goals, and to identify the preconditions under which they complement or perform better than alternative (e.g. regulatory) policy instruments or together with them as part of complex policy mixes. Case studies from Cyprus, Denmark, France, Germany, Hungary, Italy, Spain, and the UK (European Union), as well as from Australia, Chile, Israel, and the USA, are included in this book. The development of a consolidated assessment criteria helps clarify (and where possible, quantify) the effectiveness of each EPI and helps with the establishment of relevant cross-reference between the different analysed EPIs.

1.3 EPIs Performance Evaluation

Policy assessment is a necessary tool for the design of new policies and improvement of existing ones. These tools are these days part of good governance approaches and used to justify increased transparency in policy making. Often policies are designed with assumptions, guesses and expectations as to how they will affect outcomes, and ex ante impact assessments to inform policy choices are only required in a handful of countries (see Thaler et al. 2014). The lack of ex-ante forecasts, combined with even more-frequent lack of ex-post evaluation, often impedes the evaluation of performance of implemented policies or the design of future policies.

An ex-post assessment of any given EPI in order to understand and explain its success or failure must explain relevant aspects in relation with the EPI contribution towards the achievement of its stated objectives and provide clear explanation of the specific surrounding settings of its implementation. All the EPIs evaluated in this book have been assessed in relation with two types of broad criteria divided in terms of those that are output oriented and those that help understanding the EPI specific context relevant for its design and implementation.

An analysis of the so-called output oriented criteria of the EPI include an understanding of its: (i) environmental outcomes, (ii) economic costs and benefits and (iii) distributional or social equity impacts.

An analysis of the so-called context criteria of the EPI Water assessment framework and it is intended to deal with: (i) the institutional set up in place and the one required for the EPI to deliver its full potential; (ii) the transaction costs associated to the EPI implementation and how the institutional set-up and the design have dealt with this; (iii) the design and implementation of the EPI and why it has succeeded or failed in the situation analyzed.

Table 1.2 provides clear definitions of each of the assessment criteria used to understand the selected EPIs.

Table 1.2 Proposed assessment criteria for the evaluation of EPIs performance
Full size table

1.4 Objectives, Scope and Structure of the Book

We aim to present in this book most of the case studies that were reviewed ex post in the EPI-WATER (FP7-265213) project.Footnote 4 The highest added value of the work done in this project is the breath of the information that came out from the review process of specific EPIs. This basically includes the review of application of EPIs in different countries, institutional contexts and situations but performed through the lens of relevant assessment criteria that allow drawing some comparability conclusions.

This book is designed to increase knowledge about the application of economic policy instruments to tackle water management challenges relevant for the implementation of water policy (e.g. restoration of water ecosystems, tackling pollution, etc.). It also sheds light on key concepts and definitions, and conveys the benefits, limitations, transaction costs, and opportunities of using EPIs in water policy. It illustrates real challenges associated with the use of EPIs with ad-hoc examples and case studies based on a wide set of implemented EPIs within and outside the EU.

The book has a practical remit and is aimed to anyone interested in finding out more about the use of economic instruments in water. It is expected that the book will be relevant for academic researchers, consultants and practitioners working in the water management/economics field. More specifically this book aims to:

  • Support national decision-makers and experts in the development and implementation of EPIs in water management; and

  • Raise awareness of EPIs, so that interested parties can engage effectively with decision-makers and experts on the development and implementation of EPIs.

  • Help to increase understanding through the use of practical examples about the ex-post evaluation of public policy interventions.

The structure of the book is organized in three main parts in terms of the broad categories of economic instruments covered through case studies: PART I (pricing and taxes), PART II (trading) and PART III (other types of incentives, such as cooperation and risk management schemes). Each part includes a short introductory chapter highlighting cross-cutting problems, challenges, design and implementation issues of the broad instrument category. Each introductory chapter also highlights some conclusions in terms of cross-cutting issues for that specific broad category of instrument. The consecutive chapters in each part present specific case studies in the application of those EPIs. Case study chapters aim to follow a similar presentational structure mindful of the application of the proposed assessment framework. Each chapter aims to discuss the review of application of the EPI in question in terms of each of the assessment criteria towards which the economic instruments are assessed, including environmental outcomes, economic efficiency, financial revenues, transaction costs for regulator and regulated entities, social impact and equity issues and policy implementability. Mediating factors such as institutional set-up are also explored.

The overall structure of the book is as follows: Chap. 2 illustrates a short introduction to Part I of the book on water pricing and taxes and Chaps. 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, and 13 present the related case studies in this topic. Chapter 14 illustrates a short introduction to Part II of the book on water trading and Chaps. 15, 16, 17, 18, 19, 20, and 21 present the related case studies on the review of practical application of these EPIs. Chapter 22 illustrates a short introduction to Part III of the book on other relevant economic instruments and Chaps. 23, 24, 25, 26, and 27 present the related case studies. Chapter 28 provides a concluding chapter relevant for the three parts. Conclusions will be outcome oriented per type of challenge that the EPIs can address: (i) Water quality, (ii) Water scarcity, (iii) Flood risk and (iv) Ecosystem conservation.

1.5 Book Chapter Outline

This book has been divided into the following chapters:

  • Chapter 2: Water Pricing and Taxes: An Introduction

  • Chapter 3: Effluent Tax in Germany

  • Chapter 4: The Water Load Fee of Hungary

  • Chapter 5: Water Abstraction Charges and Compensation Payments in Baden-Württemberg (Germany)

  • Chapter 6: The Danish Pesticide Tax

  • Chapter 7: Subsidies for Drinking Water Conservation in Cyprus

  • Chapter 8: Residential Water Pricing in Italy

  • Chapter 9: Water Tariffs in Agriculture: Emilia Romagna Case Study

  • Chapter 10: Corporatization and Price Setting in the Urban Water Sector Under Statewide Central Administration: The Israeli Experience

  • Chapter 11: Water Budget Rate Structure: Experiences from Several Urban Utilities in Southern California

  • Chapter 12: Green Energy Certificates and Compliance Market

  • Chapter 13: Subsidies for Ecologically Friendly Hydropower Plants Through Favourable Electricity Remuneration in Germany

  • Chapter 14: Water Trading: An Introduction

  • Chapter 15: Water Quality Trading in Ohio

  • Chapter 16: Nitrogen Reduction in North Carolina

  • Chapter 17: Evaluation of Salinity Offset Programs in Australia

  • Chapter 18: Water Trading in the Tagus River Basin (Spain)

  • Chapter 19: Chilean Water Rights Markets as a Water Allocation Mechanism

  • Chapter 20: Unbundling Water Rights as a Means to Improve Water Markets in Australia’s Southern Connected Murray-Darling Basin

  • Chapter 21: The Development of an Efficient Water Market in Northern Colorado, USA

  • Chapter 22: Other Types of Incentives in Water Policy: An Introduction

  • Chapter 23: Cooperative Agreements Between Water Supply Companies and Farmers in Dorset (E)

  • Chapter 24: Financial Compensation for Environmental Services: The Case of the Evian Natural Mineral Water (France)

  • Chapter 25: New York City’s Watershed Agricultural Program

  • Chapter 26: Voluntary Agreement for River Regime Restoration Services in the Ebro River Basin (Spain)

  • Chapter 27: Voluntary Agreements to Promote the Use of Reclaimed Water at Tordera River Basin

  • Chapter 28: Key Conclusions and Methodological Lessons From Application of EPIs in Addressing Water Policy Challenges