Economic Instruments - Using value and prices for efficiency and equity (C7)

Changing the behaviour of water users towards more sustainable practices is a necessary step in achieving water security. One way to promote such change is through economic instruments. Economic incentives involve the use of prices and other market-based measures to improve the way water is managed and used. They provide incentives to water users to use water carefully, efficiently, and in a manner consistent with the public interest. They have both positive and negative effects, rewarding users that recognise the true value of water and penalising profligate and anti-social use.

Economic instruments are of the following types:

Tariffs and charges are paid by water users (households, industries, farmers) to their service providers. They can vary according to the volume of water used, its source, or the time of day or the season in which it is used. The tariff signals the economic cost of providing and using water, thereby discouraging wasteful or low-value use, and encouraging its deployment to more useful ends. To be effective, tariffs need to be volumetric-based on the amounts of water consumed. Tariffs apply to both freshwater abstraction or service and wastewater treatment charges.

Abstraction charges (C7.01) are levied on the extraction of raw water from rivers, lakes and aquifers by municipal service providers, farmers, and industrial and mining companies. Their purpose is to help regulate the over-extraction of water from these sources, to avoid environmental and ecological damage, and also to reflect the opportunity cost of the water (one person’s use deprives some other user of its benefits).

Water Markets (C7.02) make it possible for users to buy the right to use water from others holding these legal rights. These markets can either involve permanent, or annual/seasonal transfers. Water markets are well established in Chile, Australia, some Western states of the USA, and parts of Spain.

Tradable Pollution Permits (C7.03) can be bought and sold by users (typically industries or mines) as an alternative to either closing down operations or installing costly pre-treatment facilities.  These permits are a way of enforcing local water pollution controls in a way which is more efficient than the above alternatives. However, in practice these schemes are more common for the management of air pollution than for water, where it is more problematic.

Pollution Charges (C7.04) penalise the discharge of contaminated water by water authorities and companies into public water bodies or aquifers. If these are set high enough they will encourage potential polluters to change their use habits, reducing their discharges or treating their effluent prior to discharge. 

Both tradable pollution permits and pollution charges are based on economic incentives to limit pollution. Other ways to do this are “command and control” regulations which set a limit on the amount of pollutants that a company, for example, is allowed to discharge in a fixed timespan (see Tools A2).

Subsidies (C7.05)provide positive inducements to behaviour considered to be in the public interest, e.g. for connections to a public water system, promotion of safe household sanitation, to companies installing water-efficient processes or pre-treatment of effluent. These kinds of targeted subsidies should not be confused with unintended subsidies that arise from a failure to charge full cost-recovering tariffs, or ex post debt write-offs for a poorly performing utility.

Payments for Environmental Services (PES) (C7.06) are subsidies given to farmers and other land users when they follow environmentally friendly practices such as organic farming, tree-planting, catchment-protection, etc. Such practices, often desirable in themselves, help to preserve watersheds and improve water quality and are often much cheaper than other methods of treating water for drinking and industrial purposes. PES can also be viewed as compensation for abstaining from environmentally harmful practices.

Some economic instruments, notably tariffs, as well as pollution and abstraction charges, also have the purpose of raising revenue, which can either be returned to national fiscal revenues, retained by the service provider, or earmarked for specific purposes such as environmental spending. A well designed tariff or charge can serve fiscal and economic incentive purposes simultaneously; however, these motives can be in conflict, e.g. when a pollution charge successfully eliminates pollution and thereby destroys its revenue base. The use of tariffs as a financial device to raise revenues is considered in A3.03.

Economic instruments complement institutional, regulatory, technical and other kinds of tools used in water management. They offer some advantages over other tools: They provide incentives to change behaviour, raise revenue to help finance necessary adjustments, establish user priorities and achieve overall IWRM management objectives at least overall cost to society. However, economic instruments are not substitutes for other tools of water governance such as monitoring, regulation and enforcement of public health and environmental standards.

Economic instruments normally work best in combination with other supporting measures: they are unlikely to be effective acting alone. The adage "the market is a good servant but a bad master" applies here. Governments must set the right legal and institutional framework, including regulation, within which individual economic agents can operate – the unfettered market will not provide this (see C7.02).  However, properly confined and regulated, markets can produce the required adjustments very efficiently.

The use of prices and market mechanisms for water management does not occur in a vacuum, and its effectiveness depends on wider economic forces operating in society. Economic levels of tariffs may be difficult to achieve in conditions of widespread poverty, or where the prices of other essential goods and services are rising at the same time. Charging farmers more for their water may not be feasible (or fair) if producer prices are artificially depressed, or may be negated by high subsidies to fertiliser and energy. 

This is a reminder that the use of water is affected not only by its own price, but also by the prices of goods and services that consume water or affect its use in other ways. These prices are often distorted, and produce wrong signals to water users. A balanced programme of reforms has to address corrections to prices in agriculture, industry and other areas that affect the use of water (see A2). In this context, water is a key element in the Green Economy.

If subsidies are available for abstraction but waste water discharge is priced volumetrically, there can be discrepancies in reporting between the two. Measurements and proper monitoring can remove this problem, or charging one volumetric tariff to cover both initial source treatment and supply, and discharge treatment.