Economic and Financial

Instruments for IWRM

Introduction to economic instruments for water

management

Goals and objectives of the session

To know what are the public good aspects of water benefits

To manage basic economic concepts of supply and demand, and full cost recovery

To have clear definitions of economic instrument for water management

Outline

Public-good nature of water resources

Supply and demand

Main approach: full cost recovery

Definition of economic instruments

Introduction

Economic instruments are increasingly

important for IWRM

Traditional supply-oriented approaches fail to

use economic instruments, especially for

demand management

Economic instruments are valuable to

implement a more balanced supply-demand

management approach to IWRM

Benefits from water

Use for drinking, cooking, sanitation

Industrial use

Hydroelectric use

Transportation

Fishing

Agricultural use

Waste assimilation benefits Aesthetic and recreational values

Non-use values (ecological services, preservation)

Multi-sector use

Public-good nature of water resources

RIVALRY

Low High

Low

E X C L U S I

O N

High

Non-use benefits Use benefits

Public aesthetic and recreational uses Avoidance or control of water-related risks

Private aesthetic and recreational uses (club goods)

Drinking, cooking, sanitation

Waste Assimilation Crop Irrigation Livestock

Industrial

Fishing Hydroelectric Transportation

Ecological services Protected areas

Supply: producers behaviour

Try to seek to maximize benefits from the production of a good or service

Use some technology to transform inputs into some output (or multiple outputs)

Demand inputs

Will react to changes in input and output prices

The supply function

Quantity supplied

Price

Revenue, Cost

y

Fixed cost H

Variable cost fn. C(y)

Revenue fn R(py,px )

y*

Total cost = Variable + fixed

Variable cost

Short run profit

Long run profit

The role of variable and fixed costs

Demand: consumers behaviour

Have defined preferences for goods and services;

Seek to maximize the benefits (utility) they get from consumption;

Consider the costs (price) they have to pay for consuming a good or service;

Be restricted by their budgets when taking consumption decisions.

Importance of willingness to pay (WTP)

The demand side and net benefits

Price

Quantity demanded

Net benefits for consumers when a price p* is charged

p*

Competitive market

Price, WTP

Quantity produced/consumed

Y*

P*

Supply fn.

Demand fn

E

A

O

Reasons why markets are not active in the water sector

In competitive markets, supply and demand will interact to form an equilibrium price with optimal allocation of resources.

Competitive firms will recover automatically their production costs (otherwise these are out of the market).

Competitive markets, however, are seldom feasible for water services given its many public-good features and high transaction costs.

Monopoly tends to appear in the provision of large infrastructure water services (domestic use, hydropower and irrigation).

However, costs are still generated and somebody has to pay for them.

Full cost recovery approach: the situation

Plus:

V: Environmental costs

VI: Opportunity costs

Supply Costs:I: Operations and maintenance costs onlyII: Average financial (capital + O&M) cost, with capital valued in terms of historical costsIII: Average financial (capital + O&M) cost, with capital costs computed in replacement termsIV: Long run marginal cost of additional supplies

Defining economic instruments

Imbalances in supply-demand of

water services

Economic instruments can be used:

• Water tariffs, taxes and subsidies

• Fees, connection charges, abstraction

charges and bulk water pricing

• Discharge charges and pollution taxes

• Tradable water permits, pollution

permits

Think about it

Could you give examples from your own experience regarding the public good nature of water in different circumstances?

Do you think the full cost recovery policy is currently applied in your country to the water sector? How? Why?

End

The next presentation, still related to chapter 3, deals with water valuation methods.