- 1. Economic Efficiency in a Perfect Market
- 2. Markets
- 3. Market failure and externalities: Allocation using other means
- 4 - Summary and conclusion
Economic Efficiency in Water Allocation
Geoff Butcher
Butcher Partners Ltd
Christchurch
1. Economic Efficiency in a Perfect Market
1.1 Objective
We want water to be allocated so that at the margin, no transfer of water from one use to another would make someone better off and no one worse off (Pareto Efficiency). At an efficient point, the marginal productivity of water is the same for all uses.
1.2 Requirements for Efficient Allocation
If water is to be allocated efficiently then there must be:
- Flexibility in the allocation of supply (so water can shift to better uses);
- Security of ownership for those with property rights (so that they can invest capital without undue risk);
- A method of ensuring that the real opportunity cost of providing the resource is paid for by the user.
- Predictability of the outcome of the allocation process
- Equity of the allocation process
- Political and public acceptability of the allocation process
1.3 Methods of Allocation
Water is allocated at what one might call a high level and a low level. High level allocation (e.g. between irrigation and in-river uses) can not be left to the market where the market does not reflect the costs and benefits of water use (public goods and externalities). Low level allocation is the allocation within the commercial sector.
Water Allocation by A Public Institution
From a political perspective it is difficult to treat water like a market good because access to water has been perceived historically as a public right, and this "right" may be removed if water is sold to the highest bidder. From an economic perspective there is difficulty in allocating water through markets because of the associated externalities and the public good nature of water. An externality can sometimes be internalised by the payment of compensation, but this requires agreement as to initial property rights and there may be disagreement about these. Public goods are not efficiently allocated by markets because of a free rider problem. No one wants to pay for retention of water in the river because they see their payment as being almost irrelevant to an outcome which depends on all other people also paying.
Public allocation of water has the perceived advantage of promoting equity objectives strongly and enables decision makers to deal with some of the unusual aspects of water resources. The downside to public allocation can be inflexibility and a failure to recognise potential values (regulatory authorities tend to have insufficient information).
In the current policy environment in New Zealand, this high-level allocation is done under the resource management act.
Water Markets
Water markets can be loosely defined as institutions to facilitate the trading of rights to water. Trading can occur at two levels. Short-term rights to use are traded on a "spot" market, but there can also be trading of total ownership, where the rights to use exist in perpetuity.
The advantages of water markets are that they can increase total welfare by directing water to users who value water most highly. In principle, environmental agencies can compete for water resources in the market and the development of a market increases the ability of the community to internalise any externalities that may occur.
The disadvantages are that they ignore externalities including the public-good nature of environmental benefits, and there is no guarantee that the public agencies either understand the value placed by the community on environmental benefits or have sufficient money to reflect that value in prices they will pay (assuming that they do not have the original property right and have to buy the water).
User-Based Allocations
User-based allocation requires collective action from institutions with authority over the allocation and distribution of water. The implication is that an initial higher-level decision has been made to allocate water to this institution.
2. Markets
2.1 Pricing and Charging Mechanisms
Once a high level decision has been made to allocate water to a market use (e.g. irrigation), there are a number of ways of allocating water within this use.
Marginal Cost Pricing
The price of water (for all units) is set equal to the marginal cost of supplying the last unit of that water (including all external costs). This has the advantages of achieving a first-best level of economic efficiency if there is surplus capacity at that price, but this will not always be the case. Logically speaking, if there is no surplus supply capacity, marginal cost of the next unit then becomes extremely high, and price may be below opportunity cost.
Marginal Cost Pricing avoids the tendency to underprice the resource and therefore averts overuse.
Volumetric Pricing (average cost).
A constant price is charged for every unit of water used. For water use to be efficient, the marginal water price must be set equal to the marginal cost of water supply (where the cost of supply includes all externalities and reflects other users' willingness to pay for water). The chance of the price being the same as the opportunity cost is extremely remote, especially since the opportunity cost varies over time and the cost per unit usually stays relatively constant.
Output Pricing
This method does not price water directly, but imposes a tax on output produced with the aid of irrigation. This is an inefficient allocation system because there is no incentive to change the allocation of water according to its value and cost is not directly related to the mount of water used. The charge for water is effectively a tax on production, with the usual distortionary effects of taxes.
The primary advantage of this system lies in its ability to extract rental from those best able to pay (although of course the ratio of profit : output may be very variable and those with high output may not in fact be those best able to pay).
Area pricing
Area pricing requires that farmers pay a fixed fee per hectare for the right to receive irrigation water, and there is no marginal cost for additional water used. This fee is usually a fixed cost and once paid can no longer affect decisions regarding water use. It will, however, affect choices of crop or farming system, and may cause some users to exit from the irrigation scheme. Farmers who do pay the water fee tend to continue to use water even where then marginal benefits exceed the marginal (social) costs, and therefore the resulting water allocation is inefficient. However, implementation costs of this system are small, and it is often valued highly for this reason.
In some recent cases, price has been expressed on a per Ha basis, but closer investigation has revealed that it is per Ha of "standard quantity" (say 200 mm per season), and can be applied across whatever area the farmer likes. In this case it is actually a volumetric price.
Tiered Pricing and Two-part Tariff Pricing
The price per unit rises for additional units of water, or there is a fixed annual price and an additional volumetric price. The method is common where water demand or supply is variable. This form of pricing is consistent with efficient use provided that the marginal price is set at the social opportunity costs.
Table 1: Comparison of key variables of various pricing methods
|
Pricing Scheme |
Implementation |
Efficiency Achieved |
Time Horizon of Efficiency |
Ability to Control Demand |
|
Volumetric |
Complicated |
First-best |
Short-run |
Easy |
|
Output |
Relatively easy |
Second-best |
Short-run |
Relatively easy |
|
Marginal Cost |
Easy |
Second-best |
Short-run |
Relatively easy |
|
Per area |
Easiest |
None |
N/A |
Hard |
|
Tiered |
Relatively complicated |
First-best |
Short-run |
Relatively easy |
|
Two part |
Relatively complicated |
First-best |
Long-run |
Relatively easy |
|
Water Market |
Difficult* |
First-best |
Short-run |
N/A |
|
* without pre-established institutions |
||||
* without pre-established institutions
Note that in the above table the "first best" solutions in terms of efficiency are only first best if the price is set correctly and reflects the opportunity cost. The price is much more likely to be efficient if it is set by active markets because information on the marginal cost is implicit in the bids made by users in the market and is updated by every bid. A central decision maker has to try and gather sufficient information to estimate the marginal opportunity cost and to continually update that estimate.
2.2. Requirements for Trading
For trading to occur there must be property rights to the resource and a market on which to trade. There will also have to be social acceptance of a water market.
Water differs from most forms of property in that you are buying a potentially variable quantity of something which does not yet exist, and in some cases you are buying a recurring supply over a number of years.
2.2.1 Property Rights
Effective property rights must define:
- Rights and conditions of ownership tenure;
- Share of the resource being allocated (this is different to most property rights which establish a quantity, whereas water is a fluctuating resource);
- Details of agreed standards of services to be delivered;
- Constraints on transferability; and
- Constraints on resource use or access.
As the constraints on transferability and resource use are increased, the property right becomes weaker and the likelihood of getting efficient resource use declines, unless these constraints relate to the protection of some externality (such as social or environmental effects).
2.3 Development of Markets
Markets do not need to be formal (there does not need to be any organised agency overseeing transactions). The only requirement that I can see is that there must be an agreed mechanism for transferring rights and a record of ownership of the property right.
Markets already exist to a degree. In the case of Opuha dam, shares in the dam together with related water rights can be bought and sold. Shares have reportedly sold in recent months for more than ten times their initial cost.
2.4 Barriers to Markets
In various discussions of the funding of irrigation schemes I have seen proposals to limit both the ownership and use of water. In particular it has been suggested that only farmers should be allowed to own shares, and this has had major implications for the funding of projects.
My perception is that farmers are risk-averse and are much more willing to buy water once the supply is guaranteed. There is often a shortage of capital to pay for the construction of irrigation systems. If a water right market exists, then speculators with no interest in the final product can invest in the development. In return, they get a water right which they can sell on.
Limiting ownership means that investors (speculators) with no farming interest (and indeed no desire to use water in any way other than to trade it) are not able to finance the project. This significantly reduces the chances of the project proceeding and hence the chances of the water being used in an efficient manner.
Note that I used the term speculators, and that I see nothing wrong with speculators. My perception is that all those who invest in an uncertain irrigation projects are speculators. It is just that some of them will realise the benefits personally, while others will transfer to others the right to realise the benefit provided that they are given part of the benefit.
3. Market failure and externalities: Allocation using other means
There are externalities in water use, and these relate to social and environmental benefits which are not taken into account in market decisions. In some cases the externalities are internalised, and in the case of Opuha I understand that government made a grant of $1 million in recognition of the environmental benefits of a dam in increasing minimum flows. In other cases the externalities are not internalised, but the social and environmental outcomes will be taken into account in RMA decisions.
3.1 Maximizing Employment or Value Added Impacts
It is sometimes argued that employment and value added have a social value which exceeds the market value, and that hence water should be allocated in a way which maximizes employment or value added. In work done for MAF earlier this year we estimated the relationship between water use and employment or value added in different industries. The objective was to see whether different industries were significantly different in terms of the employment or value added per cubic metre of water, and to consider whether water should be allocated to those industries which generated most employment or value added per unit of water used. The implicit logic in doing this is that one believes there will be social benefits from increasing employment and / or value added in specific regions / industries. Quite apart from the whole question as to whether increasing economy-wide employment or value added is feasible in the long run by supporting particular industries, there were two problems with using water allocation to support particular industries.
3.1.1 Why Use Water as the Basis for Directing Resources into Employment Generating Industries
Use of "employment efficiency" indicators to allocate water is most unlikely to lead to economically efficient outcomes because water is only one resource that has been used to generate employment, and because other methods of generating employment may be available at much lower cost than the opportunity cost of water. A far better theoretical means of increasing value added or employment would be to either raise the returns to all factors of production (e.g. by lowering taxes) or by lowering the cost of labour (e.g. by providing a subsidy). However, political and fiscal realities limit the ability to undertake this first-best policy
Where water has to be allocated on some basis, then it is possible for the allocating agency to favour one activity over another at no fiscal cost. There will of course be a social cost in not allocating water through the market to the highest bidder, but there may also be a social benefit in allocating water in a way which increases employment beyond what the market would achieve. This social benefit is associated with the retention of the social fabric of a rural community by retaining or increasing employment. Whether there is a net benefit in intervention depends on the costs of intervention and of course the value of generating extra employment.
Table 2: Employment (FTEs) per Volume of Water Used (000 m3 per year)
|
Industry |
Direct Water Use (000 m3 / yr) |
Direct Employment per 000 m3 of Direct Water Use |
Total Employment per 000 m3 of Total Water Use |
|
Sheep/beef Dairy Horticulture Other Farming Services to Agriculture Fishing & Hunting Forestry & Logging Oil & Gas Exploration Other Mining Meat Processing Dairy Processing Other Food Manufacture Beverages & Tobacco Textiles & Apparel Wood & Products Paper & Products Printing & Publishing Chemicals, Petrol, etc Rubber & Plastics Non-met Minerals Basic Metals Fab. Metal Machinery & Equipment Transport Equipment Other Manufacturing Electricity Gen & Supply Gas Water Construction W&R Trade Accom. & Restaurants Land Transport Water Transport Air Transport Services to Transport Communications Finance Insurance Real Estate Services Owner Occ. Dwellings Business Services Central Government Local Government Education Health & Social Serv. Culture & recreation Personal Services |
101.1 34,697.5 60,211.7 104,384.3 403.1 84,491.9 1,050.8 0.0 196,177.3 115,867.9 102,917.8 2,771.5 4,317.9 7,041.6 2,935.4 138,788.8 66.3 9,571.0 114.6 8,532.1 35,370.2 0.0 360.5 0.0 72.8 238,119.3 0.0 518,906.2 0.0 58.9 5,078.7 0.0 96.2 6.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 529.5 3,324.7 861.6 1,599.6 18,564.6 1,611.7 |
366.7 1.0 0.4 0.3 45.5 0.1 9.3 0 0.0 0.2 0.1 * 8.2 0.8 3.8 8.5 0.1 278.3 1.8 13.9 0.7 0.2 0 74.2 0 66.2 0.0 0 0.0 0 0 12.3 0 49.1 0 0 0 0 0 0 0 0 109.3 7.7 115.8 69.3 1.5 20.5 |
2.2 1.0 0.5 0.4 2.6 0.1 1.6 0.5 0.0 0.4 0.4 0.5 0.4 1.0 1.3 0.1 1.0 0.6 1.3 0.3 0.2 0.9 1.2 1.4 0.9 0.1 0.1 0.0 1.3 1.8 1.0 1.5 1.2 1.5 2.3 1.1 1.8 2.0 2.0 0.1 2.1 2.2 0.9 2.7 1.3 1.1 2.3 |
Source: Ecolink average direct water use data
There is probably little reason to try and allocate water on the basis of whether or not it generates higher added value. The highest added value use is likely to be able to pay the highest price for water, unless it is a particularly inefficient use in market terms, in which case it is probably inefficient in a wider social sense.
3.1.2 Accuracy Problems
The second problem in allocating water on the basis of employment maximisation was simply that it was difficult to be sure which industry generated more employment because of data quality and variability between industry averages and particular enterprises in that industry. Conceptually you can estimate water multipliers in the same way that you measure employment multipliers or value added multipliers. A model had been developed by Massey (Eco-link), and this adds environmental and employment parameters for each industry to a national input output model. From this model you can establish for each industry the employment per 000 m3 of water used. While conceptually the model is fine, the underlying data for water in particular is weak. The main source of data on water use is resource consents, but as we all know a resource consent talks about what you can legally take. In practice people may take far more or less than their consent. The water use per $1 million was estimated for three regions (Northland, Auckland and Waikato), and the usage varied enormously between regions, even for quite homogeneous industries. The estimated use of water in the accommodation industry varied by a factor of almost 10.
Second, the figures are averages across an entire industry. In farming in particular, one would not expect marginal water use to be similar to average water use because of the mix of irrigated and non-irrigated land in a particular farm type. However, a key concept in economic efficiency is the allocation of resources at the margin1. For this reason also the figures contained in these tables have some limitations, although in the meat and dairy processing industries one might expect technologies to be reasonably constant, and hence average figures to be similar to marginal figures. In the analysis of processing, it is clear
Third, the data ignores non-abstractive use (rain), but the water used is not available to downstream users.
Finally, a resource consent is not necessarily indicative of an abstractive use. For example, hydro-electricity is a major user of water, but the water is still available to other users (albeit with a lesser potential energy and not necessarily at the same site).
In summary, the allocation of water according to its efficiency in generating employment or value added is conceptually limited and in practice we do not have the necessary data.
3.1.3 Policy Implications
It is not appropriate to allocate water purely on the basis of its ability to "generate" employment or added value2. However, an understanding of the employment generated by water where water is a limiting factor on production enables decision-makers to take into account the employment factors when making a resource allocation decision. It is appropriate to do this where the social and economic benefits associated with employment are not reflected in market prices.
Where public agencies wish to allocate water on the basis of perceived desirable social outcomes, a number of questions arise including:
- How can the water be allocated to particular "desirable" industries;
- How much "weighting" should be given to the employment which is generated;
- Is the data currently available sufficiently robust to make decisions on the "employment-generation" effects of different water uses;
3.2 The RMA
Non-market effects should be taken into account in RMA decisions, because the decision-makers are required to look at over-all efficiency (which as every economist knows includes social and environmental values) and are also required to consider social and environmental effects.
3.2.1 Problems with Non-Compensation
Resource management decisions seldom (if ever) seem to require compensation (although they do require mitigation which may be equivalent to compensation), and the reasons for this seem fairly obvious - the principal one being that to impose a requirement for compensation implies an initial property right, and the second one being that their may be no budget to pursue social benefits (e.g. conservation). The outcome of the lack of compensation is that neither of the protagonists has to be explicit or honest about the value of the water resource to them.
The failure to get an optimal allocation initially would not matter too much in terms of efficient resource allocation if trading was permitted. Unfortunately of course trading does not take place between commercial and non-commercial uses (environment and recreation). Arguably this does not matter in the short term since the RMA decision has already ascertained what outcome is best at the higher level, and provided trading is permitted between the out-of-stream users then efficiency may still be achieved. However, in the long term the relative value of different uses may change and inefficiency will arise. Again, this is dealt with to some degree by the requirement to renew consents after a specified time, and at the renewal stage a new "high-level" decision can be made.
3.2.2 Trading and loss of Social Benefits
A problem may occur if the RMA decision was based on social benefits from the out-of-stream use, and the social benefit was later lost as a result of commercial trading. For example, water abstraction was approved for irrigation because of the benefits to the farming community, but was later sold by the farmers to an exporter who loaded it in bulk tankers. One way of preventing this loss of social benefit is to make rights tradable within a sub-market, where the sub-market relates to a particular product.
3.2.3 Double Counting of Social Benefits
There may also be problems if there is double counting of benefits. For example, the Environment Court may approve damming and associated irrigation because of the environmental benefits from increased residual flows and the commercial benefits from agriculture are believed to outweigh other environmental disbenefits. However, if the commercial benefits depend on a government grant in recognition of the environmental benefit, this benefit has effectively been double counted in the RMA decision.
4 - Summary and conclusion
Although there are a number of well-researched and defined mechanisms and pricing systems to achieve economic efficiency of water allocation, it appears that in practice some combination of these provides the best answer for New Zealand.
I believe that the RMA or something similar is necessary to allocate water at the "higher" level, but there are major shortcomings in that the water once allocated becomes a free good (no compensation is required to other potential users), and hence it may be used to excess. The lack of financial compensation also leads to overstatement of value by parties to a hearing.
There is a need to establish property rights to water which are as pure as possible, to make these rights tradeable, and to permit ownership to be widely held rather than be restricted to a particular group. Important ingredients for efficient allocation are the good and free provision of information and clearly defined transaction mechanisms to facilitate the market.
- Establish "pure" property rights to water
- Allocate water by proportionality or capacity sharing of the resource
- Establish a market to facilitate transfer of water rights
- Provide full information or knowledge on the resource being allocated
- Assist in developing values for water for market and non-market uses
Problems with Failure to Allocate
Need to avoid over-exploitation of resource so need to make decision early AND state that future allocations will be made on basis of use prior to date of regulation (e.g. Fisheries Act in 1996 allocates future quota on basis of catch in 1991/92).
- Example of water use in USA: Maximum before damage occurs in order to establish a quota right, rather than minimum economically efficient in order to get optimal use of resource now.
Property Rights and Compensation
A recent environment court decision has raised some interesting rights regarding property rights to what one may call "natural water" - i.e. rainfall. My understanding is that the iussue related to a resource consent for a forest. Forests retain water in the ground (hence reducing runoff and flooding - a positive externality), but then use this water in transpiration. The transpired water is abstracted from the available groundwater, which in due course would have flowed underground off the forest property and on to other properties including those of horticulturalists.
The Environment Court decision was that the establishment of the forest would reduce the water available to other users and hence the forest should not be permitted.
I am not sure if the Court made this decision on the grounds of perceived efficiency (relative value of water in forestry compared to water in horticulture) or of prior use (the horticulturalists had been around for some time and had existing use rights). There may of course have been other environmental and social factors as well.
What we can be sure of is that neither party was required to compensate the other.
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