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/consu

med

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 only

II: Average financial (capital

+ O&M) cost, with capital

valued in terms of historical

costs

III: Average financial

(capital + O&M) cost, with

capital costs computed in

replacement terms

IV: 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.