Harry Potter and the Pendulums of Perpetual Motion:
Economic Policy Instruments for Environmental Management

David Pannell [1]
Associate Professor in Agricultural and Resource Economics at the University of WA.

There was a time, not so long ago, when "economics" was something of a dirty word in environmental circles. In Australia during the 1990s, the "landcare" movement brought a new emphasis on sharing and caring rural communities making generous sacrifices for the good of each other and of the whole community. Perhaps this contributed to the negative attitude towards economics, tainted as it is with some unsavory human qualities -- greed, selfishness, narrowness and hard-heartedness!

Pendulums swing

These days, even in this, the year of the volunteer, economic aspects of landcare and environmental management seem more respectable. There is clearly a greater recognition of the relevance to the environment of at least some of the ideas of economists. More cynically, there also seems to be an expectation that dressing environmental concerns in economic robes will help to capture greater resources from the public purse (and possibly the private sector) for use in environmental programs.

Most strikingly, there is a boom of interest in "economic policy instruments" or "market-based mechanisms", such as tradable pollution permits, auction-based systems, and environmental credits. Reflecting this boom:

• Most relevant government agencies and departments are at least sniffing around the issue of economic policy instruments, and trying to work out what they are all about. A small number of these agencies have tried, or are trying, to implement schemes based on particular instruments.
• A number of prominent environmental policy plans (particularly salinity-related plans) include economic instruments as featured elements, (e.g. the National Action Plan for Salinity and Water Quality) or as something to be examined closely (several state salinity plans).
• Australian resource economists have prepared a number of discussion papers, working papers and reviews (e.g. ABARE 2001 )
• Discussion of economic policy instruments figures prominently in meetings and workshops about the environment (e.g. the 4 th Annual AARES Symposium on "Public Funding of Environmental Issues" in Melbourne in October 2001. See: http://www.agric.uwa.edu.au/ARE/AARES/

It is a welcome sign that economic policy instruments are making the step from the environmental economics textbook to the real world. Much will be learnt from the current attempts to apply economic instruments to the environment. Some of what we learn will be helpful. Where they work well, economic instruments will increase the efficiency of use of the community's resources for managing the environment. Perhaps this will allow more natural resource and environmental assets to be protected and better protection of the most important assets.

On the other hand, most booms precede a bust, and this one will not be an exception. Indeed, the cracks are already starting to show. An officer from a NSW farmer lobby group commented recently that a "cargo cult" has developed around market-based instruments. He feels that expectations of what they can deliver have become inflated.

A number of senior government agency managers at both national and state levels have become enthusiastic about market based instruments and appear to expect that they will play a very major role, particularly for salinity. These non-economist converts to the cause appear to believe that economic instruments are like a perpetual motion machine, where you get more out than you put in!

I don't think economists have intentionally misled them. Perhaps it is just the endless search for the Philosopher's Stone - a simple solution to an intractable problem. Previously it was social processes and peer group pressure which carried the weight of expectation; now it appears to be economic policy instruments. Harry Potter's exploits ( Rowling, 1997 ) led to the destruction of the Philosopher's Stone. A similar fate awaits expectations of magical effects from economic instruments.

To protect the 'muggles' from themselves, the 'economic wizards' probably need to be more careful and more explicit about not only the strengths but also the limitations of economic instruments. Economists should be advising that the potential contribution of economic instruments is probably fairly limited, particularly in the case of salinity. It should also be pointed out that inappropriate application of economic instruments will actually reduce the efficiency of resource use. This is likely to be the case. For example, some current trials in NSW were justified at a recent meeting as attempts to "suck it and see".

To understand my heretical claims, we need to (a) go back to the basics of what economics says about market failure and government intervention, (b) factor in some of the recent technical findings about salinity and (c) consider some practical aspects of implementing economic policy instruments. First, though, some very brief background on the instruments themselves.

What are economic policy instruments?

The common feature shared by the various types of economic policy instruments is that they work by altering the financial incentives and/or risks faced by individuals whose behaviour is important (in this case, mainly farmers). The effectiveness of these instruments depends entirely on the strength of the incentive they provide relative to the strength of incentive that farmers would require in order to change their farming practices.

Possible economic policy instruments for environmental management include:

• Tradable permits/tradable rights/auctions of rights or permits
• Enhanced tax deductibility
• Tax rebates
• Subsidies on particular inputs/practices
• Rewards for outcomes
• Regulation/standards/duty of care backed by penalties or taxes
• Cross compliance
• Cost sharing

The options vary widely in terms of:

• who benefits (farmers, other identifiable individuals or groups, the broad community);
• who pays (farmers, taxpayers, consumers, beneficiaries);
• ease of targeting incentives to where they are required;
• administration costs and other transaction costs;
• the amount of information and judgement required centrally to make the instruments operational.

Some general observations about use of economic policy instruments in agriculture are pertinent:

Observation 1: Economic policy instruments cannot alter the overall desirability of a set of conservation practices (from a community-wide perspective), at least not directly. What they can do is help to increase the adoption of practices which are already socially desirable but are not being adopted for whatever reason. (A range of likely reasons for non-adoption of salinity management practices are given by Pannell 2001a ). The economic instruments increase adoption either by rewarding farmers who act "appropriately" or penalizing farmers who do not. In effect, they redistribute the benefits and costs of the treatments such that farmers are given greater incentive to act.

Observation 2: An absolute requirement for use of any economic policy instrument to be economically efficient is that the total benefits (private and public) of the farming practices being promoted must exceed the total costs of implementing them. Indeed, they must do so by enough to exceed the administrative and other transaction costs of implementing the policy program. It is quite possible (and likely in some situations) for the overall costs of some approaches to exceed the benefits, especially where the practices are highly unprofitable on-farm or the off-farm benefits of on-farm treatments are low

Observation 3: If financial incentives are paid to farmers, they must be less than the resulting non-agricultural benefits. For example, if changes in a catchment would result in non-agricultural benefits valued at $1,000,000 then any payments to farmers intended to secure those non-agricultural benefits must be less than $1,000,000. If the payments equal $1,000,000, it means that farmers are capturing all of the community's benefits associated with the treatments. If the required payments exceed $1,000,000, it means that the changes are probably resulting in a net cost to the community, rather than a net benefit.

Market failure and government intervention

"Market failure" describes a situation where a change in the way resources are managed would increase efficiency. Government intervention may be warranted to achieve that change if it does not arise spontaneously in the market.

The first observation above means that, although economic instruments may be useful tools to overcome market failure, in situations where resource degradation is not a sign of market failure (e.g. where it is actually more efficient to allow salinity to develop), economic instruments cannot alter the equation to make resource protection economically desirable.

There may be exceptions to this rule in the medium to long term if the presence of the economic instrument provides sufficient incentive for the farmers to innovate and develop less expensive ways to reduce degradation. However, my judgment is that, in the case of dryland salinity, it is much too much to expect farmers in most locations to be able to do this to a sufficient extent, without very substantial support, particularly in the forms of research and development and infrastructure.

Figure 1 illustrates potential consequences of combining observations 2 and 3. Scenarios A and B are where the recommended practices are somewhat profitable, although not sufficiently so to be more attractive to farmers than their existing farming systems. In scenarios C and D the practices are much less profitable than existing systems. The levels of non-agricultural benefits resulting from the treatments are relatively high in scenarios A and C and low for B and D.

Figure 1. Agricultural and non-agricultural net benefits from environmental treatments (e.g. planting perennials to prevent salinity) in four scenarios.

In scenario A, the combination of agricultural and non-agricultural benefits is such that it is possible for an economic instrument to change the way a farm is managed and to be beneficial overall (in terms of efficiency). The instrument could provide sufficient incentive to exceed the farmer's break-even requirement (mainly determined by the profitability of their existing land use) and prompt a change of management without violating one or more of the principles outlined above.

In the other three scenarios, either the treatment is not sufficiently profitable at the farm level, or the non-agricultural benefits are too small or both. This highlights a point which is often neglected: the private, farm-level economics of the proposed management change are critically important in determining whether a program of economic policy instruments intended to reduce external costs would be a good thing. They may even be more important than the size of the external costs. In the case of dryland salinity, this is likely to be the case more often than not.

Some characteristics of dryland salinity

Even though the off-farm costs of dryland salinity are obviously high, the off-farm benefits from on-farm treatments are often much smaller than the off- farm costs. Particularly in drier regions, the treatments are often only partly effective at preventing salinity off-site and the positive off-site effects tend to be very long delayed ( Bell et al. 2000 ; George et al. 1999 ; Hatton and Nulsen 1999 ; Heaney et al. 2000 ; National Land and Water Resources Audit 2001 ; Stauffacher et al. 2000 ) . Applying standard discounting methods to convert distant future benefits into present values for the purpose of decision making greatly reduces the magnitude of the benefits. The significance of this for economic instruments is as follows. The level of off-farm benefits from on-farm treatments sets an upper limit on what it could be worthwhile for the community to provide in financial support to farmers (using economic policy instruments) to encourage adoption of new practices. Small off-site benefits warrant only small financial support. For similar reasons, they warrant only small financial penalties for non-compliance, when a regulatory or tax-based approach is used.

For most of the agricultural land threatened with salinity, there is currently no perennial plant that can be produced profitably. When evaluated within an individual farm, the benefit:cost ratio for planting existing perennials varies widely, but in drier regions it is frequently well below one; often nearer to 0.5.

Thus, for the majority of non-irrigated agricultural land, off-site benefits from re-establishing perennial vegetation are low, or on site costs are high, or both. In these situations, use of market-based instruments are unlikely to be effective in altering farm management on the scale needed to prevent non-agricultural salinity impacts unless the incentives created are greater than the off-site benefits. The use of such large incentives would actually reduce economic efficiency, rather than increase it, because they would encourage adoption of perennials in situations where the total costs exceed the total benefits.

Some practical aspects of implementation

I have focused above on one of the practical aspects of implementation: the need, prior to introducing economic policy instruments, to identify situations where there is a clear community benefit from changes in land management which are not occurring spontaneously (in other words, the need to identify situations of prominent market failure). I am not saying that the instruments will not be "successful" in locations with no market failure, at least in the sense of promoting changes in farming practices. It is just that such "successes" may actually be better described as cases of "government failure", because they would be cases where government intervention reduced economic efficiency. The fact that interventions may display the superficial trappings of success will likely make it difficult to convince others that they are looking at government failure.

Even where market failure is identified, the potential for government failure remains. A perpetual motion machine must defy the reality of friction. For economic policy instruments, friction comes in the form of "transaction costs". These would include costs of administration, collecting scientific information, monitoring and enforcing agreements. For the schemes which are more attractive in theory, such as tradable permits, these transaction costs could be very high. The more it costs to enforce adherence to agreed outcomes, the lower are the net benefits to society from the policy. However, without enforcement, the policy is toothless and ineffective.

Efficiency is also threatened by long time lags and uncertainty. Ideally, we would like both sides of a market for "environmental services" to operate, with the efficient level of services being arrived at by the competitive interaction of buyers and sellers. In reality, the public benefits of environmental services from salinity prevention are a long way into the future. Indeed, they are so far into the future that the beneficiaries will not be around to participate in any scheme of "market-based mechanisms". Given this, it is probably necessary for government to operate as a monopoly purchaser of salinity prevention services. It is government then that must bear the risks and inefficiencies arising from the considerable uncertainties surrounding even the best projections by scientists about future salinity.

A fourth practical way in which the efficiency of economic instruments may be reduced is if there is no choice but to base them on indirect and inexact indicators of the desired outcomes, rather than on the outcomes themselves. For salinity, the desired off-site outcomes, such as protection of water quality in the Murray River, will occur many years after the action is taken; many years after the program of economic policy instruments is a matter of history. If such instruments are to be used, there is clearly no choice but to use indirect and inexact indicators of the desired outcomes, such as the area of trees planted, or the reduction in on-site groundwater recharge.

So, what action is needed?

Notwithstanding the critical tone above, I believe that further investigation is needed to design and evaluate economic policy instruments for environmental management. However, the instruments need to target situations where market failure is clear and costly. In the case of dryland salinity that will be in the minority of situations where:

1. on-site net costs of establishing perennial vegetation are small, and
2. groundwater flow systems are responsive to changes in recharge, and
3. the value of off-site assets at risk is high.

A very small proportion of the agricultural landscape of Australia satisfies these requirements. "Suck it and see" is clearly not the right strategy.

What we do in the areas where economic policy instruments are not appropriate is the subject for another paper (e.g. Pannell 2001b ). Perhaps that paper should be called "Harry Potter and the Burden of Unpalatable Truths".

References

Australian Bureau of Agricultural and Resource Economics. 2001, 'Alternative Policy Approaches to Natural Resource Management', Background Report to the Natural Resource Management Taskforce, ABARE, Canberra.

Bell , R., Mues, C. and Beare, S. 2000, 'Salinity management: Some public policy issues in the Murray Darling Basin', in Proceedings of the National Outlook Conference, 29 February - 2 March 2000, Australian Bureau of Agricultural and Resource Economics, Canberra, vol. 1, pp. 151-163.

George , R.J., Nulsen, R.A., Ferdowsian, R. and Raper, G.P. 1999, 'Interactions between trees and groundwaters in recharge and discharge areas - a survey of Western Australian sites', Agricultural Water Management , vol. 39, pp. 91-113.

Hatton , T.J. and Nulsen, R.A. 1999, 'Towards achieving functional ecosystem mimicry with respect to water cycling in southern Australian agriculture', Agroforestry Systems , vol. 45, pp. 203-14.

Heaney , A., Beare, S. and Bell, R. 2000, 'Targeting reforestation for salinity management', Australian Commodities , vol. 7, pp. 511-518.

National Land and Water Resources Audit 2001, Australian Dryland Salinity Assessment 2000, National Land and Water Resources Audit, Canberra.

Pannell,D.J. 2001a , 'Explaining non-adoption of practices to prevent dryland salinity in Western Australia: Implications for policy', in Conacher, A. (ed.), Land Degradation , Kluwer, Dordrecht, pp. 335-346.

Pannell, D.J. 2001b , 'Dryland salinity: Economic, scientific, social and policy dimensions', Australian Journal of Agricultural and Resource Economics , vol. 45, pp. 517-546.

Rowling , J.K. 1997, Harry Potter and the Philosopher's Stone , Bloomsbury, London.

Stauffacher , M., Bond, W., Bradford, A., Coram, J., Cresswell, H., Dawes, W., Gilfedder, M., Huth, N., Keating, B., Moore, A., Paydar, Z., Probert, M., Simpson, R., Stefanski, A. and Walker, G. 2000, 'Assessment of salinity management options for Wanilla, Eyre Peninsula: Groundwater and crop water balance modelling', Technical Report 1/00, CSIRO Land & Water, Bureau of Rural Sciences, Canberra.

Footnotes