1. Economic and Financial
Instruments for IWRM
Introduction to economic
instruments for water management

2. 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

3. Outline
 Public-good nature of water resources
 Supply and demand
 Main approach: full cost recovery
 Definition of economic instruments

4. 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

5. 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)

6. Multi-sector use

7. Public-good nature of water resources
RIVALRY
Low High
Low
E
X
C
L
U
S
I
O
N
High
Non-use
benefitsUse 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

8. 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

9. The supply function
Quantity
supplied
Price

10. 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

11. 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)

12. The demand side and net benefits
Price
Quantity
demanded
Net benefits for
consumers when a
price p* is charged
p*

13. Competitive market
Price,
WTP
Quantity
produced/consu
med
Y
*
P
*
Supply fn.
Demand
fn
E
A
O

14. 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.

15. 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

16. 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

17. 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?

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