This document discusses criteria for evaluating economic instruments for integrated water resource management. It outlines technical and allocative efficiency criteria as well as equity, environmental, administrative, and political criteria. It then explores specific economic instruments like water tariffs, subsidies, fees, charges, and tradable water rights. The document emphasizes that economic instruments should be tailored to local contexts and assessed through participatory processes to facilitate IWRM goals.

1. Economic and Financial
Instruments for IWRM
Application of economic
instruments

2. Goal and objectives of the session
 To discuss evaluative criteria for economic
instruments
 To understand specific economic
instruments and their application

3. Outline
 Understanding the various criteria for
efficiency: technical, allocative, equity,
environmental, administrative, political.
 Exploring water tariffs and subsidies.
 Other economic instruments.

4. Introduction
Economic instruments can be used to promote a higher level
of efficiency in the allocation of water among multiple users
and sectors. Pricing is often used as a mechanism for
achieving efficiency in water allocation and to avoid
wastage. If water provision is priced below its economic cost
there is no incentive to conserve water.
The ways in which economic instruments work will be seen
throughout this chapter.

5. Efficiency criteria
 There are two basic notions of efficiency used in economic theory:
technical and allocative efficiency. Both together are known as
economic efficiency.
 Technical efficiency is traditionally related to production and refers
to firms getting a maximum output per unit of input, or use minimum
input for a given target output. The concept, however, can also be
applied to consumers if we define “output” as the utility coming from
input use.
 Allocative efficiency, refers to the use of inputs in a way that
maximizes total net revenues for firms or consumer surpluses. This
implies using inputs in way that follows the signals of relative input
prices, equalizing marginal revenues to marginal costs.

6. Technical efficiency
water
production
a
b
c
c>a>b
Production fn.

7. Allocative efficiency in a water system with two activities
$
y2y1
P1*z1´(y1)
y* y**
v1
v2
v3
P2*z2´(y2)
The allocative efficient point is y** in which marginal product of both activities are equal. In y*,
too much water is assigned to the low value Z2 activity, and “society” can gain from
reallocating water from Z2 to Z1 (you can understand this intuitively looking at the marginal
product of Z2 in the diagram, if you allocate more water than y** to Z2, any additional unit of
water produces less income than allocating that unit to Z1, and viceversa, thus the maximum
efficiency occurs in y**).

8. Equity criteria
 Equity in water: a particularly acute equity
problem is when poorest groups pay more per unit
of water than other social groups (urban sites with
partial coverage of potable water).
 Adverse consequences for equity may derive from
efficiency driven water reallocations. However,
seldom there are clear and fair rules for
compensation, and most legal and institutional
systems are not prepared to deal with complex
water reallocations and its hypothetical required
compensation.

9. Environmental criteria
 In an institutional context where environmental
objectives are given no real expression either within
institutions or among decision makers, the water
sector will tend to reflect this situation and is very
unlikely to produce positive environmental effects.
 For example, if the overall effect of economic policies
is to favour rapid economic growth with intensive use
of contaminating processes, the water sector will only
amplify this, since water will be allocated to the
activities favoured by these policies.

10. Example: Use of economic tools for dealing with environmental
externalities: groundwater or pollution taxes
Cost with
externality
Private
cost
demand
quantity
Cost of
extraction
With
extraction tax
No tax

11. Other important criteria
 Administrative feasibility: It is senseless to
adopt economic instruments which are difficult to
implement. For instance, water tariffs based on
marginal cost pricing, which charges on the basis
of each additional unit consumed, is
administratively unfeasible in the absence of
metering.
 Political acceptability: Gains from well chosen
economic instruments are compromised if there is
adverse public reaction to it. For example, the
utilization of user fees is a sensitive matter for
most governments which want to control the rate
of price inflation, and fear the political
repercussions of price increases for basic services.

12. What are water tariffs?
 If there is a regulated monopoly for well controlled and metered
water (potable), both a regulator and the monopoly will fix a
price, demand for water exists and changes in it will build
pressures on “administered” or “regulated” prices. The price
scheme can have blocks to control demand and cross-subsidy.
 If water is not controllable to a minimum degree (like most
existing irrigation systems, i.e. 80% of water consumption), there
is no such thing like a supply or demand for water in a market
sense. In this case, water tariffs are not really prices, are devices
to cover (or recover) fixed costs for water administrations. The
concept of elasticity of demand for these irrigation systems does
not makes sense.

13. Diagram 2: Main types of water tariffs
Water use
Tariff
Fixed and variable
Variable
Variable blocks
Fixed
Fixed with
variable blocks
Types of water tariffs:

14. Water tariffs, taxes and subsidies
t*
t*+ tax
t*- subsidy

15. Subsidies (1): Definitions
 Water subsidies should be used to promote
social equity, growth, employment and
increase incomes in particular economic
sectors.
 A case for subsidization and social equity
occurs where the water service primarily
benefits the individual user.

16. Subsidies (2): Justification
Subsidies to water users are management tools that can be
justified on the grounds that:
 Many users are poor and could not afford cost-recovering tariffs;
 The use of safe water sources and basic household hygiene should
be promoted since they improve public health;
 Subsidies can be used to accelerate the uptake of water-saving, or
pollution-reducing, measures by both firms and households.

17. Subsidies (3): Good practices
Smart subsidies are targeted, transparent and tapering:
 Targeted to population groups, or to purposes, that are specifically intended to
benefit, rather than scattered across the population at large.
 Transparent so that they are accountable to citizens, users and taxpayers.
 Tapering – where the aim is to diminish subsidies over time, and eventually
eliminate them.
 There will be countries and circumstances where full financial cost recovery is a
more distant goal. Various kinds of cross-supports are possible, e.g. from
richer to poorer, larger to smaller consumers, from urban to rural, industrial to
household, etc. In economic terms cross-subsidies are second-best solutions
since they produce distortions in consumption. But they are widely resorted to
as pragmatic solutions.

18. Other economic instruments
 Water fees, when water permits are issued, like a license
linked to a permit regime. Or fees are also used for charging
access to water related aesthetical and recreational sites, or
considered as connection charges.
 Water abstraction charges, similar to water tariffs but
charged at the source of water withdrawals from multiple
users.
 Discharge charges are applied to activities which discharge
effluents into water bodies. These charges are increasingly
used to control and reduce water pollution.

19. Tradable water rights
 In some countries there are well developed water markets
(California, Colorado, parts of Spain, Australia). In others, markets
are allowed but not very active (Mexico, Chile)
 Tradable water rights promote allocations of water to higher value
uses, an important issue for IWRM
 Problems with equity impacts, management of externalities and
transaction costs.

20. Economic instruments and other water situations
 Operation and expansion of water
infrastructure;
 Management of water quality and
environmental goods;
 Provision of water management services which
are public goods (IWRM);
 Pressures for increasing supply or reallocation
of water services

21. Think about it
 Which economic
instruments are applied
in your country? Are they
achieving the goals and
objectives of facilitating
IWRM implementation?

22. End
Economic instruments are not neutral
interventions. They have pros and cons,
and their application will largely
depend and affect differently each
local context. Thus, as IWRM, they
should be assessed locally and by means
of a participatory approach.
Chapter 5 enters financial instruments
more in depth.