SEA Working Paper 00/09

Market-Based Mechanisms, Financial Incentives and Other Institutional Innovations: Assessing Their Potential for Addressing Dryland Salinity

David Pannell

Agricultural and Resource Economics, University of WA, David.Pannell@uwa.edu.au

There is increasing interest in the potential for economic instruments to contribute to the better management of dryland salinity in Australia. There are many possible instruments available; Table 1 provides an incomplete list. The aim of this discussion paper is to outline a set of broad principles and existing knowledge that determines the potential for economic instruments, and to suggest how we should move forward in this area.

Table 1. Possible economic instruments for addressing salinity

The common feature shared by the various 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). None of the instruments provides a magic bullet. In all cases, their effectiveness depends entirely on the strength of incentive they provide and the strength of incentive that farmers would require in order to change practices.

The options in Table 1 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 transaction costs;
• The amount of information/judgement required centrally to make the instruments operational.

I will not review the range of instruments in detail here. It is sufficient for now to note that some instruments will be far preferable to others with regard to salinity.

General principles shaping decision making about economic instruments

1. Economic instruments cannot alter the overall desirability of a set of farming practices (from a community-wide perspective). They can only help to increase the adoption of practices which are already socially desirable but are not being adopted for whatever reason (e.g. see Pannell 1999). They do so either by rewarding farmers who act "appropriately" or penalising farmers who do not. In effect they redistribute the benefits and costs of the salinity treatments such that farmers are given greater incentive to act.
2. An absolute requirement for use of any economic instrument to be desirable is that the total benefits (private and public) of the farming practices being proposed must exceed the total costs of implementing the farming practices. Indeed, they must do so by enough to exceed the administrative and other costs of implementing the scheme. 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
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 of $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 resulting in a net cost to the community, rather than a net benefit.

Figure 1 illustrates potential consequences of combining rules 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 salinity treatments (e.g. planting perennials) 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 farm practice and to be beneficial overall. 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 three other scenarios, either the treatment is not sufficiently profitable at the farm level, or the non-agricultural benefits are too small or both.

Some hydrological, economic and practical realities

Some of the things we already know about salinity have strong implications for economic instruments.

• Even though the off-farm costs of salinity are obviously high, the off-farm benefits of on-farm treatments are often much smaller than we would have hoped.
• Large scale planting of perennials is essential for long-term prevention of salinity. For most of the agricultural land threatened with salinity, there is currently no perennial plant that can be produced profitably. In many situations, the benefit:cost ratios for planting existing perennials are around 0.5. This degree of unprofitability leaves little or no scope for economic instruments.
• For some key non-agricultural assets, such as rural towns, the most efficient treatments will be engineering works on site, rather than perennial revegetation in the broader catchment.

From past experiences we know that:

• Monitoring and strong enforcement of agreements reached are essential for the success of economic instrument schemes.
• Wherever large sums of money are to be distributed, rorting is a serious risk and must be guarded against.

What needs to happen?

Schemes for implementation of economic instruments cannot responsibly be devised without information and assessment to determine where they may or may not be effective and efficient. The information needed includes the following.

1. Which assets are not practically savable, which are savable with additional initiatives from government, and which are on the road to being saved without additional initiatives?
2. Of the savable non-agricultural assets, which are best protected by on-farm treatments and which require off-farm treatments?
3. For those requiring on-farm treatments, what are the on-farm economics of those treatments?
4. Ideally we would like to know, what are the economic values of non-agricultural benefits from those treatments in different situations? If this information is too difficult to obtain, what are the non-agricultural physical and environmental impacts?
5. From a synthesis of this information, where would economic instruments be worth implementing and not-worth implementing? (Which regions, soil types, landscape positions, current farming systems, … ?).
6. Where they seem likely to form part of the preferred response, which of the many available types of economic instruments is preferred given the particular characteristics of salinity? (e.g. in terms of ability to target, cost of administering, transaction costs, amount of information required, distributional consequences.)

Some of the information needed is already available or in the process of being collected but reasonably significant resources would be needed to complete the assessment. If we wish to proceed with a program of economic instruments, we need to work through this process to be sure of making high quality decisions about their roles and design.

Conclusion

Overall, even without completing the comprehensive analysis sketched above, it is clear that the scope for economic instruments to make a positive difference is limited. This is because the on-farm economics of treatments are mostly adverse and the off-farm benefits per hectare of on-farm treatment are mostly small. For these reasons, the incentives created by economic instruments will, in most circumstances, be insufficient to prompt high levels of adoption of desired treatments. If the incentives are made large enough to make a difference, this will often result in the scheme costing more than the benefits it generates.

The scope for economic instruments to make a positive difference could be greater if we succeed in developing new perennial plant-based farming systems that are near to being profitable in their own right. This further reinforces the need to increase investment in development of profitable perennials, with other initiatives such as economic instruments following in the wake of successful development.

Reference

Pannell, D.J. (1999). Explaining Non-Adoption of Practices to Prevent Dryland Salinity in Western Australia: Implications for Policy, Presented at COMLAND, University of Western Australia, September 21-25 1999. (SEA Working Paper 99/08). http://www.general.uwa.edu.au/u/dpannell/dpap9908.htm

Citation: Pannell, D.J. (2000). Market-Based Mechanisms, Financial Incentives and Other Institutional Innovations: Assessing Their Potential for Addressing Dryland Salinity (SEA Working Paper 00/09). http://www.general.uwa.edu.au/u/dpannell/dpap0009.htm

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Copyright © 2000 David Pannell
Last revised: May 21, 2003.