ECONOMIC INSTRUMENTS OF WATER

1. ECONOMIC INSTRUMENTS OF WATER Innovative Water Sector Financing BY CUSH NGONZO LUWESI bfz Expert Mombasa ,Kenya 7-11 November 2011

2. To introduce economic concepts applied in Integrated Water Resources Management (IWRM) Goals of this Lesson • To provide some economic tools used to implement the “User pays” and “Polluter pays” principles in the water and sanitation sector • To explore different ways of achieving performance in the water sector through application of economic instruments

3. Learning objectives • At the end of this lesson, participants shall be able to explain the difference between water as a social /public good and water as an economic good; public water management and private water provision related services • They need to be keen with basic concepts of water services provision: consumer and producer behaviours; demand and supply curves; water market equilibrium (value and price) •They are also expected to understand how to recover the full cost in water and sanitation services provision as well as in watershed management to ensure efficiency They shall finally grasp key water pricing instruments and marketing strategies

4. THE NATURE OF WATER IN ECONOMICS A SOCIAL, PUBLIC AND ECONOMIC GOOD

5. ? The Nature of Water in Economics Question What do you this about water in each of these pictures? I’d better go to the fountain … A rice field Please! give me a cup A dam Go to stream ... There is plenty of it.

6. ? The Nature of Water in Economics Question What do EAU PURE, H2O, the Nile and Ganges waters, the cities of Amsterdam and Rotterdam… mean to you? • Water as a res communes is a fruitage of the nature and a product of ancient civilizations for sustaining life. • Water as an necessity commodity for health and environment is an inferior good • Water as a raw material is used as a dissolving agent • Water as an industrial output is a scarce resource and can be a normal as well as a luxury good • Water as express demand and supply is a local, national, regional and international market essential for poverty alleviation and development.

7. Environmental Scarcity of Water

8. Environmental Scarcity... Cont‘d ? Three categories of water stress that would be exacerbated by climate change: (i) Too little (I (ii) Too much (iii) Too dirty (Zbigniew W. Kundzewicz 2007) • High water demand for irrigation and food production, hydropower generation and industrial uses due to population and economic growth • High variability of the available water resource due to the impact of pollution, environmental degradation and climate change • Lack of adequate infrastructure and technologies to, maintain and conserve water • Increasing risk of failure of socio-economic activities in the course of climate change • Insufficient funds available for cleaning and channeling water for domestic and industrial consumption as well as sanitation purpose. • Insufficient technical and technological competence from water users to ensure efficiency • Lack of water use efficiency metrics (thresholds) • Lack of coordination of water abstraction among private users, especially in rural areas Question Do you recall the three categories of environmental water scarcity (stress) ? ? Question Do you recall the three categories of water stress?

9. Rivalry and Exclusion in Water use Question Is the practice of rationning an exclusion or a rivalry? ? • Box 3.1: Definitions of rivalry and exclusion • Rivalry: A good or service is said to be rival in consumption, if one person’s use thereof in some sense precludes or prevents uses thereof by other individuals or businesses.It refers to the nature of the consumption process. Food, for example, is a typical rival good, as consuming one unit of bread implies that one fewer unit of bread is available for the rest of potential consumers. Light from the sun (to some extent) has low or no rivalry, as consumption by one does not necessarily reduce availability for others. • Exclusion: refers to the possibility of excluding persons who are not entitled from using the good or service. A good is excludable if there is some mechanism (physical or institutional) that restricts potential users from consuming it at some time or place. Property rights are institutional devices to restrict or exclude potential consumers (or users) from goods or resources, which are generally supported by some physical mechanism to restrict access by third parties (fences, access codes, etc.). Land is generally an excludable resource, whereas “air” (not necessarily clean air) is a resource with very low, or no, excludability. (Source: Young, 1996)

10. Dublin Principle 4 Question Why do you remember why water price is a catalyser to its efficient use? ? “Water has an economic value in all its competing uses and should be recognised as an economic good as well as a social good” (Dublin Conference, 1992). Ignoring the full value of water results in the failure of IWRM If misperceptions about the value of water persist the maximum benefits from water resources cannot be derived. Valorizing water resourcesdoes not meanbacksetting the fundamentalhuman right of water access to all, but enablingaccess to potable water and sanitation to all at an affordableprice

11. Why To Be Treated as a Social Good? • In many countries, water is a public and social good due to the facts that: • Its unrivalled utilisation preserves life and promotes culture and development (i.e. It is vital commodity) • It is particularly important to view water allocation as a means of meeting social goals of equity, poverty alleviation and safeguarding health where there is no competition in its use (i.e. its consumption by some does not reduce the potential consumption of others) as well as exclusion (i.e. it is difficult or very expensive to exclude a potential water user to benefit from the resource use) • water is finally a social good for the purpose of environmental security and protection

12. Why To Be Taken as an Economic Good? Water as environmental scarce resource deserves to be a necessity economic good; It becomes necessary when extending supply is no longer a feasible option. As an input and output of any production process, it has a Value-Added and can be considered a normal as well as a luxury good Being considered as economic good is imperative for logical decision making on water allocation between competing sectoral alternative uses In IWRM, the economic value of alternative water uses helps in guiding decision makers to prioritise it as a prior investment option

13. Why…an Economic Good, Cont’d Question In the real world, in a situation of water scarcity, should water be provided to a steel-manufacturing plant because the manufacturer has the ability to pay more for water than thousands of poor people who have no access to safe water? Can you find any similar examples from the ground level in your country? How was such a situation solved? In countries where there is plenty of water resources, water is less likely to be treated as an economic good since the need to ration water usage is not so urgent. ? Yet, in IWRM encourages stakeholders to consider the economic value of alternative water uses so as to guide decision makers to prioritise water resource development as a priority in investments

14. The Paradox of Water & Diamond Value • Necessary commodities such as water have ever had lower prices compared to prices of luxury commodities such as diamond • Yet, it is not “necessity” or “luxury” that determines the price in the market but demand and supply • To answer this question, we must go behind the market demand curve. ? Question So, what’s the problem? Water has high demand than diamond , and its price shall be higher than that of diamond! Does it not seem odd to you? Your opinion, please!

15. PRIVATE WATER PROVISION SERVICES

16. Demand Curve • Consumers express their needs to the market in terms of “ demand” • This demand is an aggregate of all households’ desired purchases at each possible price Question Why is the demand curve descendant while the utility curve is ascendant? ? • The utility obtained from consuming one unit more or one unit less of the total basket is the consumer’s “marginal utility” • The motivation of each demander to purchase such an item is based on its “marginal utility” • The satisfaction someone receives from consuming commodities is called his/ her “utility”

17. SupplyCurve Question Why is it that the supply curve is ascendant while the marginal product of capital is likely to be descendant? ? • Producers express their prices according to their marginal variable costs, which obey to the law of diminishing returns and diminishing marginal product of the capital The law of diminishing returns states that as one type of production input is added, with all other types of input remaining the same, at some point production will increase at a diminishing rate This is mainly explained by the variations of the short-run marginal cost (MC) curve, which at first decline and then go up at some point, and will intersect the average total cost and average variable cost curves at their minimum points.

18. Water Pricing Negociations ? Question What is the difference? Pure and Perfect Competition Monopoly Monopsony

19. Case: Monopsony of Water Service (Labour) Question At this point , what do economic instruments of water mean to the private water developer? ?

20. ? Question Is there a need for economic instruments in managing water resources in Kenya? WhatEconomic Instruments Entail • Rational rules (« economicprinciples ») and incentivesthat influence the behaviour of bothconsumers and producers to allocateoptimallytheirresources for demand and supply

21. PUBLIC WATER MANAGEMENT SERVICES

22. Nature of Public Water Management Public services are designed to be State monopolies by the rule of the law They are designed to satisfy the needs of a whole decentralized administrative entities; but not of a specified individual person or community Public administration subjects pay taxes and other administrative charges without oftenly not knowing their actual utility They can only appreciate their satisfaction level through improvement of their welfare and environment. Question Why are stakeholders in your watershed unable to measure their consumption of public service? ?

23. Economic Instruments for Public Water Management • Policies that create a conducive environment for provision of water • services and distribution of natural resources to enhance accessibility • and equity • Regulations for a competitive water market economy, where fairness, transparency, accountability and oversight by public administrations are enhanced Question What the difference between the instruments in (c) ? ? • Actions intended to solve grievances and market failures created by high external costs from its environment to restore the efficiency of private water projects. E.g. Inflation, Forex, natural disasters, etc. • Major tools used encompass: (a) rule making; (b) legal empowerment of private parties; (c) structuring of private incentives by permitting fees, charges, tariffs, taxes, subsidies, and penalties; (d) provision of public utilities (e.g. delivery of watershed infrastructure and services)

24. Economic Instruments…, Cont’d The Government also intervenes in the water market to fix or adjust the price to the benefit of both water users and providers. It is not usually left to the market, especially when poor people cannot bear the load of inflated prices Besides “rational use of water” and “the user pays”/ “the polluter pays” principles, the government also takes into account economic principle of “cost recovery” to determine water use and effluent discharge charges and fees.

25. MAINSTREAMING SUSTAINABLE COST RECOVERY

26. Why Sustainable Cost Recovery? Private water users and providers seldom interact competitive markets to form an equilibrium price for the firms to recover their production costs This type of competitive market is seldom feasible for the operation of water service providers, owing to the fact that water is a public and a social good Even where competitive markets can be organised (e.g. potable water), water development projects tend to follow the monopolistic behaviour that features public water management services, and public water provision utilities, which operate large water treatment plants Potable water provision being often supplied directly or regulated by the State, the price formation will not be the result of supply–demand market interactions to an automatic cost recovery. Thus the need for efficient methods of water services provision that mainstream full cost recovery.

27. Full Water Cost Recovery Mainstreaming sustainable cost recovery in IWRM requires: that: (i) Service providers should aim for revenues sufficient to cover recurrent costs, and should develop sustainable long-term cost recovery policies; (ii) should Water users’ associations as a group cover service provision revenues from charges • Water providers need to act rationally by: • (i) purchasing skilfully inputs and materials at a low cost • (ii) Using efficiently these inputs and materials in production to avoid • wastage or loss, with respect to the production process thresholds • (iii) Employing a production-mix that yields high utilities and outputs, and maximizes the total benefit. • Water Use Efficiency (WUE) is mainly assessed by the relation between the total output (Y) and the total cost (TC): ? Question Do you recall the expression of agricultural water use efficiency?

28. Full Water Cost Recovery, Cont’d Under assumption of water resource fluctuation, water providers shall periodically re-evaluate their demands to meet the economic efficiency of their production (water for trade). Question What do these 3 scenarios entail? ? THERE ARE THREE POSSIBLE SCENARIOS: In a Higher Economic Conjuncture (HEC) or Above Normal Rainfall Regime (ANOR), the marginal water cost ratio is significantly below the profitability rate; an “Economic Order Quantity” (EOQ) can be achieved. In a Normal Economic Conjuncture (NEC) or Normal Rainfall Regime (NOR), the marginal water cost ratio being slightly below/ above or equal to the profitability rate, a Limit Average Cost (LAC) is the threshold In a Lower Economic Conjuncture (LEC) or Below Normal Rainfall Regime (BNOR), the marginal water cost ratio is significantly above the profitability rate, and thus a “Minimum Efficient Scale” (MES) shall be observed.

29. Full Water Cost Recovery, Cont’d Optimization of WUE, Cont’d • To achieve the EOQ under the ANOR scenario, the total water cost (TC) shall not exceed the cost of transaction (CT) with a Cost of Saving (CS): • TCAN = CT + CS (Luwesi, 2010) • To achieve the LAC under the NOR scenario, the total water cost (TC) shall not exceed the cost of transaction (CT) with an opportunity cost (OC): • TCNO = CT + CS (Luwesi, 2010) • To achieve the MES under the BNOR scenario, the Total water Cost (TC) shall not exceed the cost of transaction (CT) with a Shortage Cost (SC), that is an opportunity cost (OC) and a loss of profitability due to water shortage (LP): • TCBN = CT + CS • Where CS = OC + LP(Luwesi, 2010)

30. Cost of Water Transaction • The cost of transaction encompasses all direct and indirect costs of inputs and capital goods involved in the process of production of the water service. • These include part of permit charge, raw water volume charge, administrative cost, monitoring and evaluation cost, watershed management cost, amortization of the investment cost … and the unaccounted for water. • Box 3.8: Demand functions from water utilities sales data • “A frequently observable transaction concerning water is that occurring when a publicly owned or regulated water authority supplies water to numerous individual water users. The conditions for a free market are not met, because the buyer is faced with a take-it or leave-it price schedule from a single monopoly supplier. But because the buyer can usually take all the quantity desired at that price schedule, inferences on willingness to pay and demand can be derived if a sufficient number of observations on transactions are available, and the transactions exhibit variation in real price. • “Household water demand, as with all water demand, tends to be very site-specific, influenced by a range of natural and socioeconomic factors. The demand relationship is represented graphically by the familiar demand curve, or algebraically as: • Qw = Qw(Pw,Pa,P;Y;Z) • where Qw refers to the individual’s level of consumption of water in a specified time period; Pw refers to the price of water; Pa denotes the price of an alternative water source; P refers to an average price index representing all other goods and services; Y is the consumer’s income, and Z is a vector representing other factors, such as climate and consumer preferences.” • Source: Young (1996) • These require a full accounting of both operating and structural costs.

31. Opportunity Cost of Water • It is expressed as the “regret benefit” or the loss of projected profitability from the best next sale through the formula: • OC = r * Y (Luwesi, 2010) • Where r= the water service provider opportunity loss rate • An opportunity cost occurs due to failure of not adopting the best available alternative of using water or owing to unfavourable combination of circumstances. E.g. inflation, Forex, distance, etc. • Though not usually included in the full cost recovery for fairness, it has proven to be can be useful to guide water authorities in looking for better water allocations and prioritizing future investments in the water sector

32. Cost of Saving Water The cost of saving water is a cost incurred by accumulation of exceeding water storage, notably for opportunity lost and amortization of operating and structural costs • Algebraically it is expressed as: CS = r*Y+l*∏(Luwesi, 2010) Where ∏ is the water provider profit, computed in absolute values l is the loss of profitability under ANOR calculated as “r-1” This generally occurs especially in irrigation during the above normal rainfall regime, when farmers receive more than enough rainfall to water their crops Any demand of water shortly after that period will be charged with a cost of water saving

33. Water Shortage Cost Water shortage cost is incurred by accumulation of acute insufficient storages, eventually due to deficient rainfall regimes. It is generally computed as an opportunity cost and the loss of actual profitability due to shortage: SC = r*Y+l*∏(Luwesi, 2010) Where, ∏ is the water provider profit, computed in absolute values l is the loss of profitability under BNOR calculated as “1-r” Any demand of water during the period of drought is actually over-charged due to the shortage cost and the high demand expressed by the market. The shortage cost is generally referred to as an “arbitrary fee” and results in rationing when the government intervenes.

34. The Optimal Water Provison

35. Water Market Negociations NOTE: In the water sector, fees are generally leveled based on political motivations and the service provider’s bargaining power may not prevail to allow income meet expenditure. Thus, an agreement with the government is needed to subsidize the cost difference for the development of water services or the watershed. Nevertheless, the Water Services Regulatory Board shall take into consideration all the running costs of the service provider prior to setting tariffs. This will enable the latter to justify its price.

36. The Role of Marketing Management in IWRM Modern frameworks on water services supply and management promote a fair price to tackle the unpredictable environmental trends In most rural communities, water users still believe that they are orphans of public governance and development since they have no easy access to clean water and safe sanitation. A SWOT Analysis reveals customers' needs and requirements, fears and expectations as well as the firm’s position in the market for a Marketing-Mix that will enable water users’ behaviour change and accrue revenues Any suspicion and criticism on the service accessibility and performance, charges and fees, taxes and tariffs shall be systematically examined prior to any communication or information to the public Awareness on suspicions and criticisms about their services shall clearly be stated through mass-media advertising, physical availability and personal interaction between civil servants and taxpayers, and other promotional efforts. ? Question What is: (i) SWOT; (ii) marketing-mix What role do they play in your business?

37. The SWOT Matrix

38. The Marketing-Mix: McCarthy “4Ps” ? Question What are the so-called “4 Ps” ? Source: Adapted after Baker (1992)

39. Communication and Promotion Strategy ? Question At what stage of business development can you convey messages 1, 2, 3 and 4?

40. Total Water Services Provision Management (TWSQM) Water services providers shall always provide advices free of charge to their customers. These shall include their responsibility vis-à-vis the state and private water services ? Question How often do you conduct TWSQM in your firm? And why? These advices and support services should result from a “Total water service quality management” that addresses the following concerns: (i) What do our customers want? (ii) What service do we provide? (iii) To what extent customers satisfied? (iv) How can we improve what we offer? (v) What will this cost us and what benefits can we anticipate? These activities are likely to increase the strength of the bond between the Government, private water services providers and the water resource users’ associations.

41. Advocating for a Societal Marketing Culture in IWRM All “stake-holders” in the watershed have competitive powers; the government can only get better at doing things that matter the majority Public services are required to develop a Taxpayer-driven administrative culture to enable behaviour change toward implementation of IWRM Service delivery should be based on actual needs expressed by the public during participatory watershed planning, monitoring and evaluation Strategic organisational change shall follow what people want and are determined to make it happen rather than creating barriers and obstacles to the people's will ? Question How do you use SWOT Analysis and 4Ps in public watershed management? Effective marketing and communication shall avail easy, quick and accurate information on IWRM policies, procedures and practices Shall civil servants listen and implement what people express during opinion polls, this will help stakeholders keep a good image of public watershed services in their mind.

42. Innovative Market schemes for WRM Kenya’s ecological and human systems are highly vulnerable to the negative impacts of climate change ? Question What innovative scheme do you know and have applied? The rehabilitation of a watershed ecosystem is likely to improve water quality and provide sufficient water for a variety of uses and to different users. The implementation of novel schemes such as Payment for Watershed Services (PWS), Green Water Credits (GWC), Clean Development Mechanisms (CDM), and Reducing Emissions from Deforestation and Degradation (REDD) have recently been developed based on the premise that there are cause-effect relationships between land use and watershed functions These schemes enable water services providers and development partners to pay for watershed services that are provided by local stakeholders, in a well-defined and voluntary transaction, to secure the sustainability of their services, if and only if the stakeholders continue to supply these services (conditionality) These schemes actually results in benefits that would not otherwise have been provided without payment of local stakeholders’ environmental services made in cash or kind.

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44. ASANTENI SANA!