Economic Tools to Help Manage Asia's High Demand for Water Resources

Based on a systematic analysis that synthesizes findings from previous studies of the use of market-based instruments in selected countries in East Asia, South Asia, and Southeast Asia, the report identifies five categories of market-based instruments used to address inefficient use of irrigation water, poor intersectoral allocation of water, poor surface water quality, and failure to protect and value ecosystems:

• markets for trading water use and pollution rights;
• taxes, fees, and charges;
• subsidies;
• payments for ecosystem services; and
• information provision.

The review resulted in the following findings.

Water pricing may be effective though politically challenging.

The efficient use of water requires prices equal to the marginal cost of providing the water, including the external costs associated with its use. While this type of pricing encourages users to limit water use, cost recovery may be difficult to achieve if marginal costs are lower than average costs or average costs are decreasing (Easter and Liu 2005). However, in most cases in Asia, long run marginal costs are above average costs due to economic and population growth, so this is not a concern.

Volumetric pricing as a market-based instrument can tackle inefficient use of irrigation water by charging farmers the amount of irrigation water consumed or delivered. Findings suggest that volumetric water pricing can lead to increases in efficiency and/or shifts to high-value or less water-intensive crops (Kumar, Scott, and Singh 2011; Mukherji 2007; Shiferaw, Reddy, and Wani 2008; and Wang et al. 2010).

However, pricing has largely been ineffective at current levels and increasing the price enough to have an impact on use has been politically difficult. Implementation can be costly as it requires an extensive network of water meters and a central water authority to set the price, monitor use, and collect fees.

In Bangladesh, the Barind Multipurpose Development Authority pioneered a volumetric irrigation fee and pre-paid metering system in deep tube wells for a groundwater-based irrigation system, which resulted in substantial cost recovery of irrigation water supply (Gain, Mondal, and Rahman 2017).

Intersectoral water allocations need functional markets and strong regulatory frameworks.

In many cases, urban water supply can be augmented through transfers of water from agriculture (Molle and Berkoff 2006). Water can be transferred across sectors as a permanent change or as a temporary reallocation, such as during a drought. Two prominent examples of intersectoral water transfers in the PRC include transfers from agriculture to industrial, municipal, and hydropower use in Hubei’s Zhanghe Reservoir, and transfers of water-usage rights by the government in Ningxia (Moore 2015; Zhang 2012; and Zhang et al. 2016). Gradual permanent transfers can also occur when a source is increasingly diverted to supply a city (Molle and Berkoff 2006), as was the case in the Zhanghe Reservoir in the PRC and the Chao Phraya River in Thailand. Cases of temporary transfers have occurred in Chennai, India by buying water from surrounding wells in times of shortage and in Manila, Philippines, by reallocating water stored in reservoirs for agricultural use to municipal use.

Of the transfer mechanisms, market-based instruments include (i) trading formal rights in a regulated market with positive experiences confined to economies with a strong legal, institutional, and regulatory background, such as the California Water Bank or other markets in Australia, Chile, and the United States and (ii) purchasing water from tankers in a free market (e.g., Chennai) or from neighbors in “spot markets,” such as warabandi in India and Pakistan (Molle and Berkoff 2006).

Though infrequent, intersectoral and inter-regional water transfers can occur through formal administrative decisions with negotiation and compensation, or through water markets. Functional water markets for intersectoral and inter-regional water allocations require well-defined, quantifiable, and transferable property rights (Dinar, Rosegrant, and Meinzen-Dick 1997) and an accounting for hydrological realities such as return flows (Young 2014).

Effluent taxes can put a price on polluting discharges.

Effluent charges have been used successfully to address and curb pollution in the region. In 1978, Malaysia introduced one of the world’s first market-based instruments—effluent fees, paired with licensing—to control pollution from the palm oil and rubber industries (Hojat and Rahim 2012; Rahim 2005; Stavins 2001; and World Bank 1997). A year after the imposition of discharge standards, the pollution load fell by more than half (Catelo, Francisco, and Darvin 2016). Over a span of 2 decades, the organic pollution load decreased by about 90% and firms that owned crude palm oil and rubber mills also invested in wastewater treatment technology innovation.

The Philippines introduced discharge fees on Laguna Lake in 1997. This decreased by 88% the biochemical oxygen demand discharges between 1997 and 1999 (Stavins 2001 and Wheeler et al. 2000) and reduced the industrial sector’s contribution to lake pollution from 40% in 1997 to only 11% in 2006. Increased wastewater treatment, wastewater recycling, waste minimization, and voluntary closure or plant relocation also contributed to less wastewater discharge.

Nutrient taxes can address nonpoint source pollution of water from agriculture.

Taxing discharge can be challenging as nonpoint source pollution, such as agricultural runoff, may be difficult to observe or monitor. Nutrient taxes—an input-based policy instrument used to reduce pollution—provide a solution. Output-based policies can also encourage farmers to shift to less fertilizer-intensive crops through taxes or subsidies (Sun, Delgado, and Sesmero 2016). Additionally, perverse incentives that contribute to pollution, such as subsidies for fertilizer or payments to encourage land use change, need to be reduced.

Tradable discharge permits require a strong regulatory framework to be effective.

In a system of tradable discharge permits, the water management authority limits the amount of emissions for a particular ecosystem, then divides the total amount of emissions into a fixed number of permits. After the initial allocations (through auctions or past levels of discharge), the holders can be allowed to trade their permits in a secondary market (Borghesi 2014). Through this system, pollution abatement can be allocated to firms that have the most efficient production and abatement technologies.

In some situations, tradable discharge permits systems can outperform taxes and voluntary best management practices in terms of welfare and environmental effectiveness (Borghesi 2014; Johansson and Moledina 2005; and Young and Karkoski 2000). The political feasibility of a tradable permits program is also often higher than for an environmental tax because the initial allocation of rights to legally discharge emissions has a high market value (Borghesi 2014).

However, they require strong monitoring and enforcement of environmental regulations to be effective in pollution abatement. Information asymmetries between regulators and market participants also make compliance difficult (Borghesi 2014).

Incentives are needed to promote the use of green infrastructure.

In rapidly growing cities, surface runoff of rainwater has become a major source of water pollution and flooding because of poor infrastructure and extreme weather events. Policy instruments can facilitate the uptake of green infrastructure projects, such as rainwater collection systems, green roofs, permeable pavements, and nature-based solutions for drainage to manage runoff, as an alternative or complement to traditional flood protection infrastructure.

Development, financing, and tax incentives encourage investments and installation of green infrastructure for residential and non-residential users. Singapore’s Skyrise Greenery Incentive Scheme funds up to 50% of the cost of installing rooftop and vertical greenery (Government of Singapore, National Parks 2020).  

Behavioral nudges help influence decision-making on water use.

Psychological interventions, or behavioral nudges, to influence water users’ behavior and decision-making can complement the use of market-based instruments (Russell and Fielding 2010). These include tools, such as social comparison messages (Ferraro and Price 2013 and Torres, Marcela, and Carlsson 2016), information provision on water quality (Brown et al. 2017), and a combination of technical information,  moral persuasion, and social comparison (Bernedo, Ferraro, and Price 2014). They are likely to be most attractive for short-term use during droughts and in middle-income countries where households already have sewer connections and where wastewater treatment is already provided. (Nauges and Whittington 2019).

Creating and defining property rights is necessary for successful implementation.

This will ensure that water is available for the environment and for downstream users. The rights can then be traded at market-determined prices. For instance, by installing meters, water markets and water users (companies or individuals) can trade rights or entitlements to use water at the market equilibrium price (Easter and Liu 2005; Gómez, Delacámara, and Pérez- Blanco 2013; Hanak et al. 2011; Rey, Calatrava, and Garrido 2011; and Young 2010).

Implementation can be challenging because

• property rights must be defined simply and clearly enough to be easily traded, while sufficiently reflecting the reality and complexity of the underlying ecosystem service;
• property rights must align with existing institutional and legal frameworks;
• the nature of the property right will depend on the characteristics of the good or service and the proposed market structure; and
• property rights must account for the variable nature of water availability.

Thus, most water rights confer an entitlement that depends directly or indirectly on the amount of water stored upstream.

A hybrid policy of information provision and effluent charges may achieve pollution reduction goals.

In general, effluent charges and pollution taxes for industrial pollution in Asia have been set too low and enforcement has been weak. However, information provision and labeling for point source water pollution were successful in several countries, including Indonesia, Malaysia, PRC, and Philippines.

Experience suggests that a policy mix of both information provision and effluent charges is the best way forward in most locations. Effluent charges incentivize innovation, while information provision can help correct information asymmetries with the public and make noncompliance costlier for polluters.

Scaling up payments for ecosystem services shows promise.

Due to lack of knowledge and capacity, many policy makers have failed to recognize the economic value of healthy ecosystems and build on basin-wide and cross-sectoral synergies needed for improved water management (United Nations World Water Assessment Programme 2015). In response, there have been increasing efforts to implement and invest in payments for ecosystem services schemes in developing countries for watershed protection and biodiversity conservation, among others. These schemes have been implemented in the region with varying levels of success.

Scaling up successfully requires several enabling conditions, including political support, sustainable financing, lean institutional setup, effective tools and systems, clearly demonstrated impact, and flexibility to adapt to different conditions across target ecosystems and communities. Social benefits can also facilitate political will and resources to drive and expand programs and environmental investments (Porras 2015; Porras 2018; and Porras, Steele, and Mohammed 2016).

In Viet Nam, a national program was developed to protect watersheds that had been overexploited. This helped to reduce the government’s financial burden for forest conservation and protection, as well as improved economic conditions and created sustainable livelihoods for communities protecting and managing the forests (Vietnam Forest Protection and Development Fund 2016).

The success of such schemes also depends on well-informed ecosystem valuation studies, which quantify the price or value that consumers would be willing to pay or apply to protect ecosystem services, which can be incorporated into national income accounts and used to inform country planning and decision-making (Boelee 2011 and Dasgupta 2021). Valuation methods, coupled with information on how resources are used by involved communities, can help design markets for ecosystem services (Adhikari 2009).

The report provides the following recommendations for future applications of market-based instruments to improve water management and reduce water pollution:

• Employ behavioral nudges during droughts by using information to induce low-cost behavior changes in water use.
• Design and implement hybrid policy instruments to address water use and waste discharge, including both an effluent charge and an information provision policy, which can mitigate costs in policy implementation and create incentives for adopting environment-friendly technology and innovation.
• Expand payments for ecosystem services schemes under the right enabling conditions, including political and financial support, strong institutional setup, and transparency and communication.