Water valuation and water pricing

The economic valuation of water is a topic which gains importance both in societal and scientific terms. E.g., the Dublin Conference on Water and Environment (ICWE, 1992) has explictly highlighted the necessity to focus more strongly on the economic value of water. Dublin Conference was a turning point that wide variety of disciplines have recog-nised economic aspects of water management. The fourth Principle states that “the past failure to recognize the economic value of water has led to wasteful and environmentally damaging uses of the resource. Managing water as an economic good is an important way of achieving efficient and equitable use, and of encouraging conservation and protection of water resources”¹.

There are two schools of thought with different interpretations of this 4th principle.

The first group is the neoclassical economic view which advocates for the pricing of water by its economic value. In this view the market ensures that water is allocated to its best uses. The price of water needs to reflect the full supply cost including environmental externalities (Rogers et al., 2002). The second group promotes the integrated decision

1http://www.wmo.int/pages/prog/hwrp/documents/english/icwedece.html

making on the allocation of the scarce resources, which does not necessarily involve fi-nancial transactions. The second school mainly believes that integrated water resources management (IWRM) is the solution to water scarcity and is more adapted to all Dublin principles (Savenije and van der Zaag,2002, p.98).

Nevertheless, economic incentives and mechanisms, such as water pricing and the intro-duction of water markets, are in many contexts efficient and effective measures in water demand management (Fraiture and Perry, 2007, p.94). However, with the wide-spread absence of well-functioning water markets, the “correct” price of irrigation water is dif-ficult to ascertain (Birol et al., 2006; Hanemann, 2006; Young, 2005). The decisions by all parties, i.e., regulators in implementing policies, and users in harvesting, extracting and emitting water, take place in the absence of information about the value of alterna-tive resource uses (opportunity costs) that market trade otherwise would generate. This condition frequently results in wasteful misallocation (Libecap, 2009, p.132). In such a situation, any plan to adjust irrigation water allocation or pricing regimes must carefully consider how the adjustments may impact agricultural production. As a central step, the economic value of irrigation water for farmers needs to be quantified (Tardieu and Prefol, 2002). Therefore, applied economic valuation methods play a key role in water resources management.

Understanding the economics of water can help inform decision makers of the full social costs of water use in agriculture and the full social value or benefits that agriculture’s use of water can provide (Hanemann, 2006). The value to the user may be quantified by his/her willingness to pay, but there are additional benefits, such as benefits from return flows, multiplier effects from indirect uses and in a broader sense the benefits to meeting societal objectives (Savenije and van der Zaag,2002, p.101).

Reviews of the approaches to estimate the economic value of water can be found in Birol et al. (2006), Young (2005) and Turner et al. (2004) and with specific regards to irrigation water Johansson (2005). The theoretical and empirical basics of irrigation water pricing is analysed in Tsur (2005), Tsur et al. (2004), Johansson et al. (2002), Johansson (2000) and Tsur and Dinar (1997). Young (2005, p.46) classifies the methods for determining the economic value of water into two main groupings: deductive and

inductive. Deductive methods involve the derivation of shadow prices where water is an input into production systems. Inductive methods comprise valuations based on observed behaviour in real markets or production settings, usually when the public good aspects of water are being considered. In the absence of market prices, the value of water needs to be derived from modelling, starting from production functions and setting up the farmer’s optimization problem (Fraiture and Perry, 2007, p.95). The use of stated preference methods to investigate the economic value of water has more typically been concerned with its public good aspects, such as the value of recreational waterways. These methods are less commonly used for pricing irrigation water in agriculture (Rigby et al., 2010, p.99).

Although the first school of thought promotes economic water pricing as the most im-portant demand management tool, there is limited scientific evidence to support that claim (Savenije and van der Zaag, 2002, p.100). Water saving technology choices are hardly driven by water prices. They are mainly determined by structural factors, agro-nomic conditions and financial constraints (Fraiture and Perry, 2007, p.96). Farmers are often unable or at least unwilling to pay the full provision costs of irrigation water (Hane-mann, 2006;Young, 2005;Johansson,2005;Wilson, 1997; Sampath, 1992). Additionally, political considerations may deter policy makers from implementing the necessary price increases which are typically involved when the full provision costs are to be borne by the farmers. E.g., in mid 1990s, farmer lobby groups in Gujarat, India, influenced the state’s politics by resisting any increase in the flat-rate power tariff or decreasing the daily hours of farm power supply for pumping groundwater for irrigation (Shah et al., 2008, p.4). Similarly, during 2010-2011, the Iranian government was not able to successfully enforce a price reform policy which would have increased the pumping energy price for irrigation in order to impose the full cost recovery of groundwater pumping to the users.

The government was more successful at eliminating subsidies from energy in other sectors during the same period.