Potter and the Pendulums of Perpetual Motion:
Economic Policy Instruments for Environmental Management
Associate Professor in Agricultural and Resource Economics at the University
was a time, not so long ago, when “economics” was something of a dirty
word in environmental circles. In Australia during the 1990s, the “landcare”
movement brought a new emphasis on sharing and caring rural communities
making generous sacrifices for the good of each other and of the whole
community. Perhaps this contributed to the negative attitude towards
economics, tainted as it is with some unsavory human qualities -- greed,
selfishness, narrowness and hard-heartedness!
These days, even in this,
the year of the volunteer, economic aspects of landcare and environmental
management seem more respectable. There is clearly a greater recognition of
the relevance to the environment of at least some of the ideas of economists.
More cynically, there also seems to be an expectation that dressing
environmental concerns in economic robes will help to capture greater
resources from the public purse (and possibly the private sector) for use in
Most strikingly, there is a
boom of interest in “economic policy instruments” or “market-based
mechanisms”, such as tradable pollution permits, auction-based systems, and
environmental credits. Reflecting this boom:
Most relevant government
agencies and departments are at least sniffing around the issue of economic
policy instruments, and trying to work out what they are all about. A small
number of these agencies have tried, or are trying, to implement schemes
based on particular instruments.
A number of prominent
environmental policy plans (particularly salinity-related plans) include
economic instruments as featured elements, (e.g. the National Action Plan for
Salinity and Water Quality) or as something to be examined closely (several
state salinity plans).
economists have prepared a number of discussion papers, working papers and
reviews (e.g. ABARE 2001)
Discussion of economic
policy instruments figures prominently in meetings and workshops about the
environment (e.g. the 4th Annual AARES Symposium on “Public
Funding of Environmental Issues” in Melbourne in October 2001.
It is a welcome sign that
economic policy instruments are making the step from the environmental
economics textbook to the real world. Much will be learnt from the current
attempts to apply economic instruments to the environment. Some of what we
learn will be helpful. Where they work well, economic instruments will
increase the efficiency of use of the community’s resources for managing
the environment. Perhaps this will allow more natural resource and
environmental assets to be protected and better protection of the most
On the other hand, most
booms precede a bust, and this one will not be an exception. Indeed, the
cracks are already starting to show. An officer from a NSW farmer lobby group
commented recently that a “cargo cult” has developed around market-based
instruments. He feels that expectations of what they can deliver have become
A number of senior
government agency managers at both national and state levels have become
enthusiastic about market based instruments and appear to expect that they
will play a very major role, particularly for salinity. These non-economist
converts to the cause appear to believe that economic instruments are like a
perpetual motion machine, where you get more out than you put in!
I don’t think economists
have intentionally misled them. Perhaps it is just the endless search for the
Philosopher’s Stone – a simple solution to an intractable problem.
Previously it was social processes and peer group pressure which carried the
weight of expectation; now it appears to be economic policy instruments.
Harry Potter’s exploits (Rowling,
1997) led to the destruction of the Philosopher’s Stone. A
similar fate awaits expectations of magical effects from economic
To protect the ‘muggles’
from themselves, the ‘economic wizards’ probably need to be more careful
and more explicit about not only the strengths but also the limitations of
economic instruments. Economists should be advising that the potential
contribution of economic instruments is probably fairly limited, particularly
in the case of salinity. It should also be pointed out that inappropriate
application of economic instruments will actually reduce
the efficiency of resource use. This is likely to be the case. For
example, some current trials in NSW were
justified at a recent meeting as attempts to “suck it and see”.
To understand my heretical
claims, we need to (a) go back to the basics of what economics says about
market failure and government intervention, (b) factor in some of the recent
technical findings about salinity and (c) consider some practical aspects of
implementing economic policy instruments. First, though, some very brief
background on the instruments themselves.
are economic policy instruments?
The common feature shared
by the various types of economic policy 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). The effectiveness of
these instruments depends entirely on the strength of the incentive they
provide relative to the strength of incentive that farmers would require in
order to change their farming practices.
Possible economic policy
instruments for environmental management include:
permits/tradable rights/auctions of rights or permits
on particular inputs/practices
of care backed by penalties or taxes
The options vary widely in
benefits (farmers, other identifiable individuals or groups, the broad
(farmers, taxpayers, consumers, beneficiaries);
targeting incentives to where they are required;
costs and other transaction costs;
amount of information and judgement required centrally to make the
Some general observations
about use of economic policy instruments in agriculture are pertinent:
Economic policy instruments
cannot alter the overall desirability of a set of conservation practices
(from a community-wide perspective), at least not directly. What they can
do is help to increase the adoption of practices which are already
socially desirable but are not being adopted for whatever reason. (A range of
likely reasons for non-adoption of salinity management practices are given by
The economic instruments increase adoption either by rewarding farmers who
act “appropriately” or penalizing farmers who do not. In effect, they redistribute the benefits and costs of the treatments such that
farmers are given greater incentive to act.
An absolute requirement for
use of any economic policy instrument to be economically efficient is that
the total benefits (private and public) of the farming practices being
promoted must exceed the total costs of implementing them. Indeed, they must
do so by enough to exceed the administrative and other transaction costs of
implementing the policy program. 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
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 valued at $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
probably resulting in a net cost to the community, rather than a net benefit.
failure and government intervention
describes a situation where a change in the way resources are managed would
increase efficiency. Government intervention may
be warranted to achieve that change if it does not arise spontaneously in the
The first observation above
means that, although economic instruments may be useful tools to overcome
market failure, in situations where resource degradation is not a sign of
market failure (e.g. where it is actually more efficient to allow salinity to
develop), economic instruments cannot alter the equation to make resource
protection economically desirable.
There may be exceptions to
this rule in the medium to long term if the presence of the economic
instrument provides sufficient incentive for the farmers to innovate and
develop less expensive ways to reduce degradation. However, my judgment is
that, in the case of dryland salinity, it is much too much to expect farmers
in most locations to be able to do this to a sufficient extent, without very
substantial support, particularly in the forms of research and development
Figure 1 illustrates
potential consequences of combining observations 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.
||In scenario A,
the combination of agricultural and non-agricultural benefits is such that it
is possible for an economic instrument to change the way a farm is managed
and to be beneficial overall (in terms of efficiency). 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
In the other three
scenarios, either the treatment is not sufficiently profitable at the farm
level, or the non-agricultural benefits are too small or both. This
highlights a point which is often neglected: the private, farm-level
economics of the proposed management change are critically important in
determining whether a program of economic policy instruments intended to
reduce external costs would be a good thing. They may even be more important
than the size of the external costs. In the case of dryland salinity, this is
likely to be the case more often than not.
characteristics of dryland salinity
Even though the off-farm
costs of dryland salinity are obviously high, the off-farm benefits from
on-farm treatments are often much smaller than the off- farm costs.
Particularly in drier regions, the treatments are often only partly effective
at preventing salinity off-site and the positive off-site effects tend to be
very long delayed (Bell et
al. 2000; George et al. 1999; Hatton and Nulsen 1999; Heaney
et al. 2000; National Land and Water
Resources Audit 2001; Stauffacher et
al. 2000). Applying standard discounting methods to convert
distant future benefits into present values for the purpose of decision
making greatly reduces the magnitude of the benefits. The significance of
this for economic instruments is as follows. The level of off-farm benefits
from on-farm treatments sets an upper limit on what it could be worthwhile
for the community to provide in financial support to farmers (using economic
policy instruments) to encourage adoption of new practices. Small off-site
benefits warrant only small financial support. For similar reasons, they
warrant only small financial penalties for non-compliance, when a regulatory
or tax-based approach is used.
For most of the
agricultural land threatened with salinity, there is currently no perennial
plant that can be produced profitably. When evaluated within an individual
farm, the benefit:cost ratio for planting existing perennials varies widely,
but in drier regions it is frequently well below one; often nearer to 0.5.
Thus, for the majority of
non-irrigated agricultural land, off-site benefits from re-establishing
perennial vegetation are low, or on site costs are high, or both. In these
situations, use of market-based instruments are unlikely to be effective in
altering farm management on the scale needed to prevent non-agricultural
salinity impacts unless the incentives created are greater than the off-site
benefits. The use of such large incentives would actually reduce economic
efficiency, rather than increase it, because they would encourage adoption of
perennials in situations where the total costs exceed the total benefits.
practical aspects of implementation
I have focused above on one
of the practical aspects of implementation: the need, prior to introducing
economic policy instruments, to identify situations where there is a clear
community benefit from changes in land management which are not occurring
spontaneously (in other words, the need to identify situations of prominent
market failure). I am not saying that the instruments will not be “successful”
in locations with no market failure, at least in the sense of promoting
changes in farming practices. It is just that such “successes” may
actually be better described as cases of “government failure”, because
they would be cases where government intervention reduced economic
efficiency. The fact that interventions may display the superficial trappings
of success will likely make it difficult to convince others that they are
looking at government failure.
Even where market failure
is identified, the potential for government failure remains. A perpetual
motion machine must defy the reality of friction. For economic policy
instruments, friction comes in the form of “transaction costs”. These
would include costs of administration, collecting scientific information,
monitoring and enforcing agreements. For the schemes which are more
attractive in theory, such as tradable permits, these transaction costs could
be very high. The more it costs to enforce adherence to agreed outcomes, the
lower are the net benefits to society from the policy. However, without
enforcement, the policy is toothless and ineffective.
Efficiency is also
threatened by long time lags and uncertainty. Ideally, we would like both
sides of a market for “environmental services” to operate, with the
efficient level of services being arrived at by the competitive interaction
of buyers and sellers. In reality, the public benefits of environmental
services from salinity prevention are a long way into the future. Indeed,
they are so far into the future that the beneficiaries will not be around to
participate in any scheme of “market-based mechanisms”. Given this, it is
probably necessary for government to operate as a monopoly purchaser of
salinity prevention services. It is government then that must bear the risks
and inefficiencies arising from the considerable uncertainties surrounding
even the best projections by scientists about future salinity.
A fourth practical way in
which the efficiency of economic instruments may be reduced is if there is no
choice but to base them on indirect and inexact indicators of the desired
outcomes, rather than on the outcomes themselves. For salinity, the desired
off-site outcomes, such as protection of water quality in the Murray River,
will occur many years after the action is taken; many years after the program
of economic policy instruments is a matter of history. If such instruments
are to be used, there is clearly no choice but to use indirect and inexact
indicators of the desired outcomes, such as the area of trees planted, or the
reduction in on-site groundwater recharge.
what action is needed?
critical tone above, I believe that further investigation is needed to design
and evaluate economic policy instruments for environmental management. However, the instruments need to target situations where
market failure is clear and costly. In the case of
dryland salinity that will be in the minority of situations where:
- on-site net costs of
establishing perennial vegetation are small, and
- groundwater flow systems
are responsive to changes in recharge, and
- the value of off-site
assets at risk is high.
A very small proportion of
the agricultural landscape of Australia satisfies these requirements. “Suck
it and see” is clearly not the right strategy.
What we do in the areas
where economic policy instruments are not appropriate is the subject for
another paper (e.g. Pannell
2001b). Perhaps that paper should be called “Harry Potter and
the Burden of Unpalatable Truths”.
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Approaches to Natural Resource Management’, Background Report to the
Natural Resource Management Taskforce, ABARE, Canberra.
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issues in the Murray Darling Basin’, in Proceedings
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between trees and groundwaters in recharge and discharge areas - a survey of
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management’, Australian Commodities,
vol. 7, pp. 511-518.
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Dryland Salinity Assessment 2000, National Land and Water Resources
2001a, ‘Explaining non-adoption of practices to prevent dryland
salinity in Western Australia: Implications for policy’, in Conacher, A.
(ed.), Land Degradation, Kluwer,
Dordrecht, pp. 335-346.
D.J. 2001b, ‘Dryland salinity: Economic, scientific, social and policy
dimensions’, Australian Journal of
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Philosopher’s Stone, Bloomsbury, London.
M., Bond, W., Bradford, A., Coram, J., Cresswell, H., Dawes, W., Gilfedder,
M., Huth, N., Keating, B., Moore, A., Paydar, Z., Probert, M., Simpson, R.,
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David Pannell is Associate Professor in Agricultural and Resource Economics
at the University of WA. His research includes farmer adoption of land
conservation practices, and the economics of land conservation at farm,
catchment, and community levels. He was a member of the WA Government’s
Salinity Taskforce in 2001. In 2000 he was President of the Australian
Agricultural and Resource Economics Society. He is a Program Leader in the
Cooperative Research Centre for Plant-Based Management of Dryland Salinity.
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