The Economics of Water Efficiency: A Review Amman, September 30 / October 4, 2005 Andrea Billi, Giovanni Canitano, Angelo Quarto UNIVERSITY OF ROME “LA SAPIENZA” Centro Interdipartimentale sul Diritto e l’Economia dei Mercati

A multi-faced approach to water efficiency Physical (absolute) efficiency: using the least possible amount of water Physical (absolute) efficiency: using the least possible amount of water Hydrological/engineering approach: focuses on the way to divert water sources to satisfy all demand using less water Hydrological/engineering approach: focuses on the way to divert water sources to satisfy all demand using less water Economic efficiency: derive the maximum net benefit to society Economic efficiency: derive the maximum net benefit to society Economic approach: focuses on costs and values to balance supply and demand Economic approach: focuses on costs and values to balance supply and demand –Stand-alone welfare calculations –Multi-objectives mathematical programming Institutional efficiency: assess the functioning of an institution regarding water Institutional efficiency: assess the functioning of an institution regarding water Environmental efficiency: optimal natural resource conservation Environmental efficiency: optimal natural resource conservation Technological efficiency: extracting more valuable products for the same amount of inputs Technological efficiency: extracting more valuable products for the same amount of inputs

Why using an economic perspective? Water is unevenly distributed and its allocation is controversial, thus it is an important policy issue Water is unevenly distributed and its allocation is controversial, thus it is an important policy issue Most planners have biased or uniformed opinions about the hierarchical order of water uses to be satisfied: scarce water should be allocated to the most valuable sectors Most planners have biased or uniformed opinions about the hierarchical order of water uses to be satisfied: scarce water should be allocated to the most valuable sectors There are many interdependencies between the water sector and other sectors There are many interdependencies between the water sector and other sectors There are techniques to chose among several arrays of alternative and complementary water projects (supply expansion, demand management) for adapting demand and supply to local circumstances There are techniques to chose among several arrays of alternative and complementary water projects (supply expansion, demand management) for adapting demand and supply to local circumstances Cost recovery and financing issue are key aspect of a modern water investment policy Cost recovery and financing issue are key aspect of a modern water investment policy

Key concept on economic efficiency of water use Equal marginal values: allocate water so that all users and consumers derive the same value at the margin Equal marginal values: allocate water so that all users and consumers derive the same value at the margin Marginal cost pricing: use water up to the point in which its marginal value is equal to its marginal cost Marginal cost pricing: use water up to the point in which its marginal value is equal to its marginal cost the 2 principles give the right incentives to use water wisely The market process automatically satisfies both conditions The market process automatically satisfies both conditions When public policy dominates, the political process should mimic the market process When public policy dominates, the political process should mimic the market process  economic analysis helps taking informed decisions on water projects and policies

The basics of the economic analysis of water The hydro- social water cycle The hydro- social water cycle Sources of demand values Sources of demand values Sources of supply costs Sources of supply costs

The demand for water in WASAMED countries Major water consumer Generic water demand function

Four approaches to water valuation in agriculture ‘Farm budget’ approaches ‘Farm budget’ approaches –Residual imputation –Change in net income Farm budget: theory of cost-minimizing producer, optimal water use patterns, programming methods  the Value of Marginal Product (VMP) is equated to price or marginal cost Farm budget: theory of cost-minimizing producer, optimal water use patterns, programming methods  the Value of Marginal Product (VMP) is equated to price or marginal cost Incremental benefits: net benefits with the project less net benefits without it Incremental benefits: net benefits with the project less net benefits without it Other approaches Other approaches –Value added –Alternative cost

Accounting for efficient water use The water sector interacts with all other sectors of the economy, and could become a binding constraint The water sector interacts with all other sectors of the economy, and could become a binding constraint Water accounting registers the flows of water over time in and out of the physical system and the economy Water accounting registers the flows of water over time in and out of the physical system and the economy Water is treated as an asset, whose stock is calculated at the beginning and at the end of each given period Water is treated as an asset, whose stock is calculated at the beginning and at the end of each given period The objective is to provide a large amount of data by disaggregating water inflows and outflows per supply source and demand sector, so that: The objective is to provide a large amount of data by disaggregating water inflows and outflows per supply source and demand sector, so that: –specific water accounting indicators can be calculated –more sophisticated estimations can be performed

Modeling water policies The most advanced tools for water policy analysis The most advanced tools for water policy analysis Take into account at the same time of: Take into account at the same time of: The natural and physical processes The natural and physical processes The structure of the economy The structure of the economy The proposed project / policies The proposed project / policies The institutional setting The institutional setting Under a set of constraints: Under a set of constraints: Natural (soil, water) Natural (soil, water) Political (minimum allocations, subsidies) Political (minimum allocations, subsidies) Institutional (prices, property regime) Institutional (prices, property regime) Financial (investment restrictions) Financial (investment restrictions) Two types of nested models: Two types of nested models: Simulation: model the response of the hydro system to non- equilibrium conditions Simulation: model the response of the hydro system to non- equilibrium conditions Optimization: maximize an objective function given the constraints Optimization: maximize an objective function given the constraints Integrated economic-hydrologic models

Structure of integrated models: node-link Three types of components (nodes) Three types of components (nodes) Sources (rivers, canals, aquifers) Sources (rivers, canals, aquifers) Demands (off- and in-stream) Demands (off- and in-stream) Intermediate facilities (storage, treatment and recycling) Intermediate facilities (storage, treatment and recycling) The components are connected through the network infrastructure (links) The components are connected through the network infrastructure (links) Water demand is determined endogenously Water demand is determined endogenously Water supply is given by the simulation model Water supply is given by the simulation model Externalities (ex: salinity of return flows) are taken into account Externalities (ex: salinity of return flows) are taken into account

Elements of constrained optimization Maximize the present value of farmers’ profits at each demand site over a chosen time horizon Maximize the present value of farmers’ profits at each demand site over a chosen time horizon Based on the crop-water functions Based on the crop-water functions

Disadvantages of integrated models Complexity (but can be simplified for broad policy assessments) Complexity (but can be simplified for broad policy assessments) Insufficient data (but steps could be envisaged to improve the models) Insufficient data (but steps could be envisaged to improve the models) Very site-specific (but can be generalized) Very site-specific (but can be generalized)

Indicators Physical indicators of water use efficiency are limited in that either high or low values do not tell anything about the economic implications (higher or lower benefit to society) Physical indicators of water use efficiency are limited in that either high or low values do not tell anything about the economic implications (higher or lower benefit to society) Economic indicators and indices of water use efficiency combine physical and economic data and also account for multi-period relationships Economic indicators and indices of water use efficiency combine physical and economic data and also account for multi-period relationships Policy-related indicators of water use account for how water is used to meet social goals (ex: poverty alleviation) Policy-related indicators of water use account for how water is used to meet social goals (ex: poverty alleviation)

Main economic indicators Water productivity: Water productivity: Standardized Gross Value of Production: Standardized Gross Value of Production: Profit per unit of water consumed: Profit per unit of water consumed: Cost recovery rate: Cost recovery rate:

Directions for the future Improve data collection Improve data collection Maintain regularly a water accounting perspective Maintain regularly a water accounting perspective Carry out routinely the economic analyses Carry out routinely the economic analyses Make use of Spatial Decision Support Systems (SDDS), as a combination of: Make use of Spatial Decision Support Systems (SDDS), as a combination of: Decision Support Systems (DSS) Decision Support Systems (DSS) Geographic Information Systems (GIS) Geographic Information Systems (GIS)

Thank you!