Economic instruments involve the use of prices and other market-based measures to improve the way water is managed and used. They work by providing incentives to water users to use water carefully, efficiently and in a manner consistent with the public interest. They have both positive and negative effects.
Economic instruments are of the following types:
- Tariffs and charges paid by water users (households, industries, farmers) to their service providers, which can vary according to the volume of water used, its source, or the time of day or the season in which it is used. The tariff can signal the economic cost of providing and using water, thereby discouraging wasteful or low-value use, and encouraging its deployment to more useful ends. To be effective, tariffs need to be volumetric- based on the amounts of water consumed. Tariffs apply to both freshwater and wastewater treatment charges.
- Abstraction charges levied on the extraction of raw water from rivers, lakes and aquifers by municipal service providers, farmers, and industrial and mining companies. Their purpose is to help regulate the over-extraction of water from these sources, to avoid environmental and ecological damage, and also to reflect the opportunity cost of the water (one person’s use deprives some other user of its benefits).
- Pollution charges which penalise the discharge of contaminated water by water authorities and companies into public water bodies or aquifers. If these are set high enough they will encourage potential polluters to change their use habits, reducing their discharges or treating their effluent prior to discharge.
- Water markets in which users buy the right to use water from others holding these legal rights. These markets can either involve permanent, or annual/seasonal transfers.
- Tradable permits can be bought and sold by users (typically industries or mines) as an alternative to either closing down operations or installing costly pre-treatment facilities. These permits are a way of enforcing local water pollution controls in a way which is more efficient than the above alternatives.
- Subsidies provide positive inducements to behaviour considered to be in the public interest, e.g. for connections to a public water system, promotion of safe household sanitation, to companies installing water-efficient processes or pre-treatment of effluent. These kinds of targeted subsidies should not be confused with unintended subsidies that arise from a failure to charge full cost-recovering tariffs, or ex post debt write-offs for a poorly performing utility.
Some economic instruments, notably tariffs, and pollution and abstraction charges, also have the purpose of raising revenue, which can either be returned to national fiscal revenues, retained by the service provider, or earmarked for specific purposes such as environmental spending. Economic instruments normally work best in combination with other supporting measures: they are unlikely to be effective acting alone. The adage "the market is a good servant but a bad master" applies here. Governments must set the right legal and institutional framework, including regulation, within which individual economic agents can operate – the unfettered market will not provide this.