Pannell Discussions

No. 149, 30 March 2009

Cost sharing for environmental works

Sharing the costs of environmental works between the public and private sectors has a nice ring to it, but how to determine the shares? A commonly used principle is that costs should be shared in proportion to benefits received, but this is unlikely to be an economically efficient approach.

Cost sharing is one approach to providing environmental payments. It has been widely used as a conceptual and practical approach in Australia. There are a number of reports written about it (e.g. Marshall, 1998; Aretino et al., 2001).

Those two reports are written by economists who know what they are doing. However, in other cases cost-sharing is often taken to imply that costs from environmental works should be borne in proportion to benefits received. For example, if farmers reduce their use of chemicals, they may generate some benefits for themselves, and some benefits for the rest of the community. If the benefits to the community are three times greater than the benefits to the farmer, the idea would be that the farmer would be asked to bear 25% of the costs and the public would bear 75%.

If we accept that any system of environmental payments should be designed to achieve the most valuable environmental outcomes, then this approach to cost sharing is difficult to apply and flawed in principle. There are three problems with it. Two of them can potentially be avoided, but one cannot.

To illustrate, suppose that a farmer plants an area of trees on crop land. There are private benefits from provision of shelter for livestock and reduced wind erosion, and public benefit due to provision of habitat for wildlife. There are also direct private costs from planting the trees (the labour required, any herbicide used, equipment depreciation) and indirect private costs, because some land that used to grow profitable crops is now occupied by trees (economists call this an “opportunity cost”).

The first problem is that people tend to look at very partial estimates of the benefits, often ignoring some or all of the costs borne by people who implement the works. I have heard people talk about cost sharing based on gross benefits, ignoring both the direct and indirect costs of the works. Sometimes direct costs may be considered, but not indirect costs. In either case, the person implementing the works is being disadvantaged because the measure of private benefit being used to determine their cost share is bigger than their actual net benefit.

The second problem is that the costs that are shared often exclude the indirect costs. The direct and indirect costs are equally important to the farmer, so the exclusion of indirect costs also disadvantages them.

Thirdly, and more importantly, the whole concept of sharing costs according to benefit shares is not economically sound in any case. It cannot lead to the best environmental outcomes, except by chance.

Why is that? Last week in PD#148 we talked about two approaches to environmental payments that can be the most cost-effective approach in particular circumstances.

(a) Small temporary grants or incentive payments to encourage trialing of the desired works (provided that adoption at the required scale provides a win-win outcome), and

(b) Stewardship payments to offset the net cost to landholders from adopting win-lose options (provided the public gains are larger than the private losses).

In case (a) the payments would be pitched at the lowest level that would entice trialing. In case (b), payments would equal the net cost of adoption (direct cost plus indirect cost minus private benefits). A cost-sharing approach would never match either of these cases except by coincidence. Often it departs substantially from an efficient approach: paying far more than necessary to prompt adoption, or offering to pay far less than necessary so that adoption does not occur. In the former case, cost sharing amounts to a transfer of public funds to the private sector. If government wants to do that, fine, but there is no economic or environmental basis for doing so. In the latter case, the policy fails to meets its objective.

In saying this, I’m assuming that the aim is to achieve the greatest environmental benefits for the available public funds. If that is accepted as the goal, then the appropriate approach is to ask (i) what is the least the government can pay and still have the project proceed? (Aretino et al., 2001) and (ii) given a payment of that amount, are the public benefits sufficient to justify paying that much? You can ignore private benefits in question (ii) because asking question (i) in that way effectively means that the private sector is responsible for its own benefits.

Sometimes people assume that my Public: Private Benefits Framework (Pannell 2008) is about cost sharing, but it isn’t. Rather, it implicitly builds in questions (i) and (ii) above. The private benefit axis is used as a predictor of whether people will adopt the works, and to calculate what is the least you’d have to pay to prompt adoption, rather than to work out a cost-sharing arrangement.

David Pannell, The University of Western Australia, David.Pannell@uwa.edu.au

Further Reading

Aretino, B., Holland, P., Matysek, A. and Peterson, D. (2001). Cost Sharing for Biodiversity Conservation: A Conceptual Framework, Productivity Commission, Melbourne, http://www.pc.gov.au/__data/assets/pdf_file/0005/8294/csbc.pdf

Marshall, G. 1998. Economics of cost sharing for agri-environmental conservation. Paper presented to the 42nd Annual Conference of the Australian Agricultural and Resource Economics Society, University of New England, Armidale Australia, 19-21 January, 1998. http://www.ruralfutures.une.edu.au/downloads/costsharing_116.pdf

Pannell, D.J. (2008). Public benefits, private benefits, and policy intervention for land-use change for environmental benefits, Land Economics 84(2): 225-240. Here

Response

Cost-sharing negotiations should proceed only after a proposed management project has passed the benefit-cost test. There is little point arguing about sharing of costs for inefficient projects. The benefit-cost methodology for ranking projects essentially tells whether or not a particular project is likely to increase community welfare. This is the critical first step and should not be overtaken by undue emphasis on how the project should be paid for, and by whom. The benefit-cost analysis will also assist in identifying the stakeholders between whom the costs should be shared. -- Alistair Watson 30 March 2009

I totally agree. Some sort of formal assessment of benefits and costs is essential, in my view. Observing that Benefit: Cost Analysis is almost never actually used in environmental or natural resource areas, we developed the INFFER framework, www.inffer.org, in which we try to provide a simplified, but still rigorous, method to assess projects for their cost-effectiveness. Use of INFFER has grown rapidly over the past year. - DP


Pannell Discussions are brief pieces on issues and ideas in economics, science, the environment, natural resource management, politics, and agriculture.

148. The Economics of Environmental Payments  23 Mar 2009

150. Why don't environmental managers use decision theory?  6 Apr 2009

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