Pricing Policies in Managing Water Resources in Agriculture: An Application of Contract Theory to Unmetered Water

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1 Water 2013, 5, ; do: /w Artcle OPEN ACCESS water ISSN Prcng Polces n Managng Water Resources n Agrculture: An Applcaton of Contract Theory to Unmetered Water Francesco Galoto 1, *, Mer Ragg 2 and Davde Vagg Department of Agrcultural Scences, Unversty of Bologna, Va G. Fann, 44, Bologna, Italy Department of Statstcal Scences, Unversty of Bologna, Va Belle Art, 41, Bologna, Italy; E-Mal: mer.ragg@unbo.t Department of Agrcultural Scences, Unversty of Bologna, Va G. Fann, 44, Bologna, Italy; E-Mal: davde.vagg@unbo.t * Author to whom correspondence should be addressed; E-Mal: francesco.galoto@unbo.t; Tel.: ; Fax: Receved: 15 July 2013; n revsed form: 5 September 2013 / Accepted: 16 September 2013 / Publshed: 27 September 2013 Abstract: The paper explores how agrcultural water prcng could contrbute to lowerng water demand when uses are unobserved (asymmetrc nformaton). The topc of the paper s justfed by the fact that most water authortes worldwde do not control water uses at the farm scale. The study draws nspraton from the prcng polces of a Reclamaton and Irrgaton Board n Northern Italy. It analyses the optmal desgn of current tarff strateges wth respect both to the actual regulator s goals and the cost recovery objectve of an deal regulator drven by European Water Framework Drectve prncples and havng full nformaton. The analyss s based on the logc of a Prncpal-Agent model mplemented as a mathematcal non-lnear programmng model. Gven the current prcng structure and assumng zero transacton costs, the results show a relevant ncrease n net benefts for the deal scenaro wth respect to the actual one as water use costs ncrease. Benefts dfferences between the two scenaros mark a lmt n value below whch mechansms able to solve the exstng asymmetres between the prncpal and the agents are economcally desrable. The study concludes by showng that the current regulator s dscrmnatory strategy (prcng structure) would be better justfed wth hgher levels of cost for water use. However, the exstence of non-zero transacton costs related to the control of water uses ponts to the need for further research n order to analyze ncentve mechansms n the absence of water meterng.

2 Water 2013, Keywords: unmetered water; asymmetrc nformaton; prcng schemes; water framework drectve; rrgaton; economc analyss; mathematcal smulaton 1. Introducton The European Unon, Russa and South Afrca have recently reformed ther water polces n order to address new water-related challenges, ncludng populaton growth and clmate change [1]. These water reforms have n common a transton from an approach focused on ncreasng water supply to one that focuses on the management of water demand. These reforms were partly devoted to dentfy an nsttutonal body able to ensure a sutable management of water uses. As a result of ths process, watersheds are mostly recognzed to be the most effectve and sustanable nsttutons for water governance. Another strand of acton concerns the dentfcaton of polcy nstruments to effcently mpact the behavor of water users. In spte of the ncreasng attenton beng pad to economc nstruments, ths ssue s not sutable for generalzed solutons, snce prcng schemes should take nto account local and regonal crcumstances regardng water uses, water avalablty, farm sze and crops grown. However, economc nstruments reman explctly promoted by the European Unon (EU) through ts Water Framework Drectve (WFD). The WFD ncludes three economc concepts: (1) Full Cost Recovery (FCR) whch covers the recovery of the costs related to water servces, the potental negatve envronmental effects of soco-economc actvtes and the foregone opportuntes of alternatve water uses (resource costs); (2) The Polluter Pays Prncple (PPP) that looks at the adequacy of contrbutons to compensate for the cost of envronmental damage generated by users; (3) Incentve Prcng (IP) that deals wth the way n whch water use s pad for and whether the rght sgnals are transmtted to the water users. These concepts underscore the dual purpose of chargng for water use, namely fnancal and economc. From a fnancal perspectve, the tarff allows the regulator to recover all or part of the captal and current costs. From an economc perspectve, the tarff enables the regulator to conserve water and rase water productvty [2]. The man assumpton underlyng the regulator s ablty to acheve one or more of the above polcy objectves by way of tarffs reles on drect or ndrect knowledge of the amount of water used by ndvdual sectors or agents. Hence, water meterng s a key step n allowng local authortes to develop prcng polces that adhere to EU WFD prncples [3 11]. However, the most common prcng systems for rrgaton water n the world [12] and n Europe [12,13] rely on area-based charges, dsconnected from actual use. Indeed, water meterng s extremely controversal n agrculture and greatly constrans the adopton of effcent water prcng for rrgaton [2]. The result s the nablty of tarffs to contrbute to more effcent water use, wth, n addton, the fact that hgher tarffs (potentally needed n order to acheve cost recovery) hurt the less water ntensve crops. Ths also undermnes the EU WFD objectve of usng prcng-based ncentve mechansms to mtgate water scarcty. From an economc pont of vew, the lack of water meterng can be nterpreted n the framework of nformaton asymmetres between management authortes and farmers. Ths stuaton has prompted

3 Water 2013, some researchers to study the problem of tarff desgn when water uses are unobserved. Unmetered water s usually prced on a per area bass [14,15] but may also be prced, at least theoretcally, by chargng per unt fees on observable outputs or nputs [12,16]. If the entre water supply cost s borne by the water users, then t makes no dfference f water nputs are unobservable. A problem arses, however, when the cost of water ncludes publc good components due to scarcty or extracton cost externaltes [12]. In ths case, farmers would lkely decde to use more water than they would use n a stuaton characterzed by a socally optmal allocaton, and hence some knd of regulatory nterventon may be desrable. Avalable nformaton, such as the total harvested area, could consttute naccurate proxes for water uses and, hence, ndrect water fees may even ncrease neffcences. The prcng problem s also exacerbated when ndvdual farmers producton technologes are unknown to the water authortes (adverse selecton) [17,18] and regulaton entals transacton costs assocated wth admnstraton, montorng and enforcng actvtes [12]. Ths paper ams to verfy whether exstng area-based tarff strateges are effcent economc nstruments for water polcy and to what extent alternatve desgn n the drecton of rrgated area-based nstruments can help n better complyng wth European water polcy prncples. The case study focuses on a Reclamaton and Irrgaton Board (RIB). Ths type of nsttuton, the man provder of rrgaton water n Italy, s a user-based allocaton mechansm smlar to others n place n some Southern EU Member States [13], and s recognzed as beng an approprate nsttuton to allow for the analyss of dfferent knds of tarff polces [19,20]. Ths nsttuton provdes water for users n keepng wth the relevant Italan legslaton and mposes a payment based on a porton of the RIB s costs, shared among users on the bass of an estmaton of ther expected benefts [21]. RIB prcng polces are not necessarly focused on promotng sustanable water uses. Prcng strateges are lmted to the recovery of current fnancal costs and do not account for other fnancal costs, opportunty costs or costs assocated wth envronmental externaltes. In the case of a revson of the RIB s contrbuton system n accordance wth the FCR prncples defned n the WFD, a sgnfcant restructurng of RIB water prcng systems could occur. As specfed above, tarff strateges should be talored to the specfc types of dstrbuton systems. The nablty to meter water consumpton requres varous tools of prce dscrmnaton amed at mprovng the control of water uses [22]. Specfcally, the RIB n the case study offers farmers the possblty to choose between a tarff based on the total farm area and a tarff based on the rrgated area. These optonal contracts generate nformaton for the RIB about the actual producton technology (whch allows for a more effcent ncentve system), based on the contract chosen by each farm, as well as transacton costs due to the need to montor rrgated farmland. Gven the water demand functon and the proft functon of dfferent farm types estmated n a recent research study carred out n the RIB s area [23], and assumng that farmers are proft maxmzers and that the regulator seeks to meet the new requrements mposed by the Drectve, we examne the contrbuton of mproved contract desgn through a contract theory approach startng from the current RIB prcng strateges. The results show that beneft dfferences, arsng from the ablty to manage farmers tarff choces, vary wth ncreasng water use costs. Wthn a certan range of water scarcty, surplus dfferences may justfy the transacton cost requred to solve nformaton asymmetres.

4 Water 2013, The paper s dvded nto four sectons. Secton 2 descrbes the current prcng polces n the Case Study area. Secton 3 sets out the methodology; formalzng the producer s behavor; the secton dentfes two dfferent potental scenaros for the regulator s prcng strateges. Secton 4 presents a numercal analyss of the dentfed prcng strateges based on avalable nformaton about rrgaton n the area, under dfferent scenaros of cost recovery oblgatons and nformaton asymmetry. Secton 5 provdes a dscusson on how contract theory could help to defne strateges able to ntegrate the WFD prncples n actual prcng polces based on the experence carred out n ths study, followed by some concludng remarks. 2. The Case Study The RIB s an assocaton of persons who own property (land and buldngs) n ts jursdcton. Landowners who are assocates of the RIB are requred, accordng to the subsdarty prncple, to contrbute drectly to the pursut of the general nterest. The RIB undertakes nsttutonal (collecton of contrbutons), operatonal (management) and proactve (plannng) functons. Wth regard to the nsttutonal functons, contrbutons for reclamaton are enforced on all agrcultural and non-agrcultural assets n ts jursdcton. RIBs are also major provders of rrgaton water. Prcng strateges arsng from the use of rrgaton water are currently desgned autonomously by the RIB and vary wth respect to the type of dstrbuton system. In any case, by statute, cost allocatons among assocates are performed on the bass of the degree of beneft. In fact, ths prncple s not always rgorously met, especally when rrgaton water s unmetered. Italan RIBs have hstorcally dealt wth the recovery of operatng costs. They rely on State fundng for the coverage of nfrastructural nvestments and hence are not n charge of recoverng the related (captal) costs. Accordng to the FCR prncple, wth the mplementaton of the WFD, State nterventon should drve the local populaton towards the self-management of water resources. Accordngly, Basn Dstrcts [24] should lead the varous economc sectors usng water, ncludng those served by the RIBs, to take responsblty of the full costs requred to ensure a good hydrologcal status of the area under ther jursdcton. Lack of meterng condtons hnders the applcaton of cost sharng between farmers on the bass of water use. In ths respect, optons allowng some prce dscrmnaton are expected to favor a greater ablty to control resources, ensurng a better allocatve effcency and a more ratonal use of water for rrgaton. The case study focuses on the RIB of Western Romagna (Consorzo d Bonfca della Romagna Occdentale CBRO). The consortum covers an area of 195,000 ha of whch 70,000 ha are plans. Frut and wne grapes are the man crops grown n the area. Therefore, rrgaton s both frequent and abundant. The study area s partcularly attractve for the nvestgaton of dfferent water management nstruments: Part of t s served by pressure ppes and part receves water va open canals. As a result, dfferent prcng systems are also n place, ncludng volumetrc prcng n areas served by pressure ppes and area-based tarffs n the remanng parts of the RIB. For some of the areas served by surface water, the RIB uses a prcng regme that provdes the choce between two tarff optons.

5 Water 2013, The frst opton s a per area based tarff mposed on the entre farmland area,.e., t does not account drectly for the dstncton between rrgated and non-rrgated land n ndvdual farms. However, t takes nto account the general greater share of rrgated area for smaller farms, by settng a per hectare tarff, T a (x ), that decreases wth the ncrease n farm sze, x up to a certan threshold of land sze, x s, after whch t stablzes to a flat rate per hectare. For farmers exceedng x s, the tarff per hectare s traceable to the followng formula: Here, K s the tarff correspondng to the total pad for amount of land equal to x s and equals the ntegral of T a (x ) from 0 hectares to x s ; t a s the tarff per hectare over the remanng harvested area. Thus, f x equals x s the average per hectare tarff would be equal to K/x s. For larger farms, t a (x x s ) wll play a greater role n nfluencng the entre value pad by the farm, whle the average (per hectare) tarff wll tend to the margnal value (t a ) as x tends to +. We defne ths prcng scheme as a no ncentve tarff snce t s not capable of affectng water uses. The second opton, unlke the frst one, s based on a per hectare tarff proportonal to the quota of rr b rr b rr rrgated farmland, x, such that: T ( x ) = t x. We refer to ths prcng scheme as ncentve tarff snce t s able to affect water uses. Here, farmers are requred to declare the sze of the rrgated area. Ths practce, based on self-reportng by farmers, and hence requrng controls by the RIB, generates specfc montorng costs that are charged by way of the water tarffs themselves. Fgure 1 descrbes the evoluton of the per hectare tarff under the two prcng schemes as farm sze rr (x ), and, respectvely, rrgated land ( x ), ncreases. As x ncreases, the average fee under the frst prcng opton (blue lne) decreases from 72 /ha, for farms sze under 1.5 ha, to 27 /ha, for huge farms. In contrast, the second prcng opton (red lne) s not affected by farm sze and ts average value s constant (187 /ha of rrgated farmland). Ths double tarff scheme s mplemented for the man purpose to ensure a more equtable allocaton of costs among benefcares, snce the share of rrgated crops tend to decrease wth ncreasng farm sze. Under such crcumstances an rrgaton-related tarff proportonal to the total farmland area would be too unbalanced for large farms. b In addton, the RIB offers the opton of choosng the ncentve tarff, T ( x rr ) only to farms that are larger than 15 ha. Ths lmt s set snce the ncentve tarff requres the farmer to self-report the quota of rrgated farmland, forcng the RIB to organze controls n order to verfy complance. Costs arsng by drect montorng are charged by way of the water tarffs themselves. These costs ncrease wth the farmer s choce of the ncentve tarff scheme lmtng the regulator s ablty to check for uses. Ths explans the regulator s decson to lmt the choce of ths tarff scheme only to large farms (that are also less numerous). In a recent research fve dfferent clusters of farms were dentfed n the RIB s regon [23]. Under the current polcy, only two of them have the opportunty to choose between the dscussed tarff schemes. The frst type represents 3% of RIB farms and s characterzed by an average farm sze of ha, 37% of whch s covered by orchards; the second, represents 1% of RIB farms and s characterzed by an average farmland area of ha, 16% of whch s devoted to orchards. The two farm types represent 21% of the area managed by the RIB. As these farm types are the only ones that can choose between the two tarff optons, they are also the only ones consdered n ths study.

6 Water 2013, Fgure 1. Average tarff trends wth ncreasng total and rrgated farmland for the two tarff optons. 3. Methodology The present secton begns frst by analyzng how the producers behave gven the two tarff alternatves prevously descrbed and assumng that the farmer maxmzes hs/her profts. Then, the methodology shfts from the users to the regulator s perspectve. The tarff s no longer exogenously gven, as n the producers problem, but s rather endogenous to the regulator s problem. The key parameter drvng the decson s the cost of water. Once the publc problem s defned we consder two scenaros. The frst scenaro reflects the present stuaton. Here, the water use cost s assumed to be perceved drectly by the regulator but the tarff nstrument s used only to recover operatonal costs. The second scenaro assumes the commtment to FCR and perfect nformaton by the regulator regardng farmer types (technology). It reflects the theoretcal stuaton n whch the water use cost s entrely transferred to the producers by the tarff nstrument, whle mantanng the current tarff structure. In the producer problem, gven the RIB s prcng optons, and assumng that the farmer maxmzes hs/her proft and that the share of rrgated area has already been establshed, the choce of the tarff opton by the farmer,, may be expected to be drected towards the less costly opton: T k* T k* = mn[t a (x ),T b (x rr )], wth k = {a, b} a b rr where a and b reflect the two tarff optons and k* s the one chosen. If T ( x ) t x, then T a b (x ) wll be preferred over T ( x rr ). That s, as long as x rr T a (x )/t b the farmer s nduced to opt for the no ncentve tarff. Otherwse, the farmer s nduced to opt for the ncentve tarff. Thus, the rato between the average value of the no ncentve tarff and the margnal value of the ncentve tarff, whch decreases as farmland ncreases, provdes a threshold, Tr, such that Tr = T a (x )/t b rr = x. Ths threshold, on the bass of the actual quota of rrgated farmland, marks the transton from preferrng one tarff to preferrng the other. (1)

7 Water 2013, The prevous model can be reformulated by removng the hypothess that the share of rrgated area has already been establshed by the farmer, thus condtonng the choce of the tarff to the choce of the optmal share of rrgated farmland. The problem can, therefore, be modeled as a choce between the two prcng optons, jontly consderng the optmal rrgated area, accordng to the crteron of proft maxmzaton. Assumng that the per hectare proft functon, π ( ), s concave and ncreases as ' rr '' rr the quota of rrgated farmland ncreases, wth π, the farmer compares the ( x ) > 0 e π ( x ) 0 proft that can be obtaned under each tarff opton: Π k (x rr* ) = max[π (x rr* a ) T a (x ), π (x rr* b ) T b (x rr* b )] k rr * ( x ) s the maxmum proft that can be obtaned as a result of both the choce of tarff type and rr* share of rrgated area; x a rr*, x b are respectvely the optmal quota of rrgated areas n each tarff opton (resultng from the relevant frst dervatve of the dfference between profts and the optonal rr * tarffs); accordngly, x s the optmal share of rrgated farmland resultng from the hgher value of the net proft optons. k * The tarff choce, T, does not necessarly match the mnmum value of the two tarff optons as gven n Equaton (1). Here, when the frst opton of Equaton (2) s greater than the second, rr * a a rr * b b rr * b π( x ) T ( x ) π( x ) t x, then the farmer wll opt for the no ncentve tarff, T k* = T a rr* (x ). That s, as long as x b T a (x )/t b rr* [π (x a rr* ) π (x b )] / t b the farmer s nduced to opt for the no ncentve tarff. Otherwse, the farmer s nduced to opt for the ncentve tarff. The tarff opton threshold, Tr, s no longer compared wth a gven share of rrgated farmland, but rather wth the optmal share of rrgated farmland resultng from the choce of the ncentve tarffs, rr* x b, plus the rato between the dfferences n gross profts and the ncentve tarff, rr* [π (x a rr* ) π (x b )] / t b, and such that: Tr = T a (x )/t b = x rr rr* +[π (x a rr* ) π (x b )] / t b.the value of rr* ths last argument s always postve as x b rr* x a [25]. As a result, the threshold tends to be hgher than the ones obtaned n Equaton (1). Ths s consstent wth the fact that ths second modelng opton allows for more flexblty n farm adaptaton, whch s, by the way, closer to realty. In bref, the choce threshold s condtoned both by the publc prcng polces and the ntrnsc characterstcs of each farm type. Both the relatve values of the prce schemes (T a (x )/t b ) and the absolute values of the ncentve tarff (t b ) play a key role n condtonng prvate choces wth dfferent results, dependng on how farm types dffer. Assumng that the regulator s actng n complance wth the FCR prncple, the cost of water use (v, n /m 3 ) does not depend solely on the current operatng costs, but s rather ted to other costs, ncludng envronmental and opportunty costs. These costs should be charged to the recpents on the bass of the respectve degree of responsblty. Envronmental externaltes are related to polluton and to an excessve use of water. In the present study t s assumed that the unt cost of water usage, v, s proportonal to rrgaton water use and that the amount of water use per hectare of rrgated land vares across farms. Hence, the total per hectare water use cost s drectly connected to water uses, rr * W ( x ) rr *, that dffer as both farm types,, and rrgated farmland, x, dffer, and such that: rr * rr * CW ( x ) = v W ( x ). The publc regulator s assumed to act n the nterests of the communty by regulatng the choces of ndvduals n order to seek an optmal use of the resources. Formalzng the problem we have: (2)

8 Water 2013, max n rr* rr* rr* ( ) = γ [ π( )- ( )] = 1 Z x x CW x s.t.: k FCR T * CW (x rr* ) where x rr* k = f (T `), x rr* 0 rr* Z ( x ) s the objectve varable and represents the per hectare net socal beneft, of a regulator that acts n the nterests of the socety as a whole; ths s an often used assumpton n envronmental-economc modelng. Ths s gven by summng the weghted dfferences between the per hectare profts (excludng water tarffs) of each type of user under the regulator s jursdcton (here, farmers) and the correspondng costs assocated to water uses, consdered to be borne by socety. The weghtng term, γ, s the share of each farm type, gven by the rato between the total agrcultural area related to each farm type and the overall agrcultural area under the regulator s jursdcton. Farmers do not drectly perceve water use costs as water s managed collectvely and costs are transferred to users va tarffs. Thus, tarffs are not costs per se, but rather consttute transfers and do not enter nto the objectve functon of the regulator (whle they reman costs from the farmers pont of vew). FCR s the constrant of full cost recovery for water use. Accordng to the full cost recovery prncples, t requres tarffs that are able to recover the cost of water uses and accordng to the polluter pays prncple t mposes tarffs that are at least equal to the water use costs borne by each type of farm. Note that ths nterpretaton s strcter than the one actually gven n the mplementaton of the WFD, whch apples to entre sectors and not to ndvdual users. rr* k ' x = f ( T ) derves from the prvate problem and s the reacton functon of the rrgated farmland for each farm type that vares as the RIB s prcng polcy changes. An addtonal condton s x rr* 0. rr* The cost functon assocated wth the use of rrgaton water [ CW ( x ) ] s prmarly faced by the RIB as a result of users decsons (farmers). Currently, as prevously stated, the RIB ascrbes only a part of the cost recovery to the recpents. The FCR constrant s actvated f the regulator acts n complance wth the WFD. Hence, costs are drectly shfted to producers by way of the tarff. Under such crcumstances, the awareness of farm types allows the RIB to dentfy the optmal mx of tarff levels that mnmze the mpact of water use costs on farm profts. If the regulator does not comply wth the WFD, the effort to optmze tarff strateges s not justfed as most of the socal cost of water uses s borne by socety and not drectly by farmers. We test the model above usng two scenaros and for ncreasng values of water use costs, whch s expected to be one of the major drvers of the actual socal desrablty of more complex prcng solutons. The current water use costs correspondng to the full cost are currently unknown n the area, so a parametrzaton n a reasonable range was carred out for fnancal captal, envronmental and resource costs to be consdered n addton to operatonal costs. Specfcally, n a frst scenaro t s assumed that, regardless of the cost of water use, the RIB gnores the requrements mposed by the WFD (FCR constrant) wthout changng ts prcng polces, hence _ keepng constant the margnal values of the tarff optons ( T k* ). Ths s the present stuaton that consders only the recovery of the operatonal costs. Addtonal costs are mplctly left to be borne by socety. (3)

9 Water 2013, In a second scenaro t s assumed that the RIB knows the profts and water use functons of ts members. Under these condtons, the regulator s able to predct producers reactons to a tarff varaton and, hence, to act approprately on tarff varatons n order to optmze the collectve beneft. 4. Results The methodology was mplemented n the case study usng a recent estmaton of the per hectare proft and water use functon of two farm types n the RIB s regon [15]. Fgure 2 shows the margnal proft functons of the farm types and the margnal functons of the tarff optons offered by the RIB. The slope of the proft functons depends on the crops grown by each farm types. Proft functons cross the x-axs to a pont correspondng wth the optmal quota of rr* rrgated farmland under the no ncentve tarff regmes, x a (respectvely pont A and B n Fgure 2). The horzontal lne represents the margnal value of the ncentve tarff, t b. The projecton on the x-axs of the crossng pont between the margnal tarffs and the proft functon of the two farm types (respectvely ponts A and D n Fgure 2) s the optmal quota of rrgated farmland under the ncentve rr* tarff regmes for each type, x b (respectvely ponts C and F n Fgure 2). The dotted vertcal lnes n Fgure 2 show the tarff thresholds obtaned n Equaton (4) for each farm type. The thresholds cross the x-axs to a pont the value of whch s gven by addng to the rr* optmal quota of rrgated farmland under the ncentve tarff regmes, x b, the rato between the rr*a gross proft dfferences wth the two tarff optons and the ncentve tarff, [π (x ) π (x rr* b )] / t b. The gross proft dfferences correspond to the trangular areas ABC and DEF n Fgure 2 respectvely for the two farm types. The heght of those areas matches the level of the ncentve tarff. Thus the rr* threshold can be rewrtten as follows: Tr = x b rr* + (x a rr* x b )/2. For a tarff rato equal to the threshold farmers are ndfferent to both tarff regmes. Hence, the dscrmnatory power of the optonal tarffs s null. If the relatve rato between the tarffs s hgher rrb than the threshold, farmers wll opt for the ncentve tarff [ T b ( x ) ]. As a result, the rrgated farmland decreases by a quota correspondng to the dfference between the ntersecton of the margnal proft functon wth the x-axs and the projecton of the ntersecton of the margnal proft functon wth the ncentve tarff level. Currently the tarff rato, T a (x )/t b, s lower than the threshold for both farm types. However, few farms, only partally represented by the type assocated to ther characterstcs, currently opt for the ncentve tarff. Hence, because of the present tarff opton levels most of the farmers agree wth the no ncentve tarff, T a (x ) [26]. The prvate problem helps to understand how the publc decson-maker should drect ts prcng strateges n lght of the new challenges mposed by the WFD. Fgure 3 shows the collectve beneft of the two scenaros descrbed n the methodology. In the frst scenaro, tarff choce condtons are constant and reflect the repayment of the delvery costs borne by the water authorty. Producers do not pay any addtonal costs that are assumed to be charged to socety. In the second scenaro t s assumed that the regulator s aware of the users producton and rrgaton schemes and the costs assocated wth the use of rrgaton water are entrely transferred to the producers. Wth respect to the other scenaros, the regulator s nduced to mnmze the mpact on users benefts by settng the optonal tarff.

10 Water 2013, Fgure 2. Proft and tarff functons wth ncreasng quotas of rrgated farmland. Fgure 3. Beneft trends wth ncreasng rrgaton costs for the two scenaros. 1,600 1,400 Collec ve Beneft ( /ha) 1,200 1, Water use cost ( /m3) 1 Scenaro mplementa on of costant charges on opera onal costs 2 scenaro mplementa on of the tarff s op ons schemes on full costs Range of beneft vara on between scenaros Beneft dfferences between the two scenaros mark the acceptable lmt of the transacton costs that would arse wth the adopton of the ncentve tarffs n the second scenaro. Up to a water use cost of 0.30 /m 3 dfferences n benefts between the two scenaros are not sgnfcant: In between 0.30 /m 3 and 1.00 /m 3 dfferences n beneft ncrease from about 0 /ha to 30 /ha. From a water use cost of 1.00 /m 3 the trend n benefts n the second scenaro remans constant, whle n the frst scenaro t stll decreases. Ths s due to the fact that n the second scenaro for ncreasng levels of water use costs the regulator tends to set tarff optons n such a way as to nduce an ncreasng number of farmers to choose the ncentve tarff up untl a value at whch all farm types cease to rrgate. Currently, farmers served by pressure ppes n the regon under the case study jursdcton pay volumetrc tarffs equal to 0.12 /m 3. The level of the current tarffs s much lower than the value at

11 Water 2013, whch t s possble to ascertan apprecable dfferences n benefts between the two scenaros. Ths fact helps justfy why the RIB s lmtng the enforcement of tarff optons to a few farms. Fgure 4 shows the trend of the quota of rrgated farmland wth ncreasng water use costs for the dfferent scenaros. For the frst and second scenaros water use costs do not condton farmers water uses. In the frst scenaro, ths s due to the absence of a tarff polcy that endogenzes any externaltes assocated wth the use of water for rrgaton purposes. In the second scenaro, a tarff dsconnected from water uses s the explanaton of farmers ndfference to ncreasng water use costs. Fgure 4. Quota of rrgated farmland trends wth ncreasng rrgaton costs for the two scenaros Quota of rrgated farmland (ha) Water use cost ( /m3) 1 Scenaro mplementaton of costant charges on operatonal costs 2 scenaro mplementaton of the tarff s optons schemes on full costs Even f ndrectly, only the second scenaro shows the exstence of a relaton between water use costs and water uses. The relaton between the water use cost level and the quota of rrgated farmland n the second scenaro s explaned by the fact that at least one of the two farm types consdered n ths paper opts for the ncentve tarff. The change n slope of the red lne n Fgure 4 results from a varaton n tarff choces. Ths varaton occurs n favor of the ncentve tarff as the quota of rrgated farmland contnues to decrease wth ncreasng water use costs to a level at whch all farms cease to rrgate. For a cost of water equal to 0.12 /m 3, correspondng to the current value for volumetrc tarffs n the case study regon, the second scenaro shows a 5% reducton n the rrgated land share. A 400% ncrease n the cost of water wth respect to the current value brng to a 50% reducton n the rrgated land share, whle an 800% ncrease n the cost of water nduces farmers to cease rrgaton. 5. Dscusson and Conclusons The am of ths study was to verfy whether the exstng tarff strateges for rrgaton water are effcent economc nstruments for water polcy and to what extent alternatve desgns could help n better managng water demand n the absence of water meterng. Specfcally, the paper dscusses the desgn of a prcng strategy presently appled n the case study area that, wth the addton of reasonable montorng costs, allows for the mplementaton of an ncentve tarff whch approxmates a volumetrc prcng scheme by couplng tarffs to the rrgated area.

12 Water 2013, Accordng to the scenaros proposed, the mplementaton of the WFD prncples should enable the regulator to recover the full cost needed to provde servces. The modfcaton of the exstng tarff polces, presently based on an area-based flat rate system, s justfed f transacton costs, due to the need to montor at least rrgated areas under no meterng condtons, are lower than the dfference n beneft between the two scenaros. From ths perspectve, the RIB should adjust the tarffs for rrgaton water uses accordng to the type of prorty (fundng and/or envronmental protecton) and n complance wth the crteron of cost sharng (equty). As noted n the results, ths may, at least partally, resolve the problem of asymmetrc nformaton. Indeed, even f farmers proft and water use functons are unknown, the tarff optons, f properly calbrated, would lead some farmers to choose the ncentve tarffs, hence revealng ther water proftablty. Ths would lead to an ntermedate stuaton between the two extreme scenaros that ncludes, on the one hand, the absence of any volume-related prcng polcy and, on the other, a metculous tarff plan modulated on the margnal productvty of each farm type. Although usng qute dfferent premses from those n our study, other recent studes have analyzed the mplementaton of alternatve water prcng polces for rrgaton [10,11]. Specfcally, the analyss of Veettl et al. [10] n the Krshna Rver basn, Inda, demonstrated that farms served n the absence of water meterng tend to opt for ncentve tarff schemes mostly for hgh levels of water use costs. Ths s also consstent wth our study n whch the current low level of cost recovery does not justfy the adopton of the alternatve tarff by any of the farm types served by the RIB. Moreover, Fragoso and Marques [11], n a study carred out n the Alentejo regon of Portugal, dentfed volumetrc block tarffs as the most effcent ncentve strategy. Ths s due to the fact that farmers mostly used to have a demand elastcty for rrgaton water that ncreases wth ncreasng water use cost. In the absence of water meterng ths would probably result n the dentfcaton of fxed charge quotas as beng the best ncentve strategy. However, beyond comparng the tarff schemes, the man purpose of the present study was to analyze the regulator s behavor under dfferent polcy scenaros, gven a dscrmnatory strategy that conssts of the mplementaton of two tarff optons. Ths s very relevant n the case study areas as t allows for the dentfcaton of ncentves to lower water demand wthout major changes to the exstng prcng structure and wthout water meterng. Thus, the study descrbes a dscrmnatory strategy that enables the regulator to partally control water use n surface water delvery systems servng a large number of farms (specfcally the RIBs of Western Romagna). Under such crcumstances, ncentve strateges are consdered prohbtvely expensve [2]. That s why the regulator s currently lmtng the mplementaton of the tarff opton schemes to only a few farms. An mportant lmtaton of the research s found n the smplfed descrpton of the two scenaros. Complance or not wth WFD prncples on water prcng s the prncpal dfference between the two scenaros. However, we only analyzed the effects related to the mplementaton of the ncentve prcng prncples. The other two prncples appear as assumptons of the regulator s maxmzaton problem and are mplct n the FCR constrant. The polluter pays prncple s also mplct n the regulator s tarff polces. Moreover, the FCR constrant at the farm level s an exacerbaton of current regulatory gudance. Chargng full costs to ndvdual farmers s n fact beyond the prescrptons of the WFD, whch recommends mplementng ts prncples for the agrcultural sector as a whole, and at the rver basn dstrct level, but not at the level of each ndvdual water servce user [27].

13 Water 2013, Another sgnfcant lmtaton arses from the assumpton of perfect nformaton under the scenaro n whch complance wth the WFD prncples s assumed. In the absence of water meterng, the regulator would not be able to determne the technology used (farm types) nor control water use (rrgated land). Ths condton mplctly poses the two man problems of asymmetrc nformaton: adverse selecton and moral hazard. Smth and Tsur [12] were the frst to tackle both problems theoretcally, but only adverse selecton has actually been tested [15]. The ablty to deal wth adverse selecton allowed Vagg et al. [15] to dstngush tarffs accordng to farmers water use atttudes; hence substantally ncreasng performances wth respect to there beng no dscrmnaton. The dscrmnatory strategy descrbed n ths paper n addton to tarff optons would probably further mprove the dscrmnatory power of the regulator, strengthen ts ablty to mnmze the mpact of water tarffs on farm profts, whle provdng more adequate ncentves. Currently there are no studes, ncludng ths one, whch drectly tackle the ssues of moral hazard. Ths s the man lmtng factor of the present study as moral hazard condtons the extent to whch montorng actvtes enables the regulator to mplement ncentve strateges n the absence of water meterng. In ths study, the dfferences n performance between the two scenaros lmt the montorng costs due to the need to control rrgated land that would arse wth the adopton of the ncentve tarff. As a result, by adjustng tarff opton levels, the regulator would be able to foresee how many farms wll opt for the ncentve tarff and hence control both water uses and montorng costs. Thus, the dscrmnaton strategy descrbed n ths paper could be consdered as a startng pont for the analyss of moral hazard n the absence of water. Specfcally, the man queston wth respect to water prcng n the absence of meterng s to recognze the most cost effectve montorng strateges that would enable the regulator to overcome moral hazard arsng from false reportng. Ths last consderaton suggests a new drecton for further research. Acknowledgments The authors wsh to thank the anonymous referees for the frutful suggestons and Davd Cumng for Englsh edtng. Responsblty for the contents of the study les solely wth the authors. Conflcts of Interest The authors declare no conflct of nterest. References and Notes 1. Chrstan, J.S.; Gleck, P.H.; Cooley, H. US Water polcy reform. In The World s Water: The Bennal Report on Freshwater Resources; Gleck, P.H., Ed.; Island Press: Washngton, DC, USA, Molle, F.; Berkoff, J. Water prcng n rrgaton: Mappng the debate n the lght of experence. In Irrgaton Water Prcng: The Gap between Theory and Practce; Molle, F., Berkoff, J., Eds.; CAB Internatonal: Wallngford, UK, 2007; pp Moore, M.; Gollehon, N.; Carey, M. Multcroop producton decsons n western rrgated agrculture: The role of water prce. Am. J. Agrc. Econ. 1994, 76,

14 Water 2013, Gardner, B.D. Some mplcatons of federal grazng, tmber, rrgaton, and recreaton subsdes. Choces 1997, 12, Schable, G.D. Water conservaton polcy analyss: An nterregonal, mult-output, prmal-dual optmzaton approach. Am. J. Agrc. Econ. 1997, 79, Iglesas, E.; Garrdo, A.; Sumps, J.; Varela-Ortega, C. Water demand elastcty: mplcatons for water management and water prcng polces. In Proceedngs of the World Congress of Envronmental and Resource Economsts, Vence, Italy, June 1998; pp Varela-Ortega, C.; Sumps, J.M.; Garrdo, A.; Blanco, M.; Iglesas, E. Water prcng polces, publc decson makng and farmers response: Implcatons for water polcy. Agrc. Econ. 1998, 19, Berbel, J.; Gomez-Lmon, J.A. The mpact of water-prcng polcy n Span: An analyss of three rrgated areas. Agrc. Water Manag. 2007, 43, Yang, H.; Zhang, X.; Zehnder, A.J.B. Water scarcty, prcng mechansm and nsttutonal reform n northern Chna rrgated agrculture. Agrc. Water Manag. 2003, 61, Veettl, C.P.; Speelman, S.; Frja, A.; Buysse, J.; Mondelaers, K.; van Huylenbroeck, G. Prce senstvty of farmer preferences for rrgaton water Prcng method: Evdence from a choce model analyss n Krshna Rver Basn, Inda. J. Water Resour. Plan. Manag. 2011, 137, Fragoso, R.; Marques, C. The Economc Impact of Alternatve Water Prcng Polces n the Alentejan Regon; CEFAGE-UE Workng Paper; Unversty of Evora: Evora, Portugal, Smth, R.B.W.; Tsur, Y. Asymmetrc nformaton and the prcng of natural resources: Understandng the case of unmetered water. Land Econ. 1997, 73, Bogaert, S. The Role of Water Prcng and Water Allocaton n Agrculture n Delverng Sustanable Water Use n Europe; European Commsson: Brussels, Belgum, Bazzan, G.M.; d Pasquale, S.; Galleran, V.; Vagg, D. Irrgated agrculture n Italy and water regulaton under the European Unon Water Framework Drectve. Water Resour. Res. 2004, 40, Vagg, D.; Ragg, M.; Bartoln, F.; Galleran, V. Desgnng contracts for rrgaton water under asymmetrc nformaton: Are smple prcng mechansms enough? Agrc. Water Manag. 2010, 97, Bowen, R.; Young, R. Allocatve mpacts on alternatve methods of chargng for rrgaton water n Egypt. In Irrgaton Investments, Technology and Management Strateges for Development; Ester, K.W., Ed.; West Vew Press: Boulder, CO, USA, Besanko, D.; Sappngton, D. Desgnng Regulatory Polcy wth Lmted Informaton; Harwood Academc Publsher: Newark, NJ, USA, Smth, R.B.W. The conservaton reserved program as a least-cost land retrement mechansm. Am. J. Agrc. Econ. 1995, 77, Schlagler, E.; Ostrom, E. Property rghts regmes and natural resources: A conceptual analyss. Land Econ. 1992, 68, Coletta, A. Prcng strateges for commons: The case of water users assocaton for rrgaton. Rv. Econ. Agrar. 2010, 4,

15 Water 2013, Testo unco delle dsposzon d legge sulle acque e mpant elettrc. Avalable onlne: url=http%3a%2f%2fwww.sportelloenerga.nfo%2fndex.php%3facton%3ddownload_resourc e%26d%3d112%26module%3dresourcesmodule%26src%3d%2540random4a647f4e18d8e&e =UMA-UlDEyq0Ble6A4As&usg=AFQjCNE8hhWnPxcHbTlErxLOZeshmpmWw (accessed on 12 March 2013). 22. Carlton, D.W.; Perloff, J.M. Modern Industral Organzaton, 3rd ed.; Pearson-Addson Wesley: New York, NY, USA, 2005; pp Galleran, V.; la Va, G.; Zann, G. Water and Agrculture n Italy: Decson Rules and Scenaro Analyss, 1st ed.; Franco Angel: Mlano, Italy, 2009; pp The Basn Dstrct conssts n one or more watersheds (terrtoral unt where all surface water flow nto the sea n a sngle estuary (artcle 2 [27] paragraph 13, WFD) defned as the man terrtoral unt for rver basn management (artcle 2 [27] paragraph 15, WFD). 25. Indeed, by dervng the dfferences between the gross proft functon and the relatve tarffs wth respect to the rrgated area for each farm type the optmal soluton s reached at the equalty between margnal profts and margnal tarffs: Π f k / x rr = π ( x ' ' k = a, π ( x rr rr ) T ) = 0; The value of k(a,b) reflects the tarff choce subject to the optmal share of rrgated area ( ). The frst tarff scheme [T a (x )], beng dsconnected from the rrgated farmland, does not affect a rr water consumpton [ T ( x ) / x = 0 ]. In contrast, assumng a postve correlaton b between water consumpton and rrgated areas, T ( x rr ) s able to nfluence water uses b rr rr b ( T ( x ) / x = T ). Consequently, gven the technology, producers subject to the frst tarff scheme wll maxmze profts at hgher shares of rrgated areas than would farmers who choose the other tarff. Then, from the frst order condton of the above problem we acheve the farmland share at whch producers drect ther own choces, whch n turn s a functon of the margnal tarffs [ x rr* k = f (T `) k wth f `(T `) < 0 ]. 26. In fact, the optonal scheme n force n the case study area nduces few farmers to choose the ncentve tarff. Ther numbers proved to be too nconsstent for the dentfcaton of the fve man farm types populatng the RIB s area. As a result, the optonal tarff seems to have no dscrmnatory power. 27. European Unon. Drectve 2000/60/EC of the European parlament and of the councl establshng a framework for communty acton n the feld of water polcy. Off. J. Eur. Communt. 2000, 327, by the authors; lcensee MDPI, Basel, Swtzerland. Ths artcle s an open access artcle dstrbuted under the terms and condtons of the Creatve Commons Attrbuton lcense ( k ' ( x f rr ) = 0 k = b, π ( x ' rr ) = T b rr * x