A major area of contention in including economic concepts into assessments of allocating water centres on the value of water used for environmental purposes. This is a difficult concept to come to terms with as value means different things to different disciplines. The economic and environmental values are usually treated as two entirely different elements, measured using different incomparable techniques and currencies. If these differences could be reconciled, then policy makers and water managers should be in a position to make better decisions regarding the impacts of changing allocations on both the environment and the irrigators who use the water. The aim in this paper is to outline an approach that could be used to compare the value of changing the allocation of water in a catchment on a set of environmental indicators.
The approach requires comparing the physical environmental and economic impacts that may arise and then determine the rate at which one affects the other. A surprising result from this analysis is that it could lead to the specification of a shadow price for water allocated to the environment. Theoretical considerations A hypothetical relationship could be said to exist between the finite flows in a river directed towards human activity and those that are left for environmental purposes. Malano and Davidson (2009) describe such a relationship in a 'production possibility frontier'. At points along this frontier society makes a set of optimal choices of the use of all the flows in the river. A likely outcome is that society chooses some point on the frontier where a certain amount of the physical flow is dedicated to human activities, while the rest is dedicated to the environment. The slope of the transformation curve reveals the opportunity cost of increasing human activity in terms of foregone environmental activity. Thus, the curves allow for an assessment of whether a given improvement in environmental quality is worth the sacrifice in, say, agricultural production or income. The marginal rate of transformation (MRT) is equal to the slope of the transformation curve, which is equal to the change in one outcome (say the returns to the environment dE) divided by the change in the other (say an agricultural returns dY), or MRT = dE/dY, (1) So, according to economic theory, an optimal choice between allocating water to the environment or to another use occurs when the quantities are efficiently used (i.e. at the limits of the production possibility frontier) and that the ratio of the uses (i.e. the quantity used for the environment divided by the quantities of water for other uses) is equal to the ratio of the prices for other uses divided by the price for environmental water (multiplied by -1). An application Wei (2007) constructed an integrated biophysical and economic model of Fengqiu County on the environmentally degraded and ground water depleted North China Plain. In that model she simulated the trade-off between an index of environmental factors (a weighted index of drainage, greenhouse gas emissions, ammonium levels, crop nitrogen uptake and nitrogen leaching) and economic impacts (an index of farmers gross margins) that arise from changes in the prices farmers pay for water, thus yielding a transformation curve between these two activities. The marginal rate of transformation was determined over a range of input prices from the current levels up to 20 times greater. Increasing water prices were found to have a positive impact on environmental indicators and a negative impact on irrigator's gross margins. Regressing the environmental index against the agricultural returns results in a statistically significant estimate coefficient of -1.53. Interpreting the results The marginal rate of transformation can be interpreted as an increase in water allocated that resulted in (say) a 10 per cent increase in total agricultural returns would lead to a 15.3 per cent decrease in environmental indicators, and vice versa, over the whole range of data. However, it should be noted that the marginal rate of transformation varies along the curve. In this case it ranges from -5.5 to 6.7, (with only one element being positive and all the rest being less than -0.24). A positive marginal rate of transformation cannot be ignored as it signifies a range of complimentary points, rather than competitive ones. Rather interestingly, according to economic theory the optimal point on the curve is one where the marginal rate of transformation is equivalent to the ratio of the prices of outcomes (-Pe/Py), or MRT = dY/dE = -Pe/Py, (2) By rearranging equation (2) the one unknown variable (Pe) can be determined as: Pe = dY/dE.Py. (3) So in this case the price of environmental water is equal to 1.53 times the price of water used in agriculture.
Therefore, the price of water used in the environment in this case (over all the data) should be equal to the estimated MRT at any one point multiplied by the price of water to the irrigators at that point. In a place like the North China Plain, where ground water is over exploited and the environmental degradation is great, it would not be a surprise that for any estimate of the MRT that is greater than -1.0, any water destined to the environment has a much higher value than directing water towards irrigation. However, a point will be reached (on the transformation curve) where the opposite will be true. Malano, H. and B. Davidson (2009). "A framework for assessing the trade offs between economic and environmental uses of water in a river basin." Irrigation and Drainage 58(S1): S133-S147. Wei, Y.P. (2007) Policy Options For Improving Agricultural Sustainability on the North China Plain. A PhD thesis submittted to the University of Melbourne