Eyewitness Report - Using Market-Based Instruments for Water Demand Management

June 14-15, 2004 Ottawa

Bernard Cantin, Policy Research Initiative1

Bernard Cantin is a Senior Policy Research Officer with the Policy Research Initiative.

It is often suggested that Canada should make greater use of marketbased instruments (MBIs) to support sustainable development. To explore this proposition, the Policy Research Initiative launched its new freshwater project with an experts’ symposium on Canadian and international experiences with MBIs for water demand management.2

Market-based instruments depend on complex legislative and administrative arrangements, and so are a product of, and are constrained by, specific institutional contexts. For water demand management, the main MBIs reviewed were prices, taxes, or markets, applied with the intention of modifying the incentives to individuals, firms, or institutions regarding their decisions to use water. The symposium examined MBIs in the residential, agricultural, and industrial contexts, as well as experiences with the creation of markets to allocate water.

Understanding Water Use

Water is a very special resource that can meet very different needs. Water can be used for drinking or for cooling in industrial processes, two uses that do not need the same water quality. As David Brooks (Friends of the Earth) reminded us, the demand is often not for the water itself, but for the variety of services it provides.

We do not have a comprehensive knowledge of present water uses in Canada. The last industrial water use survey was done in 1996. In addition, we have limited knowledge of our groundwater resources and their relation to surface waters.

We do know three important facts.

  • Although Canada is relatively well endowed with water, it is not always where we need it.

  • There are signs of increasing water scarcity in a number of regions, often compounded by water pollution.

  • Municipal water infrastructures are falling into disrepair even as growing urban populations demand increased supplies of treated water and place increased demand on wastewater treatment capacity.

Finding the Right Price

Using pricing to promote sustainable use of water involves taking into account environmental costs when charging users. In Canada, however, municipal and agricultural water use is generally subsidized, and most utilities do not recover all their treatment and distribution costs. In this context, some argue that the priority should be to make sure consumers receive the right signals on water use and thus make informed choices. Once this is done, one can begin including environmental costs in water prices.

But, finding the right pricing strategy to send the right signal is not a simple task. The cost of metering individual dwellings or farms, a prerequisite to knowing how much water they use and should pay for, is high. Studies also show that while price matters, it may not be very effective in the short run to modify water use patterns. A related problem is that utilities have limited understanding of consumers’ concerns and preferences and face the  risk of actually losing revenues if price changes are too large. Diane Dupont (Brock University) thus argues that the regulatory environment faced by utilities should be modified so they have the incentive to better understand their client’s view of their services, and meet pre-specified performance standards, which should simplify and legitimize the process of establishing realistic pricing strategies. She reviewed examples from Great Britain, noting that regulatory changes do not have to involve privatization.

Another important issue is to plan adequately for infrastructure needs. Utilities most often plan for peak demand, usually in the summer when people water their gardens and wash their cars. This leads to over-investment in infrastructure, which is only used at full capacity for a few days each year. An option reviewed by Jim Robinson (University of Waterloo) is to introduce peak use rates so consumers better plan their water use, and utilities can benefit from a reduced peak demand. Utilities could experiment with these rates with a sample of consumers to determine the effectiveness of this strategy. Phil Dick (Ontario Ministry of Agriculture and Food) presented another option to control infrastructure needs, with the experience of Leamington, Ontario, a municipality with a large number of heavy water users. Early in the history of the municipality, a large water user – Heinz – got involved in the planning process and helped design a system based on capacity management where large users shift their water consumption to times of non-peak use.

In the industrial sector, 90% of companies withdraw water directly from a lake or river. While they pay for their own water infrastructure, these companies pay very little for accessing water, and thus for the environmental cost of withdrawing it. One option for governments is to implement a charge (or tax) for using water, which could reflect the actual quantity of water used. Steven Renzetti (Brock University) explained that although companies are sensitive to changes in the price of water, we do not know how sensitive. To establish the right level of tax requires knowledge about the value firms give to water, which varies, and therefore requires extensive analysis and is costly. Furthermore, raising water prices through taxes could negatively affect exporting industries. Stefan Speck (Consultant) noted that European experience does not show a detectable impact of water taxes on industrial competitiveness, but this could be because a number of sectors in Europe have been shielded from these taxes. In fact, Pierre Strosser (Consultant) argued, European water taxes have been used mainly for revenue generation and not for environmental purposes.

Yacov Tsur (The Hebrew University of Jerusalem) showed how to establish efficient pricing of water in the agriculture sector to reconcile supply and demand considerations. Reducing water use is crucial in this sector, which is the largest in terms of water consumption. (Thermoelectric power generation uses more water, but returns most to the river or lake from which it is taken.) But efficient pricing has do be examined in light of the cost of implementing it, which can be high enough to offset the expected benefits. Two other important lessons are that:

  • covering the fixed costs of water supply should be decoupled from farmers’ water demand decisions; and

  • water prices (without quotas) have limited distributional effects.

Looking at the broad picture when designing pricing schemes is important. In all countries, as Pierre Strosser and David Eaton (University of Texas, Austin) remarked, agricultural water use is subsidized. But price may not be the most important factor in explaining water consumption. Agricultural subsidies that promote particular water-demanding or dry-land crops play a more important role.

Prices and Markets

If it is difficult for utilities or governments to find the right price or tax, why not create water markets, where free exchanges between willing buyers and sellers would take care of the problem? Markets would ensure an efficient allocation of water, in the economic sense, since it would move from lower to higher value uses.

The examples of California and Texas, presented respectively by Richard Howitt (University of California, Davis) and David Eaton (University of Texas at Austin), show mixed results. A first point to note is, as is the case with the Alberta allocation transfer system presented by Beverly Yee (Alberta Environment), trade accounts only for a fraction of water used, and appears to be mostly an adjustment mechanism to cope with uncertainty and annual changes in water flows. In that sense, then, markets can indeed foster more efficient allocation of water. Regulators of the California market, however, have had to develop other instruments to take into account environmental or third party effects (effects on users external to the trade), apparently with success. In Texas, while the market is functioning well, there are signs that less well-off communities and smaller farmers are disadvantaged. An important concern, at least in Texas, is that the creation of markets has provided more efficient water circulation but it has not led to more efficient water use.

More generally, David Zilberman (University of California at Berkeley) argued, experiences with the implementation of markets show that existing systems of water allocation and rights based on seniority rules, coupled with the relatively low price of water, can limit incentives for trading. In addition, implementing markets can be costly. Government intervention is required to set them up, and to ensure monitoring and enforcement of rules. The existence of transaction costs can also limit the efficiency of markets. These costs can be high, which means water markets may not become more attractive until the resource is really scarce.

According to Mike Young (CSIRO Land and Water, Australia), the Australian experience shows that markets can be efficient to allocate water and to create new economic opportunities. However, one should look beyond them to find the appropriate tools to deal with social and environmental goals. From a policy standpoint, different goals should be pursued with different policy tools, which leads to the question of finding the appropriate instruments. For Young, the answer lies in history, with the knowledge acquired in applying specific instruments for specific goals, such as licensing to control access to a resource.

MBIs, Co-operation, and Sustainable Development

Preliminary conclusions suggest that MBIs can play a role to foster water demand management, but that role will depend on the location and institutional context in which they are applied. An important hurdle is the need to better understand and account for implementation costs, including transaction and institutional costs. A number of examples reviewed show also that co-operation can lead to a better appreciation for the need to use MBIs, and incidentally lower some of the implementation costs in designing and applying them. Co-operation requirements also apply to relevant federal and provincial agencies that have different, but complementary, responsibilities for water management. Co-operation could, in fact, extend to program evaluation and controlled experiments, as suggested by Theodore Horbulyk (University of Calgary).

Another important conclusion is that MBIs will not promote sustainable development on their own. While they can lead to more efficient water use or help recover costs, meeting environmental or social objectives requires other, carefully designed, policy instruments. Depending on the type of water use, and the specific location, different approaches might have to be adopted.

Given this, it might be time to follow David Brooks’ suggestion and start water soft path planning, that is, carefully analyze the bundle of services required from water resources, project an ideal future social setting, and backcast from there. In this way, we clarify the contemporary decisions needed to meet a desired future outcome.

In other words, it might be time to determine more precisely where we want to go, before we select the appropriate policy tools to get there.


  1. A complete synthesis report from this symposium is available on the PRI Web site at <www.policyresearch.gc.ca>.

  2. The symposium was made possible by way of partnerships with Agriculture and Agri-Food Canada, the Walter and Duncan Gordon Foundation, Environment Canada, and the Canadian Water Network. Over 60 experts, academics, and practitioners from Australia, Israel, the United States, and Europe, as well as policy makers from the Canadian federal, provincial, and municipal governments participated.