funding mechanisms to deliver water quality...

Funding mechanisms to

deliver water quality

improvements

Final report: WT1562 Project 4 Published July 2017

2

This is a report of research carried out by Vivid Economics, on behalf of the Department

for Environment, Food and Rural Affairs

Research contractor: Vivid Economics

Published July 2017

Publishing organisation Department for Environment, Food and Rural Affairs Nobel House, 17 Smith Square London SW1P 3JR

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contained herein.

4 Funding mechanisms to deliver water quality improvements: quick scoping review

Funding mechanisms to deliver water quality improvements: quick scoping review

Report prepared for Department for Environment,

Food and Rural Affairs

Final report

Published July 2017


Contents

Executive Summary ..................................................................................... 9

1 Introduction ........................................................................................ 17

2 Background ......................................................................................... 20

3 Evidence from literature .................................................................... 22

4 Evidence from interviews................................................................... 56

5 Conclusions ......................................................................................... 69

References ................................................................................................... 81

Glossary and abbreviations .................................................................................. 88

Appendix 1: Search and selection method ........................................................... 89

Appendix 2: Interviewees .................................................................................... 94

Appendix 3: Individual scheme summary tables ................................................. 95


List of tables

Table 1. Summary of literature reviewed for water quality trading schemes ... 29

Table 2. There are clear determinants of high liquidity in US WQT schemes . 31

Table 3. Summary of literature reviewed for Coasean schemes ....................... 37

Table 4. Summary of literature reviewed for nature PES schemes ................... 41

Table 5. Summary of literature reviewed for biodiversity offsetting schemes . 49

Table 6. Summary of literature reviewed for intertemporal mechanisms ......... 52

Table 7. Inter-temporal mechanisms can offer features to meet specific

objectives, while other features are common with alternative measures54

Table 8. Market-like attributes succeed in some but not all circumstances ...... 73

Table 9. Long term contracts can be desirable when supply and demand are

relatively stable ................................................................................... 75

Table 10. Matrix showing some of the search term combinations used ............. 89

Table 11. Summary of literature reviewed as a result of both formal and

informal processes .............................................................................. 91

Table 12. Interviewees ........................................................................................ 94

Table 13. Example scheme summary: Great Miami Watershed, Ohio, USA ..... 96

Table 14. Example scheme summary: Chesapeake Bay, MA/VA/WV/PA, USA97

Table 15. Example scheme summary: Lake Taupo, New Zealand ..................... 98

Table 16. Example scheme summary: Fowey River Improvement Auction ...... 99

Table 17. Example scheme summary: Northern Everglades Payment for

Ecosystem Services program ............................................................ 101

Table 18. Example scheme summary: Melbourne Stormwater Tender ............ 102

Table 19. Example scheme summary: North American watershed protection . 103

Table 20. Example scheme summary: Andean Water Fund model .................. 104

Table 21. Example scheme summary: US wetland mitigation banking ........... 105

Table 22. Example scheme summary: NSW BioBanking ................................ 106

Table 23. Mechanism summary: water quality trading scheme ........................ 108

Table 24. Mechanism summary: agri-PES ....................................................... 109

Table 25. Mechanism summary: urban Coasean bargain ................................. 110

Table 26. Mechanism summary: Nature PES ................................................... 112


Table 27. Mechanism summary: Biodiversity offsets....................................... 113


List of figures

Figure 1. The taxonomy classifies schemes into four main broad categories .... 10

Figure 2. The taxonomy classifies schemes into four main broad categories .... 24

Figure 3. A perceived need for long-term contracts was seen as a barrier to

nutrient offsets in Poole Harbour ........................................................ 34

Figure 4. There is a trade-off between environmental stringency and scheme

coverage .............................................................................................. 45


Executive Summary

Background

Defra commissioned Vivid Economics through the Water Evidence Review Consortium framework,

Evidence Review MSP contract WT1562, to collate the lessons from a wide range of funding mechanisms to

deliver water quality improvements from the UK and overseas and to assess the scope for application of such

models to England. The study’s principal aims are to:

– identify evidence and examples of innovative funding mechanisms that could be used for improving

the water environment;

– review the barriers and enablers that would be required, or need to be removed, to make

implementation of the funding mechanisms in England successful;

– evaluate the feasibility of the funding mechanisms, incorporating stakeholder opinion.

Method

The research method followed consisted of two parts: a systematic literature review and a set of

interviews. The literature review was based on formalised, structured searches of Google Scholar and

academic journal databases accessed through the British Library, involving nineteen sets of search terms.

Academic literature was prioritised according to age (five years or less), search ranking and qualitative

filtering. The same approach was applied to non-academic literature in the form of Defra and associated

organisation reports, business and NGO literature and websites. The team assessed and followed up

references in papers examined, to answer particular questions of policy relevance.

Twenty-eight half hour structured interviews and discussions were conducted with leading practitioners and

participants involved in relevant research, pilot and implemented schemes. The interviews were drawn from

academia and industry. The discussions were drawn from government and its agencies. The procedure

employed a list of target interviewees and structured questions agreed with Defra; writing of

contemporaneous interview notes, for confidential internal use only; and synthesis and anonymising of

findings for reporting.

Taxonomy

Of a wide range of mechanisms considered, four main categories were identified according to who

bore the cost and the nature of environmental change. These were:

– polluter pays to reduce a ‘bad’: primarily water quality trading;

– beneficiary pays to reduce a ‘bad’: primarily schemes reducing agricultural pollution such as

agricultural payments for ecosystem services (PES), or ‘agri PES’, and urban diffuse pollution;

– beneficiary pays to conserve a ‘good’: primarily PES to maintain high quality habitat, also known as

‘nature PES’;

– polluter pays to maintain a ‘good’: primarily biodiversity offsetting.


A separate minor category of schemes which focus on how payments and costs are distributed over

time was also identified: these are the ‘intertemporal mechanisms’. The full range of mechanisms is

shown in Figure 1 below.

Figure 1. The taxonomy classifies schemes into four main broad categories

Note: (i) * indicates a single scheme (Lake Taupo, NZ) in which beneficiary was dominant buyer of credits; (ii) Note the

distinction between agri-PES (mostly payments for land management practices on agricultural land) and nature PES

(payments to maintain natural ecosystems); (iii) shaded boxes indicate a category overlapping more than one

quadrant;

Source: Vivid Economics

Findings from the evidence

Polluter pays to reduce a ‘bad’

General characteristics:

– This category is dominated by water quality trading schemes, the majority of which are found

in North America. These are typically ‘baseline and credit’ schemes between regulated point-source

polluters, typically wastewater treatment plants, and non-regulated non-point source (NPS) polluters.

The point source polluters are capped and, should they surpass their discharge limits, are able to buy

reduce or cap bad

tradable

development rights

third party mitigation/

offsets

mitigation banking

biodiversity credits

increase or conserve

good

impactor pays

core: involves voluntary exchange

between counterparties

fringe: no voluntary exchange


pollution trading

(PPO, CAT)

inc. nutrient banking

*

same party mitigation/offsets

planning obligations, CIL

tax

regulatory standard

subsidy

(quasi-)Coasean bargain

nature PES

beneficiary pays

com

pe

nsa

tio

n fo

r la

nd

re

str

ictio

ns

com

pu

lso

ry p

urc

hase

tax c

red

its

agri-PES

land purchase

instream buyback

grants easements & convenants

Cross-cutting intertemporal

mechanisms:

• Social investment bonds

• Catchment trust funds


pollution reductions from farmers, who otherwise face no additional pollution constraint from the

scheme.

– Cap and trade water quality schemes, where all participants are constrained, are highly

unusual – only three were identified. They usually require precise attribution of discharges from

polluters, which is difficult to achieve in the case of agricultural pollution.

– The market arrangements vary. In some cases the regulator provides a clearinghouse mechanism

to smooth trading by acting as both buyer and seller. In others, participants are expected to

arrange trades bilaterally, perhaps through an online exchange or third party broker. In some cases,

the clearinghouse intermediates all market interactions between participants.

Sufficient geographical scale and low transaction costs are critical to success. Water quality trading

schemes have historically been viewed as fairly illiquid, thin markets, with few trades, due to both

geographical constraints on market size and high transaction costs. Liquidity requires scale and there may be

few sufficiently large opportunities in England. In addition to scale, low transaction costs are necessary.

Active intermediaries such as brokers are likely to be essential to achieve low transaction costs.

Intermediaries assist in matching counterparties, aggregating trades, taking on outcome risk, and/or

improving liquidity by removing the need for an exact match in terms of amount and timing of pollution

reduction. Transactions costs can be reduced through standardisation. Schemes to develop standardized

protocols and tools for estimating pollution loads and reductions will be required if diffuse polluters are to be

involved otherwise transaction costs will be too high.

Water quality trading also depends upon a regulatory framework equivalent to the North American

Total Maximum Daily Load. This system states the maximum load of pollutants that a water body can

receive: that is a pollution budget for the water body. This is different from the individual consent-based

arrangements currently in use in the UK.

Beneficiary pays to reduce a ‘bad’


– A utility company or drinks manufacturer, for example, negotiates with farmers to change

land management practices to improve water availability and quality. This is only seen at local

scale. Schemes in this quadrant are typically business-driven arrangements, negotiated between

polluters and affected parties to mutual benefit. They are generally limited to contexts where

beneficiaries with a strong private interest act independently of government.

– Further examples relate to urban stormwater and flood risk management. There are cases where large

numbers of businesses and householders are incentivised to improve drainage or rainwater storage

on their land. There are also cases in which there is a large number of private beneficiaries. In both

cases, participants have their interests coordinated by a scheme organiser, which might be a private

or a public organisation.

Even though a private arrangement, deals may have to be brokered collectively by an intermediary

which may be public or private and may be funded publicly or privately. A process of negotiation and

joint decision-making involving relevant landowners builds trust and has, in some examples, lead to near


universal participation. In other cases, participation is lower, because there are fewer potential participants

who can make a business case for joining in. In both circumstances, measures to reduce transaction costs can

be helpful. One means of reducing transaction costs is technical advice. Land managers are not perfectly

informed about mitigation options and may need support. In some schemes, technical advice in the form of

specialised farm advisors have been paid to prepare bids on behalf of farmers, and this has led to increased

take-up.

Beneficiary pays to maintain a ‘good’


– Schemes which pay landowners and tenant farmers to conserve land in a natural, low impact or

otherwise highly valued state are classified here as ‘Nature PES’. Such schemes emerged initially in

the developing world to improve the acceptability of nature conservation amongst local people by

compensating them for forgone economic opportunities.

– PES schemes are often defined as voluntary transactions which are conditional on services provided.

However, in practice, conditionality is relatively uncommon. Best practices to improve value for

money, such as additionality tests, spatial targeting and metrics related to service provision, are

uncommon.

– Amongst the best known schemes in the developed world are those led by municipalities in the USA

to conserve and manage forests to reduce risks to drinking water quality, including to reduce risk of

wildfire.

Spatial differentiation and other techniques can enhance value for money. The development of spatially-

sensitive site selection tools which are able to assess likely benefits and costs of service provision would

improve value for money and assist scheme design and execution. There are further ways to improve value

for money in beneficiary pays mechanisms. One is to require adherence to baseline practices to qualify as

eligible to participate in a scheme. These techniques to enhance value for money may be more useful than

copying practice in other parts of the world.

Some schemes which work in the US and developing world may not work in the UK. The context-

specific factors which have made Nature PES schemes viable in the developing world and USA may not be

as strong in England. These include sellers with little in the way of alternative incomes or social security in

the developed world, and buyers who cannot rely on regulatory and planning regimes to prevent pressures on

water quality in the USA. Furthermore, the conservation covenant, which builds on experience of similar

arrangements in the US suggests, is likely to be taken up by those who are strongly motivated by a desire to

conserve the land for future generations. This frequently does not involve payments and is not a general

mechanism for improving catchments.

Polluter pays to maintain a ‘good’



– biodiversity offsets occur when developers compensate for damage to habitats and species by

creating or enhancing a replacement elsewhere, often by paying a third party. In some cases, suitable

offset sites will be pre-emptively created, in a market for mitigation banking or biobanking.

– There is currently only one mandatory biodiversity offsetting scheme in the world, which has led to

widespread third party participation: wetland mitigation in the USA1. A voluntary scheme has been

implemented in New South Wales. Mandatory biodiversity offsetting has recently been under active

policy discussion in the UK.

A regulatory framework for mandatory offsetting would be essential for widespread uptake in the

England2. In its typically exercised form, biodiversity offsetting is a mechanism with low potential to meet

WFD objectives, because: (i) it is focussed on offsetting impacts to habitats and species rather than water

quality; (ii) its fundamental aim is ‘no net loss’ of biodiversity, rather than driving improvements over

baseline; (iii) it applies only to new development, and not to existing impacts. However, the basic concept

could be developed further, for example by extending the concept of environmental damage to include

‘water damage’, similar to the Environmental Liability Directive. Wetland mitigation in the USA has

attracted controversy and its environmental effectiveness has been frequently called into question because of

unsound methodologies. A UK offset scheme would need to develop sound methodologies which covers

water ecosystem services on a proper functional basis. New methodologies of this type would make the

mechanism much more applicable to water resource protection.

Trust

Trust-building bodies may be necessary to intermediate between buyers and sellers who do not

normally relate commercially to each other. Trust is a feature of every effective scheme and sometimes

institutional arrangements are needed to facilitate trust. For example, successful trading schemes typically

have a clearinghouse to resolve trades, and Coasean bargain schemes often have a landowner or NGO acting

as intermediary. Although these may add value by reducing search costs, they must also build trust. In the

future, public agencies might act as trusted agencies, but perhaps not if they also hold office as regulatory

enforcer. Another feature is the selection of commercial terms, in particular contract length, in order to

balance competing interests. A balance has to be struck between desire for dynamic flexibility, willingness to

commit long asset lives and slow ecosystem development. Without this balance, there may be much less

trade between buyers and sellers.

Cost reduction

One way to reduce costs is to introduce standard eligible practices or types of site. There are several

important aspects relating to information. The gathering and processing of information on where low cost,

high value mitigation or provision options lie, is costly. Standardisation can reduce these costs, although

1 The European Environmental Liability Directive, while it has some similarities with biodiversity offsetting, is different in that its primary

objective is to remediate damage to the original site. Off-site remediation is only required if this cannot be achieved, or to compensate for interim losses.

2 This statement is intended only to convey what would be required for widespread uptake of the mechanism in the UK, and is not

intended to advocate such a policy.


simplification at the same time reduces choice and precision. A further technique is to use competition to

force costs down: reverse auctions are a promising application of competition and can be used to reveal the

full range of possible measures available.

Conclusions

The natural capital which supplies us with ecosystem services is a critical part of our economic system.

A country which looks after its natural capital assets can have a sustainable basis for economic

growth. This work shows that success in delivering PES is as much about the way in which support is

offered by current policies as it is about the design of new mechanisms.

When one looks at the ecosystem services in catchments, it is clear that many of the valuable goods and

services they produce are public in nature. There are very few examples of private parties paying for

catchment ecosystem services in developed countries. This is primarily because many of the ecosystem

goods and services in a catchment are public in nature: that is, there is a market failure which prevents

private individuals from paying for them. Consequently, one can confidently say that voluntary mechanisms,

by private parties in private markets, unfunded by government, will not alone deliver these public goods and

services. This is supported by empirical evidence from PES schemes3 and by interviews. A corollary is that,

for the benefit of the economy, where valuable ecosystem services are public in nature, in general, they

should either be purchased by government, or private parties should be obliged by government to supply or

fund the supply of them. Thus, it is important not to define these schemes as voluntary, as such a definition

would limit their application. There will remain many voluntary opportunities, either acting in isolation or in

tandem with government funded schemes, and while these may tend to be smaller in scale and more specific

in location, they may nevertheless grow to be important locally.

The international evidence shows that water companies and local authorities are uniquely placed to

act on behalf of the interests of local beneficiaries. They are supplementary to central government funding

and both can be alive to local needs. Of the two, water companies may have more resources to contract to

avoid a bad or maintain and enhance the provision of public goods or of services, and it is appropriate for

them to purchase goods and services with a significant public component. The expansion of current UK

water company-led schemes at catchment scale merits consideration.

Existing obligations could be more fully enforced and there is scope for enhancing obligations to

deliver improved ecosystem services in the future. Polluters themselves have resources which can be used

to reduce bads and similarly private parties have resources available to maintain goods. An example is to

take the biodiversity offset concept and apply it to land use development relating to the functions in a water

catchment, as a way to mitigate pressures on catchment services. Other examples relate to agriculture and

compliance with regulation in that sector; regulatory under-compliance undermines schemes in which third

parties are willing to pay for action beyond compliance.

3 The lack of voluntarism in many major PES schemes; the existence of many developing world PES schemes being explained by

context-specific factors (lack of regulation, legal title and alternative incomes) which are not replicated in an English context; notable PES schemes in the USA being driven by state and local government.


It is clear from the evidence that public and private funds are most effectively spent when institutions

cooperate, using spatial targeting of their resources to take into account the geographical variation of

both benefits and costs and using differentiated payments to service providers. There is scope for

introducing more sophisticated designs into a number of publically funded areas, including agri-environment

schemes, and there is evidence available on how to do it. Another route to greater value for money is for

intermediaries to cooperate through simple cross-functional team working and inter-agency programme

design.

Continuing publicly-funded research and development in scheme design and performance will be

worthwhile. Some of the most promising forms of mechanism are quite new, at least in the UK, and are

evolving rapidly. This includes, for example, some schemes being developed by water utilities and the use of

reverse auction mechanisms in new applications. Other mechanisms, such as agri-environment subsides, are

long- established yet could be reformed to orient them to systemic outcomes, explicitly targeting sets of

connected ecosystem services including those germane to water quality and the water environment. There is

a level of effort taking place and needed in the future to test and understand new mechanisms, which is

leading to rapid innovation and could, within a few years, result in much more widespread deployment and

significant improvements. Government should not expect the private sector to take forward the bulk of

research and development itself.

Further investment in evidence-gathering is necessary as information on scheme performance in water

quality and flooding impacts so far is weak. Defra’s promotion of PES has been influential, and is likely to

continue to be so in the future if it continues to support PES. The evidence-gathering programmes will also,

when they are completed, plug many, but perhaps not all, of the gaps in the evidence base and support

prioritisation and decisions to proceed with investments in natural assets. Standard sources such as the

Peatland Code and the Woodland Code might then be extended to cover other habitat types, uses and

impacts, such as wetlands for water quality and flood management.

The government’s role in collecting information may justifiably adopt a wider scope, providing

guidance on measures available and creating or adapting tools for ranking projects in terms of value

for money. Although Defra is engaged in these activities, it does not yet articulate a clear sense of its own

role and strategy. However, this is something it could choose to clarify and communicate, or to develop if it

is as yet unclear. If Defra were to draw up a strategy for PES beyond its own role, a central topic that will

need to be addressed is the relationship between PES and common rights. Under PES, the beneficiary should

expect to pay, whereas under common law the downstream rights-holder should expect flows of water of

unimpaired quality; there is a clear tension between these positions.

In conclusion, there are ways in which current schemes can be expanded and private obligations

enforced and extended to deliver the environmental goods and services which society demands. There

are also ways in which the process of public spending can be tuned to achieve greater value for money.

Alongside these, there are reasons for exploring quite substantial changes in the role of water utilities in

catchments. And whichever of these and other options are taken forward, clarity over the private and public

nature of ecosystem services in catchments will be an invaluable aid in working out how these vital goods

and services are funded.


1 Introduction Objectives, approach and outputs

1.1 Objectives

Defra commissioned Vivid Economics through the Water Evidence Review Consortium framework

Evidence Review MSP contract WT1562, to collate the lessons from a wide range of funding mechanisms to

deliver water quality improvements from the UK and overseas and to assess the scope for application of such

models to England. This work will help Defra to consider policy options for future catchment management

under the Water Framework Directive and beyond. The synthesis and transfer of this knowledge to and from

people within UK government, its agencies, Catchment Based Approach and other stakeholder groups will

help each formulate and implement policy in this area. This quick scoping review builds on existing

knowledge, assembles further knowledge and transfers it to Defra.

The funding mechanisms which were specifically requested to be examined by the project are:

– beneficiary pays mechanisms, that is, payments for ecosystem services;

– polluter or impactor pays mechanisms for third party action, where one party pays a counterparty or

counterparties not under the same regulation in a bilateral arrangement;

– polluter pays similarly regulated counterparties for the purpose of joint compliance, for example in a

trading scheme.

Where other relevant mechanisms have been encountered we have also described these.

The study’s principal aims are to:

– identify evidence and examples of innovative funding mechanisms that could be used for

improving the water environment;

– review the barriers and enablers that would be required, or need to be removed, to make

implementation of the funding mechanisms in England successful;

– evaluate the feasibility of the funding mechanisms, incorporating stakeholder opinion.

The scope of the evidence review spans the full suite of water bodies embodied in the Water Framework

Directive, including wetlands and groundwater bodies, and both urban and rural schemes. Impacts other than

release of conventional pollutants are within the scope, for example, impacts on morphology and abstraction,

as is flood risk management. Developing world schemes are generally outside of the scope except for

specific cases where they are particularly illustrative of important design features or issues. For example, the

Andean water funds were chosen because of their similarity to catchment trust funds, which were in the

scope of work, whereas one requested scheme, Pimampiro, is only briefly mentioned due to lack of

instructive lessons from relevant material.


1.2 Approach

The team has reviewed national and international studies and this report contains a synthesis of the findings

to inform policy decisions, covering the general scope for mechanisms to be applied in England, barriers or

enablers which may be relevant, and stakeholder opinion. The approach involved three main evidence review

tasks, the first of which was developed alongside the second.

1.3 Taxonomy of funding mechanisms

A large number of schemes came under the scope of this report. Many have similar underlying

characteristics but different names, for example, water quality trading and nutrient offsetting. The project

team developed a taxonomy of schemes organising them according to characteristics such as who the

counterparties are, whether they are regulated, whether they are point or non-point polluters, how prices (or

other obligations) are decided, the pollutant targeted and whether proxies for pollutants are used.

The purpose of this taxonomy is to (a) clarify and clearly communicate what has previously been attempted

and (b) group schemes into families to avoid repeating details of similar schemes.

1.3.1 Quick Scoping Review on funding mechanisms

A Quick Scoping Review is a structured approach to a literature review following a specific method by

Collins et al (Collins et al., 2014). The literature came from the following main sources. It focused on the last

five years in order to cover the most recent research and latest examples:

– relevant published material in reports and journal papers found through:

o archives held by consortium members and their collaborators;

o academic databases accessible through Google Scholar or the British Library;

o references in papers examined;

– relevant Defra family reports;

– business and NGO grey literature and websites, such as the Business and Biodiversity Offsets

Programme and Ecosystem Marketplace.

The quick scoping review focused on a set of topics:

– any UK examples of water quality trading mechanisms, either in response to formalised

mechanisms, or as planning agreements or voluntary initiatives;

– international experience on water quality trading, especially the USA and Australia;

– payments for ecosystem services, especially mostly watershed services including flood management;

– biodiversity offsetting;

– schemes designed to reduce agricultural non-point greenhouse gas (GHG) emissions from excess use

of nutrients which may have wider benefits for water quality.

Please see Appendix 1 for more details on the search methodology, including search terms used.

The references were assessed against criteria of quality and relevance, noting:

– scheme objectives, categorisation according to taxonomy, design and counterparties;


– if non-UK, differences which might make the scheme less relevant to a UK context such as scale,

climate, rights allocation, legal regime;

– key lessons on scheme design, for example those set out in Annex C of the terms of reference;

– comments on barriers and enablers to implementing a comparable scheme in England.

Please see Appendix 1 for more details on the material covered by the literature review.

1.3.2 Interviews

The second part of the approach was a set of 26 half-hour structured interviews with leading practitioners

and participants involved in relevant research, pilot and implemented schemes. These were drawn from

academia, government, agencies, and industry. The team are very grateful for the time commitment made by

interviewees and their willingness to speak candidly.

The procedure was as follows:

– identify key schemes of interest and key experts;

– draw up a list of target interviewees and topics and seek approval from Defra Project Manager;

– prepare a structured list of questions and, after Defra Project Manager’s review, send invitations to

interviewees;

– internal preparatory reading relevant to specific interviews;

– write contemporaneous interview notes, for confidential internal use only;

– synthesise the interview findings for inclusion in project report.

1.4 Structure of this report

The remainder of this report is in four parts:

– Section 2 sets out the background to the work, issues to be addressed and initial hypotheses to be tested;

– Section 3 describes the findings from the literature review;

– Section 4 synthesises evidence gathered by interview;

– Section 5 offers conclusions.


2 Background Background, issues to be addressed and hypotheses to be tested

This section presents background material from the terms of reference, written by Defra and edited by Vivid

Economics.

2.1 Policy background

The Water Framework Directive (2000/60/EC) requires the UK to take action to aim to bring its water bodies

up to good status. Pollution from farms, urban areas, industry, and water companies will have to be further

reduced. The pollution pressures come from a broad range of sources including diffuse pollution from

agricultural and urban sources, such as nitrates, phosphates, pesticides, urban run-off and misconnections.

A range of tools to address the pressures will be needed including advice, regulation and enforcement. The

Environment Agency is updating River Basin Management Plans. Funding is also crucial, presently coming

from a range of sources including central Government, Common Agricultural Policy (CAP) and Rural

Development Programme for England (RDPE) and Countryside Stewardship funding, as well as the private

sector, such as water companies, and charities.

Payments for ecosystem services (PES) is an innovative and developing area. The Natural Environment and

Water White Papers (Defra, 2011a; Defra, 2011b) committed the Government to supporting and encouraging a

PES approach to improve the natural environment. For the water sector, this included exploring how to

maximise wider sources of funding through PES from the beneficiaries of clean water. The Ecosystems

Markets Task Force recognised that ecosystems-based measures at catchment level have enormous potential

business benefits (EMTF, 2013). The Natural Capital Committee also identified large economic benefits

from valuing and investing in natural capital.

PES is a cross-cutting policy theme for Defra and a lot of work is already underway, led by the Ecosystems

Evidence Team (EET), to take forward the Government’s PES commitment. In May 2013, Defra published

an Action Plan on developing the potential for PES alongside a PES Best Practice Guide which included a

range of case studies. The Action Plan states that in order to build capacity, Defra will work with others to

explore new financing models for PES and to build understanding of key issues relating to multiple funding

sources. It gave a commitment to fund new research in the water sector on financing mechanisms at

catchment level, with a view to running pilots in a number of catchments. Other Defra work in this area

includes a research project on agri-environment policy exploring the design and use of reverse auctions and

how to encourage private funding alongside public funding. A further study is looking at PES beneficiaries

in more depth, including key business sectors dependent on the natural environment, to develop an action

plan for future engagement on PES.


2.2 Previous and currently relevant work

The work draws from a number of workstreams across government, encompassing work on water quality

and agriculture, water quality and urban pollution, the PES pilot projects and water abstraction reform,

among others.

2.3 Issues to be explored

Defra commissioned this work with a number of issues in mind, which this work explores. As part of a

comprehensive review, it looks for evidence associated with the following issues:

– the level of trust in transferring money between sectors and the need for mutually acceptable honest

brokers;

– the level of business awareness and consideration of the impact on and dependence of its operations and

the water environment;

– the strength of incentives for beneficiaries to participate;

– the existence of free riding;

– the experience of evaluating improvements and availability of published market values;

– the scale of individual polluters;

– the risk of government crowding out other funders.

Defra also wished to bring together evidence on more flexible environmental compliance mechanisms, such

as by trading pollution rights between parties, although this approach is not currently part of England’s

regulatory regime. Furthermore, it suggested that among the possible institutional arrangements, the local

partnerships operating under the Catchment Based Approach might have a role to play in bringing together

interested parties. It was thought this might be particularly effective in targeting effort locally to get best

value for money in meeting local needs and in raising financial contributions from local beneficiaries.


3 Evidence from literature Taxonomy and evidence by scheme type

3.1 Overview and taxonomy

3.1.1 Taxonomy

The various water quality management mechanisms examined in the QSR were classified into four main

categories, according to: (i) whether their intention was to reduce or cap an environmental ‘bad’, or increase

or conserve an environmental ‘good’; and (ii) whether the impactor(s) or beneficiary(ies) principally bear the

cost. Mechanisms involving voluntary exchange between counterparties which are ‘market-like’ are shown

at the core of the taxonomy, while those which do not are shown on the fringe. This is summarised in Figure

1.

The core mechanisms found in the review can be summarised as follows:

– water quality trading (WQT) schemes. The rights of some or all polluters to discharge into a water

body are restricted. Polluters are able to trade their rights in order to lower abatement costs;

– payments for ecosystem services (PES) are a form of voluntary transaction where land uses likely to

secure particular environmental benefits are financially rewarded under a contractual arrangement by

beneficiaries. A distinction is made here between the following sub-types:

o agri-PES, when private or local government actors reward landowners for changing

management practices on farmed land, for example, to reduce nutrient or pesticide pollution

o agri-environment schemes are large-scale mechanisms, such as CAP payments, generally

mediated by Government or its agencies and under which farmers are paid through

recirculation of tax revenues to undertake certain land management practices4

o nature PES are when private or public actors reward landowners for maintaining or

enhancing largely natural ecosystems;

– Coasean bargains are arrangements reached independently by private parties where those harmed by an

environmental impact compensate those responsible for reducing it5. They can take the form of PES or

impact reduction arrangements which do not involve ecosystem services;

– tradable development rights are a mechanism for compensating landowners who lose the right to

develop their land, usually in order to meet flood risk management or conservation objectives (Filatova,

2013). The mechanism involves dividing land in an area where development is to be restricted into a

‘sending’ zone (for example, a flood plain) and a ‘receiving’ zone (neighbouring areas), putting a cap on

4 Large-scale agri-environment schemes are outside the project scope but are mentioned here for completeness. It is worth noting that a

large-scale agri-environment scheme in the USA, the Conservation Reserve Program, is responsible for a high proportion of watershed investment in the USA (Stanton et al., 2010).

5 Strictly, a Coasean bargain need not be one in which the beneficiary pays. One of the components of the Coase theory is that the

same outcome in terms of welfare gains could be reached regardless of how rights are allocated. However, within the context of this report, we will consider only beneficiary-pays Coasean bargains.


overall development. While development rights are allocated to landowners in the sending zone, they

cannot develop, but can sell their rights to those in the receiving zone.

– outright land purchase of upstream land or riparian zones might be viewed as the most permanent way

to ease pressures on water quality, although land management is still generally required and may entail

additional ongoing investment;

– easements are the separation and selling of certain rights for land ownership, for example, rights to

access and maintain particular management practices on land, rights to develop or sub-divide the land;

– conservation covenants are a new mechanism being considered in England and Wales, comprising of

agreements between a land or water body owner and a conservation body which ensures the conservation

of natural or heritage features on the land, and which continues to be effective after the land changes

hands (Law Commission, 2014).

– instream buyback refers to buying up of water quantity rights from abstractors to maintain flow and

ecological integrity;

– third party biodiversity offsets occur when developers compensate for damage to habitats and species

they have caused by developing a site by paying for third parties to restore or enhance replacements. In

some cases, these third parties will have pre-emptively created the replacement habitat in anticipation of

future demand (mitigation banking or biobanking). Biodiversity offsets can also be undertaken by the

developer themselves without involving third parties.

There is some degree of overlap between these mechanisms – for example conservation covenants could

provide the legal mechanism for a PES scheme or for a biodiversity offset receiving site where certain land

management arrangements are required in perpetuity.

Some of the mechanisms are particularly defined by their explicit arrangements for the distribution of

payments and costs over time, rather than who bears costs, or what is being reduced or increased. They

therefore do not fit neatly into the taxonomy. We refer to these as intertemporal mechanisms and discuss

them separately in Section 3.6. They are:

– social investment bonds where investors (such as social entrepreneurs and affected stakeholders)

provide upfront funding for a project which is then repaid to them if the project results in savings to

the public purse; and

– catchment trust funds, a mechanism which is currently vaguely defined and little-examined in the

literature, which we take to mean the pooling of resources from different beneficiaries into a central

fund, managed on a cooperative basis and disbursed to mitigation and/or service provision projects6.

In addition, there are other mechanisms not involving voluntary exchange which it is worth highlighting due

to their use in a water quality context:

– compensation for land restrictions. Some schemes that are labelled PES do not actually involve

voluntary exchange, but make land use restrictions more politically palatable by providing compensation;

– compulsory purchase of land and properties sometimes occurs in flood risk management;

6 The closest analogue about which there is detailed information are the Andean Water Funds discussed in Section 3.4, which explains

why we have examined them despite their developing world location. Because of their particular context and purpose we have, however, classified the Andean water funds as ‘Nature PES’ rather than examined them in Section 3.6.


– same party mitigation/offsets occurs when developers retain responsibility for compensating for

impacted habitats or biodiversity, either on the same or a different site;

– planning obligations such as, in the UK, Section 106 agreements7 and Community Infrastructure Levy

(CIL).

Figure 2. The taxonomy classifies schemes into four main broad categories

Note: (i) * indicates a single scheme (Lake Taupo, NZ) in which beneficiary was dominant buyer of credits; (ii) Note the

distinction between agri-PES (mostly payments for land management practices on agricultural land) and nature PES

(payments to maintain natural ecosystems); (iii) shaded boxes indicate a category overlapping more than one quadrant


The reader may refer to Appendix 1 for details of the reference material which was covered for each area of

the taxonomy. Appendix 3 contains tables, drawing from both the literature review and interview summaries,

for each mechanism which set out a summary of their appropriate scale, benefits, barriers and enablers to

application in the UK, and other information.

7 Inman and Smith (2012) note that Section 106 payments have only a limited role to play in a water context, although they are able to

contribute to the ‘conservation, creation and enhancement of areas of plant and wildlife habitat’ and ‘flood risk management and infrastructure provision’.

reduce or cap bad

tradable

development rights

third party mitigation/

offsets

mitigation banking

biodiversity credits

increase or conserve

good

impactor pays

core: involves voluntary exchange


fringe: no voluntary exchange


pollution trading

(PPO, CAT)

inc. nutrient banking

*

same party mitigation/offsets

planning obligations, CIL

tax

regulatory standard

subsidy

(quasi-)Coasean bargain

nature PES

beneficiary pays

com

pe

nsa

tio

n fo

r la

nd

re

str

ictio

ns

com

pu

lso

ry p

urc

hase

tax c

red

its

agri-PES

land purchase

instream buyback

grants easements & convenants

Cross-cutting intertemporal

mechanisms:

• Social investment bonds

• Catchment trust funds


3.1.2 Why a market-like mechanism?

Market-like mechanisms were identified in the terms of reference as a potential solution to environmental

problems due to the expectation that they will increase the political acceptability of environmental protection

by lowering and/or spreading its cost. A market-like mechanism should achieve one or both of the following:

– increase efficiency by lowering the costs of reducing environmental impacts compared to alternative

measures; or by ensuring the provision of environmental goods and services which otherwise would be

degraded by economic activity;

– harness participants’ dispersed information about where low cost mitigation and service provision

opportunities lie in order to reduce the cost to the regulator of gathering this information.

However, as explored in Section 3.8, key differences exist between environmental markets and standard

product markets. Mechanism design is largely then a process of understanding which attributes and benefits

of a market-like process can be expected to apply to a given context, and which are likely to be absent.

3.1.3 Geographical overview

There are many small and a few large water pollution trading schemes in North America, mostly with

respect to nutrients, but also metals, sediment and thermal load. Australia has one salinity trading scheme

which has seen a lot of activity, one where trading has been minimal and one small-scale ‘bubble’8 point

source-point source nutrients scheme. New Zealand has one nitrogen trading scheme where trading has been

dominated by a public body, which is now following a land purchase strategy, and has considered a scheme

for a second water body.

Payments for watershed ecosystem services in the form of nature PES are found mostly in the developing

world, pointing to strong political, institutional and geographical factors, such as large areas of relatively

intact, high-altitude upstream natural ecosystems. They emerged from a perceived need to compensate local

people for the reduced economic activities associated with biodiversity conservation (Wunder, 2005), and to

align the objectives of halting biodiversity loss with poverty alleviation by diversifying incomes.

Counterparties are often poor farmers with little in the way of alternative incomes or social security, and

water users who cannot rely on weak or absent regulatory bodies and the planning regime to maintain water

quality (Goldman-Benner et al., 2011).

Only around 15 per cent of the published literature on PES schemes relates to the developed world

(Schomers and Matzdorf, 2013), indicating that PES schemes are more prevalent in less developed countries.

Among the most notable developed world examples are investments in watersheds in the USA. US schemes

typically involve land acquisition, easements and/or cooperation with landowners rather than payments

which are specifically linked to measurable environmental services (Mercer et al. 2011; WRI, 2011a; Stanton

et al., 2010). Again, their prevalence in the USA may reflect a context of relatively greater abundance of

natural forest to farmland.

8 A bubble scheme is one where a small number of participants jointly comply with a discharge limit through any means they choose.


Given the relative proportions of agricultural land and pristine natural ecosystems in Europe, agri-PES

schemes are common in Europe, mostly in the form of agri-environment schemes. There are also well-

established schemes in the UK including Upstream Thinking in south west England and SCaMP in north

west England, as well as handful of PES-based arrangements to protect natural mineral water springs in

France, under which abstractors pay for changes in land management practices.

Biodiversity offsets have been incorporated into the legal framework of numerous countries, including

Brazil, Canada and the EU, and there are numerous examples of voluntary demonstration projects in the

developing world (Burgin, 2010). Third party biodiversity offsets within a mandatory regulatory

framework are, however, most prevalent in the USA in the form of aquatic resource mitigation banking.

3.1.4 Water body type and context

The comments in this section describe the water body types and contexts which were covered in the QSR

review process described in Section 1.3.1 and Appendix 1, given the limited time available in a Quick

Scoping Review. They are not intended to comprehensively describe the availability of literature on these

topics overall, particularly that which does not relate to the funding mechanisms outlined in the taxonomy,

for example, literature on flood risk management in general.

Most of the literature covered refers to schemes to protect catchments, surface water bodies and wetlands.

Coastal waterways are mostly covered in a context where geography prevents the dispersal of pollutants; two

of the most notable US trading schemes (Long Island and Chesapeake Bay) address nutrient pollution in

sounds or bays.

Groundwater is specifically addressed in the literature only relatively sparsely, although individual scheme

examples do occur. A Mexican national PES program was launched to prevent aquifer over-exploitation;

while notable agri-PES schemes initiated by the European mineral water companies Evian and Vittel were

designed to prevent aquifer contamination (Alix-Garcia et al., 2009; EPI-WATER, 2013).

In terms of services, water quality and availability clearly dominate. Flood risk management mechanisms

received relatively little attention in terms of practical discussion in the literature covered, although

theoretical examples were described (Filatova, 2013). Studies covering recreation and amenity services are

often tied in with very general issues, for example, valuation, ecosystem approaches, rather than specific

mechanisms, while the concept of beneficiary pays mechanisms, such as user charges for angling or entry

fees to a nature reserve, is more socially well-established and in less need of detailed design consideration.

Schemes in an urban context generally relate to encouraging investment in both ‘green’ and ‘grey’

infrastructure for stormwater management.

3.2 Polluter pays to reduce a ‘bad’: water quality trading schemes

3.2.1 Key findings

General characteristics of the studies found:


– Fifteen studies were reviewed of relevance to this quadrant.

– The literature in this quadrant is dominated by water quality trading schemes, the majority of which

are found in North America.

– North American water quality schemes are typically ‘baseline and credit’, that is credits are only

required for compliance when regulated parties go over their limit; credits are generated when a

participant puts in place recognised measures to reduce emissions below their baseline.

– In some schemes, trades take place between capped point source (PS) polluters, in others between

regulated PS and non-regulated non-point source (NPS) polluters, and in some cases, both. Point

source polluters are typically wastewater treatment plants. Non-point source polluters have until

recently comprised entirely of agricultural landowners, but stormwater pollution is beginning to be

integrated into schemes. Historically, NPS polluters have had unrestricted rights to pollute, unless

restricted by other regulations or mechanisms.

– The degree of market interaction varies between schemes. In some cases, the regulator provides a

clearinghouse mechanism to facilitate trading. In others, participants are expected to arrange trades

bilaterally, perhaps through an online exchange or third party broker.

– In some cases, the clearinghouse model goes even further, and there are no actual market interactions

between participants. In such cases, as well as buying and selling credits, the regulator may set

prices.

– Cap and trade water quality schemes are highly unusual – only three were identified. They usually

require precise attribution of discharges from polluters, which is difficult to achieve with agricultural

pollution.

Barriers and enablers:

– North American schemes have emerged as a response to a regulatory framework which imposes

Total Maximum Daily Loads, that is maximum amounts of a pollutant that a water body can receive.

The schemes help polluters minimise the cost of complying with daily load limits. In England, a

similar scheme would require an equivalent regulatory framework imposing discharge limits.

– Even though the point of trading is to reduce abatement costs, schemes without trading are common.

WQT schemes have historically been viewed as fairly illiquid, thin markets, with few trades, due to

both geographical constraints on market size and high transaction costs.

– The illiquidity and thinness arises from: the costs of finding and negotiating with counterparties;

mismatches in terms of timing of management actions with buyers’ needs; unfamiliarity with

trading; lack of trust in unfamiliar trading partners; uncertainty over the supply of credits; and

unclear liability allocation.

– A clear message from the water quality trading literature is that schemes involving non-point source

polluters require active intermediaries or third parties such as brokers and nutrient banks in order to

reduce these transaction costs.

– Intermediaries can assist in matching counterparties, aggregating trades, taking on outcome risk,

and/or improving liquidity by removing the need for an exact match in terms of amount

(aggregation) and timing (term) of pollution reduction.

– Involvement of diffuse polluters requires schemes to develop standardized protocols and tools for

estimating pollution loads and reductions, which in turn means constraining mitigation options. Such

tools help to ensure that the lowest cost mitigation options are selected.


See Table 22 in Appendix 3 for a further summary of issues facing water quality trading schemes.

3.2.2 Overview

The North American water quality schemes are typically ‘baseline and credit’, that is credits are not

required for compliance but are generated when a participant puts in place recognised measures to reduce

emissions below their baseline (Shortle, 2012; Greenhalgh and Selman, 2012). Schemes vary in the type of

polluters which participate; in some schemes, trades take place between regulated point source (PS)

polluters, in others between regulated PS and non-regulated non-point source (NPS) polluters, and in some

cases, both (Shortle, 2012; Greenhalgh and Selman, 2012). The most important schemes most frequently

covered in the literature have the following features (Shortle, 2012; Shortle and Horan, 2013; Ricardo and

Gottlieb, 2011; Greenhalgh and Selman, 2012):

– wastewater treatment plants are regulated parties which can purchase offsets from agricultural non-

point source polluters;

– they are ‘polluter pays for third party action’ mechanisms, partially capped schemes where

landowners have unrestricted rights to pollute, unless restricted by other regulations or mechanisms, while

in contrast, point sources’ rights to pollute are restricted;

– they have emerged as a response to a regulatory framework which imposes Total Maximum Daily

Loads, that is maximum amounts of a pollutant that a water body can receive, and are designed to help

polluters minimise the cost of complying with these.

The degree of market interaction between parties varies between schemes. In some cases, for example

Pennsylvania, the regulator provides a clearinghouse mechanism to smooth trading by acting as both buyer

and seller (Shortle 2012; PENNVEST 2014). In others, participants are expected to arrange trades bilaterally,

perhaps through an online exchange or third party broker. In a small number of cases, discharges must not

violate a collective cap, rather than individual caps (bubble permit schemes). In recent years, ‘nutrient

banking’ has been incorporated into some schemes; a practice analogous to wetland banking (see Section

3.5) whereby dedicated companies create nutrient reductions in advance for sale to regulated parties (Bennett

et al., 2013).

In some of these schemes, for example, Great Miami in Ohio and South Nation in Canada, the

clearinghouse model goes even further, and there are no actual market interactions between

participants (Shortle, 2012; Shortle and Horan, 2013). In such cases, as well as buying and selling credits,

the regulator sets prices. It is effectively fining PS polluters for under-compliance, paying them for over-

compliance, and using fines to fund agricultural nutrient offsets, rather than matching discrete trades.

Only three cap and trade water quality schemes were identified: Hunter River salinity trading in

Australia, San Joaquin selenium trading in the USA, and Lake Taupo nitrogen trading in New Zealand

(Shortle 2012; Quinn, 2011; Duhon, 2011). The former two of these schemes involve situations were

discharges could be easily identified, while the latter was a fairly experimental and unique scheme (see

below).


Mechanisms for stormwater regulation are gaining traction in the USA. Participants responsible for

stormwater discharges were recently incorporated into Virginia’s nutrient credit trading program

(VCN, 2013). In Philadelphia, non-residential water users face a charge on their monthly bill based on the

impervious area of their land (Valderrama et al., 2013). The possibility of allowing those with particularly

low abatement costs to offer offsite mitigation to third parties is being considered, which would effectively

turn it into a stormwater trading scheme.

The literature reviewed for this quadrant is summarised in Table 1.

Table 1. Summary of literature reviewed for water quality trading schemes

Overview / meta-analysis / theory

Individual schemes examined

Specific contexts or issues highlighted

Key references examined

Pollution trading (‘polluter pays others’)

Overviews of: • issues facing PS-NPS trading in NAm • water quality trading involving agriculture Theory of: • policy instruments for WQ protection

Poole Harbour (UK) Great Miami, Chesapeake (USA) South Nation (Canada)

• General low liquidity of US schemes • Total allowable discharge framework essential to US schemes See Poole Harbour case study

Newburn and Woodward (2012); Ribaudo and Gottlieb (2011); RSPB (2013); Shortle (2012); Shortle and Horan (2013); Suter et al. (2013); Van Houtven et al. (2012); WRI (2011b); Bennett and Carroll (2014); Greenhalgh and Selman (2012)

Pollution trading (cap and trade)

Overviews of: • water quality trading involving agriculture Theory of: • policy instruments for WQ protection

Nutrient trading: Lake Taupo (NZ) Salinity trading: Hunter River (Australia)

• CAT is not generally used for water quality mechanisms • NZ scheme is only NPS-NPS encountered; severe impact on farmers • Hunter River: IT as enabler; attention to flow and ambient concentrations

Shortle (2012); Bennett and Carroll (2014); Duhon et al. (2011); Quinn (2011)

Cross-cutting Overview of global watershed investment

Bennett and Carroll (2014);

Other Theory and overview of flood risk instruments

Groundwater water rights trading Applicability of MBIs to coastal water body in Australia NAm salinity management

• GW poses hydrological challenges to any kind of mechanism • Flood risk management mostly relates to planning mechanisms

Filatova (2013); Quinn (2011); Greiner (2014); Stanton et al. (2010)

3.2.3 Scheme examples

Chesapeake Bay in the USA is one of the best-known examples of a water quality trading scheme, but it is

actually several composite schemes run by states in the Bay’s watershed (Pennsylvania, Virginia, West

Virginia and Maryland). Significant trading activity has only been observed recently for the Pennsylvania


and Virginia schemes (Table 2), while the Maryland scheme has yet to register a single trade. Contributory

factors include: (i) implementation of clearinghouse mechanisms in the Pennsylvania and Virginia schemes;

and (ii) the recent expansion of the demand side in the Virginia scheme by the inclusion of new categories of

regulated entities, including municipalities with stormwater obligations (Shortle, 2012; Bennett and Carroll

2014; WRI, 2011b; VCN, 2013).

The Pennsylvania Infrastructure Investment Authority (PENNVEST) acts as a central counterparty for the

sale and purchase of nutrient credits in Pennsylvania. It achieves this both by running forward and spot

auctions and clearing bilateral negotiated transactions (PENNVEST, 2014). Buyers and sellers enter into a

contract with PENNVEST rather than each other, removing risk and uncertainty. The Virginia Nutrient

Credit Exchange Association is a price-setting clearinghouse mechanism for credits generated by point

sources, but those generated by nonpoint sources appear to be arranged through brokers (WRI, 2011b;

VDEQ, undated). See Table 12 in Appendix 2 for more details.

The Great Miami River Watershed Water Quality Credit Trading Program in Ohio was launched as

pilot in 2004, and is continuing as a viable program despite current development of an interstate trading

program for the whole Ohio River Basin (EPRI, 2012). It is credited as one of the first schemes in the USA

to generate significant interest in trading with non-point sources (Newburn and Woodward, 2012), and has to

date stimulated around 400 agricultural projects to create 572 tons of nutrient reductions worth about $1.6

million (MCD, 2014). Its use of two tiers of intermediaries – one to act as a clearinghouse, and the other,

more locally-informed, to advise farmers on Best Management Practices (BMPs) and credit calculations – is

likely to be a key factor behind the scheme’s success. See Table 13 in Appendix 2 for more details.

The Lake Taupo nutrient trading scheme in New Zealand is the only water quality scheme in the world

to involve trades exclusively between diffuse agricultural polluters9. The Lake Taupo Protection Trust was

set up to administer NZD 81 million in public money to fund nitrogen reductions by retiring credits, and

became by far the dominant buyer in the scheme10

. While the scheme has met its environmental objectives, it

has been viewed by may in the affected community to have had adverse economic effects on farmers (Duhon

et al., 2011), and its inherent dominant buyer may have contributed to this. The Trust has now retired from

trading due to demand not being met because of an increasingly stringent target (LTPT, 2013). See Table 14

in Appendix 2 for more details.

3.2.4 Findings

Schemes with significant trading have a large geographical extent and a clear role for third parties

Agricultural reductions are widely viewed in the USA as being much cheaper that reducing pollution from

point sources, which suggests clear gains in trade (Shortle, 2012; Shortle and Horan, 2013). However, WQT

schemes have historically been viewed as fairly illiquid, thin markets, with few trades, due to both

9 Emissions in the aforementioned San Joaquin selenium trading scheme could be measured directly due to collection of irrigation water

in sumps before discharge, effectively giving it the characterisitics of a PS-PS scheme.

10 The scheme is effectively therefore a beneficiary pays mechanism, but is included in this section with other water quality trading

programs.


geographical constraints on market size and high transaction costs (Ribaudo and Gottlieb, 2011; Suter et al.,

2013; Greenhalgh and Selman, 2012). Until 2012, trading volumes for nitrogen were dominated by a single

PS-PS scheme (Long Island Sound), while the annual quantity of phosphorus traded was insignificant until

the expansion of the Virginia nutrient credit program (Bennett and Carroll, 2014). This is starting to change

with schemes now beginning to specifically address these problems (Newburn and Woodward, 2012;

Bennett and Carroll, 2014). The policy community have identified a need to reduce transaction cost

associated with searching for counterparty, buyers’ compliance risk and counterparty risk, in order

for schemes to be viable (Newburn and Woodward, 2012). Explanatory factors for the most liquid

individual schemes before and after 2012 are summarised in Table 2.

Table 2. There are clear determinants of high liquidity in US WQT schemes

Highest liquidity trading schemes Probable reason for high liquidity

Prior to 2012: 1. Long Island Sound 2. North Carolina State nutrient offsets (no other schemes with substantial volumes)

1. Discharging into a bay; state-wide, not limited to single river basin gives greater market size 2. Use of nutrient banking: similar mechanism to wetland mitigation banking; entrepreneurs can pre-emptively generate offsets to sell to regulated parties

Post-2012: 1. Long Island Sound 2. Virginia Nutrient Exchange 3. Pennsylvania Nutrient Credit Trading Program

1. Same as above 2. Discharging into Chesapeake Bay; state-wide (allows for shard infrastructure despite geographical segmentation); clearinghouse mechanism; expansion of scheme in 2012 to include new participants, including those with stormwater obligations 3. As above, state-wide scheme into large bay; creation of clearinghouse mechanism in 2010

Source: Vivid Economics based on Shortle (2012), Bennett and Carroll (2014) and VCN (2013)

A very clear message from the water quality trading literature is that schemes involving non-point source

polluters see barely any trading without the intervention of intermediaries or third parties, such as

brokers and nutrient banks. The main reasons for this are (Shortle, 2012; Shortle and Horan, 2013; Ribaudo

and Gottlieb, 2011; Newburn and Woodward, 2012):

– the costs of finding and negotiating with counterparties;

– mismatches in terms of timing of management actions with buyers’ needs;

– unfamiliarity of trading and lack of trust in unfamiliar trading partners; and

– uncertainty over how BMP performance will affect the supply of credits and unclear liability.

Other reasons why many water quality trading schemes have seen few trades include: uncertainty over the

credits generated by different BMPs; baseline requirements removing low cost options; and regulatory caps

not being in place due to legal delays (Ribaudo and Gottlieb, 2011; Newburn and Woodward, 2012).

This evidence suggests a clear role for intermediaries to match counterparties, aggregate trades, take

on outcome risk, and/or improve liquidity by removing the need for an exact match in terms of amount

and timing of pollution reductions. Equally as important, intermediaries can build trust and cooperation,

provide information to participants about suitable land management options and how to prepare bids, help

identify suitable participants, construct workable contacts, and exploit existing networks and institutional


infrastructures to disseminate best practice (Newburn and Woodward, 2012; Ribaudo and Gottlieb, 2011;

Duhon et al., 2011; RSPB, 2013).

Rights are typically skewed towards non-point source polluters

North American schemes constrain the rights of point-source polluters but not those of agricultural polluters

(Shortle, 2012). The Lake Taupo scheme in New Zealand was highly unusual in setting individual caps for

landowners (Shortle 2012; Duhon, 2011). While it is frequently argued that rewarding landowners for

reducing pollution violates the polluter pays principle, it can be inferred that practical and political reasons

have trumped this. Likely and potential reasons for this include:

– the well-known difficulties of estimating agricultural diffuse pollution subject to uncontrollable factors

such as weather (Shortle, 2012; Shortle and Horan, 2013);

– concern not to damage the social fabric and local economy of an area by severely impacting on farms’

economic viability, as was the consequence of capping farmers in the Lake Taupo scheme (Duhon, 2011);

– awareness that farmers face competition from non-regulated parties, both domestic and foreign, while in

situ wastewater treatment plants do not; and that this could result in the displacement of pollution to other

areas if they are too tightly constrained.

Diffuse pollution mitigation options must be standardised

Water quality trading schemes are intended to provide flexibility and discretion in how pollution abatement

is achieved. At the same time, diffuse pollution cannot be measured directly. It is clear from examples in the

literature that schemes need standardised protocols and tools for estimating pollution loads in terms of

both baselines and the reductions achieved by changed management practices11

. This usually takes the form

of a spreadsheet or software tool which estimates pollution loads based on factors such as cover type, slope,

distance of loads from waterways, etc.

Such tools are useful in providing consistency and predictability, but require a set of eligible management

actions to be defined for the purposes of calculation. They also need to be adaptable to account for high

context-sensitivity, including for example soil and geology type (EPA, 2007). Their use implies that there are

also management actions which could reduce pollution but which will not generate credits; therefore it is

important for schemes using such tools to ensure that the lowest cost abatement options are rewarded, rather

than those which are easiest to estimate.

3.2.5 Case study of a UK application of water quality trading: Poole Harbour pilot

Introduction

The Poole Harbour PES Pilot, funded by Defra and managed by the RSPB in conjunction with the water

utility Wessex Water, considered the potential for nutrients offsets in a UK context (RSPB, 2013). It

examined the technical and legal feasibility of a scheme in which reductions in nitrogen discharges from

11

See examples relating to Great Miami (Newburn and Woddward, 2011), Pennsylvania (Shortle, 2012), Lake Taupo (Duhon, 2011) and Hunter River (Quinn, 2011); and general discussions in Ribaudo and Gottlieb (2011) and Greenhalgh and Selman (2012), A further example is the multi-service estimation tool supporting USDA decision-making under the Conservation Reserve Programme.


agricultural sources in the Dorset Frome and Piddle catchments could be paid for by developers seeking

planning permission, as associated sewerage would increase nitrogen loads to the Harbour. Poole Harbour is

under particular pressure from eutrophication and under the Conservation of Species and Habitats

Regulations 2010, so new sources of nitrates in the catchment must be mitigated by reducing loads from

existing sources within an overall load ceiling.

The pilot feasibility study (RSPB, 2013) concluded that there is ‘considerable potential for a nitrogen trading

market in the Poole Harbour catchment’, while previous research had shown that reducing agricultural

pollution would be the most cost-effective mitigation option. However, two major barriers were identified:

– political objections in the form of local authorities objecting to parties responsible for a very small

proportion of the overall load paying incumbents responsible for the large majority, particularly in the

face of demands for new housing; even though measures would be additional to legal requirements;

– contractual objections in the form of land managers being unwilling to accept long-term contracts over

the lifetime of new developments without unfeasibly high compensation; for example, the payments

demanded for 30 year contracts would have been more expensive than outright land purchase.

Both of the main barriers identified in the pilot originate in rights allocation

The scheme and pre-existing regulation would have allocated all rights to pollute with incumbents, with

newcomers having no rights. Instead, developers would have a binary compliance choice – exist and pay, or

do not exist – with no option to mitigate their own pollution. This contrasts with the inherent flexibility of

pollution trading schemes, where participants have the option of either reducing their own pollution or

paying for reductions.

Buyers’ own lack of flexibility would mean that demand for reductions would remain fixed long-term. This

required long-term contracts to be in place, in contrast to North American schemes where demand for

reductions can fluctuate and come from different buyers, leading to shorter contract lengths. Figure 3

summarises how various factors contributed to a perceived need for long-term contracts.


Figure 3. A perceived need for long-term contracts was seen as a barrier to nutrient offsets in Poole Harbour


Established schemes can absorb participants with no pollution rights

North American schemes generally also require new or expanding polluters to purchase credits. However,

established trading schemes have two key advantages over new schemes in having the flexibility to absorb

newcomers. First, in established trading schemes, existing capped point sources may potentially be capable

of releasing credits. Second, transaction costs are much lower in established schemes. Pre-existing buyers

will be familiar with trading concepts and accepted BMPs. Farmers can easily see in advance how much they

could earn, through the use of approved formulae and spreadsheets for estimating credits. In addition, most

successful schemes have well-established and trusted intermediaries acting as a clearinghouse. Liquidity and

well-oiled transactions appear to prevent contracts exceeding 10-15 years.

Interaction with existing measures also has implications for scheme viability

Quite rightly, given the need for strict additionality to meet the scheme’s objectives, offsets over and above

existing management practices were necessary in order to ensure load reductions. Many farmers in the

Frome and Piddle catchments would have already had NVZ and Environment Stewardship management

practices in place. These pre-existing measures mean that some cheaper mitigation options might have been

already present in farmers’ baselines, and thus unavailable as offset options. In some cases, complete land

use change such as woodland planting or wetland construction might have seemed like the only suitable

options; and these particular options appeared to have attracted a premium given the constraints on future

farming they would entail. In addition, several management options listed in case study were more expensive

than nitrogen stripping at Poole sewage plant. This contrasts with the North American schemes where

reducing pollution from non-point sources is widely known to be much cheaper than PS reductions.

Factors discussed above suggest a need to explicitly consider interactions with other policies and measures

early in scheme design, to decide whether they present difficulties or synergies, and if so whether they

Sell side

No right

to pollute

Single compliance

choice

Long-lived

asset

+

+

Need

certainty

Diffuse

pollution

Simple methods for

calculating reductions yet

to be developed

+ Long-term land

management decision

Seller locked

in

Buy side

No flexibility

Barrier to exit/

entry

Low viability and

efficiency

Unknown opportunity

cost

(agricultural produce prices change)


require adaptations. Possibilities for dealing with or harnessing scheme interactions which could be further

explored include (please note these are indicative and not to be viewed as recommendations):

– a type of water quality-focused Environmental Stewardship, using existing Environmental Stewardship

infrastructure and rewarding farmers for shifting to the most cost-effective water quality-enhancing

measures;

– reducing NVZ requirements for participating farmers as long as overall environmental and cost-

effectiveness are increased. The rationale for this is that, as a blanket measure, the cost-effectiveness of

NVZ requirements is likely to vary from farm to farm. Replacing one compliance burden with another

that is lower cost and more flexible could act as an incentive for farmer participation. A precedent for this

is the New York Catskills watershed protection scheme, where participating farmers are exempted from

water quality regulations, except ‘rogue polluter’ actions (Appleton, 2002).

3.3 Beneficiary pays to reduce a ‘bad’: ‘Agri PES’ and other Coasean bargains

3.3.1 Key findings


– Twenty-two documents were reviewed of relevance to this quadrant.

– A Coasean bargain describes an arrangement negotiated between polluters and affected parties to

mutual benefit, independently of government. This is generally limited to contexts where exclusion

is possible and transaction costs are low – that is, when beneficiaries with a strong private interest

self-identify at local scales.

– Some agri-PES schemes are examples of this kind of business-driven transaction. Typically a utility

company or drinks manufacturer negotiates with farmers to change land management practices in an

area in order to reduce nutrient or other pollution.

– Further examples of Coasean schemes are found in the literature relating to urban storm water and

flood risk management. They describe cases where large numbers of small landowners (businesses

and householders) are incentivised to improve drainage or rainwater storage on their land. In such

cases, the large number of beneficiaries require their interests to be coordinated by a scheme

organiser; hence we refer to these as quasi-Coasean schemes.


– Being a private arrangement does not preclude the need for extensive support by intermediaries and

scheme organisers. Intermediaries can play a vital role in building up trust and collaboration,

impartially resolving technical issues which could affect payments, and managing negotiations

which may require a detailed understanding of the issues facing participants.

– It is reasonable to expect that sellers who voluntarily choose to participate in a Coasean bargain will

be those who can make the best business case for doing so. This can lead to adverse selection, low

additionality and limited value for money.

– A process of negotiation and joint decision-making involving all relevant landowners participating

can lead to near universal participation, reducing but not eliminating additionality concerns.


– A lack of strict additionality might not always be seen as an insurmountable problem. A scheme may

act as a ‘nudge’, tipping participants over a threshold and allowing them to make investments sooner

and to a higher standard; as well as normalising participation and persuading others

– Land managers are not perfectly informed about mitigation options and may need support. The

difficulty of personally identifying suitable projects and bidding for funds can be a deterrent to

participation. Hybrid schemes which include input from specialist farm advisors in preparing bids

could be a solution to such problems.

– Expecting sellers to take on more responsibility for identifying mitigation options effectively shifts

cost from the administrator to them. This can widen the potential extent of the scheme (more sellers

can be considered), but reduce actual take-up (sellers may be deterred).

See Tables 23 and 24 in Appendix 3 for a further summary of issues facing schemes in this quadrant.

3.3.2 Overview

Coasean bargains are arrangements reached independently by private parties where those harmed by

an environmental impact compensate those responsible for reducing it (Perman et al., 1996). They can

take the form of agri PES schemes, or arrangements to reduction pollution which do not involve ecosystem

services. The latter are particularly prevalent in urban contexts.

The Coase theory suggests that an economically efficient, environmentally beneficial arrangement can be

negotiated between polluters and affected parties where exclusion is possible and transaction costs are low.

In the context of water resources, we can envisage that this will generally be limited to contexts where

beneficiaries with a strong private interest self-identify at local scales. Many agri-PES are examples of

this kind of business-driven transaction. Pollution reduction is required, involving land management changes

such as timing fertiliser application or infrastructure installation or maintenance, rather than direct

management of natural ecosystems. Typically a utility company or drinks manufacturer negotiates with

farmers, enacted via intermediary bodies, to change land management practices in an area. Examples in the

UK include South West Water’s Upstream Thinking project and United Utilities’ Sustainable Catchment

Management Programme (SCaMP).

Quasi-Coasean schemes12

are those where beneficiaries pay to reduce impacts, and benefits are non-

excludable; beneficiaries’ interests are aggregated by a, possibly public, intermediary. An example would be

a scheme to manage urban stormwater by paying householders to put grey infrastructures such as rainwater

storage tanks, or increase permeable surfaces, on their land (Fletcher et al., 2011; Valderrama et al., 2013;

Ursus Consulting, 2013). In such cases, the beneficiaries would be other householders who benefit from

reduced pollution in local water bodies and improved regulation of flood risk.


12

Note that this is not a term which was identified in the literature, but is introduced in the taxonomy to make a distinction between schemes which are genuinely made between independent parties and those where beneficiaries are less aware of or involved in the transaction.


Table 3. Summary of literature reviewed for Coasean schemes





PES – general

Defra background documents Overviews of: • comparison of experience in low and high income countries • factors affecting program efficiency globally Application of ES approach to WFD context Theory covering different design aspects

See Agri PES and Nature PES separately

Defra (2013b); Defra (2014); URS Scott Wilson (2011); URS (2015); Vlachopoulou et al. (2014); Kroeger (2013); Schomers and Matzdorf (2013); Vatn (2010);

Agri PES Defra background documents Auctions for agricultural schemes

Fowey River, Tortworth Brook, Place-based South Pennines (UK) Everglades ranchers (USA) Evian (France)

• Coverage of schemes where principal aim to reduce pollution through agricultural land management practices • Use of auctions for improved cost-effectiveness

Day et al. (2013); Defrance (2011); Hasund (2013); Schomers and Matzdorf (2013); Shabman and Lynch (2013); Bennett and Carroll (2014); BART et al. (2014); Quick et al. (2013); Moreddu (2007)

quasi- Coasean bargain

Overview of: • general issues for urban contexts

Hull Street Level (UK) Stormwater Tender (Australia) Philadelphia Stormwater Fee (USA)

Coverage of urban contexts with respect to (i) flood risk and (ii) stormwater management

Fletcher et al. (2011); Valderrama et al. (2013); Ursus Consulting (2013); Bennett and Carroll (2014); McPhearson et al. (2014)

Cross-cutting Overview of: • global watershed investment • PES-like mechanisms in UK

Bennett and Carroll (2014); Inman and Smith (2012); SWSC (2013); Stanton et al. (2010)


The Fowey River Improvement Auction (Day et al., 2013), is an example of a UK project prompted by a

water utility seeking to pay farmers to improve nutrient, pesticide and watercourse management. One of the

recent series of Defra pilots, it tested the replacement of a cost-sharing advisor-led system, under which

mitigation options would be identified in detailed consultation with farmers, by one where farmers submitted

bids in an auction. A key rationale was that this would overcome the resource constraint associated with

intensive input from advisors and potentially increase the extent of the scheme. The scheme clearly

highlighted several important design issues: whether metrics and criteria can replicate the rankings of expert

judgement; whether to base conditional payments on outcomes or actions; use of discriminatory or fixed

prices; and improved price discovery through revised bidding. The auction provided an estimated 20-40%

better value for money than the fixed-price alternative, while illustrating that some participants might be

deterred by factors such as procedural complexity and not wishing to compete for funds against neighbours.

See Table 15 in Appendix 2 for more details.


The Northern Everglades Payment for Ecosystem Services program (Shabman and Lynch, 2013) is a

series of pilot water management projects on cattle ranches in Florida. Ranchland owners entered into

contracts with a state agency to retain water and nutrients on their land rather than allowing them to enter a

regional drainage network. Ranchers chose the level of services to provide through an iterative process with

the buyer. The project required the development of new hydrological models based on site-specific

conditions for estimating outcomes. The key issues highlighted were the need to build effective collaborative

processes with sellers, and to draw on appropriate scientific and farming-specific financial expertise to

maintain credibility. See Table 16 in Appendix 2 for more details.

The Stormwater Tender scheme in Melbourne, Australia, (Fletcher et al., 2011) comprised a pilot project

to incentivise small-scale landowners to put in place stormwater management systems (‘greywater’

infrastructure, rain gardens and other SuDS options) to reduce urban run-off and pollutant loads into a nearby

creek. It invited bids in a reverse auction which were assessed on the basis of a composite ‘Environmental

Benefit Index’. It discovered that theoretical assumptions that the uniform price auction format used would

lead to true estimates of willingness-to-accept by landowners were not borne out in reality. In addition, it

highlighted the need to provide practical support to landowners, including removing their need to provide

upfront capital, as well as to limit eligible options in order to make bid evaluation less complex. See Table 17

in Appendix 2 for more details.

3.3.4 Findings

Voluntary participation can mean low additionality

Where only a proportion of land managers over a large area are expected to participate in a scheme, it is

reasonable to expect that those who voluntarily choose to participate will be those who can make the

best business case for doing so. This might be either in terms of overall compensation, or in terms of

scheme measures dove-tailing with investments and changes they wanted to make anyway. This means that

the scheme’s additional benefits – that is, its benefits compared to what would have happened in its absence

– may be low, resulting in relatively low value for money. This risk was illustrated by the Fowey River

scheme, where a high proportion of participants indicated that they would eventually have undertaken the

investments in the absence of the scheme, though they also bid in a proportion of their capital costs in at least

partial recognition of this fact.

However, some authors argue that strict additionality may be practically infeasible in many voluntary

schemes, and this should not always be seen as a stumbling block. Reasons why low additionality might be

accepted include (Goldman-Benner et al., 2012; Day et al., 2013):

– the inherent difficulty of establishing a ‘no-scheme’ counterfactual due to asymmetrical information;

– the possibility that the scheme is a ‘nudge’, tipping participants over a cost/effort threshold, rather than a

single primary driver;

– additional funding allowing land managers to make investments much sooner and to a higher standard;

and

– early, more easily-persuaded adopters can influence later uptake.


In any case, additionality concerns may be strongest in schemes which cannot attract near-unanimous

participation. A contrasting example of a voluntary scheme with no additionality concerns is that of Evian’s

deal with farmers to protect its catchment (Defrance, 2011), where a process of negotiation and joint

decision-making lead to almost all relevant landowners participating in the scheme. Similar outcomes were

observed in the Vittel case (Perrot-Maitre, 2006).

Intermediaries can play a vital role

Being a private arrangement does not preclude the need for extensive support by intermediaries and scheme

organisers. Intermediaries can play a vital role in building up trust and collaboration, impartially resolving

technical issues which could affect payments, and managing negotiations which may require a detailed

understanding of the issues facing farmers (Shabman and Lynch, 2013; Defrance, 2011).

In addition, land managers are not perfectly informed about mitigation options and may need support

identifying them. The need for technical support in identifying suitable mitigation options was highlighted

by Shabman and Lynch (2013), Defrance (2011) and Day et al. (2013). For example, in the Fowey River

scheme, the difficulty of having to personally identify suitable projects and the complexity and workload of

bidding were cited as a key deterrent by those farmers who did not participate (Day et al., 2013). Many

farmers felt access to a trained advisor to identify projects would have been helpful, as they were uncertain

which projects would be acceptable. This led to the result that, while the advisor felt that each project

identified had been a worthwhile investment, farmers had submitted in the bidding process only 54 per cent

of the projects that would have been identified by an advisor. Hybrid schemes which include input from farm

advisors in preparing bids were suggested as a solution to such problems.

Distribution of administrative cost can affect uptake and scheme coverage

It can be inferred that the more ‘business-like’ the arrangement, the more sellers are expected to identify and

make the case for a measure themselves, the greater the allocation of responsibility and administrative cost to

them, and the less to the scheme administrator or buyer. Those that are less able to navigate the application

process might elect not to participate. This results in a potential trade-off in scheme design relating to

geographical coverage. A shift in administrative cost and effort to sellers, reduces the administrator/buyer’s

search costs per potential seller, and so can widen the potential extent of the scheme to a large area.

However, it may deter many eligible participants, lowering eventual participation (Day et al., 2013).

3.4 Beneficiary pays to maintain a good: ‘Nature PES’ and other mechanisms

3.4.1 Key findings


– Nineteen documents were reviewed of relevance to this quadrant.

– Schemes which pay landowners and other agents such as tenant farmers to conserve land in a

natural, low impact or otherwise highly valued state are classified here as ‘Nature PES’. They often


involve multiple ecosystem services, but in a water quality context they usually relate to maintaining

forests to regulate water quality and quantity.

– Such schemes emerged initially in the developing world to improve the acceptability of nature

conservation amongst local people by compensating them for forgone economic opportunities. Some

are initiated and administered locally, some by international NGOs, while others are national in

scale.

– Some of the best known schemes, the Andean water funds, are specifically designed to provide

financial stability over the long term. They pool non-retractable contributions which are managed

collectively by stakeholders over the long term.

– PES schemes are often defined as voluntary transactions which are conditional on service provision.

However, one study points out that in the majority of real world schemes participation is voluntary

on only one or neither side (Schomers and Matzdorf, 2013).

– Other best practices to improve value for money such as spatial targeting and metrics related to

service provision, are also relatively uncommon. This is likely to be due to the extra administrative

and monitoring costs they impose, particularly when schemes are national in scale.

– Amongst the best known schemes in the developed world are those led by municipalities in the USA

to conserve and manage forests to reduce risks to drinking water quality, such as wildfire.


– The context-specific factors which have made Nature PES schemes viable in the developing world

and USA may be absent in England. This needs to be taken into account when considering any

comparable scheme.

– In the developed world, these include sellers with little in the way of alternative incomes or social

security, and buyers who cannot rely on regulatory and planning regimes to maintain water quality,

implying large gains in trade from PES which can outweigh transaction costs.

– In England, the ratio of natural habitat to agricultural land is much lower than in the US, therefore it

is less likely that watershed protection will be so strongly co-aligned with habitat conservation. The

high proportion of the value of nature PES schemes may remain in non-market benefits

(biodiversity, landscape, amenity, carbon) which are funded either publicly or through voluntary

subscription, or protected by an existing system of conservation designations.

– As with agri PES, adherence to best practice, or lack of adherence due to practical or cost

considerations, should be explicitly recognised and built into scheme design. Two particular

potential pitfalls are: (i) adverse selection resulting from flat rate payments, that is, those who

contribute least taking up full payments; and (ii) ignoring pollution hot spots due to a lack of spatial

targeting, that is, those areas where benefits are greatest are overlooked because costs may be higher.

– Where value for money best practice is used, on conditionality, additionality, price differentiation,

and sophisticated performance metrics, the extra cost they might impose might be justified.

– In England, there is institutional capacity for site selection and monitoring. If there are relatively few

eligible sites and/or individual land managers, and low spatial variation, differentiation may not be

necessary. However, in many cases, the development of spatially-sensitive site selection tools which

are able to summarise likely benefits and costs would assist scheme design.

– Non-economic motivations can be a strong driver for landowners to conserve. Conservation

covenants could provide a new mechanism which is attractive partly because it can bypass precise


technical details over baselines and water quality impacts as the basis of the contract. Experience of

similar arrangements in the US suggests that they are strongly motivated by a desire to conserve the

land for future generations, and frequently do not involve payments.

See Table 25 in Appendix 3 for a further summary of issues facing Nature PES schemes.

3.4.2 Overview

Nature PES schemes emerged a decade or more ago principally as a tool for directly compensating those

bearing the costs of nature conservation in developing countries, thereby improving its acceptability,

diversifying funding and alleviating poverty (Wunder, 2005). They often incorporate multiple services, such

as carbon sequestration, hydrological services and biodiversity, but some relate more specifically to

watershed protection.

Payment for ecosystem services schemes are typically defined as (Wunder, 2005):

(a) a voluntary transaction where (b) a well-defined ecosystem service or a land

use likely to secure that service (c) is being ‘bought’ by a (minimum one) service

buyer (d) from a (minimum one) service provider (e) if and only if the service

provider secures service provision (conditionality).

Further frequently-cited PES best practices include differentiated payments, spatial targeting and

additionality (Goldman-Benner et al., 2011).

Some of the literature makes a distinction between markets for ecosystem services (MES) as a subset of

payments for ecosystem services (Vatn, 2010). MES involve voluntary transactions on both sides between

small numbers of counterparties. In spite of the above definition, many PES schemes involve an

involuntary aspect due to the need to aggregate beneficiaries’ interests and avoid free-riding, for

example, revenue streams derived from water charges or general taxation (Schomers and Matzdorf, 2013;,

Vatn, 2010). In fact, government payment schemes with voluntary action only on the part of sellers, or

even on neither side13

, form the majority of PES schemes worldwide (ibid.). It is clear that PES is a

flexible concept.


Table 4. Summary of literature reviewed for nature PES schemes





PES – general

Defra background documents Overviews of: • comparison of experience in low and high income

See Agri PES and Nature PES separately

Defra (2013b); Defra (2014); URS Scott Wilson (2011); URS (2015);

13

Some schemes which are sometimes described as PES are more correctly described as compensation for compulsory land management practices (Schomers and Matzdorf, 2013).






countries • factors affecting program efficiency globally Application of ES approach to WFD context Theory covering different design aspects

Vlachopoulou et al. (2014); Kroeger (2013); Schomers and Matzdorf (2013); Vatn (2010);

Nature PES Overviews of: • comparison of international experience • US forest PES

Andean water funds (Latin America) Catskills-Delaware, Denver Forests to Faucet, Santa Fe (USA) Pumlumon, Pennine Visitor Giving (UK)

• use of trust funds as finance mechanisms • nature PES in a developed world context • geographical and institutional factors behind emergence of nature PES and comparison with UK • schemes frequently do not incorporate PES best practice

Bottorff (2014); Goldman-Benner et al. (2012); McPhearson et al. (2014); Mercer (2011); Schomers and Matzdorf (2013); SFWA (2009); WRI (2011a); Alison Milward Associates (2014); Reed et al.(2013)

Cross-cutting Overview of: • global watershed investment

Bennett and Carroll (2014); Stanton et al. (2010)

Other • Theory and overview of flood risk instruments • Overviews of conservation covenants and easements

Law Commission (2014); Nature Conservancy (2015);


The most noted examples of nature PES schemes for watershed protection are found in Latin America. Some

of the best known, the Andean water fund schemes in Ecuador, Colombia, Bolivia and Peru, follow a trust

fund model, an approach which combines PES payments to support watershed best-management practices

with a special purpose organisation with board representation by multiple stakeholders which manages

financial contributions from beneficiaries over the long term (Goldman-Benner et al., 2012). The activities

funded vary from paying for park guards, fencing off environmentally sensitive areas, land purchase,

securing alternative livelihoods and food sources, maintaining habitat in a defined state, and improving

social conditions. Some similar projects such as Pimampiro in Ecuador incorporate an element of long-term

financial stability, but without the institutional and management arrangements of a trust fund (Goldman-

Benner et al., 2012). See Table 18 in Appendix 2 for more details.

In a developed world context, there are PES schemes in the USA which maintain or restore natural

forests for the purposes of watershed protection, although in some (such as the NYC Delaware-Catskills

scheme) these are outweighed by agri-PES elements (McPhearson et al., 2014). Schemes such as the Denver

Forests to Faucet Partnership and Santa Fe Watershed Plan have arisen in the western United States in

response to the risk posed by wildfire to public drinking water supply, due to sedimentation and debris

(Bottorff, 2014; SFWA, 2009). These involve co-payments along with the US Forest Service for activities

such as forest thinning and ecological monitoring to reduce wildfire risk.


While US watershed protection schemes are often-cited examples of PES approaches, they should be put in

proportion; national government schemes still account for over 50 per cent of funding for watershed

protection in the USA, compared with about 40 per cent by municipalities and drinking water utilities

(Bennett and Carroll, 2014). As a generally successful model, further examples are highly likely to emerge,

although many of the watersheds with the greatest potential for investment are those which face the greatest

development pressures (WRI, 2011a). See Table 19 in Appendix 2 for more details.

In the UK, nature PES schemes remain novel. Examples include the Montgomeryshire Wildlife Trust’s

project to identify multi-service markets to safeguard the Pumlumon uplands of Powys, Wales (Alison

Millward Associates, 2014).

3.4.4 Findings

Value for money best practices (additionality and conditionality) are relatively rare

Much of the literature on nature PES schemes highlights at some length that many of the schemes falling

under the PES umbrella do not have all of these defining or best practice characteristics listed above.

For example:

– many of schemes in Latin America have non-differentiated payments and low additionality (Schomers &

Matzdorf, 2013; Kroeger, 2013; Goldman-Benner et al., 2012);

– many schemes have considerable non-voluntary element; beneficiaries are aggregated, as in national

governmental payment programs (Schomers & Matzdorf, 2013; Vatn, 2010);

– the Catskills scheme involves land acquisition and non-monetary incentives in the form of exemption

from water quality regulations (McPhearson et al., 2014).

The absence of design elemetns is likely to be due to the extra administrative and monitoring costs they

impose, particularly when schemes are national in scale (Vatn, 2010). In particular, the literature describes

targeting of funds as generally poor in developing world PES schemes, with additionality rarely achieved,

but differs in the extent to which that is considered problematic (Schomers and Matzdorf, 2013; Kroeger,

2013; Goldman-Benner et al., 2012). Some schemes have been criticised for making highly inefficient use

of funds by distributing flat-rate payments to those who would not in any case have contributed to habitat

destruction, a clear case of adverse selection (Schomers and Matzdorf, 2013). For example, payments under

Mexico’s Pagos por Servicios Ambientales Hydrologicos (PSA-H) programme to protect aquifers were

generally not taken up by those near the most overexploited aquifers (ibid.; Alix-Garcia et al., 2009),

presumably because they were in areas of greater agricultural activity where opportunity costs were higher.

There are, however, examples where schemes have evolved to better target preferred outcomes and optimal

locations, as for example under Costa Rica’s Payments for Environmental Services (Pagos por Servicios

Ambientales, PSA) national PES programme for services generated by forest and agro-forestry ecosystems

(Wunscher et al., 2006).

In other cases, low additionality has been more accepted. ES payments have been described as a

compensatory deal for legal restrictions (Pagiola et al., 2008; Schomers and Matzdorf, 2013); while the

potential inequity of not recognising pre-existing and ongoing good land management is frequently


commented on. Easily persuaded, low-additionality participants can also be seen as helping to get schemes

established and changing social norms through social spillover effects (Goldman-Benner et al., 2011).

Goldman-Benner et al. (2011) note that in the case of the Andean water funds, strict conditionality can be

viewed as a lower priority than considerations such as risk management and financial sustainability.

Conditionality implies that buyers can withdraw their finance, which reduces certainty for sellers if outcomes

are not fully within their control. The Andean water funds violate conditionality, as buyers’ contributions are

sunk and they are unable to withdraw them (ibid.). This also provides incentives for buyers and sellers to

cooperate in the long-term on land management decisions.

In addition, in a water services context, there seems to be a general lack of performance metrics related

directly to the quality or quantity of service provision, rather than simple observable land use change (see

discussion in Schomers and Matzdorf, 2013). One exception is the RISEMP silvo-pastoral scheme in Latin

America which remunerates participants according to changes in an ‘environmental service index’ over

baseline (Pagiola et al., 2007). This could be because conditionality requirements based on indicators of

ecosystem service bring extra administrative and information-gathering costs which ultimately result in

lowering resources for on-the-ground practices, though they are intended to increase value for money

(Kroeger, 2013). This trade-off is summarised in Figure 2. The cost-effectiveness of stringent monitoring and

conditionality itself therefore may need to be considered in scheme design (Kroeger, 2013).


Figure 4. There is a trade-off between environmental stringency and scheme coverage

Source: adapted from Kroeger (2013)

The England context

Given the occurrence of nature PES schemes in the developing world and USA, it is instructive to highlight

the differences between the examples cited here and the UK context. As discussed in 3.1.2, there are many

factors present in Latin America which have contributed to the emergence of nature PES schemes

which are absent in the UK. These include sellers with little in the way of alternative incomes (Goldman-

Benner et al., 2011; Wunder, 2005) or social security14

,and buyers who cannot rely on regulatory and

planning regimes to maintain water quality15

, implying large gains in trade from PES which can outweigh

transaction costs.

The Andean water fund model has evolved as a risk management mechanism in a particular context of

political instability and short-term market fluctuations for agricultural commodities (Goldman-Benner

et al., 2011). It is reasonable to suggest that a key difference with a developed world agri PES scheme is that

the costs of provision in the former are almost 100 per cent opportunity costs from forgone crops. In a UK

agri PES scheme, for example, see Fowey River; Day et al., 2013, costs faced by land managers would

proportionally be much more related to time, management, and capital equipment; in some cases output

opportunity costs might not be relevant at all. While financial stability is key in all schemes, we can assume

that the risks of funding payments with ongoing cash flow are lower in a developed world context.

A further reasonable assumption is that in a developed world scheme the risk of adverse selection is lower

due to greater institutional capacity and more resources available for scheme design and monitoring. Most

14

In many Latin American countries, unemployment protection takes the form of severance payments or mandatory savings schemes only relevant to employees, which would not extent to the self-employed or those in the informal sector. (ILO, 2014; US SSA, 2011). Social security coverage rates have historically been significantly lower in rural areas (World Bank, 2005).

15 Water governance in many Latin American countries is fragmented and faces challenges in human resources, technical capacity,

monitoring and evaluation, and political commitment (Akhmouch, 2012)

increased need

for accuracy

higher MRV costs

lower payment

budget

greater outcome

risk

premium greater

participant cost

higher payment

level requested

higher environmental quality,

lower scheme coverage


of the Defra PES pilots considered site suitability in detail (BART and Partners, 2014; Quick et al., 2013;

Alison Millward Associates, 2014), which is clearly very distinct from allowing hundreds or thousands of

participants to self-identify with little scrutiny. However, as addressed in Section 5, reductions in public

sector budgets may have the impact of reducing technical capacity in government advisory and regulatory

bodies, increasing transaction costs in scheme design where expert input has instead to be purchased.

Where nature PES schemes have emerged in the developed world, in watershed protection in the USA,

there are also context-specific factors which do not apply in the UK. These include large areas of natural

forest, most of which is publicly-owned in the western states (US FS, 2009); and responsibilities for state and

local governments, as opposed to water companies, to both ensure the supply of good quality drinking water

and assess existing and potential threats to drinking water quality (Mercer et al., 2011).

In either case, we can infer that because, in England, the ratio of natural habitat to agricultural land is much

lower, it is less likely that watershed protection will be so strongly co-aligned with habitat conservation. This

does not at all rule out multi-benefit projects. The greatest proportion of the value of UK nature PES schemes

is likely to remain in non-market benefits such as biodiversity, landscape, amenity and carbon, funded either

publicly or through voluntary subscription, or protected by an existing system of conservation designations.

It is saying that the greater burden of watershed protection might be shouldered by schemes which have this

as their primary purpose, often within agriculture.

Spatial targeting and price differentiation are critical to cost-effectiveness

As mentioned above, PES schemes have been frequently criticised for not differentiating prices for land

which is of greater environmental benefit, at higher risk of degradation, or greater cost to conserve (spatial

targeting) (Kroeger, 2013; Vatn , 2010)16

. Such price differentiation should make schemes more

economically efficient and environmentally effective. For example, as illustrated by the Mexico’s PSA-H

scheme referred to previously, it can be inferred that if water quality pressures are strongly correlated

with economic activity on the source land, then low cost ecosystem service provision will also provide

the lowest gains17

. Land managers do not have to forgo as much revenue to conserve unproductive land. The

implication is that methods or procedures to select targets for a scheme need to counter any in-built

bias towards selecting targets where environmental pressures are lower simply because they are less

costly or challenging.

How much price differentiation matters depends on how much the scheme designer can know about

sites, and how much they vary. For example, if the opportunity to take up payments is given to thousands

of individual land managers and there is a high degree of spatial variation in benefits and costs, it is highly

likely that simple forms of price differentiation will improve cost-effectiveness. If, however, site selection is

a relatively cautious process, with relatively few eligible sites and/or individual land managers, and there is

16

Significant exceptions include the evaluation of outcomes under US Conservation Reserve Programme arrangements, and the targeting of land for conversion on slopes greater than 25 degrees in the upper Yangtze and Yellow River basins in China (OECD, 2010; Bennett and Xu, 2005).

17 There need not always be a strict correlation, however, as other factors, for example, soil type and slope may also be significant.


less extreme spatial variation, price differentiation may be less necessary. In either case, the development of

spatially-sensitive site selection tools which are able to summarise likely benefits and costs would assist

scheme design.

Non-economic motivations can be a strong driver behind permanent conservation contracts

The introduction of conservation covenants – agreements between a landowner and a conservation body

ensuring the conservation of natural or heritage features on the land in perpetuity – is being considered in

England and Wales (Law Commission, 2014). It is possible that there will be cases where conservation

covenants may have water management objectives or consequences. These are analogous with the

conservation easements already in widespread use in the USA, for example to provide stream buffers, which

are generally permanent arrangements (EPA, 2014). Such arrangements could be attractive because there is

no need to enter into precise technical details over baselines and water quality impacts as the basis of the

contract. In fact, the US experience suggests viewing them as regimented economic contracts in this way

could be counterproductive; in the USA, it is the norm for conservation easements to be donated rather

than sold, in line with landowners’ strong attachment to and desire to conserve their land for future

generations (Nature Conservancy, 2015).

3.5 ‘Polluter’ pays to maintain a good: third party biodiversity offsets

3.5.1 Key findings


– Five studies were reviewed of relevance to this quadrant.

– Biodiversity offsets occur when developers compensate for damage to habitats and species by

creating or enhancing a replacement elsewhere. Third party offsets are those when this process is

undertaken not by the developer, but another organisation. In some cases, these third parties will

have pre-emptively created the replacement habitat in anticipation of future demand, known as

mitigation banking or biobanking.

– There is currently only one mandatory biodiversity offsetting scheme in the world which has led to

widespread third party participation: wetland mitigation in the USA18

. A voluntary third party offset

programme has been implemented in New South Wales. Mandatory biodiversity offsetting is under

active policy discussion in the UK.

– The main advantages of allowing mitigation to be undertaken by a third party are: to the regulator,

that it improves the efficiency of compliance monitoring through consolidation; and, to the

developer, that it allows transfer of liability.


18

The European Environmental Liability Directive, while it has some similarities with biodiversity offsetting, is different in that its primary objective is to remediate damage to the original site. Off-site remediation is only required if this cannot be achieved, or to compensate for interim losses.


– A regulatory framework for mandatory offsetting would be essential for widespread uptake in the

UK19

.

– In its historic form, biodiversity offsetting is the mechanism with least potential to meet WFD

objectives, because: (i) it is focussed on offsetting impacts to habitats and species rather than water

quality; (ii) its fundamental aim is ‘no net loss’ of biodiversity, rather than driving improvements

over baseline; (iii) it applies only to new development and not to existing impacts.

– In addition, wetland mitigation in the USA has attracted controversy and its environmental

effectiveness has been frequently called into question. Criticisms include a failure to meet ‘no net

loss’ objectives and lower ecological quality on mitigation sites compared to originals. A UK

equivalent would need to develop sound methodologies to address such concerns.

– The basic concept could be developed to address some of these limits, for example by: (i) an explicit

aim of net environmental improvement; (ii) extending the concept of environmental damage to

include ‘water damage’, similar to the Environmental Liability Directive; (iii) appropriate spatial

scales, for example landscape or catchment; and (iv) allowing environmental requirements to be

tightened over time.

– In particular, new methodologies which could capture impact pathways across habitat types would

make the mechanism much more applicable to water resource protection. Current methodologies

focus only on replacing like for like habitat without considering the impact that, for example, a

woodland could have on downstream water quality. However, no scheme reviewed in the literature

appeared to have a metric or methodology which could ensure functional equivalence across all

ecosystem services.

See Table 26 in Appendix 3 for a further summary of issues facing biodiversity offsetting.

3.5.2 Overview and scheme examples

Aquatic resource offsetting and mitigation banking have existed in the USA for forty years, driven by Clean

Water Acts. Developers can offset impacts on wetlands and streams by (Womble and Doyle, 2012):

– directly investing in mitigation measures as compensation for services lost in the proposed development

(permittee-responsible mitigation);

– providing resources to public or voluntary sector bodies to undertake the mitigation project (in-lieu fee

mitigation);

– purchasing banked credits from mitigation entrepreneurs who have pre-emptively created replacements

(mitigation banking).

The last two of these mechanisms, which are overwhelmingly the most common, involve transferring the

liability for the success of the project to the third party, unlike permittee-responsible mitigation, where

the developer is ultimately responsible for project success (EPA, undated). The number of credits generated

by a project relates to area and/or functional value of the wetland. Mitigation habitat may also be required to

take place in a prescribed radius of the development site. See Table 20 in Appendix 2 for more details.

19

This statement is intended only to convey what would be required for widespread uptake of the mechanism in the UK, and is not intended to advocate such a policy.


The New South Wales BioBanking scheme is a voluntary market mechanism which attempts to encompass

a wider definition of biodiversity and relevant metrics (NSW DECC, 2007). Ecosystem or species credits are

created by landowners who improve a habitat or increase the population of a threatened species. Individual

management actions are set out in a biobanking agreement fixed to land title. Credits are calculated using a

fixed procedure and can only be used to offset impacts to same ecological community or species. See Table

21 in Appendix 2 for more details.

A Green Paper setting out a potential mandatory national offsetting scheme for England, introduced as

part of the planning system, was released for consultation in 2013, and the idea is under active policy

discussion in the UK (Defra 2013a; HoC EAC 2013). In addition, at least one private biodiversity offset

intermediary (the Environment Bank) has been set up in the UK with the aim of acting as a broker and

‘delivery assurer’ (Environment Bank, 2013).


Table 5. Summary of literature reviewed for biodiversity offsetting schemes





Biodiversity offsetting

Literature reviewed focussed on particular applications; US wetland references were fairly high level overview

US wetland mitigation Australia BioBanking

• Mitigation banking widely used in US but some ecological question marks • Biodiversity offsetting concept would need methodological development to have wider application in water management context

Bull et al. (2013); Burgin (2010); NSW DECC (2007); Womble and Doyle (2012)

Biodiversity offsetting is the mechanism with least potential to meet WFD objectives, but this could

change

There are several reasons to conclude that, of all the mechanisms examined, biodiversity offsetting has the

least potential for water management. First, it is focussed on offsetting impacts to habitats and species rather

than water quality. Second, the fundamental aim of biodiversity offsetting is typically ‘no net loss’ of habitat

and biodiversity, so it is not designed to drive improvements over baseline, its primary motivation is to

facilitate compliance with environmental requirements without restricting economic development. Third, it

applies only to new development, and not to existing impacts. As such, it has not had a significant role in

driving water body improvements compared to a historical baseline20

in its historic form. This is in contrast

with the other main polluter pays mechanism, water quality trading.

20

However, in the New South Wales scheme it is possible for those with an interest in conservation to buy credits, thereby increasing the demand for improved/new habitat.


This is not an argument against biodiversity offsetting in itself, rather an acknowledgement of its limits. It

can be envisaged that the basic concept could be developed to address these limits, for example by:

– aiming for a net gain in biodiversity, for example through enhancing ecological networks, as

advocated in the Biodiversity Offsetting Green Paper (Defra 2013a);

– new methodologies to extend the conception of the environmental impact to be offset to include

‘water damage’. This would be more similar to the concept of remediation required under the

Environmental Liability Directive, which defines water damage as ‘any damage that significantly

adversely affects the ecological, chemical and/or quantitative status and/or ecological potential [of a

water body], as defined in [the Water Framework Directive]’

– targeting at appropriate spatial scales, for example landscape or catchment

– allowing environmental requirements to be tightened over time,; for example, the Australian

BioBanking scheme allows those seeking better conservation outcomes to buy and retire credits

The environmental effectiveness of wetland mitigation is frequently called into question

The rapid growth of wetland mitigation banking in the USA over the period 1990-2005 prompted a number

of studies strongly questioning the environmental effectiveness of wetland mitigation, reviewed in Burgin

(2010). These criticisms included21

:

– a failure to meet the overriding objective of ‘no net loss’ of biodiversity by a large margin, and a view

that the practice is slowing rather than halting the rate of biodiversity decline;

– the failure of many individual projects to comply with regulations, including insufficient size or

hydrology, and impact on other habitat types, with weak monitoring;

– lower biodiversity and overall ecosystem function on mitigation sites compared to originals;

– transfer of habitat from urban to rural contexts.

It is not clear whether these criticisms relate specifically to mitigation banking or biodiversity offsetting in

general.

The US National Research Council, however, concluded that mitigation banking is ‘more likely …to achieve

desired long-term outcomes’ (NRC, 2001) than the developer-responsible alternative, and mitigation banking

is officially preferred (Mercer et al., 2011), probably because it improves the efficiency of compliance

monitoring by consolidating offsets into fewer sites (Salvesen et al., 1996). Whether flawed biodiversity

offsetting is better than no biodiversity offsetting depends on the assumption of the underlying

distribution of rights that is made, that is, whether developers have a right to develop, or the public a right

to undeveloped habitat, and also the extent to which a representative range of services is considered, planned

and audited. If it is assumed that developers have a right to develop, constrained only by the existing

planning system, then biodiversity offsetting is an improvement on a ‘no mitigation’ scenario. If it is

assumed that the public have a right to undisturbed ecosystems, in which case nothing but the lowest-impact

development would be allowed, then it is not.

21

See also further discussions in Bull et al. (2013) which states “biodiversity offset schemes have been inconsistent in meeting conservation objectives because of the challenge of ensuring full compliance and effective monitoring and because of conceptual flaws in the approach itself”.


Biodiversity offsetting methodologies are blind to impact pathways which cut across habitat types

An additional environmental concern arises with a systemic understanding of ecosystem services. Mitigation

of a single measure, wetland type, area or suitability for a target species, does not automatically result in

functional equivalence (Bull et al., 2013). In other words, mitigated habitat that produces the same range of

services as the site lost to development is far from guaranteed.

Biodiversity offsetting methodologies tend to treat certain habitat types as equivalent without considering

how their ecosystem services might be interrelated (NSW DECC, 2007; Environment Bank website). A

methodology which treats two areas of broadleaved woodland as equivalent could mean that a woodland

which is important for maintaining water quality in a catchment is chopped down and replaced by one which,

by view of its location, is not. No scheme reviewed in the literature appeared to have a metric or

methodology which ensures functional equivalence across all ecosystem services. This is a further way in

which both the concept and associated methodologies could be extended.

3.6 Intertemporal mechanisms

Key findings:

– Seven documents were reviewed of relevance to this quadrant.

– Some of the mechanisms reviewed are characterised not only by who bears costs and environmental

objectives, but also by their explicit arrangements for the distribution of payments and costs over

time: the intertemporal design.

– The literature on these mechanisms is thin and they are included only in response to the terms of

reference to consider the potential for Social Investment Bonds and Catchment Trust Funds:

– Social investment bonds are a relatively new mechanism with previous application in criminal

justice. It has been proposed that their use could be extended to fund investments in flood risk

management.

– There was no clear definition or discussion of a catchment trust fund in the literature reviewed.

Clarity over the concept and expectations of what it could achieve would be helpful for future policy

development.


– Intertemporal considerations can be part of the design of any of the mechanisms previously

discussed. Rather than treating the mechanisms discussed here as a template, mechanisms design

needs to be based on an understanding of what the intertemporal aspects are trying to achieve over

and above what the mechanism can already do.

– For example, a trust fund design to improve financial sustainability could be inspired by, but should

not necessarily be modelled on, the Andean Water Funds, given the country-specific specific risks

they were intended to address.

– There is currently insufficient evidence that Social Investment Bonds are a workable model for water

resources. A methodology would be needed to clearly link savings to the public purse with the

investment made. This could be particularly problematic for infrequent, probabilistic events such as

floods.


3.6.1 Overview

Some of the mechanisms reviewed are characterised not only by who bears costs and environmental

objectives, as highlighted in Figure 1, but also by their explicit arrangements for the distribution of payments

and costs over time: the intertemporal design. These mechanisms include trust funds, social investment

bonds and the use of offset banking. Intertemporal mechanisms can provide solutions to specific problems

relating to timing and uncertainty including:

– ensuring payments are not dependent on uncertain or fluctuating revenues;

– overcoming problems associated with cash flow and lack of upfront capital

– this may include removing the need to seek loans from traditional financiers unfamiliar with the

environmental mechanism and likely revenues;

– removing the need to match trades exactly in terms of start time (as with mitigation banking); and

– providing a financial buffer to manage one or more risks (outcome, political, price, project).

The literature reviewed for these schemes is slight but summarised in Table 6.

Table 6. Summary of literature reviewed for intertemporal mechanisms





Nature PES Andean water funds (Latin America)

• use of trust funds as finance mechanisms; provides financial buffer for risk management

Goldman-Benner et al. (2012);


Literature reviewed focussed on particular applications; US wetland banking fairly high level overview


• Mitigation banking most popular form of offsetting; allows anticipation of future demand, identifying mitigation opportunities as they arise

Bull et al. (2013); Burgin (2010); NSW DECC (2007); Womble and Doyle (2012);

Cross-cutting High-level overview of some issues surrounding innovative approaches to water quality

SWSC (2013)

Other Potential application of Social investment Bonds

• SIBs face methodological challenges for flood risk application

Flow Partnership (2015)

3.6.2 Examples and discussion

Social investment bonds (SIBs) have recently been suggested in the context of flood risk management

(Flow Partnership, 2015). First suggested in a criminal justice context, the world’s first SIB pilot was

launched at Peterborough Prison in 2010 in order to raise finance from social entrepreneurs to reduce

reoffending rates (RAND Europe, 2014). Under a SIB, investors provide upfront funding for a project which

is then repaid to them if the project results in savings to the public purse.


The chief benefit of SIBs is considered to be transferring upfront costs and outcome risk to private investors

willing to bear these costs and risks, away from scarce public funds. In a flood risk management context

investors could include those in the best position to control the risk, that is, land managers, providing them

with an incentive to do so. The final allocation of cost would be split between (i) those who have provided

what is likely to be concessional finance; and (ii) the public purse.

SIBs are a recent public finance innovation. There have to date been no research or evaluations of a

completed SIB in any policy area (RAND Europe, 2014). Their use in a water management context would

therefore be novel and would likely to be subject to a learning process. In particular a sound methodology

would be required for attributing savings in public money to specific management actions to the satisfaction

of all parties. As floods in a given location are relatively infrequent, probabilistic events, this is likely to be

challenging, due to a lack of data points. Given the multi-benefit nature of catchments, issues of precisely

what is being invested in, what flood damage is averted, how this is audited, who pays and how non-

excludable benefits are used by non-paying beneficiaries, are all technical issues to be resolved.

Trust funds are simply the pooling of resources from different beneficiaries into a central fund managed on

a cooperative basis and disbursed to mitigation and/or service provision projects. As described above, there

is extensive experience of using analogous funds for PES schemes in Latin America, but their use in a UK

context is still at an early stage of discussion (Defra, 2013b) and there was little information uncovered in the

review.


Table 7. Inter-temporal mechanisms can offer features to meet specific objectives, while other features are common with alternative measures

Explicit inter-temporal mechanisms Comparator measures

Desirable property or problem addressed Social investment

bond for flood risk management

PES + trust fund Payment for

ecosystem services

Government-funded green

infrastructure

Government-funded

grey infrastructure

Use of natural (green infrastructure) flood risk measures ✔ ✔ ✔ ✔ ✗

Stakeholder collaboration ✔ ✔ ✔ ✗ ✗

Diversification of funding / multiple beneficiaries ✔

✔ (trust fund implies

multiple beneficiaries )

/✗ (if can get multiple

beneficiaries on board)

✗ ✗

Cash flow and timing of payments ✔ ✔

✗ (may not be

explicitly addressed)

n/a n/a

Lack of upfront capital from public purse ✔

/✗ (may matter if

public beneficiary is major contributor)

/✗ (may matter if

public beneficiary is major contributor)

✗ ✗

Cash buffer for contingencies ✗ ✔ ✗ ✗ ✗

Allocates risk of project failure to counterparties willing to bear it ✔ depends on

conditionality arrangements

depends on conditionality arrangements

✗ ✗

Allocates responsibility to reduce flood risk to those most able to control it

/✗ (partially, as voluntary)



✗ ✗

Payment can be clearly linked to an observable, non-probabilistic benefit over counterfactual

? unclear that

public savings will be apparent

✔ (can be linked to

actions or hectares)

✔ (can be linked to

actions or hectares) n/a n/a

Source: Vivid Economics; SIB analysis based on information in Flow Partnership (2015)


These intertemporal mechanisms could offer some features over and above the others described, but not all

of their frequently-cited properties are unique. When considering such mechanisms it is helpful to highlight

the specific problem the intertemporal aspects are designed to address, as well as other strengths and

weaknesses. Table 7 summarises some of these features in comparison with other measures in a flood risk

management context.


4 Evidence from interviews Points made by interviewees

4.1 Approach

Interviewees were selected from academic institutions, environmental non-governmental organisations,

industry associations and industry. All interviewees held senior management positions relevant to the field of

enquiry. The interviewees were circulated a set of questions in advance, listed in the box below, and invited

to choose three or four to discuss during the interview, since the interviews were limited to 30 minutes each.

They were instructed to speak to those issues about which they had the greatest expertise or experience and

to distinguish between factual information and opinion. The interviews were supplemented with discussions

with officials from government and its agencies.

This section is divided into three parts, allowing 13 hours of interview evidence to be structured, condensed

and analysed. Interviewees were asked to identify the most promising opportunities for PES schemes, and

their answers focused on particular ecosystem services, and so it made sense to structure the subsection on

potential opportunities around ecosystem services. The interviews often then moved on to discuss sources of

funding, where interviewees’ responses could be neatly arranged according to payees. Finally, many

interviewees had comments to make about the preferences of certain types of beneficiary or payee, about

attitudes towards other parties that might be involved, and on roles of institutions. It was convenient to

organise these comments under headings naming different types of organisation and specific public

institutions. This is how the interview evidence in this section is structured.


Box 1. Questions circulated to interviewees

In your experience or opinion, which ecosystem services are most naturally suited to a payment for

ecosystem services approach?

– Why do you think these are better suited than others?

– If you were to make some a priority, which would they be?

Which of the PES schemes that are you aware of or have knowledge of do you think would be most

widely and successfully replicable in a UK context?

– What examples do you think are good models for replication?

– What aspects make them good for replication?

– If from outside the UK, what are the prime differences with the UK?

– How widely do you think they should be replicated and how important could they become in

the delivery of ecosystem services in the UK?

– What size of scheme would they be applicable to (monetary value or other metric)?

– How long do you think it would take to implement: initial discussion to contract completion?

– What principal actions would be needed in order to replicate them?

– What key risks do you envisage in replication, either for the parties involved or implementation

risks? How could these be mitigated?

– Are there any additional societal benefits from the scheme?

Market-based schemes involve payment and there are commercial arrangements covering the payment

and the contract or use of proceeds.

– In your experience or opinion, what aspects of commercial arrangements have contributed to

the success of PES/market-based schemes and what aspects have compromised their

performance?

– Can you suggest ways in which commercial arrangements could be improved either to reduce

costs or to expand the number of parties willing to participate in PES schemes or to reduce or

better share risk?

– How crucial is the involvement of third parties and intermediaries? What are the most useful

roles they can play? What types of organisation make good intermediaries? What are the key

features of a useful, trusted intermediary?

– How do you think the term (length) of PES contracts should be determined?

– Are there any funding mechanisms that could enhance the viability of the scheme?

– What are the greatest risks in PES schemes and what do you think is the best way to manage

risks, in particular in the contracts between principal and contractor?

PES schemes involve a principal, a contractor and sometimes other stakeholders

– In your experience or opinion, which principals offer the most potential to deliver PES

schemes and what would need to be done to enable them to fund PES schemes?

– In your experience or opinion, which contractors have the greatest role to play in PES schemes

and what general or specific requirements do they have in order to participate?

How have other stakeholders enhanced the delivery of PES schemes in the past and how should they be

involved in the future?


4.2 Potential opportunities in England

Interviewees gave many comments about potential opportunities for funding mechanisms. The magnitude of

opportunities depends on local circumstances, but interviewees were able to identify those they thought

would be generally most important and focus on them.

Interviewees pointed out that the character of the potential opportunities for funding mechanisms in a

catchment, identifying the public and private benefits, will determine optimal types of mechanism in each

case. Multiple benefits are often possible due to the interdependent nature of ecosystem services and the

interventions that influence them, though drinking water resource and quality drivers have often largely

motivated the creation of PES schemes to date. They mentioned varied benefits include carbon sequestration,

wildlife habitat provision, water quality improvement from nutrient and sediment retention, and flow

regulation between wet and dry extremes of weather. Nevertheless, it was commonly expressed that there is

often one dominant ‘anchor service’ (Everard, 2014) around which connected sets of co-benefits can be

optimised.

4.2.1 Water resources

Interviewees stated that water resources are a clear candidate market-driven ‘anchor service’ in many

catchments, as demonstrated in many extant funding and subsidy schemes (such as PES and agri-

environment subsidies), and water resource outcomes are relatively easily measured and monetised.

4.2.2 Flood risk management

Flood risk management attracted more comment than any other service. Many interviewees believe that there

is significant potential for flood water management using novel funding mechanisms, both using agricultural

land upstream in catchments and amenity land downstream. Respondents expect to see a greater proportion

of flood risk management achieved through natural solutions in the future.

On the other hand, interviewees expressed the view that some mechanisms are not well suited to flood risk

management. For example, some stated that Coasean bargains are unlikely to succeed because flooding

beneficiaries do not expect to have to pay, and there are often very many beneficiaries even within a small

area, making transaction and coordination costs very large. Respondents noted that where Government can

pool the interests of multiple beneficiaries, as in the current flood levy system, and tie payments to an overall

consensual model of hydrological capacity within sub-catchments, this may provide an enabling environment

in which these schemes could function, though the transaction costs are clearly high. Raising another

options, interviewees explained that a trading scheme that requires developers to purchase flood defence

credits when developing flood plan land, might fail for the reason that buyers would be occasional and

potentially in small lot sizes, which means that a liquid market might not develop, although it seems not to

have prevented analogous biodiversity banking schemes developing in the US.

Interviewees found other mechanisms more promising. They identified Government purchase as possible,

although pointing out that Catchment Sensitive Farming (CSF) has to date addressed water quality and never

addressed flood risk. Business Improvement Districts (BIDs) were familiar to some interviewees because

they may provide means to fund more localised improvements in flood risk management, as in the Sheffield


example (River Stewardship Company), but there seem to be too few examples for interviewees to generalise

on the prospects for this type of PES. Business Improvement Districts are a means of raising additional

business rates to pay for specific improvements if 70 per cent of the businesses in the area support the

proposal.

Interviewees commented in some detail on natural capital flood schemes. They explained that it is difficult to

make confident estimates of the benefits from natural capital flood schemes, owing in significant part to the

resolution of flood models and the spatially heterogeneous nature of rainfall. Recounting that the scientific

evidence on the performance of natural capital assets in flood management is incomplete, they were

optimistic that it is about to improve, and hoped that, within the next three years, there will be evidence

sufficient to allow land-based measures to be funded as part of the Environment Agency’s flood defence

programme. They explained that flood defence grant-in-aid standards were developed to assess civil

engineering flood defence solutions. They went on to say that as the quality of evidence available for PES

improves, so grant-in aid rules could be adapted, perhaps reflecting transitions in Asset Management

Planning rules governing water quality management.

However, limitations may not arise solely from issues related to evidence standards. Some interviewees

questioned the process and resources of Environment Agency and Defra to promote natural capital assets for

flood defence. Several people hold a view that the Environment Agency and Defra have an institutional bias

towards physical, concrete solutions, and in their opinion, the flooding governance structure does not lend

itself well to green infrastructure alternatives. This criticism is addressed more at processes than people, with

examples of the EA showing enthusiasm for exploring natural flood defences in cooperation with the

Forestry Commission; but this was balanced by a claim that incentives facing area offices favoured concrete

solutions. A common view emerged that a cultural aversion to risk also inhibits exploration of non-

traditional techniques, even if the cross-functional disbenefits of narrowly framed ‘hard engineering’ are

becoming increasingly well-known.

The valuation of agricultural land from expected crop losses as a result of voluntary flooding was also raised

as an issue. Payments are perceived to represent insufficient compensation for farmers since expected value,

based on likelihood of a loss occurring, may be calculated as very low leading to very small payments.

There was some discussion of standardisation. Using the Higher Level Scheme as a model, payments could

be made at a standard rate from a menu of options, it was suggested. Respondents expressed some doubt as

to whether there would be sufficient suitable flood management sites to make a standardised approach

worthwhile.

Overall, the discussions on the barriers to funding of nature-based flooding solutions highlight the legacy of

narrowly framed incentives for the use of land, for example with rewards for agricultural production on

floodplains currently significantly overriding societal benefits stemming from the landscape functioning of

plains shaped by periodic flooding.


4.2.3 Water quality

It was a widely held view amongst interviewees that catchment-based water quality schemes funded by water

companies should be more widely adopted. In particular, water utilities paying to reduce colour and

pesticides in raw water supply were seen as opportunities. However, there was equally a view that

government is not adequately enforcing baseline regulatory compliance from farmers, and that it is also not

making use of existing mechanisms such as Water Protection Zones. Interviewees concluded that it would

therefore be necessary for enforcement to tighten up before water customers would be expected to, or willing

to, begin to pay for improvements additional to those required by legislation. A moderate view emerged that

the landowner or manager should be responsible in law for the quality of water that flows off the land –

which is in fact already a requirement under the common law – but that would not preclude them from

receiving financial help.

A number of water companies have been using or exploring the use of compensatory mechanisms to tackle

the problem of the molluscicide metaldehyde. In these schemes, water companies pay farmers the difference

between using metaldehyde for slug control and the higher costs of using less problematic substitute agents.

The challenge they face, respondents have said, is to ensure that take-up by farmers in the affected area is

almost complete, because this is the only way in which much higher drinking water treatment costs can be

avoided. If the schemes are successful, severe restriction on the open field use of metaldehyde by

government fiat might be avoided. However, not everyone thinks that it is fair that farmers should be paid to

stop this pollution, and some worry that there will be a succession of crop protection products which water

companies will have to pay for farmers not to use, with escalating costs for water customers.

In a rather different example, Severn Trent Water proposed to use a wetland as tertiary treatment. Some say

that the regulatory process for waste water treatment works is not well suited to unconventional tertiary

works such as wetlands. However, particularly in the light of the increasingly widespread use of wetlands for

low-input water quality management in the UK as internationally, some feel that is probably necessary and

entirely possible to design a new standard for wetlands, albeit potentially acknowledging wider confidence

limits that traditional electromechanical treatment techniques, and to integrate this into the mainstream of

regulatory processes. It was suggested that the preparation of the standard would have to be funded, either by

Defra or water companies collectively, perhaps through UKWIR. The justification given was that no

individual water company wishes to make this investment knowing that other water companies will free ride

on its work. If these claims are true, then without such investment, the regulatory regime effectively locks

wastewater treatment into input-intensive engineered solutions which are increasingly associated with a

range of externalities.

Nutrient pollution from agriculture was a subject of much discussion by interviewees, as it is a major

pressure on water quality under the Water Framework Directive. It is well known that diffuse agricultural

pollution is difficult to measure and monitor, but some point sources appear not to be managed either. There

was some frustration that dairy farm slurry storage regulations, and the Nitrates Directive more broadly, were

not being enforced, apparently due to financial distress of farmers and opposition of the NFU. Indeed, those

who felt was progress was too slow cited 20 years of studies and trials, and were exasperated there was still

argument in some quarters about whether it was necessary to tackle nitrate pollution. It was suggested that a


mix of compulsion, advice and third party contributions may be the way to tackle diffuse pollution from

agriculture, coupled with catchment nitrate accounts.

Pollution trading was mentioned as a possible mechanism. North American examples such as Nutrient Net,

the Pennsylvania-Chesapeake online trading and calculation system, and the Ohio River Basin were cited as

having delivered results or are showing promise; meanwhile, interviewees thought that the nutrient trading

scheme explored but not taken up at Poole Harbour might be applicable in other areas where the environment

is sensitive, of high value, and where source contributions into a defined receptor area can be defined.

Finally, retention of soil was seen as a priority, and one that advantaged by soil retention measures being

very cost-effective. Here, port and highways authorities were named as potentially having an interest in

promoting soil retention measures but were not (yet) contracting with farmers.

4.2.4 Biodiversity

Biodiversity was highlighted by a number of interviewees as a priority area in which perceptions might be

changed from ‘fortress conservation’ to the production of biodiversity as if it were more akin to a crop.

There are differences in views about how easy it is to make biodiversity offsets work well. Those in favour

said that biodiversity offsets would be straightforward to do, but one should learn from the best of a number

of international models, because no single country gets it right. Germany was offered as an example with

some attractive aspects for biodiversity mechanisms, its funds pooled at Länder level to allow landscape

scale intervention for biodiversity. Here, PES is used in the maintenance of traditional wetlands and ancient

heaths in northern Germany, with commitments made for 30 or more years. Respondents underlined lessons

learned from mistakes that should be avoided in future, relating to consistent monitoring and enforcement

and the establishment of robust definitions of functional equivalence; interviewers felt that these aspects

were weak in a number of schemes in Australia and USA.

4.2.5 The potential for carbon offsets as a supplementary funding source

Where the measures taken involve planting of trees or re-wetting of upland peat or degraded wetland areas,

carbon capture or sequestration represent a major proportion of total benefit value created, interviewees

claimed. They explained that there are good estimates of the carbon stored in these schemes and systems of

assurance for standardising the quality of schemes, including the Peatland Code, and a derivative code, the

Woodland Carbon Code. These codes have the potential to improve the quality and marketability of many

projects with a primary water management driver. There are already approximately 200 projects registered

and 100 validated under the Woodland Carbon Code. The interviewees explained that the services from these

projects are mostly bought by firms as part of their corporate social responsibility activities, where budgets

are small, and the carbon benefits may be recorded in the companies’ greenhouse gas accounts. The buyers

are not necessarily looking to buy projects which are optimised to deliver multiple ecosystem service

benefits but are often most interested in the carbon benefits. Interviewees lamented the fact that the carbon

offsets these projects generate are not admissible in mainstream emissions trading, so attract a much lower

market price. They emphasised that much greater financial resources would be mobilised for these projects if

they could access mainstream carbon markets or if they could be supported through credit purchase to the

same value of the mainstream carbon market.


4.2.6 Physical modification

There appear to be few or no mechanisms which address the physical modification of watercourses.

Nevertheless, an interviewee suggested the role of in-channel and riparian ecosystem functioning to improve

water quality warrants further exploration, including the role of fluvial geomorphology in a range of

ecosystem services (as reviewed by Everard and Quinn, in press22

).

4.2.7 Urban areas

Some respondents felt that urban ‘green’ and ‘blue’ corridors might be more widely encouraged if a

recognised framework existed relating design characteristics to a potential range of ecosystem service

outcomes and their indicative economic values, supported by evidence of available design options. They

explained that currently the evidence on impacts is undeveloped and the pattern of benefits seems to be quite

complex. They would welcome more thinking on investment in protected, restored or emulated natural

processes in urban areas. The most sophisticated work in this area has been on the repositioning of woodland

estates around the urban fringe, although some guidance manuals about the wider role and design of green

infrastructure are available (for example Grant, 2012)23

.

4.3 Sources of funding

4.3.1 Incentives

From the interviews, it became clear that a range of interconnected public and private benefits are likely to

arise from interventions promoted by many funding mechanisms, creating the potential to leverage multiple

funding sources from both the public and private sectors. A diversity of actual and potential private,

voluntary and local government funding sources exist: this work has not compiled an account so that the

magnitude of those funding sources can be compared. Interviewees related that there are very few funds from

corporate social responsibility (CSR) budgets and these budgets are anticipated to remain small. They

explained that this is because CSR spending creates limited commercial value, as it has weak influence over

consumer purchasing behaviour unless measures are strongly linked to core business as in the case of supply

chain stewardship schemes.

The descriptions which interviews gave showed that many funding schemes promoting ecosystem-based

solutions, such as water quality protection, have tended to date to focus on solving a specific ecosystem

service problem rather than on optimising across a range of ecosystem services. This indicates that the

bundling rather than layering of funds might help to deliver projects designed to achieve multiple benefits. In

practice, this may reduce potential benefits for any single funding beneficiary, with a potential result that a

disproportionate payment burden might fall on a major scheme proponent party investing in an ‘anchor

service’ around which other funding sources were integrated.

22

Everard, M. and Quin, N.W. (in press). Realising the value of fluvial geomorphology. International Journal of River Basin Management. DOI: 10.1080/15715124.2015.1048457.

23 Grant, G. (2012). Ecosystem Services Come to Town: Greening Cities by Working with Nature. Wiley-Blackwell, Chichester, UK


Respondents have been deeply involved in pilot schemes. They set out how pilot schemes have involved

substantial resources relating to site identification, contractual design, stakeholder coordination and

evaluation. These observations raise the question whether similar funds will be available for repeat schemes.

One can conclude that, since funding is limited, it is vital that transaction costs are reduced if widespread

uptake of such schemes is to be promoted.

4.3.2 Water companies

Some interviewees would welcome a wider and more clearly defined role for water companies in delivering

catchment ecosystem services, while others would be concerned if water companies were to play a role

which is out of proportion to the benefits they directly derive in the narrow terms of the water services they

supply to their customers. Where these views were stated, the interviewees were not able to state the

reasoning behind them. Some interviewees raised a concern that the evidence for the impact of water

company-led schemes is still not well developed and that if this remains the case then the recent expansion of

water company PES schemes may not be sustained. Reflecting on the evidence heard, it seems that to a

certain extent, this is a result of the narrowly defined role and economic rules imposed on water industry

privatisation in the UK, superseding the formerly broader if underfunded remits of regional public sector

Water Authorities: consequently, revisions to the role of water utilities might offer a way to support an

integrated catchment-based approach.

Having received a strong steer that an ecosystem services approach should be taken to every assessment

undertaken, respondents noted that Ofwat has now changed its assessment methodology so that water

companies can take a catchment approach to ecosystem service projects. They confirmed that this change in

regulatory approach has been instrumental in encouraging all water companies to propose PES schemes in

the 2014 Periodic Review of company business plans and prices, albeit that some are no more than

operational investigations. Interviewees thought it will be several years before new evidence emerges on the

economics of these investments but, if the evidence is supportive, the water companies may develop the

concept in all sorts of innovative ways. Many of these opportunities are likely to be found in upland areas,

and many involve payments to farmers. People within water companies hold a variety of views on the ethics

of paying farmers, which are most acute when paying farmers to comply with existing regulatory obligations

(a prerequisite for PES and related schemes to promote additional benefits).

4.3.3 Government

Interviewees were asked not to comment on agri-environment schemes, consistent with the project’s terms of

reference. However, some wanted to point out that funds from the Common Agricultural Policy (CAP) could

be used in wetlands and flood management schemes, and there might be scope for insurers to co-fund. Some

gave a strong message that PES funding is very small relative to agri-environment schemes and suggested

that it would make sense to fund measures through CAP payments, suggesting that CAP rules could be made

more adaptable so that they can include greater clarity about how measures contribute to clearly articulated

ecosystem service benefits and incorporating the most recent evidence on the effectiveness of these

measures.


When prompted, interviewees agreed that further important improvements in the efficient use of agri-

environment funds might be achieved through redesign to use auctions to seek out best value for money in

measures offered by sellers; through leveraging co-funding from other buyers of ecosystem services; and

through a transformation into an integrated multi-service, multi-habitat scheme at landscape scale. Some

interviewees volunteered that a further improvement would be to take further steps to identify what farmers

are required to do under cross-compliance, more rigorously enforcing these obligations as a condition of

subsidy payments, and then focussing on measures to deliver additional benefits. They commented that the

government has the resources within its agri-environment High Level Scheme, now part of Countryside

Stewardship, operating at landscape scale, to deliver reforms such as these as well as, though cross-

compliance obligations, the powers to enforce them.

In addition, some interviewees noted that the funding of Catchment Partnerships by Defra is very small given

the challenges and potential benefits of taking a more integrated approach.

4.3.4 Local authorities

Local authority budgets are facing large cuts under Government ‘austerity measures’. Hence, the capacity for

local authorities to explore new funding mechanisms will be limited. For example, interviewees mentioned

that LAs are not currently treating flood defence based on agricultural land as a priority, despite its potential

to deliver intended benefits more cost-effectively and sustainably.

4.3.5 Private companies

The interviews showed that there is interest within the public sector in engaging companies whose businesses

depend on water. Research has been carried out in this area (URS, 2015) and there is hope that companies

might become an important source of funding. Interviewees identified the Catchment-based Approach as a

suitable framework for integrating and apportioning private funding.

However, the evidence from interviews suggests that the potential funding from private companies is and

will remain small relative to demand. Specifically, while it may be possible to engage support from a range

of land-based industries, there are seldom strong private incentives, except for specific, local instances most

often related to the food and drink sector. Interviewees struggled to identify buy-side demand outside the

water sector, where it is driven by regulated water quality standards. A common view was that potential

beneficiaries have low awareness of PES potential, and when informed may find the scale of commercial

benefits and uncertain value for money unattractive.

4.3.6 Visitor contributions

Interviewees expected that visitor charges can only ever make partial contributions to the cost of maintaining

environmental quality, and high rates of participation in visitor charging may not be consistent with an open

access philosophy, the exception being angling, which is established as a private paid-for right and which has

been very influential in driving water quality improvements. Visitor payback initiatives targeting general

recreation, explored under Defra-funded PES Pilot research, have not proven particularly successful. In

general, the amounts of money collected in this and related schemes have been too small to have a significant

impact on environmental outcomes. From this evidence, one may conclude that the small amounts raised


suggest that, as a generality, visitors do not tend to be altruistic, expressing a clear preference that funds

raised be used to enhance the visitor experience. Thus, respondents suggested, by targeting use of scheme

proceeds, it may be possible to stimulate an increase in visitor contributions. In those areas where it has

potential which is yet to be realised, it requires working with local businesses. An interviewee suggested that

it is best to use an opt-out rather than an opt-in for visitor contributions, otherwise the contribution rate is

low. Experience in the Lake District showed greater revenue-raising potential from over-night stays, and

where revenues are dedicated to tangible projects such as footpath enhancement, than from day visits and

water-related ecosystem service functions.

4.4 Roles and institutions

The evidence collected revealed that many of the funding schemes to date have been led by innovative,

visionary individuals shaping corporate decisions. They have not yet been adopted as a mainstream

approach.

4.4.1 Buyers and sellers

The terms of reference drew a distinction between buyers and sellers. It is known that the buying and selling

parties within a mechanism depend upon the initial allocation of rights, as well as the local situation and

opportunity. At interview, it became clear that water companies are willing to be buyers of measures which

are not required by legislation and are not covered by agri-environment schemes, but will not pay for

compliance with legal obligations. In addition, environmental NGOs may not support allocations of rights

which do not oblige farmers to deliver baseline ecosystem services from their land.

4.4.2 Intermediaries and institutional arrangements

A catchment-based approach is an aid to the delivery of some ecosystem services, as it is the functioning of

the catchment overall that generates the services. Within this catchment-based approach, interviewees told

how it is common to find cultural barriers to cooperation between land use types but, with care and effort,

multi-stakeholder partnerships can be successful. When farmers are involved, activities may be built into

farm plans. They cited experience that coordination at catchment scale can be facilitated through a catchment

plan, and a lead organisation is needed to support its development. A variety of environmental services can

be encompassed in catchment-level planning.

There was a difference of views between interviewees about the best structures for coordinating actions

within a catchment. Partnerships and catchment trust funds can be used to pool resources, interests and

funds, but they may encounter a free rider problem where participants rely on others to put in effort and

funding. Some expect that these sorts of voluntary arrangements will only work where there is a small

number of participants to keep coordination costs low. Experience of interviewees to date suggests that the

positive attitude of partners, particularly where there is a core of dedicated parties often with significant

interests, such as land ownership and/or fishery or other rights, combined with availability of technical

expertise have been critical factors where catchment partnerships have been successful. There is considerable

variation between catchment partnerships, even within a local area. Evidence from overseas also attests to

variability. In Australia, interviewees explained, Catchment Management Authorities are very variable in


quality with a small number being excellent as well as there being some poor performers. Federal funders in

Australia have responded by imposing restrictive conditions on the use of the majority of funds allocated to

these authorities.

While there is strong consensus that a trusted, honest, transparent intermediary, with excellent outreach

skills, that leads coordination functions within the catchment can be very productive, many believe that the

quality of relationships which this entity has with participants is a key determinant of performance. For this

reason, the affiliation of the organisation elicits strong responses from interviewees.

A distinct role from a trusted intermediary is that of market operator. Governments and agencies feel

uncomfortable about acting as broker between buyers and sellers, but the evidence suggests that they should

be prepared to consider stepping in, where they have appropriate resources to offer and/or where the

alternative parties are inappropriate. Some broking activities are led by NGOs, the intermediary role of the

Westcountry Rivers Trust in the ‘Upstream Thinking’ and formerly the ‘Tamar 2000’ and related

programmes, being well-established cases. The alternative is private brokers, but interviewees mentioned

precedent showing that once brokers are invited to supply market operation functions, the brokers can

become entrenched, making it difficult to change market arrangements. There seems to be no in principle no

reason why markets should not be run by a public body.

4.4.3 Finance

A final role for an intermediary is to transform the term of commitments, enabling short term commitments

from buyers or funders to be translated into long-term contracts with sellers where appropriate, for example,

for the establishment and maintenance of wetlands, or peatland re-wetting. These financial intermediaries

may need a government guarantor.

When asked whether the seller might have a financial constraint and projects have high up-front capital

costs, interviewees gave the example of peatland re-wetting. They elaborated that many restoration project

payments are made in arrears which makes it difficult for some land managers or owners to cope with the

cash flow demands of a project. Reflecting on these challenges, finance, perhaps in the form of European

Structural Investment Funds, social impact bonds or capital from impact investors might be available in these

situations. A local holder of funds could also be envisaged, for example setting up catchment ‘banks’ to lend

money for capital projects. The small scale of individuals means that the infrastructure for such activity

might have to be operated at a national scale through an organisation such as the Green Investment Bank,

with individual fund accounts held for local catchments.

Interviewees also suggested that livestock agriculture is a prime opportunity for finance, because some

livestock businesses may need financial restructuring before they can participate, being indebted and in

financial distress. Here a distinction can be drawn between finance for PES schemes and financial re-

engineering to improve the financial strength of a business. The former may be integral to a PES scheme,

helping to ease the cashflow impacts of a PES contract. The latter may be an enabling action that helps to

bring sellers to the table without being part of the PES scheme itself, by helping to strengthen their financial

position. The financial viability of the party offering PES services will need to be a consideration when

writing PES contracts, whether or not financial support is offered.


From the interviews, it is not clear how much value the provision of finance has to add to PES schemes.

There is ongoing work, among interviewed organisations, trying to find financing solutions for new

woodlands, but the returns from market products alone are too low. If the monetisation of benefits can be

enhanced, the sponsors believe, commercial finance might become possible.

4.4.4 Defra and its agencies

In the view of interviewees, the role of government is to manage rights and markets, to set broad frameworks

and legislation, to change attitudes and build support before introducing obligations, and to coordinate other

parties. Defra’s interest is primarily in water quality, particularly nutrients, because it has found diffuse

nutrient pollution particularly difficult to address.

Within the Defra family and more broadly among technical specialists, individual ecosystem services are

managed within separate silos, respondents candidly reported. The separation of specialists between

Environment Agency and Natural England, and in divisions and associated dedicated funding streams and

objectives within these organisations, makes integrated working more difficult. While there are examples of

integration between these two agencies, one of which is Catchment Sensitive Farming, it has been slow and

is not yet more pervasive, according to those aware of the work. It was suggested that the management of the

water cycle and land should be integrated, as indeed should nature conservation and the metrics identified for

WFD compliance. Three areas were identified by interviewees for potential greater synergies:

common methods and approaches: the absence of common methods and approaches across the Defra

network is beginning to be addressed by initiatives such as co-working on a common ecosystem

services framework and common language;

coordination of customer relationships: the lack of coordination of farm visits across the Defra

family;

disciplinary separation: for example, Defra spends almost all of its science budget on identifying

relationships between action and impact, but this has so far not been compiled in a way which allows

it to inform the economic analysis; and

coordination across the functions: the coordination of enforcement, advice and payments activities.

There were several comments that the Environment Agency floods department could be much more engaged

in natural water and flood management solutions.

The next iteration of River Basin Management Plans in 2021 was identified by interviewees as a major

opportunity to incorporate a wider range of funding and other management measures into landscape-scale

planning clearly target at a linked set of ecosystem service benefits.

4.4.5 NGOs

NGOs are involved in some PES schemes, some with a vital role such as articulated above in respect of the

Westcountry Rivers Trust and ‘the Upstream Thinking’ programme. Other NGOs own and/or manage

landscapes valued for a range of socially beneficial services. The views heard suggested that the NGO

community at large has not yet settled on a uniform position with respect to its future potential and role in


promoting non-statutory schemes, and this may remain the case given the broad diversity of types and goals

of NGOs.

4.4.6 Design aspects

Interviewees made a number of recommendations about the promotion of funding mechanisms, including the

use of:

reverse auctions, which have wide potential for improving value for money and the simultaneous

presentation of options, and may be more cost-effective than the use of networks of advisors to

identify and select projects in sequential fashion;

remote sensing applied more broadly as a means to monitor outcomes germane to payment-by-

results schemes, and for monitoring cross-compliance;

agricultural inheritance tax relief tied to sustaining natural capital;

conservation covenants to secure land uses in the long term;

the offer of compensation even for compulsory acts, an example being a Management Order which

Natural England can use on managers of Sites of Special Scientific Interest. This compels action but

does not exclude the manager from receiving agri-environment compensation payments;

opportunity maps showing layers of ecosystem services beneficiaries and supply potential;

standardised models for BMPs to reduce transaction costs and to encourage market transactions;

Defra’s websites to continue to share experience;

tools to assess the impact or value for money of projects;

consider codes for habitat types in addition to the existing peatland and woodland codes, and also

paying greater attention to a range of connected ecosystem services, where Defra might ultimately

own and maintain a family of these codes.


5 Conclusions Opportunities for water quality improvements

5.1 Questions posed

This conclusions section draws together the answers provided by this work to the following questions,

paraphrased from the terms of reference:

– What examples are there of innovative funding mechanisms that could be used for improving the

water environment and what evidence is there of their performance?

– How feasible are the funding mechanisms, incorporating stakeholder opinion?

– What enablers and barriers would be required, or would need to be removed, to make

implementation of the funding mechanisms in England successful?

The answers to the first two questions are set out in Section 5.4 and the third question is answered in Section

5.5.

5.2 Motivation for water quality improvements

The natural capital which supplies us with ecosystem services is a critical part of our economic system.

A country which looks after its natural capital assets can have a sustainable basis for economic growth, both

narrowly defined as GDP and broadly defined as welfare. In a water management context, and in addition to

any non-monetised benefits, natural capital investments have the potential to:

– reduce the costs of providing clean water, leaving more resources available for productive

investment;

– create better quality water resources for water-intensive industries;

– enhance environmental quality, boosting tourism and recreational opportunities;

– reduce the need for expensive infrastructure (new sewers, reservoirs, flood defences), providing

savings to both water companies (lowering water bills to consumers) and the public purse;

– reduce insurance premiums, leaving more money in consumers’ pockets;

– reduce the likelihood of fines under the WFD; and

– reduce the public cost of flooding including disruption to businesses and public services.

When one looks at the ecosystem services in catchments, it is clear that many of the valuable goods and

services they produce are public in nature. Consequently, one can confidently say that voluntary

mechanisms, by private parties in private markets, unfunded by government, will not alone deliver these

public goods and services. This is supported by empirical evidence from PES schemes24

and by interviews. A

corollary is that, for the benefit of the economy, where valuable ecosystem services are public in nature, they

24

The lack of voluntarism in many major PES schemes; the existence of many developing world PES schemes being explained by context-specific factors (lack of regulation, legal title and alternative incomes) which are not replicated in an English context; notable PES schemes in the USA being driven by state and local government.


should either be purchased by government, or private parties should be obliged by government to purchase

them. Thus, it is important not to define these schemes as voluntary, as such a definition would limit their

application.

5.3 A strategy for PES funding

A central topic that will need to be addressed in Defra’s strategy towards PES is the relationship

between PES and common rights. Defra does not yet publicly articulate a clear sense of its own role and

strategy in funding of PES. However, this is something it could choose to clarify and communicate, or to

develop if it is as yet unclear. If Defra were to draw up a strategy for PES beyond its own role, a central topic

that will need to be addressed is the relationship between PES and common rights. Under PES, the

beneficiary should expect to pay, whereas under common law the downstream rights-holder should expect

flows of water of unimpaired quality; there is a clear tension between these positions. Further details of

actions that could be taken are described below.

5.4 Innovative funding mechanisms and how they perform

Polluter pays to reduce a bad

US baseline and credit schemes can perform well but are based on a different regulatory regime. These

are found mostly in the US, in the form of baseline and credit schemes, where they have a successful record.

Participants receive maximum daily loads which can be traded, but the daily load system is different from

that which we have in the UK. This suggests that the mechanism could be worth considering only if there are

additional reasons to introduce pollutant budgeting here.

There is more to learn about how much public, political support there is for polluter pays. The UK

pilot in Poole Harbour encountered political difficulty from water utilities being asked to pay farmers and

also struggled to create contract terms which satisfied participants. The former might be overcome with

pollutant budgeting and the latter with experience and the intermediation of contracts (see comments later on

intertemporal mechanisms).

Polluter pays mechanism work best at scale. The US, the prime example of these schemes, possesses

situations at scale. Suitable conditions in the UK may also be limited to a few local areas, given that the US

schemes operate at a spatial scale which would be large for the UK.

Beneficiary pays to reduce a ‘bad’

For a beneficiary to pay, it has to receive private goods in return, whether it is an individual

beneficiary or a collective. Examples are flood risk mitigation from urban storm water. There have been an

increasing number of examples of politically-sponsored action by water utilities in England; there have been

very few examples of other private arrangements, and payments in those cases have been small. This paucity

of examples could be in part unfamiliarity but is likely to be mostly explained by the public nature of the

goods. It remains to be seen how effective the water company schemes prove to be and how the benefits and

costs compare: evidence on performance is gradually accumulating.


Evidence suggests that a significant proportion of the societal benefit in water company sponsored

schemes is public in nature rather than private to the water company. Politically, beneficiary pays

encounters resistance unless legal controls on polluters are fully enforced first, which is more tightly than

some controls, for example in agriculture, appear to be enforced currently. The mechanism seems to have

high potential for water companies. A greater water company scope could eventually lead to changes in legal

duties and obligations of water companies, but for the time being the beneficiary pays schemes might

continue to develop by mutual agreement between government, Ofwat, water utilities and their customers.

The current schemes provide the foundations on which future expansion could be built.

Beneficiary pays to maintain a good

At present, the beneficiary pays mechanism is found mainly in developing countries which lack

effective, formal regulation. It is particularly common in the form of payments to maintain forests. Almost

all examples involve national government, municipalities, water utilities, or all three. In contrast, water

utilities and municipalities in the UK may not currently have the same obligations as those in developing

countries and may not have the same needs.

Two of the key factors in delivering value for money with this mechanism are spatially sensitivity

when selecting sites and the use of differentiated rather than flat payments. These factors might deliver

great improvements in value for money in the UK agri-environment schemes. Existing payments to maintain

a good in the UK could be revised to enhance value for money through spatial targeting and differentiated

payments in agriculture. The same approach could be taken in other activities, modifying some existing

expenditure streams on flood defence, water resources and habitats protection.

The pooling of funds may also enhance value for money. Benefits might similarly be obtained from

combining funding, for example in flood defence, health, agriculture and leisure together to increase value

for money. It is instructive that all the international and national examples are funded from the public purse

or a franchised tax base. There is a question here whether the expansion of budgets, which appears only

likely to come from public funds or a change in water utility legal duties, could receive any significant boost

from private firms. If the benefits are mostly public in nature, then private contributions seem unlikely.

Polluter pays to maintain a good

Third party biodiversity offsets have been reasonably widely tested and experience shows that

measurement and enforcement are challenging, while there remain doubts over the effectiveness of

compensatory measures. Other than wetland banking, terrestrial rather than aquatic services have been the

focus to date. The wetland experience suggests that the definition of damage could be extended from species

and habitats to water services. Furthermore, it may be possible to shift from the common objective of ‘no net

loss’, which does not deliver improvements, but could reduce pressure from deterioration, and instead

employ an objective of ‘net gain’, although it might be challenged by developers. A further issue to be

addressed is functional equivalence, which is often overlooked in current schemes. These issues show that

the mechanism has potential provided effort is put into design, monitoring and enforcement. Before it could

be applied to natural capital within catchments, some research and development ought to be carried out,

since it would be a novel application.


Intertemporal mechanisms

There is little evidence on the suitability of social investment bonds and catchment trust funds to

deliver catchment outcomes. It remains unclear whether private parties would step forward to offer services

and whether they would succeed in delivery. However, there is a clear demand for term intermediation, and

this could be actively developed when government is purchasing services from private suppliers.

Trust funds are one specific vehicle, but an alternative, which is pooling of funding at catchment or sub-

catchment scale, may offer more promise. In the pooling option, the barriers between institutions, which are

seen to operate in siloes, could be broken down and more cooperative arrangements put in place.

5.5 How to enable performance by removing barriers

Success in delivering PES is likely to be as much about the way in which instruments are used and the

support offered by other policies as it is about the design of new mechanisms. The work has identified

five ways to enable performance of funding mechanisms, described in turn below:

– choosing mechanisms by matching attributes of mechanisms and situations;

– enabling trust and reducing costs through intermediaries;

– improving market liquidity and risk allocation through contract design;

– reducing the information costs through regulatory choices (choice editing, rules of thumb, use of IT

and auctions); and

– encouraging innovation and specialisation from niche providers.

5.5.1 Evidence gathering

Further investment in evidence-gathering is necessary as information on scheme performance in water

quality and flooding impacts so far is incomplete, though has much improved in recent years. Defra’s

promotion of PES has been influential, and is likely to continue to be so in the future if it continues to

support PES. The evidence-gathering programmes will also, when they are completed, plug many, but

perhaps not all, of the gaps in the evidence base which allows the prioritisation and decision to proceed with

investments in natural assets. Standard sources such as the Peatland Code and the Woodland Code might

then be extended to cover other habitat types, uses and impacts, such as wetlands for water quality and flood

management.

There is a level of effort taking place and needed in the future to test and understand PES

mechanisms, which is leading to rapid innovation and could, within a few years, result in much more

widespread deployment and significant improvements. Some forms of mechanism described in this

review are quite new, at least in the UK, and are evolving rapidly. This includes, for example, some schemes

being developed by water utilities and the use of reverse auction mechanisms in new applications. Other

mechanisms, such as agri-environment subsides, are long- established yet could be reformed to orient them

to produce more targeted and strategic outcomes, explicitly targeting systems of connected ecosystem

services including those germane to water quality and the water environment. Continuing and increased

publicly-funded research and development in scheme design and performance will be worthwhile.


5.5.2 Choosing mechanisms by matching attributes of mechanisms and situations

The examples described in this chapter show that ‘market mechanisms’ typically have some market-

like features, but this is never purely the case, so some public involvement is almost always needed.

They are usually limited by practical or political considerations, as well as the public good nature of the

clean water. Individual schemes exist on a spectrum of more and less market-like features.

The most market-like schemes have the following attributes:

– excludability: benefits which could be captured and willingly paid for by beneficiaries;

– actors who independently identify opportunities and reach deals with little intervention;

– differentiated prices which reflect lower costs and/or greater benefits of provision across sellers.

These market-like characteristics are not always present for the following reasons:

– information problems: beneficiaries who are not aware of benefits; and sellers who are not aware of land

management options;

– transaction costs which threaten to offset much of the gains in trade; and

– unwillingness on the part of farmers or others to participate.

These characteristics are elaborated in Table 8.

Table 8. Market-like attributes succeed in some but not all circumstances

Most market-like when … Intermediate when … Least market-like when …

Suppliers and beneficiaries self-identify and negotiate own agreement

Participants brought together by public body or other intermediary

Beneficiaries are not aware of benefits and need public body to represent their interests

Prices can vary between sellers and/or over time

Some price differentiation to allow targeting and recognition of differences in value

Prices are uniform and fixed

Underlying conditions lead to gains in trade: Beneficiary pays: WTP clearly exceeds WTA ’Polluter’ pays: heterogeneous abatement costs together with low transaction costs and low risk

There are potential gains in trade, but intermediary needs to reduce transaction costs and/or risk, examples: aggregate trades; insurance pool of credits

Underlying conditions will not lead to gains in trade:

Beneficiary pays: WTA exceeds WTP;

’Polluter’ pays similar abatements costs or transaction costs and/or risks are prohibitive

Participants better informed than regulator about cost of and opportunities for abatement/provision

Participants and regulator on joint learning curve; mechanisms allow flexibility but options are constrained in order to maintain tractability

Regulator generally better informed about abatement/provision options; participants benefit from strong guidance

Strong environmental equivalence between different options allows simple, replicable contracts with little risk of perverse outcomes (fungibility)

Environment equivalence can be maintained by careful scheme design; however, strong assumption of fungibility could lead to lower environmental standards

Low environmental equivalence requires strong targetting and intervention; trades must be developed case-by-case to avoid spatial dislocation and poor environmental outcomes



Some authors have claimed PES schemes can be delivered privately, but the evidence reveals barriers.

The more theoretical literature on PES envisages independent negotiation between informed, independent

buyers and sellers able to privately capture significant gains in trade. It has been claimed, for example, that

PES approaches are (Engel et al., 2008):

likely to be efficient, as the actors with the most information about the value of the

service are directly involved, have a clear incentive to ensure that the mechanism

is functioning well, can observe directly whether the service is being delivered, and

have the ability to re-negotiate (or terminate) the agreement if needed

While examples exist, they are the minority of PES schemes.

The problems of additionality and cost of information pervade PES schemes. The evidence reveals that

all PES schemes, for both public and private goods, face two main practical barriers to adoption:

– beneficiaries may not be fully informed and willing to co-ordinate, as experience of multiple beneficiaries

in the Defra PES pilots attests;

– there is potential for adverse selection in voluntary schemes, as shown in the Fowey River PES pilot and

some nature PES examples, where participants may put forward actions which they had already taken or

planned to take, reducing the additionality of the scheme.

Solutions to these barriers are discussed below.

5.5.3 Enabling trust and reducing costs through intermediaries

Intermediaries are often a principal actor in schemes (Vatn, 2010). Their functions can be to approach

stakeholders and build trust; provide a forum for cooperative management; maintain a strategic overview;

help ensure financial sustainability; reduce free-riding by aggregating and coordinating beneficiaries’

interests; and act as repositories and disseminators of knowledge about management options. Next to

financial incentives, participation in PES schemes is influenced by factors directly within the purview of

intermediaries, namely the quality of procedural rules and stakeholder interaction (Schomers and Matzdorf,

2013). The grounding of successful schemes – in particular voluntary schemes – in collaborative processes

which encourage ownership of the problem is emphasised in the literature (Shabman and Lynch, 2013;

Defrance, 2011).

Future schemes should consider the role of an ‘intermediary’, matching and building cooperation

between buyers and sellers in the public interest. In some cases this is the regulatory body, whose main

role of setting up ground rules, selection processes and MRV procedures may be supplemented by other

duties. In others, a special purpose vehicle comprising of several stakeholders, and possibly incorporating

scientific expertise, may be set up, particularly if there is seen to be a need for intermediary functions

independent of the regulator in order to build up trust.

All but one of the North American water quality trading schemes that have seen significant trading

have clearinghouse formats. They play a critical role in reducing transaction costs and risk by:

– removing the management time needed to find and negotiate with counterparties;

– removing barriers of distrust with both unfamiliar counterparties and the concept of trading;


– providing a replicable transaction so there is no need to draw up contracts from scratch; and

– pooling compliance risk and transferring liability away from buyers.

A water company or local government wishing to instigate a PES program for watershed protection in

the UK has itself to build cooperation with a number of parties. There is no reason why this could not be

achieved, but it requires institutional cooperation. Over time, and in the absence of other regulatory controls,

this institutional cooperation has become strong in parts of the US. It is likely that a combination of water

quality safeguarding responsibilities and municipal and state political and financial infrastructure has been a

key factor in the emergence of PES in watershed protection in the US.

5.5.4 Improving market liquidity and risk allocation through contract design

The success of a PES scheme may depend on identifying suitable forms of contract between buyers

and sellers. It is striking that financial stability and long contracts are required for some schemes, but

destroy viability in others. It is worth considering the reasons why dynamic flexibility appears to be good for

participants in US water quality trading schemes but not those in Andean water funds. Table 9 summarises

the factors.

Table 9. Long term contracts can be desirable when supply and demand are relatively stable

Factor Andean water fund US WQT scheme

Cost faced by sellers Mostly opportunity costs of agriculture, subject to volatile market fluctuations

Likely to be much less aligned with agricultural commodity prices; more likely to be management time, capital costs, etc.

Seller alternatives Possibly precarious living with no social safety net Already making good living; land management changes eat into time

Supply No further supply available because most or all of the land in watershed needs to be protected

Load reductions mostly treated as substitutable and need not be tied to any one landowner; not all landowners need to be involved; load reductions also available from point sources

Demand Stable, long-term demand from municipalities Periodic compliance implies demand fluctuates

Implication

Long-term financial stability and contracts are vital Shorter term contracts preferred


Where supply is capital-intensive, long-term contracts may be particularly important. Where there is

varying demand and supply of highly substitutable units, dynamic flexibility and shorter term contracts will

be preferred. Other reasons for preferring long-term contracts in the bottom quadrants of the taxonomy,

conserving environmental goods, include:

– uniqueness of a particular place or scarcity of a particular habitat;

– desire to conserve the environmental good for posterity;

– irreversibility of land use change, or time taken to reverse change.


The Andean water fund format offers some lessons that are transferable to the UK. The features which

are independent of geographical context and which might prove attractive are:

– the provision of reserve funding for contingencies and unforeseen operational costs;

– locking in long-term cooperation and commitment from a range of stakeholders; and

– providing a replicable institutional and financial framework for the intermediary role in PES-like

schemes, so that schemes do not have to start from scratch.

The local version of an Andean water fund would be a catchment trust fund.

Access to capital may present a barrier to participation in PES schemes, but regular payments may

offer conditionality and provide ongoing incentives. Various solutions to these design needs are described

in the literature:

– the NSW BioBanking scheme deployed a trust fund mechanism which invests the proceeds of

biodiversity credits on sellers’ behalf and releases payments over time (NSW DECC, 2007);

– the Philadelphia stormwater review noted long payback periods for stormwater retrofits, and suggested

that entrepreneurs (see 3.8.6) could be encouraged to both provide capital and take on projects on

participants’ behalf, repaid through stormwater fee rebates (Valderrama et al., 2013);

– the Melbourne stormwater tender study suggested scheme organisers making deals directly with

equipment suppliers to remove participants’ need for upfront capital.

None appears to offer a comprehensive treatment of this issue and it requires care in future design.

5.5.5 Reducing the information costs by choice editing, rules of thumb, use of IT and auctions

There is more likely to be a role for a regulator or coordinator in PES schemes than normal goods

markets. Environmental market-like mechanisms may fail to exchange information because of low liquidity,

in part arising from the spatial attributes of the environmental goods. If left unaddressed, this would lead to

low volumes of trade. Standard markets can signal what buyers value and what can be produced at a

particular cost through prices arising from repeated interaction amongst participants. Where this is absent in

PES schemes, it creates a role for a regulator or coordinator.

The regulator or coordinator can identify and select options, allocating resources in the absence of a

market. There are two processes where information might be used by the regulator or coordinator:

– identifying the set of possible mitigation or ecosystem service provision options available;

– selecting the options to proceed with.

Information requirements are highest for the regulator or coordinator where deliberative procedures and

qualitative judgements are used; lowest when buyers and sellers negotiate independently; and intermediate

where procedures rely on selected ‘rule of thumb’ criteria and numerical indicators.

Choice editing can reduce costs. A common finding in the mechanisms reviewed is that information loads

on both the regulator and participants can be reduced by specifying a set of eligible measures. In the case of

water quality trading, there is a need to constrain the list of measures and standardise the calculation of

impacts. There is a direct trade-off between procedural simplification and limiting choice which cannot be

avoided.


Good procedural designs, identified by government, can enhance value for money achieved in resource

allocation. As experience grows with PES schemes, procedures can be improved and government may wish

to play a role in creating common procedural standards, particularly in the use of appropriate metrics and

evidence of effectiveness. It is well placed to do this because of the expert organisations it sponsors and the

oversight it has over many actors in the space. Explicit procedures for identifying options include actively

selecting sites using existing expert networks, or setting a simple set of eligibility criteria based on

approximate knowledge about what is and is not likely to be effective. Options selection might involve a

‘value for money’ ranking based on either qualitative judgement or numerical indicators incorporating both

environmental improvements and cost. The procedures can be refined over time as knowledge accumulates.

Simplification and rules of thumb are likely to be needed if PES schemes are to be more widely

adopted, and government guidance may be needed. The more potential measures, actors and locations

there are, the more qualitative judgement is likely to become onerous, time-consuming and lacking in

transparency, and the more it may need to be replaced by exclusion criteria and numerical indicators.

Applying such simplifying techniques obviously loses information. Testing the rules against expert

judgement in an iterative process is one way to improve their design (Day et al., 2013) but government can

play a role in making these lessons widely available in the form of guidance. In preparing this guidance, it

can comment on the performance of metrics used to establish value for money ranking and select options.

Care is needed to ensure that metrics:

– correlate well with other desired environmental benefits or outcomes;

– scientific uncertainties are understood in measuring the metric and how it changes with respect to

different land management practices.

In the case of mechanisms where buyers and sellers negotiate themselves, the government’s role may

to supply information, for example through access to scientific expertise, or to evaluate schemes and

their impacts on the receiving environment. In such cases, intermediaries are likely to learn quickly about

costs and results of measures and become an increasingly comprehensive repository of information. While

farmers are likely to have good knowledge about what will work best on their land once presented with

options, it is less likely to be the case that they will present a viable trade in the absence of encouragement

and advice.

Auctions show great promise as a mechanism for improving value for money. Auctions were

encountered in at least four of the mechanisms reviewed25

. Depending on the design, auctions can help to

reveal private willingness-to-accept and improve efficiency by introducing competition. Their success

depends on the following factors (Moreddu, 2007):

– the regulator has little information about mitigation/provision options;

– there is a large number of heterogeneous potential participants;

– there is a homogenous quantity upon which offers are based:

– in the case of the Fowey River, Stormwater Tender and Conservation Reserve Programme auctions,

this involved calculation of composite environmental improvement indices; and

25

Great Miami WQT scheme, Pennsylvania/Chesapeake WQT scheme, Fowey River Improvement Auction and Melbourne Stormwater Tender. They are also used in agri-environment schemes in the United States Conservation Reserve Program and an agri-environment scheme in Germany according to Schomers and Matzdorf (2013).


– in the case of Great Miami, the auction was based on expected nutrient reductions linked to eligible

measures.

Auctions are not suitable for small-scale local application. Auctions are not efficient in contexts of

‘…small scale, local environmental goods’ (Hasund, 2013). The arguments from the literature are in

agreement with the findings of the Fowey River conclusion that ‘…an auction might be preferred for large-

scale schemes, particularly where there is little detailed knowledge of a region’ by the regulator (Day et al.,

2013).

Finally, the provision of information through use of information technology has clear potential and the

UK could explore the use of similar tools to LandServer to operate at catchment level. Online

transaction platforms designed to match buyers and sellers and spreadsheet-based decision support tools

were mentioned in a number of schemes. Some used IT infrastructure for real-time monitoring and reporting

of pollutant loads (Quinn, 2011). The potential for online spatial assessment tools for collating and

presenting information about opportunities could be further explored. LandServer is one such tool already

available in the USA (http://www.landserver.org/). It helps landowners evaluate ecosystem services on their

land and their consequent eligibility for any conservation funding opportunities26

.

5.5.6 Encouraging innovation and specialisation from niche providers

High transaction costs, specialist expertise and access to capital could create a space for business

model innovation. Entrepreneurs, who are third parties (individuals or private companies) might be able to

adopt commitments and undertake projects on behalf of landowners. This model has already been employed

in the energy sector, where energy service companies (ESCOs) have had some but limited success

developing a market for energy performance contracting. An analogous role for Water Services Companies

(WASCs) has been suggested in the UK (SWSC, 2013). This could be considered in the context of wider

thinking on the role of water companies in the long term.

Wetland creation and management is one example where new entrants and innovative models might

be encouraged. Entrepreneurs (including NGOs) are already key to the success of US wetland mitigation

and nutrient banking. They have incentives to identify mitigation opportunities and by repeated learning and

doing have the potential to become more specialised and innovative, increasing overall efficiency.

5.6 Which funding mechanisms are most feasible

All four categories of funding mechanism can make a contribution to maintaining and improving ecosystem

services in catchments. The two most feasible are continuations and expansions of existing schemes

The water utility model offers the opportunity to increase funding in Periodic Review 2019. Water

utilities already operate ‘beneficiary pays to reduce a bad’ schemes in order to improve water quality and

availability. Subject to emerging evidence on their performance, these schemes could be expanded further. In

26

A similar pilot is being currently undertaken by Oxford University funded by LIFE – called Natur- eTrade

http://www.landserver.org/


the medium term, for Periodic Review 2019, a process for developing water company plans and level of

ambition will be needed, and in the long run some strategic decisions may have to be taken to formalise the

remit of water utilities in paying to reduce ‘bads’ and in catchment management. The feasibility of

expanding water utility funding may also depend on the success of tighter enforcement of compliance with

pollution regulations, particularly in agriculture.

Within existing government expenditure, combination or pooling of resources, combined with greater

spatial targeting, could increase value for money, helping to maintain outputs as resource inputs are

cut. The ‘beneficiary pays to maintain a good’ measures do not offer increased funding but instead there are

ways to increase the value achieved from the same funding. It involves pooling of funds across budgets or

pooling of effort across activities when targeting the maintenance of specific assets, or the delivery of

functional improvements, or mitigation of pollution. It is primarily a coordination activity. It requires greater

cooperation between government, local authorities, water utilities, nature conservation charities and land

owners.

Offsets present some challenges in securing commitments and making effective measurement but they

could make a contribution to water quality policy goals and so should be seriously considered. The

third category, ‘polluter pays to maintain a good’, in which offsets is the principal mechanism, is feasible in

the sense that it will be following examples already operating in other countries, but presents greater

challenges than the first two categories. In particular, the success of offsets depends upon the quality of

measurement and enforcement, on the development of novel functional equivalence metrics for catchment

services, and on the strength of the financial vehicles supporting the offsets. None of the existing schemes

offer satisfactory template solutions in these areas. Thus this category would require further development and

piloting before it could be widely employed. Without undermining its potential contribution, it is worth

noting that it would be somewhat limited in impact because it could only act to limit the effects of land use

change. It would not address ongoing pollution, natural capital maintenance funding or improvement.

Market instruments generally work best at scales not available in the UK, but it is worth examining

whether there are particular locations where they could function well. The final category, market

instruments, of the form ‘polluter pays to reduce a bad’, may be feasible in some medium-scale locations in

the UK, pilots have shown. The feasibility of their general application in the form of market instruments is

uncertain and might be limited to specific pollutant loads such as nitrogen. Further investigations would be

needed to determine where and whether they could be introduced, and whether pollutant budgeting is a

necessary component of them. Meanwhile, existing pollution regulations offer a feasible alternative in which

polluters are forced to pay to reduce a bad.

A wide range of ecosystem services could be supported by PES schemes, so only by joint consideration

of service outputs will value for money be achieved. A summary of the potential for specific examples of

these mechanisms, the effort and actions required to enable them and the services they might be best suited

to deliver, are all listed in Error! Reference source not found., based on the discussion above. They all

ave wide applicability across services. The polluter pays and beneficiary pays have been assessed as having

high potential primarily because there is scope to tighten regulation of diffuse pollution and to use water

utilities as a vehicle for channelling beneficiary payments to improve catchments. There is also high


potential from beneficiary pays via government, through agri-environment schemes and flood defence

expenditure in particular, since these already command high budgets and additional value can be added

through improvements in design. Polluter pays to maintain a good in the form of developer offsets offers

medium potential, but could be very important locally, because development only affects a small proportion

of total land area.

Table 10. Feasibility and applicability in England

Service Scale of

opportunity

Policy

enabling

effort

Enablers Services

Water

resources

Water

quality

Flood

management

Carbon Biodiversity

Polluter pays to reduce a bad: pollution trading

M Medium Regulated cap, platform

y y n y n

Beneficiary pays to reduce a bad: bargain

L (water cos)

S (others) Small Mapping y y y n y

Beneficiary (government) pays to maintain a good

L Large

Existing programmes: agri-environment, flood defence, habitats etc, Mapping

y y y y y

Polluter pays to maintain a good: developer offsets

S Small Legal requirement, monitoring

y y y y y

Notes: Developer offset narrowly viewed as biodiversity only but could be extended to other ecosystem services. L = large, M

= medium, S = small.



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Ribaudo, M.O. and Gottlieb, J. (2011), “Point-Nonpoint Trading – Can It Work?”, Journal of the American

Water Resources Association 47(1): 5-14

RSPB (2013), “The Feasibility of a Nitrogen PES Scheme in the Poole Harbour Catchment”, Defra PES pilot

report

Salvesen, D., Marsh, L. , Porter, D. and de Grove, J. (eds) (1996), “Mitigation Banking: Theory And

Practice”, Island Press

Schomers, S. and Matzdorf, B. (2013), “Payments for ecosystem services: a review and comparison of

developing and industrialized countries”, Ecosystem Services 6: 16-30


SFWA (2009), “Santa Fe Municipal Watershed Plan, 2010-2029”, Santa Fe Watershed Association,

available at: http://www.santafenm.gov/document_center/document/780

Shabman, S. and Lynch, L. (2013), “Moving from Concept to Implementation: The Emergence of the

Northern Everglades Payment for Environmental Services Program”, Resource for the Future Discussion

Paper DP 13-27

Shortle, J. (2012), “Water Quality Trading in Agriculture”, OECD

Shortle, J. and Horan, R.D. (2013), “Policy Instruments for Water Quality Protection”, Annual Review of

Resource Economics 5:111-38

SWSC (2013), “Sustainable Water Stewardship: Innovation Through Collaboration”, report by the

Sustainable Water Stewardship Collaboratory, available at:

http://www.cisl.cam.ac.uk/publications/publication-pdfs/sustainable-water-stewardship-innovation-through-

c.pdf

Stanton, T., Echavarria, M., Hamilton, K., and Ott, C. (2010), “State of Watershed Payments: An Emerging

Marketplace”. Ecosystem Marketplace. Available online:

http://www.foresttrends.org/documents/files/doc_2438.pdf

Suter, J.F.,. Spraggon, J.M., Poe, G.L (2013), “Water quality trading experiments: Thin markets and lumpy

capital investments”, GWF Discussion Paper 1328, Global Water Forum, Canberra, Australia

The Nature Conservancy (2013), “Water Funds Business Case: Conservation as a Source of Competitive

Advantage”, available at: http://www.watershedconnect.com/documents/water_funds_business_case

URS Scott Wilson (2011), “Barriers and Opportunities to the Use of Payments for Ecosystem Services”,

Final Report to Defra

URS (2015), “Payments for Ecosystem Services: Developing the Evidence Base on PES Beneficiaries in

England”, Final Report for Defra

Ursus Consulting (2013), “Payment for Ecosystem Services (PES) Pilot on Flood Regulation in Hull”, final

report to Defra

US FS (2009), “Forest Ownership in the Conterminous United States”, available at:

http://www.nrs.fs.fed.us/pubs/rmap/rmap_nrs2.pdf

US SSA (2011), “Social Security Programs Throughout the World: The Americas, 2011”, US Social

Security Administration


Valderrama, A., Levine, L., Bloomgarden, E., Bayon, R., Wachowicz, K., Kaiser, C. (2013), “Creating Clean

Water Cash Flows: Developing Private Markets for Green Stormwater Infrastructure in Philadelphia”, report

for the Natural Resources Defense Council available: http://www.nrdc.org/water/stormwater/green-

infrastructure-pa.asp

Van Houtven, G., Loomise, R., Baker, J., Beach, R., Casey, S. (2012), “Nutrient Credit Trading for the

Chesapeake Bay: An Economic Study”, report for the Chesapeake Bay Commission

Vatn, A. (2010), “An institutional analysis of payments for environmental services”, Ecological Economics

69: 1245–1252

VCN (2013), “Nutrient Pollution Trading”, Virginia Conservation Network website:

http://www.vcnva.org/index.php/our-work/healthy-rivers/nutrient-pollution-trading

VDEQ (undated), “Trading Nutrient Reductions from Nonpoint Source Best Management Practices in the

Chesapeake Bay Watershed: Guidance for Agricultural Landowners and Your Potential Trading Partners”,

Virginia Department of Environmental Quality

Vlachopoulou, M., Coughlin, D., Forrow, D., Kirk, S., Logand, P. and Voulvoulis N. (2014), “The potential

of using the Ecosystem Approach in the implementation of the EU Water Framework Directive”, Science of

the Total Environment 470–471 (2014) 684–694

Womble, P. and Doyle, M. (2012), “The Geography of Trading Ecosystem Services: A Case Study of

Wetland and Stream Compensatory Mitigation Markets”, Harvard Environmental Law Review Vol.36 (1):

229-296

World Bank (2005), “Social Security Coverage in Latin America”, Social Protection Discussion Paper Series

no. 0523, Social Protection Unit, World Bank

Wunder, S. (2005), “Payments for environmental services: Some nuts and bolts”, CIFOR Occasional Paper

No. 42, Center for International Forestry Research

Wünscher, T., Engel, S. and Wunder, S. (2006), “Payments for environmental services in Costa Rica:

increasing efficiency through spatial differentiation”, Quarterly Journal of International Agriculture 45(4):

319-337

WRI (2011a), “Forests for Water: Exploring Payments for Watershed Services in the U.S. South”, World

Resources Institute Issue Brief 2

WRI (2011b), “Comparison Tables of State Nutrient Trading Programs in the Chesapeake Bay Watershed”,

World Resources Institute Fact Sheet available at:

http://www.wri.org/sites/default/files/comparison_tables_of_state_chesapeake_bay_nutrient_trading_progra

ms.pdf


Glossary and abbreviations

agri PES sub-category of payments for ecosystem services schemes undertaken on

land already under agricultural management

BMP best management practice

CAP Common Agricultural Policy

CIL Community Infrastructure Levy

Coasean bargain a bargain to limit or allow an environmental impact negotiated by private

parties independently of government, first described theoretically by the

economist Ronald Coase

EPA US Environmental Protection Agency

intertemporal referring to allocation choices over time, rather than within a given

contemporaneous time period

liquidity referring to a high volume of activity in a market, typically important for

driving efficiency and price discovery

MES market for ecosystem (or environmental) services

MRV monitoring, reporting and verification

nature PES sub-category of payments for ecosystem services schemes relating to

conservation of natural ecosystems (as opposed to agri PES)

NFU National Farmers Union

NPS non-point source

NSW New South Wales

NVZ Nitrate Vulnerable Zone

PES payments for ecosystem (or environmental) services

PS point source

QSR Quick Scoping Review

SIB Social Investment Bond

Social Investment Bond Mechanism for financing public projects via private investors rather than

through public money. Investors typically provide concessional finance (that

is, not expecting a market return) to fund projects with a public benefit, with

the expectation that they will be fully or partially repaid through resultant

savings to the public purse.

UKWIR UK Water Industry Research

WASC water services company

WQT water quality trading


Appendix 1: Search and selection method

We searched Google Scholar, Web of Knowledge, Econ Lit for the following terms (this is a summary rather

than showing the precise syntax used of each search):

– (nutrient OR nitrogen OR phosphorus) AND trading;

– a set of searches for every possible combination in the matrix shown in Table 10;

– (user charge OR visitor payback OR wetland beneficiary pays OR payments for ecosystem services)

AND (amenity OR recreation OR tourism) AND water;

– wetland mitigation AND (Water quality OR Flood risk OR Amenity OR Recreation OR Tourism).

Table 11. Matrix showing some of the search term combinations used

Ben

efic

iary

pay

s

Pay

men

t(s)

fo

r ec

osy

stem

ser

vice

s

Pay

men

t(s)

fo

r en

viro

nm

en

tal s

erv

ices

Bio

div

ersi

ty o

ffse

tt(i

ng)

Trad

ing

sch

eme

Eco

no

mic

inst

rum

ent

Mar

ket-

bas

ed

Watershed protection

Water quality

Nutrient management

Abstraction

Groundwater

Flood risk

Wetland

This resulted in nineteen separate searches. The results were then aggregated into five sets (covering water

quality trading, PES, biodiversity offsetting, other possible market-based instruments for water management

and tourism, recreation and amenity). Literature in each of these five sets was then prioritised as follows:

– automated filtering/sorting:

– references older than five years and with fewer than five citations were removed, in order to gain the

most up-to-date and policy-relevant information, rather than early stage papers covering the basics;

– Google Scholar results were left ranked according to their ranking in the search

– discretionary filtering:


– results were then further screened on the basis of relevance, scope, quality and coverage of a

sufficient diversity of contexts and issues.

The literature identified by the formalised search process was supplemented by sources suggested by the

Steering Committee, and sources sought by the team to answer particular questions of policy relevance

Table 11 summarises the topic areas covered by the papers selected through both processes, and details of

the exact references.


Table 12. Summary of literature reviewed as a result of both formal and informal processes

Overview / meta-analysis / theory Individual schemes examined Specific contexts or issues highlighted Key references examined

Pollution trading (‘polluter pays others’)

Overviews of: • issues facing PS-NPS trading in NAm • water quality trading involving agriculture Theory of: • policy instruments for WQ protection

Poole Harbour (UK) Great Miami, Chesapeake (USA) South Nation (Canada)

• General low liquidity of US schemes • Total allowable discharge framework essential to US schemes See Poole Harbour case study

Newburn and Woodward (2012); Ribaudo and Gottlieb (2011); RSPB (2013); Shortle (2012); Shortle and Horan (2013); Suter et al. (2013); Van Houtven et al. (2012); WRI (2011b); Bennett and Carroll (2014); Greenhalgh and Selman (2012)

Pollution trading (cap and trade)

Overviews of: • water quality trading involving agriculture Theory of: • policy instruments for WQ protection

Nutrient trading: Lake Taupo (NZ) Salinity trading: Hunter River (Australia)

• CAT is not generally used for water quality mechanisms • NZ scheme is only NPS-NPS encountered; severe impact on farmers • Hunter River: IT as enabler; attention to flow and ambient concentrations

Shortle (2012); Bennett and Carroll (2014); Duhon et al. (2011); Quinn (2011)

PES – general Defra background documents Overviews of: • comparison of experience in low and high income countries • factors affecting program efficiency globally Application of ES approach to WFD context Theory covering different design aspects

See Agri PES and Nature PES below Defra (2013b); Defra (2014); URS Scott Wilson (2011); URS (2015); Vlachopoulou et al. (2014); Kroeger (2013); Schomers and Matzdorf (2013); Vatn (2010);

Agri PES Defra background documents Auctions for agricultural schemes

Fowey River, Tortworth Brook, Place-based South Pennines (UK) Everglades ranchers (USA) Evian (France)

• Coverage of schemes where principal aim to reduce pollution through agricultural land management practices • Use of auctions for improved cost-effectiveness

Day et al. (2013); Defrance (2011); Hasund (2013); Schomers and Matzdorf (2013); Shabman and Lynch (2013); Bennett and Carroll (2014); BART et al. (2014); Quick et al. (2013); Moreddu (2007)

quasi- Coasean bargain

Overview of: • general issues for urban contexts

Hull Street Level (UK) Stormwater Tender (Australia) Philadelphia Stormwater Fee (USA)

Coverage of urban contexts with respect to (i) flood risk and (ii) stormwater management

Fletcher et al. (2011); Valderrama et al. (2013); Ursus Consulting (2013);


Overview / meta-analysis / theory Individual schemes examined Specific contexts or issues highlighted Key references examined

Bennett and Carroll (2014); McPhearson et al. (2014)

Nature PES Overviews of: • comparison of international experience • US forest PES

Andean water funds (Latin America) Catskills-Delaware, Denver Forests to Faucet, Santa Fe (USA) Pumlumon, Pennine Visitor Giving (UK)

• use of trust funds as finance mechanisms • nature PES in a developed world context • geographical and institutional factors behind emergence of nature PES and comparison with UK • schemes frequently do not incorporate PES best practice

Bottorff (2014); Goldman-Benner et al. (2012); McPhearson et al. (2014); Mercer (2011); Schomers and Matzdorf (2013); SFWA (2009); WRI (2011a); Alison Milward Associates (2014); Reed et al.(2013)


Literature reviewed focussed on particular applications; US wetland references were fairly high level overview


• Mitigation banking widely used in US but some ecological question marks • Biodiversity offsetting concept would need methodological development to have wider application in water management context

Bull et al. (2013); Burgin (2010); NSW DECC (2007); Womble and Doyle (2012)

Cross-cutting Overview of: • global watershed investment • PES-like mechanisms in UK

n/a for cross-cutting Bennett and Carroll (2014); Inman and Smith (2012); SWSC (2013); Stanton et al. (2010)

Other • Theory and overview of flood risk instruments • Overviews of conservation covenants and easements • Potential application of Social investment Bonds

Groundwater water rights trading (1) Applicability of MBIs to coastal water body in Australia NAm salinity management

• GW poses hydrological challenges to any kind of mechanism • Flood risk management mostly relates to planning mechanisms • SIBs face methodological challenges for flood risk application

EPA (2014); Filatova (2013); Flow Partnership (2015); Law Commission (2014); Nature Conservancy (2015); RAND Europe (2014); Quinn (2011); Greiner (2014)


In addition to this formalised process, we:

– took account of research already undertaken by Defra and the Defra family

– used web searches to find supplementary information, as a formalised web search did not provide

practically useful results

– used additional references, sourced or already known to us, to inform and illustrate key points of

interest


Appendix 2: Interviewees and discussants

Table 13. Interviewee and discussant affiliations

Organisation

Birmingham City University

CLA

Cornwall Local Nature Partnership

Defra

Environment Agency

Eunomia

Flow Partnership

Forestry Commission

National Trust

Natural England

NFU

PepsiCo

RAND Corp

RSPB

The Nature Conservancy

The Rivers Trust

The University of Western Australia

United Utilities

University of East Anglia

Wessex Water


Appendix 3: Individual scheme summary tables


Polluter pays to reduce a ‘bad’: water quality trading schemes

Table 14. Example scheme summary: Great Miami Watershed, Ohio, USA

Design

Design overview Baseline and credit trading scheme covering 314 point sources in a watershed dominated by municipal WWTPs. Point sources can purchase

nutrient reductions from upstream farmers, who do not face discharge limits.

Role of intermediary Two-tiers of intermediaries. Overall administration by a state public body (Miami Conservancy District). Pre-existing, “socially embedded”

lower-level intermediaries in the form of Soil and Water Conservation District Offices with good local knowledge. First-tier intermediary acts as

a clearinghouse buying and selling all credits. Second-tier intermediaries advise farmers who might participate on BMPs and associated credit

calculations. Search and transaction costs for scheme participants are virtually eliminated. “It would have been very costly” for first-tier

intermediary to identify farmers alone.

Option identification Second-tier intermediaries with good local knowledge help identify suitable farmers and provide advice on BMPs.

Option selection A type of reverse auction – applications are ranked based on the lowest cost per pound of nutrient reduction in bidding rounds.

Value for money considerations Reverse auction allows differentiated pricing. It is not clear how or whether additionality and adverse selection have been addressed. Clear

conditionality requirement.

Risk management (1) A trading ratio is used to account for uncertainty in measuring; (2) an insurance pool of credits is available in the event of failed projects; (3)

contingency plans. Single buyer model makes credits inter-changeable and removes buyers’ liability.

Monitoring, reporting &

verification

Filing of annual inspection reports to confirm that BMPs are still in place.

Other Scheme provided incentives for early participation while regulatory framework was being developed.

Evaluation

Success: Environmental Environmental benefits unclear as TMDL is still being established. Co-benefits are considered in selection process but peripheral.

Economic In first six years, 345 projects generating 454 tons of reductions, worth about $1.5 million. Would have been greater but scheme started before

TMDL was in place.

The scheme claims to be first US WQT scheme to allow a diverse array of BMPs to generate credits. One paper describes it as a “turning point”

after several years’ experience in the US of schemes resulting in no or few trades, with significant demand for credits.

Stakeholder A collaborative approach with intermediaries was reported to lead to widespread support. Contracts of typically 5-10, but up to 20, years in

length.

Other Useful period of “bedding in and learning before start of compliance period.


Further information http://newserver.miamiconservancy.org/water/documents/WQCTPfactsheet2014FINAL_000.pdf

Newburn & Woodward (2012)

Table 15. Example scheme summary: Chesapeake Bay, MA/VA/WV/PA, USA

Design

Design overview There are four individual state trading schemes in the Chesapeake watershed: Maryland, Pennsylvania, Virginia and West Virginia. The

Chesapeake TMDL is subdivided into 92 segments each with annual nitrogen and phosphorus limits.

The key similarities and differences between state schemes are as follows:

• each allows both nitrogen and phosphorus trading; three also include sediment trading

• each follows the standard North American template of allowing both PS-PS and PS-NPS (agricultural) trading, where point sources are sewage

facilities and (except for MA) industrial wastewater treatment plants

• all require most new or expanding point sources to offset their loads through credit purchases

• all except one have segmented trading areas based on river watersheds

• required offset contract lengths vary by scheme (5 years, 10 years or unspecified)

• two (PA and VA) provide clearinghouse mechanisms, one of which (VA) sets credit prices

Virginia included municipal separate storm sewer systems and facilities with stormwater permits as participants in 2010; dealing with

stormwater’s contribution to discharge limits has been considered for the other schemes.

Role of intermediary Chesapeake Bay Commission representing the General Assemblies of Maryland, Pennsylvania and Virginia, aims to identify environmental

needs and advance state and federal actions to improve water quality.

Each individual scheme has individual regulator and some have a clearinghouse intermediary (e.g. Virginia Nutrient Credit Exchange

Association).

Option identification Information not available in reviewed literature

Option selection Applicants prepare and submit project proposals

Value for money considerations To satisfy additionality requirements, agricultural operations must meet varying baseline requirements to ensure they are already fulfilling

their portion of state nutrient reduction goals.

Risk management Two schemes (PA and WV) provide credit reserve pools for risk management, and one (VA) provides a creditor of last resort. Trading ratios are

employed (except for PA) to account for the uncertain outcome of NPS reductions.


verification

Either contracts and/or certification documents containing annual certification and verification plans; or verification may occur at any time



Other

Evaluation

Success: Environmental Virginian scheme was modified in 2010 to tighten baseline requirements and to specify that trading should not degrade local water quality

Economic Pennsylvania and Virginia are the two schemes which see large trading volumes, in both cases since improvements were made to the schemes

in 2011-2.

• Pennsylvania’s program had eight trades in five years prior to the creation of a clearinghouse mechanism; now it is the third largest scheme

by volume traded in the US

• Virginia’s program is the second largest scheme by volume traded, and the only scheme with significant phosphorus trading

• Very clear that the schemes with clearinghouse mechanisms as well as risk management provisions have seen the most trading. Maryland’s

scheme (which has neither) has yet to see any trading.

Virginia scheme stormwater elements are credited with costing “about half what the state would have had to spend on building storm-water”

infrastructure and scheme is hailed as great success in policy community.

Stakeholder Information not available in the reviewed literature

Other

Further information Bennett and Carroll (2014); van Houtven et al. (2012); WRI (2011b); VCN (2013); VDEQ (undated); Shortle (2012)


http://www.baltimoresun.com/features/green/blog/bal-nutrient-pollution-trading-in-limbo-in-maryland-as-it-expands-in-virginia-20141216-

story.html#page=1

Table 16. Example scheme summary: Lake Taupo, New Zealand

Design

Design overview Cap and trade scheme designed to reduce nitrogen loads from diffuse agricultural pollution in Lake by 20% (as distinct from reducing costs for

regulated point sources, like US scheme). Unique scheme due to:

– status as only truly diffuse pollution cap and trade scheme ever attempted

– beneficiaries (represented by a public body) pay to reduce pollution by buying up credits

Rights allocated according to historic land uses (grandfathering). Land uses classified as permitted, controlled or non-complying activities, with

only controlled activities covered by the scheme.

Role of intermediary Waikato Regional Council developed and implemented scheme. Lake Taupo Protection Trust set up to establish NZD 81 million in public money

to fund pollution reductions. Online marketplace for trading established.


http://www.baltimoresun.com/features/green/blog/bal-nutrient-pollution-trading-in-limbo-in-maryland-as-it-expands-in-virginia-20141216-story.html#page=1

http://www.baltimoresun.com/features/green/blog/bal-nutrient-pollution-trading-in-limbo-in-maryland-as-it-expands-in-virginia-20141216-story.html#page=1


Option identification Online guide for farmers to help self-identify.

Option selection Farmers could put in place any option for which they would be awarded credits by software tool

Value for money considerations Unclear from reviewed literature

Risk management Unclear from reviewed literature


verification

Farmers engaging in controlled activities apply for a resource consent with local authority. This requires them to establish a baseline based on

existing management practices. Software tool used to standardize benchmarking. Farmers wishing to engage in a trade required to set out new

practices in a nutrient management plan.

Other

Evaluation

Success: Environmental Regarded as effectively limiting nitrogen losses to the lake

Economic The LTPT effectively set both the price and quantity of abatement by having a fixed budget to meet a target. The effective result was a

dominant price-setting buyer which may have contributed to excessive hardship for some participants (see below). A 2011 evaluation noted

almost all credits purchased by two dominant buyers (the LTPT and a large dairy farm), probably related to lack of trade intermediation to

reduce negotiation burden and counterparty risk.

Stakeholder flexibility offered by the scheme viewed as preferable to alternative of fixed restrictions. However, the scheme is perceived to have driven

many farmers out of business and split up communities. Bulk of initial credits came from sale and conversion of whole farms.

The allocation methodology raised the classic objection of allocating greater rights to historic polluters. Forestry owners particularly objected

that grandfathered rights would lock them into low nitrogen uses. “Determining how nitrogen allowances would be allocated across a wide

variety of land uses and individual situations proved to be on the of most contentious issues”.

Other In terms of adverse social impacts, it’s possible that the scheme aligned abatement costs too closely with the opportunity costs of farming – in

other words, scaling back on production may have been only means of compliance for some farmers.

Scheme took ten years to finalise, possibly due to its novelty.

Further information Duhon et al. (2011)

Beneficiary pays to reduce a ‘bad’: ‘Agri PES’ and other Coasean bargains

Table 17. Example scheme summary: Fowey River Improvement Auction

Design


Design overview A water company (South West Water) funded capital investments by farmers to improve nutrient, pesticide and watercourse management.

Farmers were invited to submit bids for funds via a reverse auction. Additional changes in farm management practices were incentivised but

not mandatory.

Role of intermediary Set scheme rules and administered auction

Option identification Farmers self-identified given eligibility criteria (upstream of water treatment plant and greater than 15 ha) and information

Option selection Twelve types of eligible capital items to make VfM assessment easier. Farmers identified own mitigation options. Options ranked according to

VfM measure based on size of the grant request, the type and quantity of capital works, operational commitments included, and a farm’s

location in the catchment.

Value for money considerations Use of auction to improve VfM. Use of capital items made strong conditionality condition (withholding of payments) possible. Cut-off in terms

of participant size; maximum grant to any one farm of 14% of total budget (provides implicit minimum no. participants); minimum value for

money threshold for all bids. Covenant added to deeds of farm for investments over £5000

Risk management Implicit minimum no. participants spreads risk


verification

Payments contingent on documentary evidence of purchase, proper maintenance and insurance of capital items

Farm management practices stipulated in some contracts where part of the bid but not subject to further verification

Other Bidding process which allowed revisions, hence opportunity to learn and price discovery

Numerical option selection method was tested in comparison with expert ranking and modified until the two corresponded

Evaluation process built into scheme

Evaluation

Success: Environmental too early to say

Economic Estimated 20-40% better value for money than the fixed-price alternative. Action-based scheme could theoretically pose greater additionality

risk – possibility that farmers would bid for actions they had already planned to do. As farmers were self-identifying, this posed further risk of

adverse selection. These risks were minimised by tying bids to capital items (much easier to verify need and confirm ongoing presence).

Competition for funding was not the only determinant of bid level, but the rate of success amongst those aware of competitive pressures was

higher.

Stakeholder Generally acceptable; 30% of farmers approached prepared bids. Some non-participating farmers cited reasons such as not wishing to bid

against neighbours, or letting a utility company “get involved” with farm management. Time constraints and complexity were also cited.

“Amongst those farmers that did not enter a bid the key issue deterring participation appears to have been the difficulty of having to

personally identify suitable projects and the complexity of bidding.” However, more farmers participated than found it too complex.

Contract length of 10-25 years raised concerns, particularly among tenants.

Other

Further information Day et al. (2013)


Table 18. Example scheme summary: Northern Everglades Payment for Ecosystem Services program

Design

Design overview Series of pilot water management projects on cattle ranches in Florida. Ranchland owners entered into contracts with a state agency to retain

water and nutrients on their land rather than allowing them to enter a regional drainage network. Buyer was South Florida Water

Management District (state agency responsible for improving water quality).

Role of intermediary Florida Ranchlands Environmental Services Project committee ran project; a collaboration between state and federal agencies, NGOs,

academics and ranchers.

Option identification Only landowners engaged in production of beef cattle in designated catchments eligible.

Option selection Ranchers submitted proposals to compete for funding, including assessment of potential to provide services, upfront costs faced and annual

payment required. Ranchers then chose the level of services to provide through an iterative process with the buyer.

Value for money considerations • Contracts based on expected environmental outcome (conditionality) based on models; water and phosphorus retained.

• Competitive bidding process

• Landowners must be in compliance with existing state and federal wetlands regulation.

Risk management Outcome risk removed by basing contracts on model predictions of average annual water retention or nutrient removal service expected

during a 10-year rainfall period. Objective of achieving the average service level over 10 years.


verification

The project required the development of new hydrological models based on site-specific conditions for estimating outcomes. Standardised

tools used to estimate expected water and phosphorus retained, as well as baselines. Models based on site-specific conditions.

Other

Evaluation

Success: Environmental Too early to say

Economic Too early to say

Stakeholder • Need to build effective trust and collaborative processes with sellers emphasised; also maintaining credibility by drawing on a range of

scientific and financial expertise. Both absolutely key to stakeholder acceptance. Collaboration on methods for documenting service levels and

finding cost-effective ways to measure services.

• “Collaboration requires dedicated leadership with skills in facilitation, project management, fund-raising, and basic understanding of the

interests and constraints of each of the collaborators.”

Other Individual negotiation is possible where numbers are small

Further information Shabman and Lynch (2013)


Table 19. Example scheme summary: Melbourne Stormwater Tender

Design

Design overview Uniform price auction pilot project, inviting bids by small-scale landowners (allotment holders, householders) to put in place stormwater

management systems (grey infrastructure, rain gardens) to reduce urban run-off and pollutant loads into a nearby creek. Concerns that

stormwater treatments cannot ignore private lands and should do more to address flow management as well as pollution control.

Role of intermediary Set project rules. Provided web-based tool for participants to develop bids. Information dissemination (community workshops, one-to-one

consultations, telephone support, approved list of equipment providers)

Option identification ‘Expression of Interest’ sent out to landholders. Those who responded invited to prepare full bids.

Option selection Reverse auction. Bids evaluated on the basis of an "Environmental Benefit Index” which assesses degree to which a project will (i) reduce

runoff frequency (ii) reduce pollutant loads and (iii) reduce potable water usage. Different weights used to highlight different priorities. Web-

based tool allowed participants to calculate EB units for their project.

Value for money considerations Uniform price auction intended to remove “profit-seeking behaviour”. Reserve price means bids that are not sufficiently cost-effective will not

be accepted. Comparison of receipts with auction price paid allowed VfM evaluation.

Risk management Unclear from reviewed literature


verification

Landholders submitted receipts for work undertaken

Other

Evaluation

Success: Environmental Resulted in 1.4 ha, 1% of catchment impervious areas under mitigation. Future auction rounds will be revised to test improvements to EBI;

“the index in its current form does not consider the full range of hydrologic indicators necessary to properly assess the impact of a proposed

stormwater retrofit measure”

Economic Second chance’ bidding round required to use up all of funds and reduce profit-seeking behaviour; authors not convinced that uniform price

auction conforms with theory that profit-seeking behaviour will be eliminated.

Stakeholder 1 in 7 of eligible landholders prepared bids, half responded to EoI

“Future auction rounds will be revised to … provide an auction process which is simpler to understand, and provides greater practical support

for landholders who wish to undertake works.” Perceived to have improved community awareness of problem and solutions.

Other

Further information Fletcher et al. (2011)


Beneficiary pays to maintain a good: ‘Nature PES’

Table 20. Example scheme summary: North American watershed protection

Design

Design overview There is little detailed publicly available information about many individual schemes. There appear to be two main types:

• Mixture of agri-PES and nature PES: Combination of land acquisition, easements and/or cooperation with landowners to maintain both

natural forests and reduce impacts on agricultural land. Main example is the New York-Catskills scheme. Program provides farmers with a small

fixed regular sum and exemption from water quality regulations in return for participation in Whole Farm planning program.

• Western forest model: co-payments for management practices to reduce risk of wildfire in public forests and subsequent water quality

impacts due to sediment and debris (for example, Denver Forests to Faucet Partnership, Santa Fe Watershed Plan)

Role of intermediary NYC-Catskills: Watershed Agricultural Council works with farmers to “provide technical staff to work with farmers in custom designing pollution

control measures which are heavily informed by farmers’ own first-hand experience and knowledge”. Catskill Watershed Corporation

administers community infrastructure.

Option identification NYC-Catskills: All farmers encouraged to participate

Western forest model: Single landowner, clear land management practices

Option selection NYC-Catskills: Program develops custom pollution control measures for each farm informed by farmers’ own first-hand experience and

knowledge

Western forest model: Single landowner, clear land management practices

Value for money considerations Information not available nn reviewed sources

Risk management Information not available nn reviewed sources


verification

Observation of agreed management practices. Detailed ecosystem service flows do not form basis of contracts.

Other

Evaluation

Success: Environmental NYC-Catskills: success – watershed provides 100% of water requirements for 9 million people. Drinking water supply is of such high quality that

filtration is not required.

Western forests: too early to say

Economic NYC-Catskills: program estimated to have cost an eighth of the cost of water filtration plants

Western forest: information not available

Stakeholder NYC-Catskills: 95% of commercial farmers in the Catskills-Delaware participate


Western forest: tbc for final report – not much available information

Other

Further information Mercer et al. (2011); Bottorff (2014); McPhearson et al. (2014)

Table 21. Example scheme summary: Andean Water Fund model

Design

Design overview A public-private trust fund model which combines PES payments to support watershed best-management practices with long-term financial

management. Definition: “a PES approach that for financial management uses a trust fund managed by an external entity. In addition, water

funds share the following criteria: (1) multiple water service users or user groups, (2) payments that support implementation of watershed

best-management practices and conservation, and (3) a board of directors with stakeholder representation that decides how to spend the

revenue.”

Examples: FONAG and FORAGUA in Ecuador, FONACRUZ in Bolivia. In some schemes, contributions are entirely voluntary; in others,

contributions are aggregated (for example, water user fees).

Role of intermediary A special purpose organisation with board representation by multiple stakeholders which manages financial contributions from beneficiaries

over the long term.

Option identification The activities funded vary from paying for park guards, fencing off environmentally sensitive areas, land purchase, securing alternative

livelihoods and food sources, maintaining habitat in a defined state, and improving social conditions.

Option selection Process of negotiation between board and relevant communities. Finding ways to secure and improve livelihoods is key.

Value for money considerations The Andean water funds violate conditionality, as buyers’ contributions are sunk and they are unable to withdraw them. However, this

provides incentives for buyers and sellers to cooperate in the long-term on land management decisions. Some authors argue “requiring

conditionality may limit the use of creative finance mechanisms such as trust funds that can provide long-term benefits” and “requiring

additionality can exclude benefits from social diffusion”.

Determining counterfactual of current and future threats to land otherwise deemed impractical.

Risk management Evolved as a mechanism to deal with risks (political instability and short-term market fluctuations for agricultural commodities) of funding

payments with ongoing cash flow and increase financial sustainability.


verification

Relatively easy to observe that land clearance has not taken place.

Other “Water funds are more than a financial model: they are an institutional, financial and biophysical mechanism that link water services users to


providers through payments.”

Evaluation

Success: Environmental Generally considered successful in halting land clearance and providing water services. Details not provided in reviewed literature.

Economic Details of costs, cost-effectiveness and economic impacts not provided in reviewed literature.

Stakeholder Successful model for building cooperation and joint decision-making

Other Ignoring PES best practice where there are clear benefits and practical reasons for doing so

Further information Goldman-Benner et al. (2011); The Nature Conservancy (2013)

Polluter pays to maintain a good: third party biodiversity offsets

Table 22. Example scheme summary: US wetland mitigation banking

Design

Design overview Developers must offset impacts to wetlands and streams “for the purpose of providing compensation for unavoidable impacts to aquatic

resources permitted” under Clean Water Act. They can do this by: (i) undertaking responsibility for a mitigation project (permittee-responsible

mitigation); (ii) providing resources to public or voluntary sector bodies to undertake the mitigation project (in-lieu fee mitigation); (iii)

purchasing banked credits from mitigation entrepreneurs who have pre-emptively created replacements (mitigation banking).

The “bank instrument” is a “formal agreement between the bank owners and regulators establishing liability, performance standards,

management and monitoring requirements, and the terms of bank credit approval”. This defines the number of credits available for sale. Sites

must be within a “service area” (usually a watershed), a geographical area within which impacts can be compensated. Developers are

frequently required to offset larger areas of wetland than have been lost via use of trading ratios.

The number of credits generated by a project relates to area and/or functional value of the wetland. Credit determination protocol varies by

district.

Role of intermediary An Interagency Review Team reviews, approves and provides oversight of the bank instrument

Option identification Mitigation banks identify suitable bank sites in advance (subject to approval)

Option selection Permittee finds a bank which has matching number of required credits

Value for money considerations Perceived to have lower admin cost for regulator than permittee-responsible mitigation because of consolidation

Risk management Liability transferred from permittee to mitigation bank. Performance bonds required to cover construction and post-construction monitoring.



verification

“Ecological assessment techniques” are required to certify that credits provide the required ecological functions.

Other Approval of credits typically takes 6-18 months.

Evaluation

Success: Environmental Mitigation banking has attracted some strong criticism on environmental grounds. Historical literature (1990-2004, reviewed in Burgin (2010))

suggests:

• some argue it has fallen well short of achieving ‘no net loss’

• many projects do not comply with regulations, including insufficient size or hydrology, impact on other habitat types

• some evidence that mitigation sites are less biodiverse in terms of plant species and have poorer ecosystem function

This has led to debate over whether practice should continue.

However, National Research Council has concluded that banks are “more likely than traditional compensatory mitigation to achieve desired

long-term outcomes”

Can result particularly in transfer of habitat from urban to rural contexts (where it may be less value for amenity, etc.)

Economic Perceived to have strong benefits over permittee-responsible mitigation:

• coordination of planning and scientific expertise

• reduced project uncertainty

• more rapid and cost-effective

Stakeholder Rapid growth of wetland banking in 1990s shows strong stakeholder approval. There are now at least 450 banks. Permittees find transfer of

liability particularly attractive.

Other

Further information Burgin (2010); Bull et al. (2013); Womble and Doyle (2012)

http://water.epa.gov/lawsregs/guidance/wetlands/mitbanking.cfm;

http://www.ecosystemmarketplace.com/pages/dynamic/web.page.php?section=biodiversity_market&page_name=uswet_market

Table 23. Example scheme summary: NSW BioBanking

Design

Design overview Landowners establish biobanks on their site and earn credits by improving habitat or increasing the habitat or population of a threatened

species. Developers can buy the credits to offset impacts from their development. Two types of credit: (i) ecosystem credits can only be used

to offset biodiversity impacts in the same ecological community; (ii) species credits can only be used to offset biodiversity impacts on the same

http://water.epa.gov/lawsregs/guidance/wetlands/mitbanking.cfm


threatened species. Developers run the BioBanking Assessment Methodology, which determines what impacts the development will have on

biodiversity values, and assesses the number and type of credits that are needed to offset the impacts. A biobanking statement sets out the

credit requirements, and is then submitted with a development application.

The scheme is voluntary. The incentive for developers is in streamlining existing biodiversity assessments.

Role of intermediary New South Wales Department of Environment and Climate Change is responsible for registering biobank agreements, maintaining public

registers, monitoring performance and applying penalties for non-compliance. Local government required to incorporate biobanking

statements into development consent.

Some of the income to landholders is paid through a BioBanking Trust Fund which invests funds deposited through the sale of biodiversity

credits on behalf of the biobank site owners. This is designed to provide ongoing incentives and provide resources for new site owners, given

their continuing commitment.

Option identification Landowners identify suitable sites in advance (subject to approval). Sites must have biodiversity value under the Threatened Species

Conservation Act 1995.

Option selection Counterparties find each other through a public register. A match in terms of the same habitat/species must be made.

Value for money considerations Clear contractual conditionality. In addition, biodiversity credits may only be created in respect of management actions that are additional to

those already required on a particular area of land.

Risk management Not clear how project risk is managed. Landowners face penalties if contractual obligations are not met.


verification

NSW DECC undertakes site audits and enforces biobanking agreements

Other Biobanking agreements are registered on the land title and the obligation to manage the land is binding on future owners of the site.

Evaluation

Success: Environmental Protection of sites in perpetuity viewed as one of environmental strengths. Methodology assesses composition, structure and function of

ecosystems. Scheme review recommended strengthening environmental outcomes, particularly riparian areas and wetlands, as well as

through better monitoring, enforcement of mitigation hierarchy, and maintaining a strategic overview.

Economic Uncertainty over both demand and supply of credits seen as barrier to participation by some sellers and developers.

Stakeholder “Standardised, consistent, scientific approach to measuring biodiversity impacts” and biodiversity gains considered to be one of scheme’s

strengths. However, administrative time and cost seen as barrier to participation by some stakeholders.

Other

Further information NSW DECC (2007); NSW and OEH (2014)


Appendix 3: Mechanism summary tables

Table 24. Mechanism summary: water quality trading scheme

Objectives Reduce cost of meeting quantitative discharge limits by allowing regulated parties to trade obligations

Appropriate scale Catchment; trading may need to be segmented geographically by catchment if scheme is designed to protect water body fed by several

catchments (such as a bay). Large catchments more likely to see trading activity.

Other benefits and synergies Some land use management practices may have water regulation, soil quality, biodiversity and carbon storage practices; but such practices

need to be recognised by other mechanisms in order to be encouraged

Contextual factors • North American schemes have evolved as a response to Clean Water Acts and a regulatory framework which includes calculation and

enforcement of Total Maximum Daily Loads; in particular, agricultural abatement is widely viewed as much cheaper than point source

abatement, therefore large gains in trade justify trading

• Pre-existing trusted intermediaries with detailed local farming knowledge important to success of some schemes

• Lake Taupo (NZ) scheme built on existing system of benchmarking and compliance with the conditions of consent

Barriers to application in UK • Involvement of point source participants likely to be needed for scheme liquidity; therefore a regulatory framework setting out periodic caps

for all relevant point source polluters in a catchment

• Building regulatory framework which sets quantitative discharge limits for catchment, and allocating rights, in order to achieve schemes at

sufficient scale

• Possible existing regulatory drivers (e.g. Conservation of Species and Habitats Regulations 2010) may skew rights allocation to incumbents

• Determining nutrient targets and consideration of pollution pathways can be complex and must be credible to all parties

Enablers • Possibility of interactions with emissions trading to provide extra revenue sources, if methods to estimate carbon savings from land use

changes can be improved

• Development of spatial mapping tools and tools to link discharges with land management practices

Risk management considerations Outcome risks and liability arrangements need to be addressed by scheme design; reducing buyer and seller liability through clearinghouse

mechanism has been factor of success of some US schemes

Policy interactions and

interdependencies

Existing regulation which determines baseline (e.g. Nitrate Vulnerable Zones, Environmental Stewardship) needs to be explicitly acknowledged

in scheme design

Trade-offs • Strict enforcement of polluter pays principle vs. political acceptability; allocating rights to historically high polluters (grandfathering) may be

viewed as the least socially disruptive allocation basis.


• Closeness of trusted intermediaries vs. cost-effectiveness: some evidence of strategic bidding by farmers linked to price information and

bidding advice provided by intermediaries in Great Miami scheme

• Caution over NPS-NPS trading after New Zealand experience

Overall potential application in

England

Issues of scale and liquidity would need to be addressed for potential application in English catchments. Schemes much more likely to be

feasible if they involve point source polluters for two reasons:

• Likely gains in trade as a primary justification

• Additional scheme flexibility and liquidity as credits can also be bought from point source polluters

Further examination of the feasibility of a regulatory framework which allows this would be required.

Table 25. Mechanism summary: agri-PES

Objectives Deliver environmental improvements by compensating farmers for putting certain land management practice changes in place. Often driven

principally by the desire to reduce nutrient and pesticide pollution in ground and surface water bodies.

Appropriate scale If government aggregates beneficiaries’ interests, can be national (agri-environment scheme). Otherwise, benefits captured by private

beneficiaries likely to be relatively small scale (Coasean bargain).

Benefits and synergies • Schemes often achieve biodiversity, soil management and other benefits; this can be an explicit objective and part of design (as with

Environmental Stewardship) or an incidental co-benefit.

• Potential to develop new category of Environmental Stewardship scheme focussed on water management objectives

• Creative mix of compulsion, advice and third party contributions may be the way to tackle diffuse pollution from agriculture

• Potential for payments for soil retention to avoid dredging and port siltation

Contextual factors Small scale schemes may build on existing long-term relationships between beneficiary and sellers. For example, the Fowey River scheme built

on the existing Upstream Thinking Initiative and adopted much of the legal apparatus developed by the Westcountry Rivers Trust for this. In

addition, Westcountry Rivers Trust had already been operating an advisor-led scheme which had built up local knowledge and experience.

Barriers to application in UK • Perception that baseline regulatory compliance not adequately enforced

• Perceived unfairness of paying agricultural polluters by some stakeholders

• Beneficiaries other than water utilities, such as large industrial water users, are at arms’ length and unlikely to co-fund. Non-utility

abstractors can free ride on utility-led schemes.

• Ofwat assessment methodology needs ongoing reform to strengthen legitimacy of agri-PES investments in utility business plans

Enablers • Establishment of trusted intermediaries with good outreach skills, avoiding confusion between ‘honest broker’ and regulatory roles

• Incentivise greater cost-sharing of schemes on the part of non-utility abstractors through abstraction pricing


• Knowledge sharing networks, particularly to pass on experience of business benefits and replicable contractual and governance

arrangements

• Greater responsibility for landowners for quality of water flowing off land

• Reducing high transaction costs of site identification, contractual design etc. observed in pilot studies

• Clarification over appropriate role for water companies and development of evidence base over utility-led scheme effectiveness

• Coordination at catchment scale through catchment plan

Risk management considerations Beneficiaries and contractual arrangements need to anticipate impact that non-controllable events, i.e. weather, can have on outcomes (see,

for example, Everglades scheme)


interdependencies

• Cross compliance, Nitrates Directive, Environmental Stewardship Scheme

• Baseline compliance with existing regulation needs to be achieved before many agri PES deals would be viewed as adding value

• Reductions through voluntary measures can remove need for regulation

Trade-offs • Potential extent vs. complexity for sellers. Mechanisms where sellers self-identify, such as auctions, have advantage of requiring less advisor

input but additional complexity and workload for participants can be a deterrent.

• Voluntarism and additionality. Schemes where only a proportion of participants are required run risk of adverse selection and low

additionality.

• Environmental stringency and scheme coverage

Other • Coasean arrangements likely to occur where small number of participants leads to low coordination costs

• Farmers not always the rational economic agents expected by economic theory. They may have concerns in competitive arrangements about

bidding against neighbours, as well as a sense of responsibility and stewardship which financial incentives can weaken.

• Involvement of all, or nearly all, landowners removes likelihood of adverse selection. In some cases full involvement might be critical for

scheme success

• Potential for strategic behaviour and ‘blackmail’ if agri PES schemes become the norm? (See Section 4.1.3)

Potential application/feasibility

in England

Catchment-based agri-PES schemes are already happening in England. Greater involvement of other beneficiaries and water regulation

framework which encourages land management investments could broaden application. Funding from private sector and demand outside of

utilities likely to be small.

Table 26. Mechanism summary: urban Coasean bargain

Objectives Encourage take up of stormwater management measures by small-scale landowners (householders, business owners, etc.) to reduce urban

run-off and/or improve flood risk management


Appropriate scale Neighbourhood, town, city, local authority district

Benefits and synergies • Some measures may increase green space and improve environmental quality

• Raise awareness among residents of issue and what they can do to help

• Potential scope for evidence-gathering with Environment Agency’s flood defence programme

Contextual factors Existing water pricing arrangements may facilitate scheme. For example, in the Melbourne Stormwater Tender scheme, fixed rebates for the

installation of rainwater tanks were already widespread in Australia; in the Philadelphia scheme, non-residential customers had a monthly fee

based on the impervious area on their parcel built into their water bills

Barriers to application in UK • Unfamiliarity amongst flooding beneficiaries of rationale of paying for improvements. There are often very many beneficiaries even within a

small area, making transaction and coordination costs very large

• Difficult to make confident estimates of the benefits of natural capital flood schemes

• Perceived institutional bias towards grey infrastructure

Enablers • Deliberative processes to engage and communicate with householders and business owners; leadership from trusted NGO

• Scope for insurers to co-fund

• Pool interests of multiple beneficiaries

• Evidence on benefits of natural capital flood schemes improving

• Use of websites and marketing campaigns to get householders involved.

• Possibility of ‘eco-entrepreneurs’ analogous to energy service companies

Risk management considerations Purpose of mechanism is to encourage investments/projects by very many non-expert small-scale landowners, with obvious project

performance risk which may deter participation. Transfer of project performance risk to third parties with specialist expertise (eco-

entrepreneurs) could be considered (as in Philadelphia scheme).


interdependencies

Planning system, flood risk management policy

Trade-offs None obvious from reviewed literature

Other • Need to consider time constraints, availability of upfront capital, possible surges of demand for equipment and services, and making scheme

as simple as possible (for example having a simplified, limited range of eligible options) in scheme design.

• Beneficiaries may actually be the same people as sellers


in England

No obvious reason why mechanism could not be applied in England but would need to test with local authorities and any other bodies who

might be involved in local implementation


Table 27. Mechanism summary: Nature PES

Objectives Ensure continuing water provision and quality by maintaining (or increasing) natural ecosystems (or, conceivably, high quality, biodiverse

agricultural ecosystems), by compensating affected parties for forgoing alternative land uses

Appropriate scale Local to watershed to national. National schemes do not tend to process information about high value provision opportunities well and often

use fixed rate payments.

Benefits and synergies Maintenance of high quality ecosystem has obvious biodiversity, carbon sequestration, amenity and existence value benefits.

Contextual factors • The circumstances under which nature PES schemes for water management have become prevalent in the developing world include aligning

conservation with poverty alleviation, large areas of intact natural ecosystems, and weak regulatory and property rights regimes.

• In the USA municipalities are responsible for water quality under the Safe Drinking Water Act. This has been a primary driver for the

emergence of municipally-led PES schemes. The USA also has large areas of intact natural forest.

Barriers to application in UK • The costs of excluding economic activity from areas of high habitat quality are much lower and there is already a strong system of

conservation designations, as well as projects such as the National Forest.

• Ratio of natural habitat to agricultural land is much lower, therefore it is less likely that watershed protection will be so strongly co-aligned

with habitat conservation. The greatest proportion of the value of nature PES schemes is likely to remain in non-market benefits (biodiversity,

landscape) which are funded either publicly or through charities, or protected by restricting development.

Enablers • Mapping of ecosystem services and associated benefits and threats.

• Design of new standards highlighting potential nutrient retention potential of wetlands

• Reducing high transaction costs of site identification, contractual design etc. observed in Defra pilot studies

Risk management considerations Desired land uses are likely to be required for an indefinite period, therefore threats to long-term financial stability need to be indentified and

explicitly included in scheme design (for example, through trust fund).


interdependencies

Existing conservation designations, Biodiversity 2020, Higher Level Stewardship

Trade-offs • Simplicity vs. cost-effectiveness (price differentiation has potential to select higher benefit or lower cost sites, but adds complexity)

• Voluntarism and additionality. Schemes where only a proportion of participants are required run risk of adverse selection and low

additionality.

• Adherence to VfM best practice and design flexibility (additionality may need to be relaxed)

• Environmental stringency and scheme coverage

Other • Unlike agri PES, measure is related to maintenance or change of land use as a whole, therefore costs are more strongly aligned with

agricultural prices. As future agricultural prices (hence opportunity costs) are unknown, landowners are likely to expect high prices for

measures designed to be in perpetuity.


• Counter possibility that lowest cost sites are simply those with least environmental pressure through conscious prioritization and targetting


in England

Needs to be clearer understanding of where conservation measures additional to those already in place can be best aligned with water

management objectives

Table 28. Mechanism summary: Biodiversity offsets

Objectives Achieve ‘no net loss’ of biodiversity by allowing developers to compensate for biodiversity losses on other sites.

Appropriate scale Individual projects on parcels of land of tens to hundreds of hectares; may be in context of national scheme.

Benefits and synergies Obvious co-benefits of biodiversity and other ecosystem services.

Contextual factors Regulatory driver required for widespread adoption. New South Wales scheme emerged out of existing required assessments of ecological

impact.

Barriers to application in UK Biodiversity offsetting is under active consideration in UK. Metrics and methodologies need development to address concerns over reflecting

full complexity of habitats and special status of some conservation designations (HoC EAC, 2013).

Enablers • Regulatory framework for mandatory offsetting.

• Building awareness of auditing and validation responsibilities amongst local authorities

• Build on existing methodological work related to Environmental Liability Directive.

• Extension of biodiversity offsetting concept to allow: (i) net gain in biodiversity; (ii) offsetting of ‘water damage’, as with European Liability

Directive

• Establishment of robust definitions of functional equivalence

Risk management considerations USA experience shows clear risk that offsets may not be genuinely ecologically equivalent. Also risks of lower public access to offset sites.


interdependencies

Biodiversity offsetting Green Paper released for consultation in 2013 and offsetting pilots launched in 2011.

Some possible overlap with Environmental Liability Directive

Interactions with existing conservation designations

Trade-offs Simplicity vs. thoroughness of methodologies calculating ecological equivalence. More complex methodologies can increase administrative

cost and time to both regulator and participants; but simple methodologies can lead to perverse or sub-optimal outcomes.

Other No net loss of water habitat rather than ecosystem services such as water regulation or quality is primary focus. This raises two key concerns

for water management policy:

• two parcels of land of equivalent habitat may be viewed as interchangeable despite differences in ecosystem services provided

• loss and offsetting of other habitat types (especially woodland) can impact on water management, which is very unlikely to be taken into

account by the offsetting methodology.


Mechanism focus on new rather than existing impacts gives it limited scope.

• Awareness of concerns over monitoring and enforcement in US and Australian schemes, and improvement in any UK application


in England

Policy already under consideration in UK, pending results of offset pilots.

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