John Ward, CSIRO Land and Water PERU

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Experimental testing of market based policy
solutions to groundwater recharge Linking the
ideal with the real

• John Ward, CSIRO Land and Water PERU
• John Tisdell2
• Stuart Whitten1
• 1CSIRO Sustainable Ecosystems
• 2Griffith University

2
Experimental economics Session outline

• NRM decision process
• Overview of experimental research
• Current and emerging applications of experimental
  methods
• Case studies Coleambally
• Laboratory and Field applications.

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NRM Policy Decision Support Process
Changing community values
New information
External Interrupts
Political pressures
Identify alternatives
Identify objectives
Beginning of Process
Filtering process to short list alternatives
Problem Definition
Recommendation Adopted
In depth analysis and evaluation
No
Satisfied with results
Yes
Draft recommendation
End of Process
Impact Assessment
Final Recommendation
From Hajkowicz, et al. (2000)
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Identify potential impediments to the development
of efficient recharge credit markets
Identify the problem
Determine the importance of impediments to the
catchment, and a range of potential solutions
Design
Identify and develop potential policy solutions
Use economic theory, experience and farming
community knowledge to develop and shortlist the
most significant impediments and rank the most
promising solutions
Test policy solution options
Testing
Community engagement farmer demonstrations
Scientific investigation using experiments
Field application of test results
Adoption
On-Ground recharge trial
Framework for wide scale application for salinity
reduction
Review of the trial results
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Actions, Targets, and Impacts
Test reliability
Policy??
Actions
Targets

• Biodiversity
• Wind erosion
• Recharge salinity
• Soil health

Impacts

• Vegetation management
• Habitat protection
• Revegetation of LNS
• Sustainable farming
• Alternative farming systems (inc. deep-rooted
  perennials)

• Environmental
• Economic
• Social

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Overview of Experimental Economic Research

• Why experiment with policy options?
• What makes an experimental study more than just
  another workshop?
• What type of things have experimental economists
  studied in the past?
• What are the bounds of experimental economics?
• Where is experimental economics going and what
  does it or can it contribute to natural resource
  management and policy design?

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Why experiment with policy options?

• The study of economics is moving from logical
  positivism and field observation to one of
  experimentation under controlled conditions.
• One of the problems with substantial
  institutional change is that modification and
  irreversibility makes the process slow, cautious
  and costly to society.
• Experimental economics yields a formal and
  replicable system for analyzing alternative
  policy options and associated institutional and
  market structures before they are actually
  implemented.

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What makes an experimental session different?

• Controlled Environment transparent benefits with
  credible threats
• Agents (people) are given endowments of
  resources (e.g. water, credits), information
  (e.g. regarding others endowments or
  preferences), technology (production functions),
  and preferences over outcomes.
• Institutions rules of engagement between the
  agents (e.g. message space or choice set), rules
  and enforcement.
• Induced value theory (payment incentives and
  penalties)
• creating the salient features of an economy in a
  laboratory consist of agents operating within
  institutions.
• Use of a proper reward mechanism allows an
  experimenter to induce pre-specified
  characteristics in the agents.
• Reward mechanism transparent and salient.
• Real people engaging under real rules for real
  stakes.

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What type of things have experimental economists
studied in the past?

• Market and auction structures.
• The problems associated with public goods and
  common pool resources.
• Individual and collective decision making.

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Market and auction structures

• Historical foundation of experimental methods
• Chamberlain (1961), Smith (1962)
• Trading institutions
• Tender systems
• Uniform price, discriminate price, first-price,
  second-price (Vickery), Dutch, English.
• Market systems
• Allocation of entitlements
• Closed (open and closed), posted offer, double
  auction
• Market efficiency and distributive justice,
  winners curse
• Impact of information asymmetry, market structure
  and power and factors influencing collusion.
• Complexity of information processing

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Prisoners dilemmas and public goods

• 2 person/n-person prisoners dilemma games
• Linkage to game theory and theorists.
• Voluntary contribution mechanisms in public good
  environments
• What improves coordination..
• Threshold points and provision points
• Experience, reputation, reciprocity and learning
• Information (symmetric v asymmetric)
• Communication, castigation and sanctions

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Individual and collective decision making

• Judgement
• Perceptions and memory biases
• Bayesian updating and representativeness
• Choices under risk and uncertainty
• Prospect theory- reference points, loss-aversion,
  risk attitudes, trust and ultimatum games.
• Generalisations of expected utility theory
• Altruism, pro-social behaviour and reciprocity
• Pro- social behaviour
• Variable sequence of choices
• Influenced by social norms and collective choice

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Bringing stakeholders along for the ride

• Given a well defined set of research questions
• Survey of key stakeholder attitudes and opinions
  eg water reform, salinity, environmental flow
  restoration, water pricing
• Purpose to ascertain what the stakeholders see
  as the salient issues to build into the
  experimental setting and refine research
  questions.
• Collect field economic data and biophysical
  models ( eg EMSS, SEDNET, Swagman, EB index,
  recharge accounting tools)
• Work with key stakeholders in the field
  (community decisions).
• Determine key treatments in the field and
  replicate in the lab.
• Deploy in the Field for demonstration, experience
  and adoption

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Current and emerging applications of experimental
economics

• Further advancement of economic theory testing
• Institutions which promote coordination and the
  development of social contracts to manage natural
  resource stocks- behavioural economics
• Testing Natural Resource Policy options
• Need to test, under controlled experimental
  conditions, natural resource policy options
• Applied, complex experimental testing of policy
  design and institutional engineering.

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Context how to construct the simulation?

• Rationale for the traditional experimental
  approach
• Clean test of theory
• Isolation of determinants
• Generalizability of theory, or domain specific?
• Replication and Extension of data range
• Cost-benefit concerns and Flexibility
• BUT
• Behaviour occurs in context-rich environments
• Behaviour may differ depending on who is playing
  - and with whom
• Limited information gt imputed information by the
  participants

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Context characteristics

• NOT desired when experiments are tests of general
  economic theory
• Desirable when experiments are tests of what
  economic agents do in the circumstances under
  investigation
• Policy tests
• Tests of applicability external validity

Abstract Pure theory
Reality
Variable Context
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Realism and Models

• To mimic reality or a formal model?
• Neither Friedman and Sunder
• Like fractals, reality has infinite detail
• Equally futile is to try and replicate a pure
  theory.
• Solution Design an experiment to answer the
  research question, given the demands and
  requirements for adoption.

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Testing tradeable recharge rights in the
Coleambally Irrigation Area

• The recharge problem
• too much water is being used in irrigation areas
  leading to crop loss from soil salinity and
  waterlogging
• But the shared groundwater resource means these
  costs are external to landowners and thus not
  fully included in land management decisions
• Desire by irrigators and CICL to find more
  flexible and cost-effective means to achieve
  recharge management goals as an alternative to
  regulation
• Excess recharge can be managed by a target
  recharge cap.
• Accrued cost savings by the gains from trade.

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Predicates of a cap and trade instrument

• There is credible and reliable science to
  establish a threshold level
• There are cost effective monitoring schemes in
  place that are transparent, consistent and
  credible to all participants.
• The nature (toxicity) of the pollutant is such
  that market exchange will not result in localised
  concentrations
• There is sufficient differentiation in
  individual abatement costs across the catchment.
• There are regulatory agencies with effective
  regional jurisdiction to monitor and enforce
  individual violations.
• There are sufficient numbers of participants to
  ensure cost effective exchange opportunities and
  satisfaction of trading requirements
• The transaction costs of monitoring, gathering
  information, enacting the exchange and
  enforcement are low in relation to the potential
  benefits gained
• There are adequate and effective administrative
  institutions to ensure a functional market and
• It is politically feasible to develop
  transferable, enforceable and tradeable private
  property rights, to minimise government
  intervention and allow flexibility of decision
  making.

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Simulating the catchment biophysical and
economic data
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Simulating the catchment biophysical and
economic data

• Experimental simulation comprises 12 players
• 12 heterogeneous farms farms in different
  landscape positions each with 5 management
  decisions
• Characterised by variable recharge rates, farm
  income and marginal values of recharge units.
• Net farm income is the sum of the farm decision
  income plus trading income (converted to player
  income).

Cap entitlement for farm 1 63 recharge units
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A laboratory environment managing expectations

• Animating the experimental environment
• Participants number, individual or group status
• Positions (sellers, buyers, enforcement)
  decision set
• Analogue of the catchment decision environment
  (choices)
• Player recruitment and assignment
• Number of Experimental sessions
• Player payments
• Instruction sets rules and authorised actions
  and quiz
• Communication and controlled interaction

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Recharge trading prediction 407 units _at_ 43
Gains from trade 17,501
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Experimental metrics Market price (Mp)
Recharge units traded (Ro) or recharge
reduction Aggregate income for farms 1-12
(Y)
Hypothesis 1 HA providing information on
individual recharge contributions will reduce
recharge levels Hypothesis 2 HA providing a
forum for group communication, will coordinate
information management decisions and lead to
reduced recharge levels Hypothesis 3 HA
providing a voluntary market mechanism to trade
recharge entitlements will reduce recharge and
result in gains from trade Hypothesis 4 HA
individual non-compliance penalties and a
market for recharge will lead to lower levels of
recharge
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Total recharge
a a ac d
cd e e
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Crop loss
a a b c c
d e
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Player income (farm and trading income)
a a b b c
d d
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Field trial Total Recharge
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Field trial crop loss
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Conclusions

• Information (recharge) is necessary but not
  sufficient for a cost effective solution to
  excess recharge
• Communication and a market work equally well to
  coordinate available information.
• Combining communication and the market proved the
  most effective in reducing recharge and players
  income.
• Converting a social cost to individual non
  compliance penalty (point source) did not reduce
  recharge or increase income compared to 3)
• The gains from trade are 1.38 of total income
  the transaction costs of establishing and
  administering a market must be accounted for.