The Design of Pricing Policies for the Management of Water Resources in Agriculture Under Adverse Selection

Water pricing policy for irrigated agriculture is considered as a key issue in the Water Framework Directive (WFD) implementation. The main obstacle is that a large part of the water used in agriculture is unmetered. The objective of this study is to assess the Water Authorities (WA)'s choices between different options of incentive pricing policies (IPP) and to evaluate their economic performance compared with flat rate (FR) solutions. The applied method relies on a principal-agent model under adverse selection, in which WAs are less informed than farmers about the water use costs and profits. In this respect, the paper provides a theoretical interpretation of how different information conditions, profit and cost structures contribute to affecting WAs' pricing strategies and their ability to deal with some of the WFD principles. The study shows that, in the absence of water metering, WAs can still set up incentive pricing strategies by formulating menus of contracts that are more efficient than flat rate payments. Also, we show that, at least for cases in which there is only a small differentiation in water costs among farmers or no transaction costs, the first-best solution (the solution that yields the highest return from the use of the resource) can also be optimal under asymmetric information. The main policy recommendation is that, in the absence of water metering, a wider set of incentive pricing options should be considered, the performance of which, however, should be evaluated based on the specificities of each irrigated region.