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D1.02. Economic Value of Water

Economists and analysts use several methods for calculating the value of water for water projects and policies. However, there can be large differences between values when evaluating competing uses for water reallocation purposes. One of the techniques to assign monetary value to water in the absence of prices is shadow pricing. This Tool defines what “real economic value” means, discusses the role shadow pricing plays in the economic valuation, identifies major techniques for economic valuation of water, and discusses practical limitations of using shadow prices in relation to water.

Real Economic Value and Shadow Pricing

Prices are said to be a gross estimation of the value for traded goods and services. The market price doesn’t capture the “real” value of a product or service, however. For example, a kilowatt hour produced through burning coal or by a solar panel may be equivalent in terms of price, though it involves different social and environmental costs and, in that regard, would not hold for equal “values” depending on the way it was produced. Observed prices fail to reflect true economic values, taking into account government regulations that set prices for commodities, as well as taxes, subsidies and trade restrictions that create distortions in the market. In other cases, there may be no market price at all (UNDESA, 2012).

Economists use shadow pricing to assign a monetary value to the non-marketed or “abstract” goods and services, in hopes of better reflecting their total social, economic, and environmental costs and benefits (Tinch et al., 2019). In the absence of water markets or where these markets function poorly shadow pricing is used to estimate the economic value of water (UNDESA, 2012). This is often the case in agriculture where the water charge is below the marginal value product of water and shadow pricing is utilised to conduct different types of analysis (Diao & Roe, 2000; Bierkens et al., 2019). Shadow pricing method should reflect different economic values depending on when, where, and how water occurs (van der Zaag & Savenije, 2006).

Real Economic Valuation for Benefit-Cost Analysis

One of the most widely used economic techniques to evaluate projects or policy choices is Benefit-Cost Analysis (BCA) (Tool D1.01). This approach requires systematic enumeration of all the benefits and all the costs, tangible, or intangible, whether readily quantifiable or difficult to measure, that will accrue to all members of society if a particular project or policy is adopted (Stokey and Zeckhauser, 1978). Shadow prices are used for initiatives where the assignment of a dollar value doesn’t reflect the expected benefits associated to delivering a particular good or service. For example, a river bank cleanup programme involves costs that can be easily assigned to a dollar figure, though many of its benefits may not be so straightforwardly quantifiable money wise. In this case, analysts would assign a shadow price to positive externalities such as the improved health of the surrounding ecosystem and the higher wellbeing of local residents (Tools C4). Through shadow pricing, the economic analysis could then internalise the wider social and ecological impacts of the project (i.e. make them economically commensurable) which, in turn, would better inform decision-makers on the true “value” of the cleanup scheme.

When applying the BCA evaluation framework, there are two critical steps that must be undertaken:

1. Determine all impacts of the project or policy, favorable and unfavorable, present, and future.

2. A monetary value should be assigned to these impacts (benefits are favorable impacts; costs are unfavorable impacts).

For example, for a water infrastructure project (a piped water distribution system) or a water reallocation policy (capping groundwater withdraws for agriculture), the evaluator must determine positive and negative externalities to all members of society (and to the environment). Step two in the BCA framework would lead the evaluator to resort to shadow pricing valuation of those benefits and costs that are not already assigned to a monetary value. To bring this to conclusion, BCAs cannot be accurate without shadow pricing, as it would disregard externalities and merely focus on these marketed costs and benefits (ADB, 2017; EC, 2014).

Methods for Calculating the Real Economic Value

A variety of methods can be used to measure the real economic value of water (Möller Gulland et al., 2020; UNESCO, 2021). Most of those methods fall under the umbrella of three different economic valuation approaches, (1) revealed preference; (2) cost-based; and (3) stated preference.

“Revealed Preference Approaches” observe actual peoples’ behaviour in markets where water is relevant. This includes methods such as:

There are also “Cost-Based Approaches” that infer the value of water derived from costs incurred to mitigate damage, replace the service, or avoided costs if the services are well maintained (López-Morales & Mesa-Jurado, 2017):

Lastly, there are “Stated Preference Approach” methods which involves questioning stakeholders directly for their preferences when market transactions cannot be used as a basis to estimate the value of water.

There are several other cross-cutting methods which are not necessarily linked to one economic valuation approach in particular (UNESCO, 2021):



Challenges within Economic Valuation of Water

Despite a wide variety of methods available, economic evaluation of water remains a difficult task due to several reasons: