Climate and Water Quality Policy Design for Agriculture with Environmental Co-Benefits

Abstract

Many Agro-environmental practices, such as reduced fertilizer use or establishment of green set-asides, which are incentivised by policy instruments, may have simultaneous positive effects on multiple environmental goods. These environmental co-benefits increase the social desirability of a given policy instrument. In this paper we focus on water quality and GHG emissions and examine how climate and water quality policy instruments affect both their primary target emission and co-benefit emissions. We trace out especially the relative role of land use versus input use in emissions reduction. To facilitate this comparison, we define the socially optimal policy instruments when environmental co-benefits are either accounted for or omitted. Simulations for the Finnish agriculture show that if only water quality damage is internalised then the divergence from social optimum where both damages are internalised is not very large, while if only GHG emissions damage is internalised then the difference to the social optimum internalising both externalities is much larger. The optimal fertilizer tax rate is uniform (19%) when GHG emission damages are internalised but is differentiated when water quality damage or both externalities are internalised. The optimal fertilizer taxes vary from 19% to 58% and depend on soil type, soil quality and tillage method. Optimal tax on soil emissions vary from €15/ha in clay soils to €231/ha in organic soils. The analysis further demonstrates that land use has stronger effect on reducing water quality and GHG emission damages than changes in input use and thus extensive margin impact dominates intensive margin impact. Finally, policy-related transactions costs (PRTCs) affect the net tax revenue ranking of policy scenarios. Policy scenario focusing on water quality results in the highest net tax revenues, but consideration of PRTCs can change the net tax revenue ranking of policies as policies targeting water quality have relatively strong reduction in the net tax revenue due to the requirement to implement differentiated fertilizer tax that entails relatively high PRTCs.