Investment as an adaptation response to water scarcity

Investment as an adaptation response to water scarcity “Water in the Murray Darling Basin: Have we finally got it right” Workshop Brisbane 21-22 October 2010 Mallawaarachchi, McClintock, Adamson and Quiggin

Agriculture • Complex, dynamic production environment • Returns rarely known with certainty • Vary over time • Farmers strategies to managing risk/uncertainty • Poorly understood: irrational, slow adoptors, needing extension • Choice of investment and its timing • Greatest potential to affect business viability

Aim • Examine how farmer investment behaviour is influenced by uncertainty and risk • Explore insights from the use of Real Options and State Contingent approaches • Draw implications for public investment and formation of policy

Climate change & agriculture Many sources of uncertainty and complexity: Climate change outcomes for different regions Impacts on production and land and water over time, space and different farming enterprises Characteristics that make NPV and benefit-cost analysis problematic. Reliable data often absent – unknown

Water reform Early focus on: • Establishing markets and realising gains from trade; • Financial incentives for on-farm works for WUE • Address externalities such as rising water tables, soil salinisation and downstream water quality

Financial incentives to address externalities Became programs to achieve: Social – community resilience to change in future water supplies; and Environmental – securing water for environmental needs

Policy consequences • Financial incentives maybe not best tool for these goals, ie. • Sufficient private incentives; • Localised water savings = Basin level savings

Policy consequences cont’ • Potential bias towards farming systems that: • reduce flexibility; and • increase exposure to risk • Directing public funds into areas unlikely to achieve intended environmental and social goals • Moral hazard • Impede adjustment

Adaptation • Farmers’ response to risks: • Self-protection • mainly for private gains • Mitigation • mainly collective gains

Adaptation cont’ • Downside risk – increases cost of self-protection and mitigation. • Policy supporting adaptation: • Focus on reducing investment risk by enabling farming systems to gain flexibility. • Function under wider range of climatic conditions • Withstand more severe climatic shocks • Will involve various forms of investment over timeframes that vary according to individual context.

Realign policies Support efficient pathway for adaptation by minimising investment risk Institutional innovations (Jeff Connor) Policy reforms Property rights (Peter Gooday) Capacity sharing (Lin Crase) R&D – provide means to adapt uncertainty, investment risk hasten adaptation

Adaptation • Two options for self-protection and mitigation: • Cope in SR • Adjust in LR • These responses can be analysed as a set of stage contingent claims or as Real Options • Understanding how uncertainty influences decisions is important for good policy

Successful adaptation • Endowment • Government policy • Markets • Government policy has tended to support coping responses rather than adjustment. • This is likely to reduce resilience of the farming system to exogenous shocks of change Each play a role in determining successful adaptation

Real Options Risk management strategies: • Delay an investment to wait for more information about a project’s return • Temporarily suspend production

Risk management strategy: Delay an investment to wait for more information about a project’s return Value thru avoiding downside risk Achieved by tradeoff potential losses from waiting with profits forgone by delay. Eg. Investing in a water conserving technology Uncertainty from: the value of water savings, access/ availability of supplies (no water, technology is obsolete), price of inputs for new technology (eg energy, skilled labour)

Risk management strategy: • Temporarily suspend production when conditions are unfavourable: • Value thru potential to avoid losses Eg Growing annual crops : • can adjust in size and mix according to variability Eg Flood irrigation (good soils, good management): • low capital, so lower financial cost of suspending production • Gravity fed, so limited exposure to energy price hikes

State Contingent Approach • Identifiable states of nature • State-allocable inputs • State-contingent technologies • State-contingent outputs Dry Normal Wet Water (x) Production practices y = f (x,...) Cotton Wheat Rice

Building Resilience Value I I Ideal pathway R With Social investment R F Without Social investment 2004 2010 Time

The difficult issues

Towards agreement

Policy insights • Uncertainty is certain • Economies need to adjust, and they do. • Markets will fail, and they have always been so. • There are many sources of market friction • SS and DD will never match • Public policy need to induce innovation and not add to market distortions • Private and social interest will be in mismatch

Policy insights- moving forward • New policy role for governments • Promote innovation and collective social goods • Drop the market failure rationale for policy • Focus on market creation • Address externalities • Agriculture’s Gross Values are a source of distortion • Need to narrow the gap between private and social interest

Policy insights – Moving forward • Where uncertainty influences a decision to invest: • Financial incentives to induce adoption will need to be higher than indicated by traditional NPV, esp where some water savings are relinquished • Private interest in infrastructure program?? • Delayed adoption can be a legitimate risk management strategy – may be socially optimal too. • To allow resilience there needs to be a wider set of choices that can allow better use of all resources

State Aware Approach • Identifiable states of nature • State-allocable inputs • State-contingent technologies • State-contingent outputs R&D Dry Normal Wet R&D Water (x) Production practices y = f (x,...) R&D Institutions Human services Arts Literature

Investment as an adaptation response to water scarcity