Credit Purchasing Potential Assessment – Debits

cascade-ADAS-sidebyside

The purpose of this work package was to bring together the findings from previous work, primarily WP3, to identify the potential for a PES scheme within the Milford Haven and Cleddau catchments. This section details the main actors within a PES scheme as well as the types of structure which are most likely to deliver a functioning PES scheme.

Successful PES schemes tend to have four principal groups involved; these are generally; buyers, sellers, brokers and knowledge providers. This section provides further detail on the roles of three of these groups (buyers, sellers and brokers) and how they might interact with a nutrient offsetting scheme in Pembrokeshire.

It has been assumed that for this scheme the knowledge providers are well known enough, and work closely together enough not to be further detailed here. The Ecosystems Enterprise Partnership and RAG, combined with wider stakeholder groups (e.g. Marine Energy Pembrokeshire, PLANED, PSAN), have sufficient knowledge and capability within the local area to undertake the role of knowledge provider, with support from others, without requiring further details to be outlined in this report.

Typically in PES schemes buyers are considered to be: “beneficiaries of ecosystem services, who are willing to pay for them to be safeguarded, enhanced or restored”[1].

Buyers tend to be broken down into three broad types:

  • ‘Primary buyers’ (buyers who benefit directly from, and pay directly for, improved ecosystem service)
  • ‘Secondary buyers’ (organisations that buy improved ecosystem service provision on behalf of sections of society e.g. water company)
  • Tertiary buyers’ (organisation that buy improved ecosystem services provision on behalf of society as a whole e.g. government via agri-environment schemes)

A review of potential buyers in Pembrokeshire identified the following organisations / sectors as the most likely to perform the buyer role:

Primary Buyers

  • Industry
  • Developers
  • Port of Milford Haven
  • Farmers
  • Ministry of Defence (MOD)
  • Highways Agency
  • Holiday Resorts
  • Recreational Groups

Secondary Buyers

  • Dwr Cymru Welsh Water
  • Pembrokeshire County Council / Pembrokeshire Coast National Park Authority

Tertiary Buyers

  • NRW
  • Welsh Government

 

Buyers in the Pembrokeshire Context

For a PES scheme to work there must be a clear demand for the service being sold and its provision must be financially valuable to the buyer(s).  Without a willing and able buyer, there is no prospect of a PES deal. Whilst the scheme must be financially valuable to the buyer(s) they must also be in a position to at least cover the costs incurred by the seller(s) in providing the service over the life of the agreement. Therefore typically from a buyer’s perspective, if the payments to secure a service are less than those associated with any alternative means of securing the desired service, the PES scheme would be beneficial.

In the context of Pembrokeshire the relationship between the buyer(s) and the ecosystem services, in the majority of cases, are different to a more typical scheme. The generally accepted definition of such a scheme is a ‘voluntary transaction where stakeholders enter into PES agreements on a voluntary basis’[2]. With the exception of water companies and perhaps recreational groups, the potential buyers identified above are not likely to be directly relying on improving water quality to continue with their business or activities.

As a result, instead of the buyer being a beneficiary of ecosystem services, who is willing to pay for it to be maintained, the buyer in this context would be paying for an ecosystem service to be improved that benefits wider society[3].

They would take on the role of buyers in the absence of an alternative because it has been mandated by the regulatory bodies, either through planning permissions or the permitting regime. For this reason it is unrealistic to expect the buyers to interact with the scheme voluntarily. In addition, as demonstrated by WP3, the level of nutrient loading originating with developers / industry / water companies, compared to farming, was so low that it would be difficult to see what the incentive would be for non-farming buyers to voluntarily join a scheme.

Lack of Buyers and the Impact on a PES Scheme in Pembrokeshire

Since the inception of this project, a major concern has centred on whether there are sufficient buyers available within the catchment to generate and sustain a PES scheme. Whilst the list in 2.1.1 is relatively extensive and includes a lot of potential buying ‘activities’ very few of these will impact on the nutrient load within the waterbodies.

There has always been a clear steer from the Ecosystem Enterprise Partnership that this research should focus on Nitrogen (in all forms) only. Consequently, an organisation could only be viewed as a buyer if they were responsible for increasing the N levels within the catchment. This would reduce the potential pool to development[4], new industry, changes to industrial processes or additional industrial processes, farming practices and very few others.

In addition, due to the characteristics of the catchment (low population levels, largely rural, highly developed industrial base but with little prospective increase in N loading) the likelihood of a significant enough buyer emerging that would support and drive a PES scheme appears to be relatively remote. As a result, buyers, or lack of them has been a major consideration when undertaking additional work around the type and structure of the ‘toolkit’ itself.

[1] Smith, S., et al. (2013). Payments for Ecosystem Services: A Best Practice Guide. Defra, London

[2] Smith, S., et al. (2013). Payments for Ecosystem Services: A Best Practice Guide. Defra, London

[3] The ultimate aim of the project is to ensure that the SAC (and SSSI sites) are not prevented from achieving favourable condition due to nutrient loading. As a result, the ultimate beneficiary of this is UKPLC because moving towards or achieving favourable status prevents the European Commission raising an infraction against the UK for not complying with community law. This could ultimately result in a financial penalty which would have to be paid for by wider society through the tax system.

[4] Water companies typically calculate that the average load into sewage treatment works is 1.21kg of N per population equivalent per year. This figure has been used, when calculating potential increases in load from development, based on Welsh Government and Local Authority projections.

Under a PES scheme sellers are generally identified as land, or other resource managers, who can secure or improve the level of an ecosystem service by maintaining good practice or amending other activities. Sellers within Pembrokeshire are predominantly drawn from the following industries and sectors:

  • farmers
  • agribusinesses
  • Dwr Cymru Welsh Water
  • Pembrokeshire County Council / Pembrokeshire Coast National Park Authority
  • Non-agricultural landowners (e.g. MOD, forestry businesses, National Trust)
  • environmental non-governmental organisations (eNGO)
  • shoreline owners and management authorities

Unlike the buyers side there does not appear to be a shortage of sellers. The water quality analysis undertaken in Work Package 3 showed the probable contribution to nutrient loading from agricultural sources. There are over 1000 agricultural holdings within the catchments and whilst it is clear not all would be interested this still provides us with a significant pool of sellers.

In addition, the contribution to reducing nutrient loading provided by other types of seller listed above should not be ignored. There are potentially sizeable land holdings under the management of these alternative sellers which could provide areas for relevant measures to be put in place without being subject to the issues usually encountered with farmers.

At a minimum, sellers are expected to comply with existing regulatory requirements (for example, farmers must keep their land in Good Agricultural and Environmental Condition (GAEC)). However, there is also a case to be made that in certain circumstances, where good environmental practices is the norm, payments would be focused on more far-reaching interventions with corresponding ecosystem service benefits.

The impact of the proposed interventions on sellers may vary. For example, some interventions may provide benefits to both buyers and sellers. Installing fencing to prevent livestock from entering watercourses, for example, may benefit both buyers (through enhanced water quality) and sellers (through reducing the loss of lambs or the incidence of foot disease in cattle). In these instances, a match-funding approach may be appropriate with sellers co-funding the intervention. In other cases, interventions may have a clear adverse effect on outputs from the land or resource and payments will need to cover the full costs to the seller. In some instances, cash payments might be accompanied by in-kind payments such as the provision of capacity building, advice on best practice or help with accessing government grants.

Nutrient Reduction Measures Available to Farmers

In a PES scheme the sellers are responsible for securing or improving the level of an ecosystem service by maintaining good practice or amending other activities. In order for the system to work effectively all sellers would be required to take up a range of measures from a standardised list. For the purposes of this work the measures that we would propose offering to farmers is the same ADAS list of measures that form part of the First Milk scheme.

The main reason for choosing these measures, and the N reduction they deliver, is that they are accepted by NRW, which removes the need to identify alternative measures and get them agreed. Consequently, we are confident that these measures will be capable of delivering significant reductions in N application, as well as leaching from catchment land contributing to a reduction in nutrient loading in the waterbodies over the next few years.

A list of potential measures, along with the projected N reduction and associated cost reductions is included in Appendix 5.

Potential Issues with Sellers in a PES Scheme

Though it appears clear that there is a sufficiently large pool of sellers this does not automatically mean a PES scheme would be successful. A scheme is only going to be attractive from a seller’s perspective if the payments received at least cover the value of any returns foregone as a result of implementing the agreed interventions. This can be especially difficult with changing agricultural prices and profits over long contract periods, as demonstrated by agri-environment schemes such as Glastir.

Under any PES scheme the role of the Broker or Brokers is crucial and schemes benefit from being coordinated by an independent, trusted broker, such as a local conservation trust, social enterprise or farm adviser. However, a body taking on the broker role needs to have both a technical understanding of the problems and solutions, an ability to manage large volumes of money, and already has or can build relationships with Buyers and Sellers as well as the scientific and regulatory community.

The evidence from the literature review clearly shows that a trusted local intermediary will be the most suitable body capable of mobilising and sustaining the required dialogue between stakeholders.  Indeed there are examples of pilot schemes that have struggled or underachieved because of the lack of an independent broker. However, stakeholders involved in a scheme must be careful not to assume that an organisation that appears to fit the requirements of a broker would be able to perform that role. For example, in the Fowey Project, the Fowey Harbour Commission was seen as an ideal broker given its perceived longevity in the area and well regarded technical knowledge however, the Commission was less sure as it considered itself to have limited environmental and land management expertise and little knowledge of parts of the catchment.

In the context of a scheme in Pembrokeshire it is envisaged that a broker or brokers would have to be capable of delivering the following activities:

  • liaising with buyers and sellers and stakeholders holding oversight functions such as RAG and Welsh Government
  • identifying baskets of potential measures that will deliver service provision;
  • aggregating multiple landowners / farmers to form a group of sellers capable of delivering joined up, landscape scale interventions;
  • assisting in determining prices, accessing grants, structuring agreements and agreeing a mutually acceptable payment regime;
  • scheme implementation and administration including; assisting landholders develop plans; application evaluations; payment of credits; maintaining sufficient load reduction if sellers withdraw; certification, and verification
  • handling disputes; and
  • enforcing the delivery of the land based measures.

The previous work packages have clearly demonstrated the need for some solution to the high levels of nutrient loading within the Milford Haven and Cleddau catchments. This section presents and outlines two potential scheme structures that would, based on the outputs from the previous Work Packages, provide the most likely chance of success in delivering improvements in water quality.

Two options are being presented here as they both have advantages and disadvantages and an understanding of each is important to help ensure that an informed choice on the most appropriate scheme can be made.

Nutrient Offsetting via an Ecobank

Nutrient offsets occur where a party seeking to undertake a development activity (a buyer), contracts another party (a seller) to undertake an activity or activities to reduce the amount of nutrient in the catchment equivalent to the additional pollution arising from the development plus an additional percentage so the nutrient load reduces rather than remains static.

In such a scheme an independent central body, i.e. the broker (under guidance from the RAG), would bring together buyers and sellers in order to set up and manage the trade of credits. Sellers would agree, in principle, with the broker the measures they would be happy to implement on their farm. The broker would then be able to calculate the likely benefit of each potential seller and have a ‘bank’ of credits waiting until a buyer entered the scheme.

Based on the findings of the literature review and discussions with the regulators in Pembrokeshire, it is suggested that regulation (either in the form of planning permission, Section 106[1] or permitting) would be the mechanism for involving the buyers. Once the buyer or buyers is known, the broker would be responsible for setting up the agreement, and managing the legal and financial elements. A visual representation of how a nutrient offset would work is shown in Figure 13.

ecobank diagram

Figure 13: Offsetting Scheme Structure

In order to achieve a sufficient reduction in nutrient loading it is suggested that the agreement with the seller is a contract that lasts 10 years (to bring this in line with most agri-environment schemes it would probably require the option of a 5 year break clause). As most buyers will be undertaking schemes with an asset life beyond that initial 10 years, the level of investment (i.e. the number of credits that need to be purchased) would reflect the nutrient increase over a longer period. Based on current Treasury rules this is likely to be 25 years, though 50 years might be more appropriate considering the length of time environmental improvements take to materialise.

It may be possible to include a break clause at 5 years for the sellers, however this would be strictly controlled by the broker. In order to maintain the nutrient reductions a pool of replacement sellers would need to exist with sufficient nutrient reduction measures to ensure no worsening of the nutrient load status as a result of one or multiple farms pulling out.

Advantages

This system utilises a market based approach to generate economically efficient outcomes.  A trade will occur when one party values polluting at a higher level than it costs another party to reduce it elsewhere.  These differences in values will result in a trade. This approach is generally considered to be a cheaper (for society) method of reducing pollution than through blanket regulation because pollution will be reduced by for those for whom it is cheapest to do so.

In addition, the cost of reducing the nutrients is borne by the private sector, not by public finances which are currently under so much pressure.  Setting up the system may be borne by a third party (private or public) but the cost of offsetting is faced by the private sector.  Therefore the polluter pays principle is adopted. Those causing additional pollution are required (where regulated) to pay for the right to do so.

This mechanism is also an effective way of preventing development projects, and therefore the local economy, being impeded by nutrient control activities, as long as there is no net impact (as an absolute minimum) in the catchment.

Disadvantages

Due to the contribution made by farming to the elevated nutrient loading in the catchments a PES scheme can be seen as essentially a vehicle for subsidising farmers who are producing the most pollutants. The benefit of a nutrient trading scheme is questionable when the majority of pollutants originate from farms.  It is also difficult to introduce and regulate an offset scheme to farmers, when they have been previously undertaking the same activities for free. These difficulties are typically why farmers are considered to be sellers, which contravenes the polluter pays principle.  Any reduction in farm pollution is determined by the scale of the buyers.

In order to achieve a sizeable reduction in nutrients in the catchment, sufficient buyers must exist to drive the market and these developments must be of sufficient size (therefore sufficiently large offsets) to make the administrative burden in setting up the scheme look attractive.  If only a small number of trades/offsets take place the costs of the scheme will not be worth the administrative requirements.

Voluntary offset regimes have been undertaken for biodiversity in the past with mixed success. Regulation and planning approval could compel any buyers to offset as a condition of development.  But in Pembrokeshire the vast majority of pollutants come from activities that are unregulated under the status quo and are unlikely to be regulated in the future.

Determining the levels of nutrient loading associated with developments, and the associated activity to offset these emissions is complicated.

Non-point pollution sources are difficult to measure and therefore determining the required actions to offset any development is difficult. Substantial modelling may be required to understand required activities for offsets.

Trading between nonpoint sources (farmers) is unlikely to be viable because no variability exists in the costs of reducing pollution (Cockerill and Hutchinson, 2007). Therefore not only are farmers difficult to regulate, or to engage on an offset scheme, they also may not present the economic fundamentals required for such a scheme.

[1] Section 106 of the Town and Country Planning Act 1990 (as amended)

A reverse auction is where the roles of buyer and sellers are reversed – the bidder is the seller and not the buyer. Each seller calculates the cost to them of implementing a specific scheme and tenders a bid accordingly. The budget allocated to an auction is typically provided by a public body and represents the amount of funding that interested parties will allocate to achieve a specific environmental target.

Once a budget is set and the management actions designed to deliver the benefits have been identified, the sellers construct bids which provide details of the compensation cost required in order to deliver specific land management measures. The payment or compensation required to carry out these changes will be dependent on the land characteristics, productivity of the landholder, the level of environmental awareness, income, size of landholding, etc. The lowest bid is not always the winner, as most bids are different and weighting originates from service the seller is proposing.

There are several varieties of auction – open bid and sealed bid. In an open-bid auction, information relating to the bids are shown in real time – this can be either the exact price, or a ranked position, while identities of bidders are hidden. In Sealed bid auctions, no information is available to any of the participants throughout the auction.

When all bids from Sellers have been received the bids are assessed according to cost efficiency. Usually relative weights are applied to individual benefit variables to reflect those benefits that are most highly valued. Management actions proposed in individual bids will be scored accordingly. Bids will then be ranked in terms of environmental benefit per unit of cost.

Contracts will be awarded to the Sellers who have submitted bids that offer most environmental benefit per unit cost, up to the point where the budget is exhausted. The Seller will then implement the management activities outlined in their bids, in return for the agreed payment.

Auctions can operate to meet a fixed target or fixed budget depending on circumstances. The former auction awards contracts to bidders who submit the most environmental benefit per unit cost up to the point where the environmental target has been reached. Conversely, the latter type will award contracts up to the point where the budget has been spent.

Both types have weaknesses namely the cost of meeting the target will be unknown when a fixed target needs to be met, whereas the total environmental benefit will be unknown in the when the scheme is constrained by a fixed budget.

Advantages of online reverse auctions are based on time and price. Where price is a priority, they provide opportunities to obtain better prices, as the auction process quickly lowers prices. Additionally, they are generally quicker than other types of procurement processes, where there are quicker reactions to changing markets. As such, the auction is efficient, both for the buyer and seller; Sellers can focus time on direct proposals, and buyers can quickly find new business and customers.

There are disadvantages for both the buyer and seller. The buyer will often be subjected to the additional associated with setting up a reverse auction – through registration, subscription and commission fees. Moreover, as sellers compete with others, their profit margins may be reduced as they are forced to lower prices[1].

Auctions can be preferred when benefits of investments can be estimated accurately without specific knowledge of each farm consequently this approach can reduce the cost element of engaging with a large number of farms as is required under a typical trading scheme.

 

Auction diagram_3

 

Figure 14: Potential Structure of a Reverse Auction

 

Participants

Participants would include farmers and land managers with management control over eligible farms and they would be able to apply for grants to deliver land-use change or for capital investments.

Funding

A fixed pot of money would be used to fund the auction(s). The funding does not need to originate with one organisation but typically with Reverse Auctions this is what ends up happening. The budget would be allocated to the sellers through a competitive bidding process in which farmers would enter bids for funding the N reduction activities.

Advantages

A reverse auction has the advantage of utilising competition between those seeking conservation contracts to reach an economically efficient outcome.  Those farmers who find it the cheapest to undertake pollution activities will more likely win the auction.

The key to the reverse auction approach is that it requires landholders to determine their own price for setting aside or improving their native vegetation. By having to decide how much they are willing to accept in a competitive setting (because other landholders are also bidding), the landholders must consider seriously the relative values of the land in both its current and future managed states.

The costs in compiling bids falls on those who are looking to secure the contract. This minimises the amount of on farm visits required for the auction administrator and therefore can bring down the overall administration costs associated with the scheme (it is acknowledged that this could also be a disadvantage and this is explored below). As a result, inverse auctions can deliver large cost-effectiveness gains.

In Australia for example, the inverse auction mechanism applied in the Tasmanian Forest Conservation Fund programme resulted in a 52% cost-effectiveness gain (compared to a first-come-first-served approach to allocating PES contracts). Likewise in the United States, a local PES programme in the Conestoga watershed found that the use of inverse auctions resulted in a seven-fold increase in the reduction of phosphorus runoff per dollar spent compared to a fixed price approach[2].

The market is driven by those who provide the funds and therefore not dependent on the numbers or scale of buyers. In addition, as it is a voluntary initiative it requires no new legislation.

The other benefit of this approach is the quasi-standalone nature of an auction. Essentially one could be held as frequently or infrequently as required, depending on the available buying fund. Other systems need more or less continuous throughput of buyers and sellers in order to maintain the process.

One other benefit of the auction system is that it reduces the advisor input with regards to farmer liaison and farm visits. This reduces costs and makes the processes more cost effective. However, when considering the significant problem of nutrient loading and the cost of putting a bid together there may be a case for the Broker being more involved than would typically be normal. This would allow the greatest level of benefits to be realised (it is more likely that the upper limit of 20kg/ha reduction rate would be achieved with input from a knowledgeable, independent broker than if the farmer was doing it themselves) for what is likely to be a relatively small cost. The evidence from the First Milk case study clearly shows the value of advisor interaction and it is recommended that at least during the first auction there is significant advisor input.

An outcome-based design would make the payment a farmer received conditional on the levels of improvement in water quality resulting from that farmer’s actions. Such a design would have the clear advantage of ensuring that the scheme only paid for verified improvements in water quality.

Finally, the Firstmilk case study has shown that NRW is confident that an output based system will deliver the required improvements and as a result it is recommended that an output system is chosen over an outcome one.

Disadvantages

Considerable effort is required to design and administer a reverse auction. Cockerill and Hutchinson, (2007) detail the extensive prior testing required for this type of auction including theoretical model of bidding behaviour, laboratory experiments, field experiments with real bidders and activities.

There is no guarantee that sellers will agree with the need for land management measures, or they may not want to implement them on their land. This could lead to inflation in the cost of delivery (i.e. if sellers don’t see the value in implementing the measure or cannot identify how it will increase profit or offset costs then the bid they submit is unlikely to be good value), or sellers may just not submit bids at all. Both these scenarios would severely limit the value for money of such an approach as well as the ability to reduce nutrient loading.

If it is a publically financed scheme, which has no guaranteed outcomes, i.e. a cap on nutrients is not set. Nevertheless, pilot schemes should help the implementing agency anticipate the scale of nutrient reduction and budget required.

Large transaction costs on the part of the bidders in estimating their bids add to administrative burden experienced by farmers.

Output based auction systems may result in funders paying sellers for actions that have the potential to deliver water quality improvements, without any guarantee that the level of improvement in water quality is sufficient. In addition, an auction allows a seller to bid for actions that they planned to do irrespective of whether the scheme existed or not. Such payments would not yield additional improvements in water quality but would transfer the cost for that activity from the seller to the funder / buyer.

All PES schemes whether output or outcome based tend to lack accurate and robust monitoring that allow the contributions of individual sellers / groups of sellers to be recorded via changes in water quality. In such a situation it becomes very difficult to identify whether measures are working effectively and if not why not. The long term viability of a scheme will depend on its ability to adapt, especially the ability to change emphasis if the original aims and objectives are not being met.

In addition, water pollution outcomes are highly variable depending not only on farmer actions but also on a variety of natural processes that are not always well understood. As a result, farmers would have only limited control over the levels of payments they might receive. A mechanism where payments are unpredictable is likely to discourage farmer participation.

Combining the Schemes

A third option might be to develop a hybrid scheme, selecting the best elements from nutrient trading and reverse auctions.    For example, once a publically financed scheme which auctions nutrient reduction contracts has been proved to be effective, new funding from more traditional ‘buyers’ could partially, or fully fund (dependent on the scale) this auction.

New developments that result in nutrient pollution could be required to buy (through a S106 agreement, a planning condition or via the permit system) credits to offset the additional discharges into the catchment. The funds resulting from the purchase of credits can go towards funding an auction.

Over time the burden of financing the periodic auctions could move from the public to the private sectors. This would not preclude organisations such as Welsh Government retaining an interest and providing funding it just removes the need for them to do it, as without them the scheme would fail.

[1] Kuo, C-C., White, R. E. & Rogers, P. (2003) A critical review of online reverse auctions. Available from: http://www.sbaer.uca.edu/research/swdsi/2003/Papers/091.pdf

[2] Selman, M., S. Greenhalgh, M. Taylor, and J. Guiling (2008), “Paying for environmental performance: potential cost savings using a reverse auction in program sign-up”, World Resources Institute, Policy Note No. 5, Washington DC.

The success of a PES scheme is predicated on there being four main actors; the buyers, the sellers, the broker and the knowledge providers. Analysis of the Milford Haven and Cleddau catchments shows there is a big enough pool of sellers to sustain a PES scheme whilst the EEP and RAG, as well as other groups can readily perform the role of knowledge provider.

The role of broker is more complicated and changes depending on the type of PES scheme chosen. There are a number of organisations within the area which could perform such a role, however initial discussions with these bodies has shown an initial reticence which is understandable as so many important points have yet to be decided. It appears likely however, that one or more organisations would be able to perform the role of a successful broker.

The buyer remains the one main element of a PES scheme that has not yet been satisfactorily resolved. Initially there appeared to be sufficient potential buyers, especially within the Port of Milford Haven and surrounding areas. However after analysing the available information further, it is clear that the number of buyers that would move from being a potential buyer to an actual buyer is very small.

Much of this is due to the focus on nitrate which prevents organisations that could join a scheme from doing so because there activities will not result in an increase to the nutrient load in the waterbodies. However, it is also because there simply isn’t sufficient activity within the catchments creating increased nutrient loading levels to stimulate and maintain a PES scheme.

As there is not obvious solution to this lack of buyers it is likely to inform the type of PES scheme ultimately proposed.