Environmental Services Provided by Agriculture - the Setting of Environmental Targets and Reference Levels

Abstract
Policy discussions about agri-environmental measures focus on the efficiency implications of different approaches to the allocation of resources. This paper seeks to shed some light on the subject by adding the analysis of ‘reference levels' as distinguished from ‘environmental targets'.

Whereas targets relate to the economic criterion of an optimal allocation of resources, reference levels reflect the distribution of costs between farmers and society. A given environmental target is compatible with a multiplicity of reference levels, the choice of which leaves the efficiency of the final outcome unaffected, while resulting in different pattern of cost distribution.

Property rights based reference levels involve a distinction between the avoidance of negative environmental effects and provision of positive ones. In accordance with the polluter pays principle, avoiding negative environmental effects means farmers must comply with environmental requirements at their own costs, whereas farmers who engage privately owned factors of production in the provision of positive environmental services would receive remuneration for doing so.

1. The policy issue: environmental effects of agriculture
Environmental effects of agriculture have increasingly become a concern of environmental policies related to agriculture. On the one hand, intensification of agriculture can create problems not just in relation to landscape and biodiversity, but also for soil, water and air. On the other, the abandonment of land used for agricultural purposes, also due to economic reasons, creates pressure on landscape and biodiversity.

Since private optimisation of production does not systematically take into account such effects, the allocation of resources is not satisfactory from the viewpoint of society which has preferences not only for the supply of safe and healthy food but also for an integer environment. Achieving a desirable state of the environment requires policy measures which encourage positive environmental effects and minimise negative ones.

Technological developments and commercial considerations to maximise returns and reduce costs have given rise to a marked intensification of agriculture in the last decades. The common agricultural policy (CAP) played a role in contributing to the intensification of EU agriculture. Water pollution, erosion problems, and damage to bio-diversity provoked environmental policy measures constraining agricultural activities with a view to protect the environment.

Environmental policies relating to agriculture are often associated with policies constraining agriculture. However, during the last 15 years, awareness has grown that maintenance of the unique semi-natural environment of farmed landscapes with a rich variety of species is dependent on the continuation of well-adjusted forms of farming. The differentiated landscape and related biodiversity shaped by agriculture over several centuries is put at risk by developments in agriculture.

When the farmed landscape was created, the driving force was economic necessity and the response of farmers was the adoption of the best available agricultural technology. Thus stonewalls were needed to clear fields and to control stock. However, technology has moved on to the extent that imperatives are now completely different. No commercial farmer would today contemplate building a stonewall in place of a fence; the market for pollarded willow is no longer there. Instead the farmer who chooses economically efficient agricultural practice in 1998 finds that many traditional landscape features have to be sacrificed.

Thus stone or earth terraces may fall into disrepair, leading to erosion and even to loss of farming potential. Stonewalls are expensive to restore and their agricultural function is superseded by the electric fence. The living landscape, such as pollarded and coppiced trees, small and irregular fields, farm woodlands and hedgerows, a diverse mosaic of land uses, and traditional rotation patterns, including perennial ley and fallow, are also threatened by the commercial realities facing farming.

2. Joint provision of agricultural commodities and positive environmental effects
Where environmental benefits are no longer delivered automatically through traditional forms of land use, often well adjusted to the needs of certain areas, targeted agri-environmental measure are necessary with a view to ensure a satisfactory level of land-use-related environmental benefits. Many programmes exist in Member States to meet the costs of preserving the landscape and its cultural heritage under the Agri-environment Regulation. In the Less Favoured Areas, compensatory allowances are designed to encourage farmers to maintain, and not to abandon the countryside.

Such measures are targeted to agricultural activities, which gave rise to criticism, since it is believe that full de-coupling of payments from agricultural activities was the only acceptable way of public intervention. However, it is the agriculture activities, such as maintaining grazing systems, mowing, and ploughing, which create the environmental conditions required preserving certain species, to protect soils and to ensure the maintenance of the cultural values of landscapes. Therefore, the linking of agri-environmental measures to agricultural activities is the most efficient way to achieve the environmental effects wanted.

The economic implications of the joint provision of environmental services and agricultural production can be shown with the help of the figure 1. Let us assume a certain level of production, for instance of beef on pastures, which follows from an individual optimisation of production while being combined with a certain level of environmental benefits X ⁰> ₁ (landscape and nature values) at a certain point of time. Let us further assume a demand function D ^E> expressing society's preferences for environmental values.

In the original situation, agriculture creates considerable benefits for society (the shaded triangle under the demand function) as a by-product of profitable activities. With the supply function S ^E> ₁, the marginal costs of providing high nature values become positive only beyond X ⁰> ₁. However, the costs increase in X ⁰> ₁ remains irrelevant with the prior intersection of the demand function D ^E> with the x-axis. This indicates that society's demand for landscape and nature values is fully satisfied at zero additional costs.

Changing economic conditions in beef production - be it higher competitive pressure pushing the farmers towards more intensive production, or an unfavourable economic prospect suggesting to give up beef production in certain areas - could change this situation significantly. In both cases, the level of beef production generating favourable environmental conditions would be reduced.

Under these circumstances, already a level of environmental benefits going beyond X ⁰> ₂ is assumed to create positive marginal costs, as indicated by S ^E> ₂, the supply curve for high nature values generated by agriculture. The social optimum would be achieved where the supply function S ^E> ₂ has an intersection with the demand curve D ^E>. At this point, agricultural activities would generate the socially optimal level of environmental benefits X* ₂. It is clear that this level of environmental benefits would be provided by farmers only if the related per unit costs P ^E>* >were covered.

3. Achieving environmental objectives through agri-environmental measures
As shown in figure 1, paying for the provision of environmental services is a legitimate undertaking which increases social benefits since it contributes to achieving society's objectives related to the rural environment and landscapes. Such payments are established on a voluntary and contractual basis under agri-environmental programmes. Farmers receive an incentive to join programmes up to the marginal supplier. Under these circumstances, cost-efficiency of the measures is ensured.

The case for agri-environmental measures results basically from missing markets for public goods. With public goods, an optimal allocation of resources cannot be reached, unless allocation mechanisms are set in place which can handle the high degree of publicness of environmental goods. A high degree of publicness implies high exclusion costs and joint consumption. With these characteristics, the provision of such goods would normally fall victim to the "free rider problem" where people consume such goods without paying for their provision. The presence of these two characteristics suggests that collective action would be the appropriate allocation mechanism.

The externality problem - i.e. the lack of institutions which stipulate who may do what with respect to the environment - is another specific case, which is subject to agri-environmental policies. It has to be noted, however, that most agri-environmental issues result from the public goods problem and are to be solved in the presence of prior defined property rights.

Agri-environmental payments ensure the maintenance of agricultural practices, which are well-adjusted to the environmental requirements of certain areas. The purpose is, however, not to maintain production, although this is sometimes a side effect. Whereas this coupling of agri-environmental payments to production activities has been criticised sometimes for having distorting effects on agriculture markets it has to be emphasised that in the above-described case, the provision of environmental services is intrinsically linked to agricultural production methods. Therefore, de-coupling from agricultural production (in the meaning of production activity) is not even desirable from an ecological point of view. The idea of de-coupling would reasonably imply only „de-coupling from production output".

The most dominant side effects of agri-environmental measures on production would be anyway output reduction since agri-environmental conditions include most often a reduction in production intensity. However, even if the production was in some cases higher as compared to the alternative case of abandonment of land use, this is in no way a distortion of markets.

It is the logic of the EU agri-environmental measures is to pay farmers on a voluntary and contractual basis for the provision of agreed environmental services and not to encourage a higher output. The money is distributed to those who sign contracts and fulfil the pertaining conditions, which often means reduction of intensity and output. The premia granted under agri-environmental programmes are based on the calculation of income losses or costs incurred. That is, such payments do not reward additional production.

4. Efficient allocation of resources to agri-environmental services as public goods
Where markets do not function with respect to the supply of public goods, policies such as agri-environmental measures have a role to play. In order to ensure that agri-environmental policies increase welfare, it is necessary to base them on efficiency calculations. The efficiency considerations developed in figure 1, where the supply of environmental benefits S ^E> ₂ at the price of P ^E > ₂ stands for an efficient solution, can be taken as a point of departure.

The case of joint provision of environmental benefits and agricultural production indicates that the supply of environmental benefits at a price higher than zero represents a situation where different objectives compete for the use of scarce resources. This conclusion can be generalised beyond the above-described case where perceived positive environmental effects are delivered by private activities and therefore call for a remuneration of such services. The pursuit of environmental objectives refers generally to the problem of allocating scarce resources to competing objectives.

The more generalised solution to the allocation problem is depicted in figure 2. The upper part of Figure 2 shows the benefit functions resulting from two different objectives competing for the use of a scarce resource, let us assume land. From left to right, environmental benefits B ^E> are increasing, since more resources are devoted to increasing environmental quality. The maximum of environmental benefits is reached in X ^E>.

From right to left a more intensive productive use of land yields higher benefits from the farm activity B ^A> which – in an isolated optimisation of agriculture benefits – reach their maximum X ^E>.

It should be born in mind that the assumption made is not that high production intensity always results in environmental damages. However, by definition, an antagonistic relationship between the state of the environment and the intensity of land use can be stated for a specific range of land use options where the competition between production and environmental protection for the use of scarce land starts to be an issue.

Increasing environmental benefits do not come for free; their provision is accompanied by increasing opportunity costs OC ^A> due to reduced benefits resulting from a productive use of land. OC ^A> is derived from the difference between the actually achieved benefits from agricultural production B ^A> and the maximum level achievable at X ^A>. The socially optimal allocation of resources X* is reached when the sum of benefits from both types land use B ^A+E> reaches its maximum.

In the marginal view, as depicted in the lower part of figure 2, the optimal allocation of resources is reached where the marginal benefits from environmental quality MB ^E,> resulting as the first derivative of B ^E> equals the marginal opportunity costs MOC ^A>. The function of marginal opportunity costs MOC ^A> is established as the first derivative of B ^A>, the benefits from agricultural production.

Achieving the optimum of resource allocation, as established above, requires policy measures which reduce the level of agricultural resource use X ^A> resulting from an isolated optimisation by farmers down to the target level X*.

5. A property rights based approach to distributing costs
Whereas the above considerations help to establish efficiency criteria for achieving environmental targets, the question still open would be as to whether such targets should be achieved by imposing the costs on farmers or by offering them positive incentives.

Figure 2 indicates clearly that ensuring a certain environmental quality is equivalent to taking decisions on the use of scarce resources. This implies that answering the question of who has to bear the costs of providing a certain level of environmental quality is equivalent to answering the question of who receives the factor income of the resources utilised.

The latter question is normally answered by making reference to the prevailing property rights. Therefore, the identification of property rights provides the key to solving consistently the cost distribution problem.

It is common sense that those who can claim the property rights to certain resources or factors of production are entitled to receive the factor income from either forms of use, whether it is agricultural production or the provision of environmental services. The practical implications of this are explained in figure 3. It should be noted that the cases discussed in figure 3 do not differ with respect to the allocation achieved but only with respect to who will bear the costs of achieving it.

Let us assume an optimal allocation of resources X* >as derived from the previous considerations. As explained above, X* >represents a certain level of environmental quality and a corresponding level of agricultural production, here referred to as "production intensity".

Case A represents a situation where the achievement of the desired level of environmental quality X* >does not result in binding constraints for an individual optimisation of agricultural production. This situation corresponds to the one of S ^E> ₁ in figure 1. Under such circumstances, a satisfactory level of environmental quality is available without taking any policy actions.

The situation is different in case B where the status quo of agricultural land use X ^A> is much more intensive than what would correspond to the desired level of environmental quality X*. Optimisation of allocation then requires policy measures reducing the agricultural production intensity X ^A >down to the target level X*. Should - according to society's equity perception and legal traditions - the property rights in land use be defined at a level which excludes a production intensity higher than the level corresponding to X*, the costs of switching from X* to X ^E >falls on the farmer. In this case, the reference level X ^R>, indicating the farmer's right in land use, matches with the environmental target X*.

A favourable situation as regards the interest of the farmers is depicted in case C. Here the status quo of agricultural production X ^A> is acknowledged as being covered by property rights, i.e. the reference level X ^R> matches with X ^A>. Under these circumstances, the reallocation of resources from X ^A> to X* can be considered as an activity where the farmer withdraws privately owned factors of production and resources from agricultural production and devotes them, instead, to the provision of environmental quality. Of course, he would feel inclined to do so only if society was ready to pay him for such services, i.e. the costs of going from X ^A> to X* >are born by the public, whereas the factor income from resources devoted to achieving environmental objectives would accrue to the farmer.

Having regard to the practice of EU agri-environmental policies, the reality would be somewhere in between the cases B and C. In Case D, society expects the farmer to reduce intensity from X ^A> to X ^R >at his own costs, since his property rights in land use do not include high profit yielding intensities beyond the reference level X ^R>. However, where society's environmental ambitions go beyond the reference level X ^R >as the point beyond which constraining the farmer's activities would be an infringement of property rights in land, society would have to remunerate farmers for their provision of environmental services corresponding to X*.

Case D is in line with the practice of EU agri-environmental payments covering income losses and costs incurred of environmental services going beyond good agricultural practice. The understanding of "good agricultural practice" would be one where farmers apply the degree of environmental respect, a reasonable person would apply anyway, including the compliance with mandatory environmental legislation. The term of "good agricultural practice" matches with the concept of the reference level X ^R>.

6. Defining agri-environment measures with respect to "reference levels"
Reference levels as referred to in section 4 were an issue in the 1997 OECD conference in Helsinki dealing with environmental benefits from agriculture. Reference levels generally indicate a point on a scale of environmental commitments up to which environmental objectives would be pursued without compensating those who are forced to adapt their behaviour. However, the pursuit of environmental targets beyond the reference level would be seen as an infringement of property rights, which calls for covering the costs or income losses of those who provide such levels of environmental quality. The latter case is that of individuals providing environmental services by means of privately owned factors of production and resources.

Reference levels are distinct from environmental targets. The setting of environmental targets reflects society's preferences for a desired allocation of resources. The setting of reference level is equivalent to identifying and assigning property rights, which has distributional implications, while having no direct allocation implications. Whereas the setting of environmental targets relates to efficiency considerations, reference levels reflect the distribution of costs between farmers and society which is based on society's equity perceptions and legal traditions.

With a view to further clarify the relationship between "reference levels" and "environmental targets", the above considerations can be introduced into the context of an optimal policy set-up as developed in figure 2. Figure 4 shows the optimal allocation of resources X* with respect to both environmental quality and agricultural production. As postulated in figure 3, the achievement of X* is compatible with different reference levels.

In line with the principles of EU agri-environmental policies, figure 4 reproduces the scenario of case D in figure 3 with a view to reflecting the implications concerning allocation and income distribution resulting from a specific environmental target in combination with a specific reference level.

In the scenario assumed in figure 4, the private optimum of resource allocation to agricultural production is achieved in X ^A.> This allocation visibly differs from X*, the allocation which reflects both the benefits from agricultural production, and society's preferences for environmental services.

The reference level X ^R >is considered as the level of environmental care that society expects farmers to apply as "good agricultural practice" without receiving financial incentives. Any preservation or improvement of environmental quality beyond X ^R >would be seen as an agri-environmental service, delivered by means of privately owned factors of production and resources. Farmers would be ready to provide such services, if they received an adequate remuneration.

The individual sum of premia accruing to the single farmer is derived from multiplying the units of environmental services provided (e.g. number of hectares under management contracts) with the per unit premium p ^E>. The premium p ^E> is equivalent to the opportunity costs of providing environmental quality MOC ^A> minus the costs c ^A>, which have to be born by the farmers under the rules of good agricultural practice.

Under this setting, farmers would participate up to the marginal supplier of environmental services, for whom p ^A >matches exactly his individual costs. The infra-marginal providers receive a so-called ‘producer rent'. While being sometimes confused with over-compensation, producer rents are normal phenomena observable in any market, the existence of which is fully compatible with overall cost efficiency. In a dynamic view, producer rents are the motor of development, since they represent an individual incentive for switching to production functions which allow for achieving a higher efficiency in providing environmental quality.

The total costs resulting from the shift from X ^A> to X* is represented by the triangle ¹>> >under the farmers marginal cost function MOC ^A>. These are covered by premia payments at a total of P ^E>. Whether the net-payments accruing to the sector of a whole is positive or negative depends on whether the total of producer rents P ^A>/2 is bigger or smaller than that part of the costs which has to be born by farmers under the rules of good agricultural practice ²>>.

7. Implications of defining reference levels for the polluter pays principle Reference levels have been introduced as a concept distinct from environmental targets with a view to reflecting prevailing property rights. As discussed above, the setting of reference level determines the distribution of costs resulting from the provision of defined levels of environmental quality (to individuals or the public), while having no implications for the allocation of resources.

As referred to in figure 3, a multiplicity of possible reference levels is compatible with an economic optimum achieved by re-allocating resources from the initial assignment of property rights. Of course, the stream of revenues from using factors of production and resources for achieving environmental objectives would differ with a different pattern of initially assigned property rights, i.e. with different reference levels.

The great achievement of introducing the „reference level" into the debate is that this concept not only helps to clarify the distinction between efficiency and distribution implications of different policy set-ups but also to shed light into the discussion of the polluter pays principle.

In providing an operational criterion for distinguishing the provision of positive effects from the avoidance of negative ones, the concept of „reference level" helps to understand that the polluter pays principle has different implications depending on the prevailing property rights scheme and the resulting range between reference levels and environmental targets.

According to these criteria, one would speak of the „avoidance of negative environmental effects", where the compliance with environmental rules does not conflict with existing property rights and, therefore, would be required without any compensation. This is the case of achieving levels of environmental quality below the reference level, for which the polluter pays principle implies that the costs fall on the originator of environmentally negative effects.

Any achievement of environmental objectives being more ambitious than the reference level would be the case of "providing positive environmental effects", where environmental quality is provided on the basis of private property rights. In this case, a remuneration of those who provide the positive effect of environmental improvements by means of privately owned factors of production or resources would be necessary.

This is not in conflict with the Polluter Pays Principle. The Polluter Pays Principle does not require the imposition of costs on owners of resources or factors of production who make use of their property rights. It is the very meaning of property rights that owners claim the right in remuneration, should they cease to make a profitable use of their property and leave it to third parties for whatever purposes, including environmental ones.

It is sometimes said that the Polluter Pays Principle requires that with the appearance of new environmental requirements, the costs should automatically stay with those whose activities have a direct implication for the state of the environment. However, cost distribution is basically a question of prevailing property rights and there is no logical argument in favour of such an „expropriation by default". Everybody would agree that, where ensuring a certain level of environmental quality requires an input of labour and capital, this could not be imposed on individuals by force. However, where environmental objectives require land, taking away existing rights in land use is not less an expropriation, the acceptability of which is questionable.

The Polluter Pays Principle justifiably requires that the costs of avoiding or remedying environmental harm are born by the originator of such harm in cases, where the harmful activities are not based on entitlements under private property rights. As regards emerging environmental issues, policy makers are often in the position of defining and explicitly assigning property rights for the very first time. Whether the legislator should follow claims of "presumptive rights" expressed by current resource users or shift the property rights with the public would then be a question of society's equity perception and legal traditions. This decision would not affect the final allocation of resources, including the achievement of environmental targets. The allocation of resources has to be optimised in either case following the criteria developed under section 3.

Distinguishing the "provision of positive environmental effects" from the "avoidance of negative environmental effects" by means of the "reference level" follows consistently the direction of cost allocation and payments. With negative effects, the costs stay with the legally defined polluter, whereas positive effects call for a remuneration of those who provide such effects by means of privately owned factors of production and resources.

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The views expressed in this paper are those of the author and do not necessarily reflect the position of the European Commission Back to text.
¹> The total costs are calculated as (p ^E>+c ^A>).X*/2 Back to text1
²> The part of the costs falling on the farmer is calculated as C ^A>=c ^A>*.((X*-X ^R>)+X ^R>/2) Back to text2