Cost-Effectiveness and Policy Design

A highly desirable characteristic of a policy is that it is cost-effective, i.e. that it achieves the policy objective at lower cost than other possible policies. This is especially important when there is pressure to reduce program budgets. A number of design features can improve the economic performance of environmental policies.

Targeting means directing conservation incentives (e.g., payments) to farms and fields where the application of appropriate conservation practices yields low cost environmental gains (e.g., improved water quality), contributing to cost-effective resolution of environmental problems. A long line of research (for example, Better Targeting, Better Outcomes, EB-2, March 2006) has found that certain land—defined in terms of resource characteristics (e.g., topography, soil type), farming practices, and geographic location—tends to contribute a disproportionate share of pollutants to the environment. For example, nitrogen runoff from farms in the Mississippi/Atchafalaya River Basin contributes to the formation of a large area where dissolved oxygen becomes too low for many aquatic species to survive (see Reducing Nutrient Losses From Cropland in the Mississippi/Atchafalaya River Basin: Cost Efficiency and Regional Distribution, ERR-258, September 2018). This "hypoxic zone" forms every summer along the coast of Louisiana and Texas. A cost-effective policy to reduce nitrogen flowing into the Gulf would direct incentives to farms where the adoption of better nutrient management or runoff reduction (e.g., stream-side buffer) practices would reduce nitrogen loads to the Gulf at the lowest possible cost.

Conservation policies commonly encourage the adoption of specific conservation practices on land in need of treatment. Various indicators can be used to identify such land, including physical characteristics of the field (slope, soil type), location (adjacent to a stream or over an aquifer), and production practices (for instance, conventional tillage, fall application of fertilizer, and presence of confined livestock or poultry). Research has demonstrated the economic benefits of targeting in conservation programs. The challenge is to identify indicators that are effective in helping pinpoint farm, field, and practice combinations that can most cost-effectively solve the environmental problem being addressed.

An alternative to direct targeting of conservation resources is to employ a performance-based policy (see Rewarding Farm Practices versus Environmental Performance, EB-5, March 2006). This type of policy provides incentives based on the amount of environmental performance achieved. The greater the level of performance, such as a reduction in nitrogen losses to water, the greater the incentive payment. The economic rewards are highest for cropland that produces the greatest environmental benefit at the lowest cost, bypassing the need for explicit targeting by the program agency. The incentive structure also spurs producers to find the set of practices that produces the greatest benefit at the lowest cost. Since fields vary greatly in their physical and agronomic characteristics, the practices farmers choose are likely to vary across fields. This flexibility, allowing farmers to decide for themselves how to provide environmental services, leverages farmers’ familiarity with their land to increase cost-effectiveness.

The downside of this approach is the need to measure the performance of conservation practices, which can be costly and require custom tools, such as field-scale modeling tools. Because of the need to model each candidate field in a conservation program, the management costs of implementing a performance-based approach are likely to be much higher than for a practice-based approach.

Nevertheless, performance-based approaches are starting to be employed in incentive programs for farmers. Water-quality trading programs are performance-based in that payments are based on the number of "credits" produced. Trading programs use field-scale modeling tools to estimate the credits that each management practice will generate. Farmers choose the most beneficial management measures, given the expected price of credits. Research in the Chesapeake Bay (see An Economic Assessment of Policy Options To Reduce Agricultural Pollutants in the Chesapeake Bay, ERR-166, June 2014) found that a performance-based approach could achieve water-quality goals at a much lower cost than alternative approaches that focused on specific practices, even with targeting.

An important issue related to the efficiency of both targeted and pay-for-performance policies is whether the gains in environmental quality are additional. Additionality occurs when a conservation payment causes a change in conservation practice use, agricultural input use, or land use that improves environmental quality in a way that would not have occurred without the payment (see Additionality in U.S. Agricultural Conservation and Regulatory Offset Programs, ERR-170, July 2014, and The Effect of Conservation Payments on Farmer Adoption Varies Across Conservation Practices, Amber Waves, May 2018). For example, if a producer intended to adopt a conservation practice because it made good business sense without the payment, a payment supporting adoption would not yield additional environmental gain. That is, support for conservation practices that are not additional depletes conservation program resources without increasing environmental gain beyond what would have been realized without the payment.

Another program design feature that can improve efficiency is to let farmers bid for contracts (see Options for Improving Conservation Programs: Insights from Auction Theory and Economic Experiments, Amber Waves, January 2015). Most programs (even trading programs) offer a set price for a particular practice or level of performance. Alternatively, farmers can simultaneously offer (or "competitively bid") a level of management (for a practice-based program) or performance (for a performance-based program) and also state their required compensation level. The managing agency then chooses among the bids to find the most efficient allocation, given its budget. Farmers who seek "excessive profit" from their offer risk being underbid by others. Accordingly, farmers have incentives to provide improvements at lowest possible cost, and to not bid much higher than this cost.

In the Conservation Reserve Program (General Signup) a landowner who wants to enroll can submit a bid to the local USDA field office during a specified enrollment period, indicating the land that would be enrolled, the proposed management practices, and a rental rate (i.e., compensation price). All submitted bids are ranked by USDA on the basis of their Environmental Benefits Index (EBI) score and their cost. Bids are accepted until the acreage goal (set by Congress), rather than a budget goal or performance objective, is met. Farmers can improve the chance of acceptance by offering to accept a rental rate below the maximum allowed for the parcel(s) offered or by proposing more environmentally robust management measures (such as planting trees rather than grass). Several studies have concluded that the bidding process has increased the CRP's cost-effectiveness.