Dualism from a Natural Resource Perspective: Water, , and in China 1

Fredrich Kahrl and David Roland­Holst 2

UC Berkeley

1. Introduction

China’s meteoric economic growth has led to improvements in living standards that defy even the most optimistic expectations held by its people a generation ago. However, these unprecedented gains have been accompanied by serious market failures in natural resource allocation, with implications that threaten the extent and sustainability of China’s new prosperity. Nowhere is this dilemma more apparent than in patterns of water use, where the momentum of growth is challenging China’s ability to develop, sustain, and allocate resources effectively. Rapid urbanization is a primary accelerator of water demand, while China’s still dominant rural sector retains its responsibility as the world’s largest food producer.

Because of competing resource needs, some observers fear a violent collision between these two essential sectors of the modern Chinese economy. Like the classical development debate over dualism and labor migration, this reflects concern that urban and rural water use are jointly constrained by factor endowments, locked in a fixed­sum growth game. China certainly faces major challenges in water allocation and use, but two arguments can be posed against the most pessimistic views. First, the experience of the and its aftermath demonstrated that productivity growth in agriculture can more than offset the effects of rural labor exodus. Second, much of China’s present day water and energy demand patterns have evolved without the disciplinary benefits of market forces. Under prevailing regulatory systems, scarcity and adverse external effects have little or no economic recognition on an incremental basis. Thus private agents fail to adapt until shortages or crises emerge.

For both these reasons, the scope for policy reform to resolve China’s sustainability dilemma is considerable. This will require a combination of market reforms and commitments to public investment and R&D, all of which are essential to improve individual and allocative efficiency. Interestingly, water and energy arise independently as part of China’s sustainability problem, yet the appropriate policy

1 This report is part of a series of research studies into alternative energy and resource pathways for the global economy. In addition to disseminating original research findings, these studies are intended to contribute to policy dialogue and public awareness about environment­economy linkages and sustainable growth. All opinions expressed here are those of the authors and should not be attributed to their affiliated institutions. Center for Energy, Resources, and Economic Sustainabilty, UC Berkeley. 2 Energy and Resources Group and Department of Agricultural and Resource Economics, respectively. responses will bring these two resources together as part of the solution. More sustainable water use, in both the rural and urban sectors, will require more energy­ intensive agriculture and water treatment. At the same time, agriculture holds considerable energy potential in biofuel development, including energy crops, , and green recycling.

In this paper, we survey current trends in rural and urban use of these two resources, with particular reference to their combined influence on China’s growth prospects. In doing so, we discuss not only the material context of resource stocks and allocation patterns, but also the institutional context that decisively influences resource use. Based on these observations we devise a set of water and energy reform scenarios and simulate the effects of these with a dynamic CGE model of the Chinese economy. The results of these simulations provide evidence about the scope for policy reform to achieve sustained high growth in both rural and urban China.

2. Water Scarcity in China

At 427 m 3, annual per capita water use in China is 50 percent lower than the global average, 3 yet the country’s water resources are already under significant stress. China’s annual water deficit is roughly 40 billion m 3 in normal years, about half of its cities are facing some degree of water shortage, and the decline in surface and resources has become an impediment to socio­economic development (NDRC, 2005).

Water scarcity in China is driven chiefly by three factors: a polarized spatial distribution of water supply and demand, which regionalizes supply constraints; deteriorating and low water productivity, which have reduced the country’s useable water supply and limited the effectiveness of what is used, respectively; and rapidly growing urban demand for water, which has given rise to inter­sectoral competition for water among agricultural, industrial, and residential users.

Regional Water Imbalances China’s water shortages have evolved in the context of the country’s skewed spatial distribution of water resources, arable land, and population and economic centers. Eighty­three percent of China’s water resources are located in provinces bordering or south of the Yangtze River (Map 1), whereas 41 percent of the country’s population, 56 percent of its cultivated land, and 42 percent of its GDP lie in provinces to its north (NBS, 2005).4 The four central municipalities and provinces in the North China

3 China data is from NBS (2005); global average is based on a 633 m3 / person•year estimate from UNEP (2004). 4 South of the Yangtze here includes the 17 provinces and municipalities that either border on or are south of the Yangtze. 11/13/2006 2 Plain, 5 China’s most water scarce region, have 12 percent of the country’s cultivated land and produce 17 percent of its agricultural output on 2 percent of its water resources (NBS, 2005) (Figure 1). Using a broader metric, per capita water resources south of the Yangtze River (2,643 m 3/perso n) are 3.5 times higher than those to its north (763 m 3/perso n) (NBS, 2005).

Figure 1: China’s Distribution of Water and Cultivated Land

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% South of the Yangtze North of the Yangtze Beijing, Tianjin, Hebei, River River Shandong

% China's Total Water Resources % China's Total Cultivated Land

Source: NBS (2005).

China’s northern region is part of a continental monsoon climate system that brings rain only for a short duration during the summer, meaning that most agriculture in northern China must be irrigated. Sixty­three percent of the cultivated land in the North China Plain, for instance, is irrigated (NBS, 2005). While rainfall is abundant south of the Yangtze River (Figure 2), irrigation is used extensively throughout China; the ratio of irrigated land to land dips below 40 percent only in poorer provinces and in the sub­tropical provinces of Guangxi, Guangdong, and Hainan (NBS, 2005). Throughout most of the country, growth in irrigated land has leveled off since the 1980s, with pockets of continued expansion; 43 percent of the growth in irrigated land in China from 1995 to 2004 occurred in the country’s Northeast (NBS, 2005).

5 Including Beijing, Tianjin, Hebei, and Shandong. 11/13/2006 3 Figure 1: Annual Rainfall in China, 1993­1997

Groundwater is the principle source of water for agricultural and municipal use in much of northern China because of its relative abundance in the Hai­Huai­Huang (Yellow) River basin region, which supplies much of the north’s water (Han, 2003). Agriculture in particular is a major user of groundwater in the North China Plain, with roughly 85 percent of total groundwater withdrawals in Hebei Province by agriculture (Xu et al., 2005). Overextraction of groundwater in northern China has led to aquifer depletion, ecosystem degradation, salinity intrusion, and a subsidence problem in several major cities (Han, 2003).6

Large­scale technical solutions to China’s regional water imbalances are underway. As China’s second largest hydraulic engineering project behind the Three Gorges Dam, the South­North Water Transfer Project (南水北调工程 | nanshui beidiao gongcheng) will seek to alleviate some of China’s regional water imbalances by diverting water from the Yangtze River to northern China. Initial transfers are scheduled to reach Shandong Province by 2007 and Beijing by 2010. By 2050 and at a projected cost of 500 billion yuan (US$62.5 billion), 7 the project is expected to transfer 44.8 billion m 3 annually, equal to the total utilization capacity of the Yellow River (Chen, 2005).

6 For instance, in 2004 the People’s Daily reported that 46 Chinese cities are beginning to sink as a result of subsidence related to groundwater overexploitation. “China to raise water prices to ease water shortage,” People’s Daily, March 26, 2004. 7 Using an exchange rate of 8 yuan = US$1. 11/13/2006 4 Table 1: Water Availability and Use in China’s 10 Main River Basins and River Groupings, 2004 River Basin Water Total Use Use­ (North/South) Availability (bnm 3 ) Availability (bnm 3) Ratio Songhua (N) 118.99 36.96 0.31 Liao (N) 41.90 18.90 0.45 Hai (N) 29.96 37.00 1.23 Huang (N) 62.80 37.21 0.59 Huai (N) 75.22 55.64 0.74 Northwest (N) 130.04 59.97 0.46 Yangtze (S) 873.46 181.54 0.21 Pearl (S) 351.29 86.23 0.25 Southeast (S) 132.38 31.63 0.24 Southwest (S) 596.93 9.69 0.02 National 2,412.96 554.78 0.23 Note: Southeast, Southwest, and Northwest include smaller river systems in those regions. Source: MoWR (2004).

Water scarcity in China is currently concentrated in the country’s north. The Hai River basin’s water resources reportedly exceeded sustainable yield in 2004, and use­ availability ratios in the country’s northern river basins are distinctly higher than in southern river basins (Table 1). 8 However, the confluence of urbanization­induced demand pressures, deteriorating water quality, and low water productivity have created inter­sectoral competition for water throughout China and turned water resources management into a key national policy issue.

Urbanization and Inter­sectoral Competition for Water In 1980, urban residents comprised 19 percent of China’s total population; by 2004 their share had risen to 42 percent (NBS, 2005). By 2020, various estimates project that China’s urban population will rise to roughly 55­60 percent of the country’s total population (Shen, 2000; Wang, 2004) (Figure 3). In absolute terms, these statistics imply that 350 million rural Chinese relocated to urban areas from 1980­2004, and that another 250 to 300 million rural residents will move to urban areas from 2004­ 2020.9

8 It is unclear whether ‘water availability’ is defined in the Ministry of Water’s accounting system to discount water made unusable through, for instance, contamination. 9 The latter numbers are based on a 2020 population estimate for China of 1.424 billion (UNECOSOC, 2005). 11/13/2006 5 Figure 3: Chinese Population Trends (millions)

1000

800

600

400

200

0

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Urban Population Rural Population Although some of the growth in China’s urban population may be a function of what constitutes ‘urban’ (Zhang and Zhao, 1998), residential water use in areas designated ‘urban’ across China’s river basins is 2.4­4.3 times higher than that in areas designated ‘rural’ (Figure 4). Over the past decade, water demand growth in urban areas in China has increased tremendously. The number of people in urban areas with access to tap water rose by 83.5 million between 1996 and 2004 (NBS, various years). 10 Supporting this expansion has required a 77 percent increase in the length of urban water supply pipelines, from 203,000 km to 358,000 km, over the same period (NBS, various years). In 1980 China’s pipeline stock was roughly 36,000 km (World Bank, 2006a).

Figure 4: Urban and Rural Residential Per Capita Water Consumption (L/person·day) in China’s River Basins

10 Data from 1995 are not available through NBS. 11/13/2006 6 350 300

n 250 o

s 200 r e

p 150 / L 100 50 0 t rl t e s o a i g st i a s z e u a n a e a t ia h H a e u e g w L g u w H P th n th n th u a r o H u o Y o S o S N S

Urban Residential Rural Residential

Source: MoWR (2004).

The rural­urban water divide does not adhere to a neat division into agricultural and residential and industrial uses; rural areas need water for residential and industrial use, and peri­urban areas need water for agriculture (Meinzen­Dick and Appasamy, 2002). In addition, extensive linkages exist among all three sectors. Growth in urban consumption driven by new residents creates complex multiplier effects for both rural and urban industrial and agricultural water use. Demand for housing induces demand for , which requires large volumes of water for cooling. The changing diet of new urban residents, and greater consumption of meat products in particular, creates new water demand for irrigation and .

Figure 5: Agricultural, Industrial, and Residential Water Use in China, 1980 and 2004

450 400 350 300 250 200 150 100 50 ­ Agriculture Industry Residential

1980 2004

Sources: 1980 percentage shares are from NDRC (2005); 1980 total water use of 443.7 billion m3 is from chinawater.net website (www.cws.net.cn); 2004 use data is from NBS (2005).

11/13/2006 7 Much of the potential for inter­sectoral competition and conflict over water in China during the past two decades was mitigated through a 25 percent expansion of the country’s water supply and a 6­fold increase in agricultural water productivity from 1980­2004.1 1 Thus, while agriculture’s total water use fell a modest 8 percent over this period, its share of water use fell dramatically, from 88 percent to 66 percent; shares of industrial and residential water use doubled and increased by a factor of 6, respectively (Figure 5). The World Bank (2001) projects that agriculture’s share of water use in China will be around 50 percent of the country’s total water use by 2050.

As in the case with scarcity, China’s national water use composition masks significant regional variation. Excluding the less industrialized southwest and the anomalous northwest river basins, Figure 6 illustrates the greater prominence of agriculture in northern river basins, and industry in southern river basins. Residential demand is more consistent across these basins, ranging from 9 (Songhua River basin) to 16 percent (Pearl River basin) of total use. Thus, while inter­sectoral competition for water exists throughout China, the nature of this competition — and strategies to mitigate it — vary by region.

Figure 6: Agricultural, Industrial, and Residential Water Use in China, 1980 and 2004

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

e t l i i a g t t r a o u n s tz as a ua H ia h es e g e e H L ua w w th P ng th th an u o H u r Y o S o o S S N

Agriculture Residential Industry Source: MoWR (2004).

11 Water supply data are from NBS (2005). Water productivity here is calculated as gross output divided by water input. Agricultural gross output for 1980 and 2004 is from NBS (2005). Sectoral water inputs for 1980 and 2004 are based on the sources in Figure 5. 11/13/2006 8 Continued urbanization will amplify inter­sectoral competition for water, even as urban growth induces higher water demand from all three sectors. Anticipating these pressures, the Chinese government has set a near­term goal of zero­growth in agricultural water consumption, micro­growth in industrial consumption, and a gradual decrease in total urban per capita water consumption during the 11 th Five­ Year Plan (2006­2010) (NDRC, 2005).

Figure 7 illustrates the challenges of balancing water allocation. Assuming that this zero­growth goal for agricultural water demand can be met and sustained over the medium term, and that water supply from 2004­2020 increases at the 1980­2004 average annual growth rate of 0.9 percent, growth in industrial water demand will determine how much remains for residential consumption. At historical rates of industrial water demand growth (4.3 percent), water available for per capita urban and rural residential will fall by 31 percent. Reducing industrial demand growth to 2 percent would increase the volume available for residential consumption by 45 percent (Figure 7).

Figure 7: Implications of Industrial Water Demand Growth on Per Capita Urban Water Consumption in China, 2004­2020 (L/person·day)

350 300 250 200 150 100 50 ­

4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

2% Annual Growth in Industrial Water Demand 3% Growth in Industrial Water Demand 4% Growth in Industrial Water Demand

Notes: The above assumes an annual average growth rate of 0.9 percent for water supply. Sectoral water use data are based on the sources in Figure 5. National urban­ rural per capita water use ratio is assumed to remain at 2004 levels of 3.12 (MoWR, 2004). 2020 population data are from UNECOSOC (2005).

Growth in water supply will more realistically be highly uneven across the country, even accounting for large­scale water diversion projects. In China’s northern region, dealing with inter­sectoral water conflicts will likely emerge as a top policy priority in the next two decades. Improving water quality and productivity will be important for preempting these conflicts.

11/13/2006 9 Water Quality and Water Productivity

Deteriorating water quality and the inefficient use of water greatly amplify China’s water supply constraints. Growing volumes of untreated industrial and residential wastewater, increasingly augmented by , , and runoff from the agricultural sector, have contributed to a steady decline in China’s water quality over the past twenty years. Outdated distribution and use equipment, particularly in agriculture, have contributed to historically low water use efficiency and water productivity.

Quality constraints on China’s water supply are dramatic, and are particularly severe where physical constraints are most severe. Roughly one­third of the water in China’s monitored rivers has limited or no usability because it does not meet minimum quality standards; in the north this number increases to 40­60 percent (World Bank, 2006a). Indeed, on major rivers water quality is uniformly worse in northern China — and particularly on the Hai and Huai Rivers — than in southern China (World Bank, 2006a). The World Bank estimates the cost of ­induced water scarcity to be 1­3 percent of local GDP in water scarce areas of China (World Bank, 2006b).

Water pollution control and treatment has improved significantly in China over the past decade. Industrial emissions, historically the largest concern in China, have largely come under control. By the end of 2004, 91 percent of industrial wastewater reportedly met national standards for discharge, a more than 50 percent reduction in untreated wastewater from 2000 (NBS, 2005). Industrial wastewater that remains untreated is relatively concentrated geographically; 45 percent of untreated water is discharged in the five provinces of Hubei, Hunan, Guangdong, Guangxi, and Sichuan (NBS, 2005). Advances in controlling industrial pollution have largely been the result of forced closings of smaller industrial facilities and requirements for larger facilities to install treatment equipment (World Bank, 2006a). Despite progress in reducing industrial pollution, increased residential wastewater and non­point agricultural pollution have offset many of these gains.

In 2000, the Ministry of Construction stipulated that 50 percent of the residential wastewater in towns and cities should be treated by 2010, with higher requirements in major cities. By 2005, China’s 661 cities had 708 treatment facilities with a combined capacity of 49.12 million m 3/da y, a more than doubling of 2000 capacity (MoC, 2005). Despite such large­scale increase, more than half of urban residential wastewater in China remains untreated, and 297 cities still have no treatment facilities (MoC, 2005). Figure 8 shows the unevenness of per capita capacity across Chinese provinces and municipalities.

11/13/2006 10 Figure 8: Provincial Per Capita Wastewater Treatment Capacity, 2004 (m3 /per son·day)

300,000

250,000

200,000

150,000

100,000

50,000

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i g g g g i u a n n a x x i x n u t n i i ia n a n n n ing x n ji o n n ji a u ing s h n g u g o x a e in e a ing h q o a n o g h a s a u n g g h d a il n ji ij n b b ji g a d ibe n n n n ina h J n a M n g iz a n e u u ian e e n ian h n ing T injian o ing e a u a a n u h r u A F T ic u J iao h ian B o H a il H S X N h e a Q H G H H S J G S Y G L Z h h e n u S S C H n G I

Source: Based on NBS (2005). Non­point agricultural pollution creates a separate challenge for Chinese regulators. While point source industrial and residential wastewater is amenable to capital­ intensive treatment solutions, non­point runoff from the agricultural sector requires either difficult load estimation schemes or fundamental changes to production techniques (Hanley et al., 1997). Although a large portion of the pollution in China’s rivers originates in runoff of nitrogen and organic materials from agricultural activities, China’s regulating agencies not yet have a coherent strategy to control agricultural water pollution (World Bank, 2006a).

Despite improvements, China’s water productivity remains low by international standards. At roughly 150 m 3/US$1, 000 value added, China’s industrial water productivity is one­fifth to one­tenth that of advanced levels in OECD countries (NDRC, 2005). Average water use per hectare in China (6,750 m 3/ ha) is lower than in the U.S. (7,556 m 3/h a), but conveyance losses and on­farm water efficiency (40­45 percent) are higher than in OECD countries. Particularly for agriculture, there is believed to be considerable potential for water saving through conservation and replacing outdated equipment (Hong et al., 2003). Across agricultural, industrial, and residential uses, conservation and technical efficiency are the two pillars of the government’s still evolving water strategy (NDRC, 2005).

With a relatively fixed supply of water and growing inter­sectoral competition for water, institutional incentives play a basic role in determining the extent to which overall and sectoral scarcity induces the policy innovation, conservation, and technology adoption that, in turn, eases allocation inefficiencies. Under China’s current water management regime, where prices do not fully, and in some cases remotely, reflect the marginal value of water, incentives work instead in favor of competition and conflict. As in labor markets, resolving the “dualism” problem in China’s water use hinges on questions of pricing, institutions, and productivity.

11/13/2006 11 3. Dualism in China’s Water Use

Dualism

In development economics, the theory of dualism examines rural­urban linkage across labor markets. The basic issue has to do with the extent to which a reserve of workers can be drawn from agriculture to emergent industry, without either reducing food output or retarding industrialization by driving up wages. Classical dualists, such as Lewis (1955) and Fei and Ranis (1964), argued that labor was in surplus in agriculture, with zero opportunity cost, and thus costless migration to urban areas could offer a perfectly elastic supply of labor for industrial development. By contrast, neoclassicists, such as Jorgenson (1961), asserted that rural labor was fully employed, thus migration would reduce rural output and escalate wages in the absence of technological change in agriculture (Figure 9).

Figure 9: Agricultural Production Possibilities with Respect to Labor

Lewis turning point Slope = real average wage in Tech change in Ag agriculture

Full employment Surplus labor A+ Ag employment Neo­classical Classical Dualism in Water Use in China

What can be said for labor is readily extensible to other dual­use natural resources, such as water and land. If water is in surplus in agriculture with marginal product close to zero, then water “migration” to industrial and domestic uses is essentially costless. Alternatively, if water is scarce in agriculture, without technological change that raises productivity water migration reduces farm yields and increases water prices for industry and municipal use. In China, as we have shown, the potential for both scenarios exists based on different regional water endowments. As regional water supplies are increasingly linked through inter­basin transfers, accelerating urbanization and urban industrial growth create competition for water sources both among sectors and between regions. In this sense, the traditional dualist emphasis on the agricultural side of the production system fails to capture the fundamental market disruption resulting from emergent urban demand. 11/13/2006 12 Figure 10: Rural and Urban Water Allocation under Administered Prices

Urban Water Demand Rural Demand WU=pwMPw WR=pwMPw

Surplus P Deficit

0 1 WU WR WU National Water Resources To account for both sources of factor (in this case water) demand, consider Figure 10, which depicts water demand for both urban and rural use, derived as the marginal revenue product from corresponding aggregate production functions. While the agricultural demand schedule has remained relatively stable, urban water use has been dramatically stimulated by a combination of industrial growth, migration, and higher water intensity of urban lifestyles (discussed in the previous section). These forces have intensified the aggregate demand for water and, in the absence of intervention, would to sharp price increases, and accompanying factor substitution or innovation to raise the marginal product of water in both sectors.

Under a system of administered water prices (e.g., P0), such as in China, the overall 0 1 economy moves from water surplus (WR – WU ) to water deficit (WR –WU ). To restore water use patterns to more sustainable trends, price adjustments are needed to promote efficiency and conservation. On the domestic and industrial use side, these slow the pace of water demand growth and thus water scarcity. On the agricultural use side, efficiency and conservation shift agriculture’s water demand schedule to the left, allowing the agricultural sector to sustain output while its share of water use steadily decreases. When resource prices do not take full account of present and future opportunity costs, private agents make choices that can reduce efficiency and induce welfare transfers, either contemporaneously or between generations. Unsustainable patterns of resource use are a classic result of such market failures, where agents follow patterns of resource use dictated by distorted cost/price signals. This problem often arises in administered price regimes, where resource costs are determined by relatively narrow policy priorities and may fail to incorporate fundamental information about present and future scarcity. China’s incipient transition away from administered prices is an explicit recognition of the need to incorporate scarcity values in the cost of water. 11/13/2006 13 4. Water Pricing and Institutional Reform

While price reform is the sine qua non of more efficient water allocation in China, price adjustments alone are insufficient for promoting a smoother redistribution of water from lower value agricultural to higher value industrial and residential uses. Institutional changes that better link use and price, and that equip water users with the ability to better respond to price signals, are a foundation for extensive water price reform in China. Central to these changes are more clearly defined rights to water.

Price Elasticity for Water in China

Water prices are widely recognized among Chinese policymakers to be too low, and significant price reform has been underway since 2003. Price reform fills the dual need, both in rural and urban areas, of encouraging conservation and efficient use and of allowing cost recovery in water infrastructure projects. A key assumption in implementing price reforms is that higher water prices will induce either less water­ intensive production techniques or adoption of technologies that lead to more efficient water use or an expansion of water supply. In China, these linkages are in many cases either deeply flawed or do not exist.

Demand for irrigation water in China is relatively price inelastic. From 1949 until the late 1970s, irrigation water was free, and was instead paid for through ’ labor inputs into water delivery infrastructure. Nominal tariffs were levied beginning in the late 1970s to help finance local water management after the dismantling of China’s commune system, but at only a fraction of the levels required to cover operations and maintenance expenses. Although prices for irrigation water have risen throughout China’s post­reform period, real prices from 1980­2000 remained largely unchanged (Lohmar et al., 2002).

Because of the small size of most farm plots in China — average farm holdings were roughly 0.13 hectares per household in 2003 (NBS, 2004) — fees for surface water are levied on a volumetric basis at the point of entry into irrigation districts, and then on an irrigated area basis for individual . In other words, farmers pay for water based on how much land they irrigate and not on how much water they actually use. Lohmar et al. (2002) find that this system creates a free rider problem and often encourages higher water use, particularly as irrigation districts get larger and more difficult to monitor. More surprisingly, many farmers do not know how much they pay for water, even though it is a substantial portion of their expenditures (Lohmar et al., 2002). As a result of this system, Hong et al. (2003) argue that, below a relatively high threshold, price increases do little to improve productivity and instead amount to a wealth transfer from farmers to the public sector.

Empirical evidence from areas in northern China that pricing groundwater volumetrically indicates that volumetric charging has increased on­farm water efficiency and has led to a shift toward higher value crops (Xiang and Huang, 2000 11/13/2006 14 c.f. Lohmar et al., 2002). The latter may not be entirely concordant with central government grain security policies, but does illustrate the principle that irrigated farming can be profitable at higher water prices (Zilberman and Schoengold, 2005). Although the transaction and agency costs of assessing volumetric fees for surface water use on individual farms are likely to be substantial, in some regions and increasingly over a larger geographic area they may be less expensive than the cost of water shortages. Additionally, any system of clearly defined and potentially transferable water rights in China must find ways of overcoming these costs. Experience elsewhere in the developing world has shown that the obstacles high transaction costs pose to markets for water diminish as scarcity increases (Schoengold and Zilberman, Forthcoming).

In urban areas in China, the relationship between prices and water use is similarly complex. Zhang and Brown’s (2004) analysis of water use in the municipalities of Beijing and Tianjin suggests that urban water use in these two cities is both income and price inelastic. This inelasticity is perhaps not surprising given that the bulk of domestic water use in China is for indoor use and that there is little deviation in household size. To the extent to which this situation reflects conditions in greater China, conservation awareness and appliance standards may have a greater effect on water use than price increases. Despite this, in water scarce Tianjin the city government has adjusted water prices seven times to encourage conservation, with the price of drinking water rising five fold, since 1999.1 2 Nation wide, the Ministry of Water Resources is instead designing an increasing block rate price schedule to preempt the emergence of heavy domestic water users. 13

Where domestic use prices have a more significant effect is in their relationship to water quality and wastewater treatment. Previous analysis has shown that urban residents are willing to pay significantly more for higher quality water (ADB, 2003). While this fact has likely figured into the Ministry of Water’s plans to raise wastewater treatment fees by a factor of eight in the near­term future,1 4 fee increases have met with public resistance in many areas and fee increases will likely require a more gradual process (Zhong and Chen, 2005). Increases in treatment fees should provide capital needed to finance and operate treatment facilities, many of which sit idle at the time of writing because cities lack the funds to run them. Because of uncertainties in the share and severity of other sources of pollution, the potential for greatly expanded wastewater treatment capacity to free up water supply is uncertain.

In contrast to agricultural and domestic users, industry in China has proven to be more responsive to water price increases. Government efforts to reduce industrial

12 Huang Shan, “Water Conservation Awareness Cultivated in Tianjin,” chinagate.com.cn, October 8, 2006. 13 “China to raise water prices to encourage conservation, efficiency,” Ministry of Water Resources website, December 12, 2006. 14 Supra note 12. 11/13/2006 15 water use led to a leveling off of urban water supply in the mid­1990s, despite continued increases in residential use (World Bank, 2006a) (Figure 11). Based on a survey of 1,000 industrial facilities in China, Hua and Lall (1999) estimate an average water price elasticity of ­1.0, suggesting considerable room for lowering water intensity in industry. For a variety of reasons, industrial users already pay significantly higher water prices than either domestic or agricultural users in China (Lohmar et al., 2002).

Figure 11: Urban Water Supply in China, 1978­2003

Sources: NBS (various years), c.f. World Bank (2006a).

Across agricultural, domestic, and industrial users, water tariffs are highly fragmented and reflect neither the scarcity value nor the opportunity cost of water. China’s relatively fixed water supply, coinciding with urbanization­led water demand growth across all sectors, will necessitate some degree of allocation. Without means to allocate water that reflect its marginal value elsewhere, inefficient use will lead to sectoral shortages or higher water prices, and will impede economic growth. As agriculture has often been given short shrift in de facto water allocation, a continuation of current allocation practices in the face of increasing scarcity will decrease agricultural output. Much of Chinese policymakers’ reticence to adjust rural water prices stems from uncertainty over the effects of market­oriented adjustments on rural incomes and on national grain security. However, the status quo will not necessarily support the central government’s rural development priorities; the effects of pricing reforms on grain production in China are similarly unclear. Comprehensive, detailed research to identify the potential scope for and distributional impacts of allocative reforms should form the informational basis for decision­making. Indeed, a major obstacle in clarifying rights to water, for instance, is the paucity of data on water use.

5. Modeling China’s Water Allocation Adjustment Process 11/13/2006 16 Generally, market reforms can achieve greater efficiency if they allow resource prices to respond more dynamically to changing supply and demand conditions. Having made the argument for efficiency, however, it must be acknowledged that many established resource policies have a strong legacy component — a set of defined stakeholders who have benefited from the policy and might be adversely affected by change. In addition to this group, others may be adversely affected by changing the status quo. Thus the political feasibility of reform then depends on policy makers’ ability to anticipate these adjustment needs. In a modern market oriented economy, however, price directed interactions are so complex that policy makers relying on intuition alone are unlikely to achieve anything approaching optimality. In response to this, a new generation of empirical general equilibrium models has emerged to elucidate these complex interactions and improve the foresight and ultimate effectiveness of policy.

In addition to tracing real patterns of demand, supply, and resource use, computable general equilibrium (CGE) models can track detailed income­expenditure linkages that help determine the ultimate welfare effects of resource and other policies that indirectly change patterns of economic activity. Using a detailed China CGE, we can better ascertain who benefits from more sustainable approaches to water use and whose adjustment needs can be anticipated.

To illustrate this methodology and for the sake of present discussion, we consider four indicative policy scenarios:

Table 2: Water Reform Scenarios for China

1. Baseline – This is a business­as­usual scenario that constitutes the dynamic reference trend for evaluating counterfactuals.

2. Economywide water use fees – Here we impose a uniform endogenous tax on water use, defined with respect to a fixed total use value derived from sustainability conditions.

3. Two­tier pricing – Agriculture is not taxed, but urban water users pay a surcharge to meet the aggregate use target of the last scenario.

4. Two­tier pricing with endogenous productivity growth – Using the same water tax regime as the last scenario, what level of water productivity growth would be needed to meet the sustainability targets without increasing taxes?

11/13/2006 17 6. Conclusions and Future Research

Water scarcity in China is defined by three overarching features: regional water imbalances; rapid urbanization and growing inter­sectoral competition for water; and deteriorating water quality and low water productivity. Regional supply imbalances and low quality and productivity amplify supply constraints, but not uniformly throughout the country. In the context of growing supply constraints, rapid urbanization and urban growth — inducing higher water demand for domestic, industrial, and agricultural use — to increased inter­sectoral competition for water.

The notion of ‘dualism,’ borrowed from development economics and labor market theory, provides a useful framework for considering rural­urban competition for water resources. Sharp growth in urban water demand leads to water “migration” from agriculture to higher value industrial and domestic uses, significantly raising water prices. Under a flexible price regime, price adjustments lead to conservation, efficiency, and substitution. Under a fixed price regime, sharp growth in urban water demand produces water deficits.

In China, where agriculture consumes 69 percent of the country’s water but produces 26 percent of its GDP (NBS, 2005), higher marginal values of water are often found in industrial and municipal use. Allocation pressures are already apparent in many areas of northern China. In most cases, water has been reallocated away from agriculture, and most of the country’s current shortages are in agriculture. In some cases, however, inefficient use of water by agricultural users has led to the closure of industrial facilities (Lohmar et al., 2002). The inability to make Pareto improving trades through transferring water rights has become a major barrier to more rational allocation policies.

Partial solutions to China’s water allocation problems, such as large­scale inter­basin transfers, cleaning up urban water supplies, and significantly expanding water treatment capacity, might postpone the need for more fundamental reform by increasing water supplies in the near to medium term. However, in water scarce northern China inter­sectoral competition for water has already locked the government in a dilemma. On the one hand, inter­sectoral competition for water will, on average, create water shortages for farmers. Water shortages in agriculture, in turn, lead farmers to switch to dryland crops, with potentially negative consequences for their incomes and running contrary to government policies. Alternatively, equalizing marginal water prices across agricultural, industrial, and domestic use through, for instance, a tradable permit scheme will doubtless have distributional consequences. Resolving this dilemma will require detailed research on the potential impacts of policy reform.

11/13/2006 18 7. References

Chen Ying. 2005. “Water Stress in China: Shortage and Pollution.” Presentation at CASS­Nottingham Environmental Infrastructure Workshop, 22 – 24 June. Crook, Frederick K. and Diao Xinshen. 2000. “Water Pressure in China: Growth Strains Resources.” Agricultural Outlook, Economic Research Service/USDA, January­February. Fei, John C. H. and Gustav Ranis. 1964. Development and the Labor Surplus of Economy: Theory and Policy. Homewood, Illinois: Richard D. Irwin, Inc. Hanley, Nick, Jason F. Shogren, and Ben White. 1997. Environmental Economics In Theory and Practice. New York: Oxford University Press. Han Zaisheng. 2003. “Groundwater resources protection and aquifer recovery in China.” Environmental Geology 44:106–111. Hong Yang, Zhang Xiaohe, and Alexander J.B. Zehnder. 2003. “Water scarcity, pricing mechanism and institutional reform in northern China irrigated agriculture.” Agricultural Water Management 61: 143–161. Jorgensen, Dale. 1961. “The development of a dual economy.” Economic Journal (71): 309−334 Lewis, W.A. 1955. The Theory of Economic Growth. Homewood, Illinois: Richard D. Irwin, Inc. Lohmar, Brian, Wang Jinxia, Scott Rozelle, Huang, Jikun, and David Dawe. 2002. “Investment, Conflicts and Incentives: The Role of Institutions and Policies in China’s Agricultural Water Management on the North China Plain.” Chinese Center for Agricultural Policy Working Paper 01­E7. Meinzen­Dick, Ruth S. and Paul P. Appasamy. 2002. “Urbanization and Intersectoral Competition for Water,” in Finding the Source: The Linkages between Population and Water. Washington DC: Woodrow Wilson International Center for Scholars. Ministry of Construction (MoC). 2005. “Ministry of Construction Report on China’s Urban Water Treatment Situation.” Document No. 149 [建设部关于全国城 市污水处理情况的通报] Ministry of Water Resources (MoWR). 2004. China Water Resources Report 2004. Beijing: MoWR. [2004 年中国水资源公报] National Bureau of Statistics (NBS). 1995­2005. China Statistical Yearbook. Beijing: China Statistics Press. National Development and Reform Commission (NDRC). 2005. “China Water Conservation Technology Policy Outline.” Announcement No. 17. [中国节水 技术政策大纲] Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat (UNECOSOC). 2005. World Population Prospects: The 2004 Revision. New York: United Nations. Shen Jianfa. 2000. “Chinese urbanization and urban policy,” in Lau C. M. and Shen Jianfa (eds.) China Review. Hong Kong: Chinese University Press. United Nations Environmental Programme (UNEP). 2004. Global Environmental Outlook 2003. Nairobi: UNEP.

11/13/2006 19 Wang Dayong. 2004. “Several Acute Issues in China’s Urban Planning.” Urban Planning Overseas 20(1). World Bank. 2001. China: Air, Land and Water – Environmental Priorities for a New Millennium. Washington, DC: World Bank. World Bank. 2006a. Water Quality Management: Policy and Institutional Considerations. Washington, DC: World Bank. World Bank. 2006b. Physical and Economic Burdens from Air and Water Pollution in China. Washington, DC: World Bank. Xu Yueqing, Mo Xingguo, Cai Yunlong, Li Xiubin. 2005. “Analysis on groundwater table drawdown by land use and the quest for sustainable water use in the Hebei Plain in China.” Agricultural Water Management 75(1): 38­53. Zhang, L. and Simon X.B. Zhao. 1998. “Re­examining China’s ‘Urban’ Concept and the Level of Urbanization.” The China Quarterly 154: 330­381.

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