Implementing the water framework directive: Contract design and the cost of measures to reduce nitrogen pollution from agriculture

The performance of different policy design strategies is a key issue in evaluating programmes for water quality improvement under the Water Framework Directive (60/2000). This issue is emphasised by information asymmetries between regulator and agents. Using an economic model under asymmetric information, the aim of this paper is to compare the cost-effectiveness of selected methods of designing payments to farmers in order to reduce nitrogen pollution in agriculture. A principal-agent model is used, based on profit functions generated through farm-level linear programming. This allows a comparison of flat rate payments and a menu of contracts developed through mechanism design. The model is tested in an area of Emilia Romagna (Italy) in two policy contexts: Agenda 2000 and the 2003 Common Agricultural Policy (CAP) reform. The results show that different policy design options lead to differences in policy costs as great as 200-400%, with clear advantages for the menu of contracts. However, different policy scenarios may strongly affect such differences. Hence, the paper calls for greater attention to the interplay between CAP scenarios and water quality measures.