2.2　Modern Market-Based Incentive-Compatible Model for Optimal Allocation of Hydropower Resources

2.2.1　Selection of Modern Market-Based Model for Resources Allocation

Based on previous research findings[5],it can be identified that the stakeholders in sustainable utilization of hydropower resources fall in two categories.One is the owner of resources at macro level,i.e.the state;the other is the users of resources,including various groups or individuals.

The selection of effective resources allocation model relies heavily on the coordination of two groups of stakeholders.As what they pursue in resources allocation is quite different,in exploiting hydropower resources it should be taken into consideration the benefits of various types,micro or macro,regional or global,short-term or long-term in coordinated arrangement.In line with this,modern market-based allocation model with incentivecompatible institutional arrangement is adopted for sustainable utilization of hydropower resources.

Incentive compatibility unified the individual self-interest and group mutual benefits.The ideal market economy differentiated itself from other economic systems by its most prominent feature:effectiveness of information utilization and incentive compatibility of market(Tian Guoqiang,1993).But due to market deficiency,it is impossible to achieve incentive compatibility,nor high efficiency of resources allocation.Many countries developed their economy at the cost of natural resources destruction and natural environment degradation,including depletion of water resources and deterioration of water environment.A correctly operated(efficient)market is the most effective mechanism for a country to promote effective utilization of resources,reduce environmental degradation and stimulate sustainable development(Perkins,2005)[6].The key is to find an approach to build an incentive-compatible market.Institution,endowed with the function of meeting individual or group needs,is an incent mechanism to go after maximum benefits and economic efficiency.Modern market-based allocation model is intended to fully redress market failure by giving the essential role of market in resources allocation to its full play and provide an incentive-compatible mechanism for stakeholders through institutional arrangement.

There are two features of modern market-based allocation model.One is the incentive compatibility among stakeholders with the minimum operating friction coefficient and maximum economic efficiency.The other is its low operational cost,long operating life and sustainability.The modern market-based water resources allocation model is shown in Figure 2-1 below.

The model contains first of all the planning measures the government take to ensure the safety of water resources,a super economic public goods,that is to say,the government guarantees the basic water resources in the river basin.Then a two-way allocation is adopted in which the market mechanism is designed to ensure effective allocation of resources and government scheduling is used to overcome market failure caused by externality,natural monopoly and public goods.Effective institutional arrangement is also adopted to dissolve the market failure caused by intergenerational problems.In other words,the incentive-compatible allocation gives full play to the basic role of market in allocating resources,takes measures like planning,market mechanism,government scheduling and institutional arrangement to realize an incentive-compatible state of stakeholders in allocation of hydropower resources.

2.2.2　Institutional Arrangement for Modern Market-Oriented Resources Allocation

The role of institutions should be played to its full to ensure the efficiency of resources allocation.Institutions function to restrain individual acts and integrate them into a finite set;they also provide people with information to help overcome uncertainty.It can be seen that institutions can lower transaction costs.Water institutions,corresponding to the modern market-based hydropower resources allocation model,are intended to fully utilize the interactions between market mechanism and government scheduling to achieve multiple goals of allocation hydropower resources,including efficiency,sustainable development and equitable distribution,which required guarantee of institutional arrangement at multi levels.The institutional arrangement for modern market-based hydropower resources allocation is explained as follows.

(1)From a macro perspective,institutions should guarantee the supply of two public goods.One is the safety of hydropower resources ensured by integrated management and effective planning.Resources safety is related to sustainable economic and social development.It is not only an economic issue,but also a social and political issue.In other words,it is a super economic public goods.Market mechanism has the advantage of resolving economic efficiency at micro level,whereas for the supply of special public goods,government scheduling is more effective.The second is the ecological water for river basin.Establishing transparent ecological water right and compensation mechanism can contribute to the sustainable utilization of hydropower resources.

(2)From a medium perspective,institutional arrangement may reduce transaction cost by constructing stakeholder governance to eliminate asymmetric information.While market plays its basic role in resources allocation to full,government scheduling is implemented to correct market failure to improve allocation efficiency[7].However,decentralized decision-making in real sense does not exist for market mechanism or government scheduling due to the limited quantity of transactors.A lot of strategies exist between different governments,government and enterprises,and different enterprises.Stakeholder governance is a commensurate institutional arrangement to solve the problem of information asymmetry to ensure allocation efficiency.The integrated basin management and stakeholder governance establish punishment and information exchange mechanism,providing institutional guarantee to turn non-cooperative game to cooperative game.

(3)From a micro perspective,institutional arrangement resolves fairness and efficiency in resources allocation.Totally market-led allocation is very likely not accepted in the view of ethical and social values.The dual structure consisting of water right and water price is an institutional arrangement protecting vulnerable groups and industries for their water right and affordable water price.[8]

2.2.3　Incentive-Compatible Model for Allocation of Hydropower Resources

In market economy,profit-seeking of pure market conduct would cause enterprises'short-sighted behaviors of seeking only immediate interests and discarding ecological environment,resources conservation and sustainable development.Administrative measures and improvement mechanism are therefore required to restrain such behaviors.Incentivecompatible model can just manifest the constraints required.If state government is seen as principal,and local governments,enterprises,and other organizations are seen as agent,then a principal-agent model can be introduced.In this model,double moral hazards exist with particular focus on the agent side.Credit mechanism is therefore introduced in which the agent's performance(credit)in the previous period could affect the principle's expectation on its performance for next period.The principal allocates its resources according to the credit of the agent;the agent consequently should endeavor to keep its credit.The incentives that the principle usually takes may include reducing resource quota and raising resource price.

In the principal-agent model established for resources allocation,the principle is the central government or the government owning the management right of river basins,and the agent is the local government or enterprises exploiting water resources.For the principle of hydropower resources,the goals of hydropower resources allocation lie in two aspects.One is to sufficiently meet the water demand of all sectors and residents and maximizing overall economic benefits.The other is to minimize resources depletion and realize sustainable development.For the agent of hydropower resources,without the effective constraints from the principal,profit maximization is the only target of utilizing resources due to the profit-seeking conduct of Economic Man.The right of allocating resources and the authority of administrative penalties that the principle owns make the credit mechanism effective.The credit indicators for local government as agent may include rational allocation of hydropower resources,quality of domestic water supply,water pollution.The credit indicators for enterprises exploiting water resources as agent may include water pollution and pollution discharge.Based on the above analysis,the benefit/utility function model for principle-agent resources allocation is established below.Three main assumptions are firstly given:

Assumption1:The principle rationally allocates its hydropower resources for residential water consumption,agricultural water use,industrial water use,and eco-environmental water use.αi,i=1,2,…,n stands for level of efforts that the principle makes on producing the best possible economic results and saving and managing hydropower resources for various uses;α=(α1,α2,…,αn)is the vector of level of efforts.The agent knows its own level of efforts,but it cannot be directly observed by the principle who has to estimate it according to the results of efforts.x i stands for the estimated value of the agent's effort level made by the principle;x i=f(αi)+εi,εi～,x=(x1,x2,…,x n)is the estimated value of vector for effort level,of which x i stands for the quantitative indicator designed according to the target contracted with the principle,such as ratio of water deficiency,degree of contamination,and wastage rate.

Assumption 2:C(α)stands for the cost of balanced use of water the principle asks for,satisfying

The expectation that the principle has for the water use of the agent is the sustainable utilization of hydropower resources,and the benefit B(α)is the strictly convex function for each componentαi,meeting function of ,i=1,2,…,n.

Assumption 3:The principle is risk neutral,whereas the agent is risk averse and the risk aversion utility function isμ=-e-ρw,of which w stands for the real money income,that is,the degree of risk aversion.The principle comes up with incentives according to the estimated value of the agent's effort level,and the incentive cost is S(x).

With the above assumptions,the expected net income of the principle is the difference between the expected income of the principle and the incentive cost for the agent.Considering that the principle is risk neutral,its certainty equivalent net income E1 is the expected net income,expressed as:

E1=B(α)-E[S(x)]

The expected net income of the agent is the difference between the incentive income from the principal and the cost it pays for balanced water use;considering the agent is risk averse,its certainty equivalent net income E2 is expressed as:

Only when the agency contract meets the incentive compability can the agent be ensured to actively participate in managing and protecting hydropower resources for sustainable utilization.The principle-agent model for hydropower resources allocation is targeted at the maximization of the certainty equivalent net income of both on the premise of sustainable utilization.It is expressed as:

max

s.t.

stands for the retained earnings of the agent(minimum requirement).Participation constraint(or individual rationality,IR)means that the agent will protect and management hydropower resources as required by the principle only when its expected net income is no less than the retained earnings;IC means the incentive compatibility constraint for the mutual goal of the two parties(i.e.certainty equivalent).

It can be seen from the principle-agent model for hydropower resources allocation,the accuracy of designing and quantizing the variable of agent's effort level when the principle prepares the contract for water use will directly affect the incentives assigned to the agent.When analyzing the hydropower resources allocation of specific river basin in specific areas during specific period,one should select and design applicable functions to draw up a mathematical model which can effectively describe the objective reality.Then appropriate approaches and computer softwares are selected to analyze and solve the model.Lastly,rational hydropower resources allocation scheme should be proposed on the premise of the solution of the model.

While applying the principle-agent model to guide the hydropower resources allocation,the principle needs to establish a set of institutional system to normalize the principle-agent relation to strengthen restraint on the agent for managing and protecting hydropower resources.For instance,market measures,like emission permit trading,can be used to fix resource protect in economic operational mechanism;government administrative measures can be taken to strengthen the constraints.