Origin of the Problem
Farmland is a private good in Germany, owned and cultivated by roughly 374,000 agricultural businesses (Federal Ministry of Food 2010). Participating in a market economy, each of these businesses tries to maximise their profitability. Profitability in agriculture is mostly determined by the crop output per cultivated area (crop yield), which leads the market players to constantly seek out technology that increases productivity (Tongeren 2013). If the additional revenue from applying a certain technology exceeds its investment costs, farmers will adopt it. A central nutrient to increase crop productivity is Nitrogen, which is one of the core ingredients of fertilizer (Tongeren 2013). Organic fertilizers (such as liquid manure) are available at very low costs in Germany due to the extensive livestock population. If overall demand for liquid manure is low, livestock farmers will even give it away free of charge (Matheis 2014). This encourages farmers to apply large amounts of organic fertilizers to their farmland in order to guarantee a maximal crop yield. However, the practise only achieves minor productivity improvements as the relationship between nitrogen availability and crop productivity can be described as logarithmic: Productivity growth declines with increasing availability of Nitrogen (Leghari et al. 2016). Additionally, the practise causes substantial portions of fertilizer (and nitrogen) to spill over into the environment (Deutsche Welle 2018).
Looking at the situation from the perspective of classical economics, the described behaviour of agribusiness is to be expected, as it follows the idea of a rational, utility-maximising individuum. Moreover, it is expected to lead to a maximum of social welfare (Proost 2016). However, this is currently not the case . Society as a whole has to bear the significant costs that accompany the fertilisation practise exhibited by farmers. This is due to the fact that the large amounts of farmland fertilizer pollute groundwaters, lakes, and rivers with nitrate, a product that results from a chemical conversion of nitrogen. Nitrate damages these ecosystems and is, above a certain dose, even harmful to human health (European Commission 2019).
This is an example of negative externalities, or costs that come with a certain market behaviour, but are unaccounted for by the perpetrator. From an economic perspective, the situation poses a market distortion as the marginal private costs (MPC) of fertilizing are unequal to its marginal social costs (MSC). As shown in figure 1, market forces will in such a case find an equilibrium at a lower price and higher quantity (PPri, QPri) than they would when MPC equals MSC (PSoc, QSoc). In the given case, the result is that the price of fertilizer is too low and a too high volume of it is being used. Subsequently, a loss in social welfare (the green area in Figure 1) occurs.
The Nitrate Directive, which dates back to 1991, remains the primary legislation to restrict nitrate pollution in the EU. It imposes a threshold of 50 milligrams per litre in groundwater and surface freshwaters (European Council 1991). In July 2018, the European Commission took Germany to court for failing to comply with this regulation, putting the country’s government under legal as well as public pressure (Deutsche Welle 2018). In response, Germany revised its Fertiliser Application Ordinance (Düngeverordnung, DüV) and a new version came into effect in 2017 (Kuhn 2017; Federal Ministry of Food 2017). Its key regulation is a nitrate emission standard which fixes an application limit of 170kg Nitrogen per hectare per year. According to the DüV, this will translate into less than 50mg nitrate per litre, as requested by the EU’s Nitrate Directive (Kuhn 2017; Federal Ministry of Food 2017).
However, from an economic perspective, this approach might not lead to optimal results. As the government does not know the abatement cost functions for fertilizer of every single one of the 374,000 German agrobusinesses, it is unlikely that the nitrate emission reduction will happen in the most cost-efficient manner (Proost 2016). Some farmers will face very high abatement costs when taking measures to comply with the regulation. Other’s low-cost abatement potential might remain unused, as there is no economic incentive to reduce nitrate emission any further than the threshold (van der Weijde 2019). This raises questions about the suitability of the measure.
In this respect, an externality tax on nitrogen-based fertilizers could lead to the same overall reduction results while optimising the aggregated abatement costs. It would aim to internalise the marginal cost of damages (MD) into the polluter’s MPC in order to achieve parity with MSC. As shown in figure 1, market forces would then find a new equilibrium at a new quantity and price (PSoc, QSoc) and, by that, maximise social welfare. The tax would raise polluters’ marginal production costs. By trying to minimise their production costs, polluters would automatically minimize nitrate emissions as well. Because all polluters would be subject to the emission tax, those for which abatement costs are low would drastically diminish the use of nitrate, while those with high abatement costs might only undertake limited reduction efforts. The latter would pay the emission tax to the government, which could then use it to fund mitigation of nitrate’s detrimental effects. Consequently, the overall emission reduction would be similar to the one achieved through an emission standard, but at lower cumulated abatement costs.
However, there are several challenges to this approach. First and foremost, setting a tax level that correctly reflects the external costs of nitrogen use in agriculture is challenging. Some of the associated damages (such as the increased costs for water purification (Burack 2019)) might be simple to quantify, while others, such as the loss in biodiversity in water bodies, are not. Furthermore, a tax-based approach would disincentivise the use of fertilisers (and its benefits) altogether. This would decrease social welfare, although it would hardly impact the pollution problem, which is mainly caused by nitrogen overuse and subsequent spill-over.
To cope with these problems, it is recommended to introduce a more customized measure: A tax on nitrogen excesses only. On an individual level, the tax could be based on a businesses’ nitrogen balance. The balance would take into account how much nitrogen the farmer in question has used (in the form of fertilizer) and compare it to their nitrogen output (through sold crops and seeds). If a positive difference occurs, there is proof of nitrogen overuse (and, therefore, nitrate spill-over), and the business would be taxed. As a result, the tax would only disincentivise the overuse of fertilizers and its associated spill-over effects which are the reason for nitrate pollution of water bodies. Simultaneously, it would promote more efficient application techniques (Federolf et al. 2016), while allowing farmers to maintain a high crop productivity.
Joscha Müller is a Guest Writer for King’s Think Tank and studies M.Sc. Sustainable Energy Systems at the University of Edinburgh.
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