The conservation of ecosystems is often seen as a cost to society rather than as an investment that sustains nature and human livelihoods. For example, natural forest and wetland ecosystems filter and purify water while absorbing rain and snow melt for gradual release. When these ecosystems become degraded, large investments in water treatment plants, dams, and flood control structures may be needed to replace these lost “ecosystem services.” Despite the economic value of these services ecosystem protection is chronically under-funded. By understanding the financial value of these services and investing in their conservation it may be possible to save money spent to replace lost services and to increase investments in sustainable forest management.

The hydrological services of forests, chiefly water quality and water flow, are among the most valuable of the many ecosystem services from forests. An ecosystem approach to watershed management seeks to achieve water management objectives by conserving forest and wetland habitats, creating buffer zones along rivers and streams, shifting away from farming and road-building on steep slopes, and avoiding agricultural chemical use in sensitive areas.

The scope for using financial incentives to encourage the conservation of forest watersheds is potentially huge for at least two reasons. First, the global market for water is immense and second, investments in sustainable watershed management may be substantially cheaper than investments in new water supply and treatment facilities. Reid (2001) estimates that the majority of the world’s population live downstream of forested watersheds and therefore are susceptible to the costs of watershed degradation. Further, about 13 percent of the world’s land area is needed to protect water supplies for the global population — an area that will grow with the population. By investing approximately $1 billion in land protection and conservation practices New York City hopes to avoid spending $4-6 billion on filtration and treatment plants (Echavarria and Lochman 1999). Elsewhere in the United States — Portland, Oregon; Portland, Maine; and Seattle, Washington — have found that every $1 invested in watershed protection can save anywhere from $7.50 to nearly $200 in costs for new filtration and water treatment facilities (Reid 1997). In South Africa removing thirsty alien tree species in Cape Town’s watershed and restoring native vegetation produces water at a fraction of the cost of water delivered through diversion or reservoir projects (Gelderblom and van Wilgen 2000).

Public sector agencies have traditionally made most investments in watershed management but that may be changing. Typically, funds for watershed management and protected areas (which are often justified in part based on their water benefits) come from government general revenues and are not based on the value of water that these areas provide. This approach has been effective in some places, but there are also serious limitations. One problem is that many governments have serious revenue shortfalls caused by ineffective tax systems or depressed economies. Burgeoning social welfare demands compete with public sector investments in protected areas and natural resources management, which have actually declined in many countries during the past decade. A related problem is that using general revenues may not be equitable since some people and businesses use much more water than others do. Also, the political leadership in many places has failed to develop and implement effective policies and institutions to sustain public benefits from forests. Meanwhile, there is growing recognition that traditional watershed management projects, which rely either on regulatory approaches or subsidies to encourage the adoption of soil conservation techniques on private lands, are not having the impact desired (Kaimowitz 2000). Watersheds continue to degrade and most water users around the world pay less than it costs to provide the service and often waste the resource, even where it is increasingly scarce.

Given these problems, investors and policy makers around the world are exploring alternative approaches to achieve watershed management goals and many governments are privatizing their downstream public water and hydroelectric utilities (Tognetti 2001, Trust for Public Land 1997). Governments and the private sector alike are looking for new, lower cost approaches to deliver high quality water. As a result, there is growing interest in ecosystem approaches to ensure water services and in how financial mechanisms can be used to improve the production of those services.

The purpose of this paper is to help forest owners, policymakers, and investors assess the feasibility of developing markets or other financial incentive mechanisms for watershed management and give them general guidance on developing new mechanisms. Our overall goal is to help forest owners add financial value to their forests based on the water-related benefits they provide, thus increasing their incentive to maintain healthy forests. This paper presents an overview of findings derived in large part from a global scoping of innovative cases of markets and financial incentive mechanisms prepared for Forest Trends by Perrot-Maître and Davis (2001). A table comparing elements in these cases is included at the end of this paper as Annex 1, and the case studies may be found on the Forest Trends’ Web site. http://www.forest-trends.org.

In this overview, we begin with a summary of the biophysical relationships that link forests, water, and people (Box 1). We then introduce the different types of financial mechanisms for watershed management, illustrate how they are currently being used in practice, and focus on a set of questions that can help guide the development of new mechanisms. From analyzing current mechanisms we derive preliminary lessons and rules of thumb for innovators. We conclude with recommendations for next steps in advancing the development of financial incentive mechanisms for watershed management.