In the early 1990s, southwest China’s Baicai Village developed a novel experiment in community forestry—a joint stock forest plantation—to reverse the environmental impacts of deforestation and encourage reforestation. With the central government’s priority shift toward conservation in the late 1990s, Baicai’s allowed timber harvest fell nearly five fold, reducing both village incomes and funds and incentives for forest stewardship. Given that part of its plantation harbors the headwaters of the Xiaozhaizi River, through a payment mechanism downstream villages might be able to compensate Baicai for a portion of its forest management expenditures.

In greater China, the failure of regulatory policy to control watershed degradation and promote forestry prompted the central government to look to new approaches to restore, maintain, and enhance the hydrological benefits provided by riparian forests. Of the six forest large-scale forest conservation programs begun in the late 1990s, two involved payments to forest manag-ers for planting and sustaining trees and the notion that environmental service providers should be rewarded has been incorporated into China’s Water Law and Forest Law.

Though scattered provincial initiatives are beginning to take shape, payments for watershed services (PWS) in China are almost exclusively central government driven and financed. Provincial, prefecture, county, and township led PWS programs might help to reduce pressures on central government resources and better target payments to service providers, but there are currently real financial, technological, and human resource constraints on local governments’ ability to fund and administer PWS schemes.

This report explores the challenges to establishing PWS at a township and village level along the Xiaozhazi River. Although PWS may indeed have potential as a tool to promote improved forest management in China’s smaller basins like the Xiaozhaizi Watershed, in the Xiaozhaizi case PWS is not currently a feasible mechanism for linking watershed service providers with beneficiaries. Baicai was not included in a 2002 water purchase agreement between two downstream villages because of its lesser contribution to river flow, the inability and unwillingness of downstream villages to pay, and cross-jurisdictional coordination difficulties.

The Xiaozhaizi case offers three prominent lessons for PWS in China.

(1) Policy, regulatory, and administrative reforms may often be more effective than PWS in encouraging forestry investment. In Baicai, for instance, a loosening of its logging quota restrictions could do more to encourage conservation than potentially costly attempts to measure and value its hydrological contributions to the Xiaozhaizi River.

(2) Scale issues will play a pivotal role in China’s future PWS designs. Much like the hydrological benefits of forests, optimal institutional arrangements for PWS will be site-specific and involve a trade-off between administratively complex, expensive central government programs and the scarcity of local resources. In many regions like Xiaozhaizi, rural residents are only paying a fraction of the cost of water provision and ability to pay is the overriding constraint on PWS.

(3) Tenure and institutional arrangements will be key to the success of PWS schemes in contributing to rural incomes. In Baicai, collective management of its forest plantation would reduce costs and improve monitoring and enforcement under a hypothetical PWS mechanism. Small, often fragmented, individually managed plots, alternatively, raise administrative costs for PWS and can complicate service provision. Creating and cultivating intermediary institutions to aggregate these smaller plots will be a central challenge for PWS in China.