Are consumers willing to pay for environmental 
    Iain McGuffog


This article was originally published in The Business Economist vol. 36 no.1



The main responsibility for delivering improvements in quality of the UK river and coastal waters have fallen on the water companies since privatisation. The UK Environment Agency identifies sources of pollution from the water industry and requires capital investment, approved by the economic regulator Ofwat at a five yearly price review, to deliver improvements. Most of the visible and obvious sources of pollution directly caused by the Water industry have been removed over the past 15 years. More difficult decisions in the future have to be made on water quality improvements that will consider the cost and benefits of a proposed requirement. This is particularly true under the EU driven Water Framework Directive (WFD), which requires all water courses to maintain 'good ecological status', which not only requires a view on sustainability but includes derogations where the costs of a solution can be shown to significantly outweigh the benefits.

Whilst this is a study that has applied specifically to the UK water industry, the 'polluter pays' and 'precautionary' principles that environmental regulators and campaigners promote also affect other sectors. Therefore being able to understand how these principles are turned into economic values is likely to be of increasing significance as the concepts of sustainability and Corporate Social Responsibility achieve universal importance.

Background and theory

In order to accept a calculation of the costs and benefits from choosing a particular level of pollution, we have to accept that a socially optimal level of pollution can be established. As Coase (1960) established, this requires the existence of property rights; the right to use a resource. Pollution can be seen as using the resource of a clean environment with its' cost being the impact this has on habitats, the diversity of species etc. The government (usually through the appointment of a regulator with a remit) has the role to ensure that the equilibrium of socially optimal pollution is reached, whether property rights sit with the polluter or with those who suffer from the pollution. This requires clarity of who has the property rights before the regulator can do this.

When there is no optimal level of pollution because cause and effect of pollution with property rights cannot be established, or where the existing level of pollution is clearly far in excess of where an optimal level could be (due to absence of information, market failure or transactional costs in excess of any potential solution), then standards are likely to be the best way of achieving the desired environmental impact. For instance in the UK water environment, several European Directives have been the main source driving environmental improvements in the recent past; the banning of sewage sludge disposal at sea and the Bathing Waters Directives being examples.

However there is a risk with standards that due to information shortfalls the regulator sets a standard at a level that encourages the amount of pollution to be higher than it otherwise would be. An example of this would be where changing technology would in any case have resulted in reduced pollution as a side-benefit from normal market forces.

The key advantage of using standards is that the focus on achieving a specific level of pollution is outcome rather than input focused. In measuring the costs and benefits of achieving an optimum level of pollution, for instance through the use of environmental taxation, the focus is more on inputs and expectations of what will happen as a result rather than enforcing a level of standards to be met.

The Water Framework Directive concentrates on the management of habitats on a catchment basis rather than setting standards that apply across the board. This is further down the route of outcome management, but still arguably requires an assessment of what outcome is at the optimal level of pollution. The alternative to setting an optimal level of pollution would be to insist on relative standards through a requirement to show no environmental deterioration or through targets (a 10% reduction in measured pollution over the next 3 years, for instance).
Similar objectives at a national level have been set through CO2 emission targets and the Climate Change Levy mixture of taxation, efficiency incentives to large energy users and subsidies to renewable energy producers. However this is to meet a global pollution objective. The application of this type of policy framework is more complicated for the more localised water environment.

In applying a 'polluter pays' principle, valuation of benefits is used to answer the question of 'how much' is a reasonable amount to pay. This takes for granted that there is some optimal level of pollution and that property rights to pollute exist at this level. An alternative to this would be to apply a 'precautionary' principle, whereby pollution should be avoided through emission limits based on visible or likely harm, rather than allowing a level of pollution that matches up costs and benefits.

WTP and WTA compensation

Traditionally there are two main ways that a monetary valuation is placed on an optimal level of pollution. Willingness to Pay (WTP) establishes a welfare value equivalent to purchasing a good and therefore requires a preference between a monetary value and a particular level of pollution. This inherently accepts therefore a prioritisation in favour of the highest welfare outcome for the least cost (whoever that cost falls on, whether it be taxpayer or polluter profits). The individual consumer favours a reduction in pollution until the optimal level of pollution is reached.

The alternative to this concept is the Willingness to Accept Compensation (WTA) from the polluter. In theory this should have the same value as the WTP which most studies have measured. Those studies that have compared both have largely found a higher WTA than a WTP, probably due to WTA implying property rights with the sufferer of pollution rather than the polluter.


Diagram 1

Diagram 1 establishes a situation where the optimal level of pollution is reached at point Q*. Above Q* the cost of achieving that level of environmental quality is above WTP or WTA for it. This is effectively a comparison between the marginal cost and the marginal benefit from moving from one level of pollution to another.

The way that WTP has been applied in practice can be seen in the UK water industry. The Environment Agency identified potential water improvements that could be improved through changing the activities of a water company, for instance by providing for a higher level of treatment at a sewage works than previously required. Where there is a statutory requirement to enact the improvement, no assessment of the costs and benefits is carried out. For other optional schemes, a Benefit Assessment Guidance process was developed by the EA. This was largely based on an assessment of benefits that could be transferred based on a review of previous WTP studies. The benefits of the improvements were largely assessed on a national basis and then applied pro rata to individual local schemes. This has the advantage of being a relatively simple and easily applied approach to comparing the costs of benefits. In effect it provides for a simple hurdle cost rate that varies with the perceived benefit from the scheme and the population that are seen to benefit from it. The benefits valued not only include amenity from use or enjoyment of a water body but also non-use or heritage values from the knowledge that the sustained environmental quality will be available in the future. However this approach to WTP also has particular disadvantages:

- Use and non-use values could not be adequately split from the WTP studies.
- The studies themselves produced wide ranges of WTP estimates for a similar quality improvement
- Population circles and average population density numbers were used even for coastal and rural areas (in other words a coastal scheme would include benefits for people who apparently lived out at sea!)
- No mechanism for reflecting 'polluter pays' and the impact of diffuse pollution existed. In effect the benefit transfer process reflected a 'consumer pays' principle given that the studies asked water consumers what they were willing to pay through an increase in bills.
- Disbenefits from the proposed improvement (eg from increased power consumption) were not directly considered.

Some of the difficulties with WTP studies can be seen from a brief review of some of the research used in the EA BAG approach.

Georgiou et al (2000) derived positive willingness to pay from contingent valuations from 'protecting the environment', 'for the sake of children/future generations' and 'for wildlife'. However 54% of the local people interviewed in the study of the River Tame used in the study had never actually visited it. The survey itself was based around a more general urban regeneration scheme for the area and therefore the transferability of benefits to more general environmental issues is questionable.

ERM (1997) established a willingness to pay from a study involving three rivers, including the River Tavy in the South West. However only 1/3rd of those surveyed had any WTP and only 50% of those who did were definite about it. More interestingly, the study also suggested that those surveyed did not recognise the environmental problem described as impacting their own local river. This highlights the risk that contingent valuation studies can overestimate a WTP when compared to a real economic transaction. The study also found that the WTP would be extremely low if a levy was simply attached to water service bills. This suggests that the method of payment and environmental improvement results in a significant difference in WTP even for the same environmental improvement. In other words, it matters who pays, and how.

EFTEC (2002) took a valuation approach based on a cost through water charges compared to a 1% smaller risk in stomach upsets through improving the quality of coastal bathing waters. The study also included valuations through reducing sewage-related litter, although the valuation appears to include other beach litter including dog mess. The study also suggested that people were more concerned with having accurate water quality notices rather than being willing to fund reducing the risk of occasional failures in water quality. This again emphasises that the basis of the study needs to be reflected in how it is transferred in making cost benefit assessments of particular schemes. Around 30% of the people surveyed in this study expressed a zero willingness to pay. Around 50% of these expressed a negative willingness to pay as they made statements such as "too much has been spent already". Those who were seen as a making a protest about the level of water charges were excluded from the overall WTP the study identified, on the grounds that they must gain some utility from the improvement claimed. We show later why such an opinion from the survey is logical from an economic perspective and therefore why excluding such individual opinions results in a significant over-estimate of the WTP.

The assumption of economic rational behaviour towards utility gains from environmental improvements is a key assumption in environmental economics. This assumption requires consumers to value one unit of utility gained at the same amount of one unit of utility lost or forgone. However prospect theory and research into individual approaches to risk contradicts this view. Kahneman & Tversky (1979) set out that it is logical to be risk averse for gains whilst being risk seeking for losses. This inconsistency between choices is that people are willing to take a chance of avoiding a loss altogether and accepting a risk of a much larger loss rather than take the certainty of a relatively smaller loss. The sociology of this economic decision is that people are in general more sensitive to negative rather than positive stimuli. In a choice on environmental quality between the large chance of a small environmental gain but with a small chance of a large loss and no change in status, the preference will be for no change in status. This suggests that marginal environmental improvements that have a small chance of a negative counter effect (either through odour from works, higher energy use or bills) should have an inferior utility valuation to simpler schemes that manage the environment to maintain the current level of environmental quality (assuming that this is stable). This would support the emphasis in the Water Framework Directive of maintaining good ecological status rather than seeking specific environmental goals and social utility gains as has often been used to justify water quality schemes in the past.

Tversky & Kohler (1994) found "that probability judgements are linked not to events but to the descriptions of the events… the judged probability of an event depends on the explicitness of its description". This highlights an important shortcoming in contingent valuation studies in assessing consumers' attitude to environmental risk. Tversky also found evidence for what is described as 'ambiguity aversion'; people prefer known to unknown risks. If an environmental problem as described is not one that reflects their own experience this will affect the validity of the value that they put on the environmental gain. As we have shown earlier, the WTP studies frequently found a large non-use existence value based on a description of environmental damage that did not reflect their own environmental experience. The valuation they gave therefore reflects the value to them of their own environment worsening to that described rather than being a benefit that can be applied to their own environment of a marginal change in environmental quality from its current status. Choice experiments that provide people with information may result in an exaggerated WTP. Choices can also be logical even though they do not appear to be rational. It is instinctive to human survival for known risks to be accepted more than unknown ones. For instance, cars are more dangerous than plane transport for the same journey. However, we use cars every day and understand how they work so accept the day to day risk. Most people travel by planes on an irregular basis and therefore fear the risk more. This attitude to risk can also be applied to decisions on environmental quality. Similar use of prospect theory to this was suggested by Pearce (2002) in a report for the Environment Agency, although the EA do not appear to have taken the logic into account in their application of WTP studies.

A recent working paper (Langford et al, 1998) suggested that public perceptions of health risks from polluted coastal bathing waters varied using cultural theory, where consumers are categorised as hierarchists, egalitarians, fatalists or individualists. Evidence was found that hierarchists and egalitarians reduced their WTP established through a contingent valuation study when told that the improvement would be funded through higher water bills. Fatalists and individualists, by their cultural nature, would not logically value a WTP that included non-use values, although they did not reduce their WTP based on water bills rather than taxation as to them these were considered equally as bad methods.

Diagram 2

As we identified before, the WTP of consumers will be affected by the standards that are imposed in general even before an individual choice is made. A no deterioration requirement, for instance, may result in a kink in the WTP line for a particular level of environmental improvement as shown in Diagram 2. This is because a level of stranded asset investment would be required to maintain a particular level of pollution. This result could not have been achieved through taxation as this standard would be set because the optimal level of pollution is unknown. If all costs were fixed for the current level of pollution and the real optimal level of pollution was below the standard then the result would be sub-optimal overall.

In the water environment we should also consider that some causes of pollution are more measurable and controllable than others. For instance, climate change that affects the flow of water in the river will have an ecological impact separate from the affects of abstraction and discharge into the river. Agricultural run off is also a significant cause of water environment damage. Whilst current policy is focused on the effect of water company activity where the regulation of the industry means that sufficient data is kept so that the impact can be assessed, there is not a similar requirement of agriculture to control nutrient run off from fields. This means that there is a certain level of pollution beyond which a policy that focused solely on pollution from one sector would fail to produce meaningful costs and benefits (as the WTP for solving pollution from that single source may already be exceeded). This may still result in an optimal level of pollution, but at a cost higher than would otherwise be obtained if the taxation/subsidies could be used on the agricultural pollution rather than the cost of meeting standards being imposed on the water industry.

Diagram 3

In Diagram 3 Qa represents the environmental quality that would exist from agricultural and diffuse pollution even with zero pollution from other sources. MB1 represents the increased marginal benefit if agriculture could be controlled through the same mechanism as other sources of pollution. Q1 represents the real socially optimal level of pollution with the triangle to the left of Q1 towards Q* being the extra cost imposed on the other sources of pollution as a result.
As mentioned earlier, if Q1 is reached then there is still an optimal level of pollution. However the measurement of the overall Willingness to Pay may be affected by one source of pollution contributing more to the Marginal Environmental Cost than would otherwise be the case.

Developing a risk based approach

To maintain a water body at a good ecological status requires a balance between deciding on the quality of point sources of pollutant discharge (such as from industry and sewage treatment works) and managing the amount of diffuse pollution (such as from agriculture). In general, tackling a point source of pollution will result in both a discrete one-off cost and on-going step change in marginal costs after that. Tackling diffuse pollution will in general involve an increasing marginal cost for each element of improvement (for instance by restricting the amount of fertilizers that farmers apply). Therefore point sources of pollution by their nature face investment in sunk costs if required to deliver an improvement, as shown in Diagram 4. If there is uncertainty about the source, ecological status or benefits from the improvement then it could be socially better to tackle diffuse pollution first rather than forcing point pollution sources to be improved. This suggests that a risk based approach by applying ranges to both the costs and the benefits of an improvement would produce better environmental decision making than the existing Benefit Transfer and Cost Benefit ratio approach.

In applying this scenario any improvement between Q and Qa should be achieved through tackling diffuse rather than point sources of pollution. The disadvantages of this are that diffuse sources, by their nature, are harder and more uncertain sources to tackle than point sources. Another disadvantage is that this does not directly reflect a 'polluter pays' principle, as the point source may be contributing to the pollution problem but they are not paying their share of the total WTP for improving the environmental quality.

Diagram 4

The solution should be to apply confidence intervals around both the costs and the benefits of an improvement, to reflect the degree to which both the step change in point source costs and the diffuse pollution solution are achievable and to reflect the range of benefits that the available studies suggest are appropriate, including local surveys rather than interpolating national total benefit valuations. The WTP benefit can also be shown to vary with the level and significance of the improvement compared to the existing local environment and the degree to which the proposals represent the avoidance of a risk of deterioration (when a higher Willingness to Accept Compensation valuation could be used) rather than the potential benefits from a quality gain.

In Diagram 5, Q represents the current level of environmental quality and WFD+5 represents the quality required under the Water Framework Directive with a 5-year time horizon. However there is a risk with WFD+5 that the cost will be significantly above the willingness to pay, because the real cost and benefits could be between points 1 and 2 rather than the central estimate at point 0. To avoid imposing excess costs on the point solution the Environment Agency should seek to restrict diffuse pollution first to reduce this uncertainty. There is a significant probability that this on its own could produce the required environmental solution. A risk adjusted amount of money could be 'taxed', eg through discharge licenses, from the point source of pollution and used to provide compensation and fund the reduction in diffuse pollution. If this proves not to be enough, this money and complimentary amounts of compensation from diffuse sources of pollution should be used to fund part of the step change in cost imposed on the point source of pollution. To the extent that these transfers from sources of pollution have other adverse consequences, the WTP can be adjusted at a local level to reflect this (eg the social consequences of a reduction in agriculture). This results in simplified and locally applied pollution trading.

Diagram 5


In conclusion, it would not appear to be appropriate to automatically assume economic rational behaviour in justifying loading new environmental costs on businesses using the 'polluter pays' principle. To meet the concepts of sustainability and to reflect what is in reality a 'consumer pays' principle requires the risks to the current environmental status to be assessed and an approach that reflects future probability and consequence into account. Environmental regulators and companies should therefore refine their approach to sustainability to take into account the social and cultural status of the ultimate consumers.

Future work proposals

Particular further areas of research that are apparent from this paper are to examine how efficiency in terms of economies of scale varies with specific local environmental regulation rather than setting overall environmental outcomes that have to be achieved. It would also be interesting to then compare the approaches for environmental assessment to those used in establishing levels of customer service and product quality. This may help to establish alternative methods of evaluating environmental improvements than using contingent valuation studies and other similar approaches.


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