the value of water: is the concept useful for policy...
TRANSCRIPT
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The value of water: is the concept useful for policy making?
Vania Paccagnan
Senior Economist
Environment Agency
Draft: please do not quote without author’s permission
Submitted to the Regulatory Governance Standing Group Biennal Conference
Dublin, 17-19 June 2010
Abstract
Water policies in England and Wales pursue a variety of objectives - from reversing over-abstraction to
adaptating to climate change - through a mix of policy instruments. Current policy mix was introduced some
decades ago and might not be able to tackle effectively future pressures arising from population increases
and climate change.
Recent reviews, commissioned by the Government, have reiterated how existing instruments should be
reviewed and new policy instruments introduced to face these challenges. The thrust of both the Cave and
the Walker reviews is that water, to be managed sustainably, should be priced to consider its “true” value.
Economic literature has extensively analysed this concept, by discussing different components of the value
of water. Nonetheless, there is still a gap between theoretical findings and how these are applied in practice.
This paper, by reviewing the concept of the value of water and its practical applications, discusses the
information issues that need to be tackled when implementing pricing policies. Scarcity charges will be
analysed against a set of criteria by considering theoretical findings and empirical evidence. Their interaction
with other policy instruments will be considered.
In its conclusions the paper will assess desirability, feasibility and effectiveness of pricing policies in
attaining regulators’ objectives.
Keywords: pricing policies; value of water; scarcity charging; full cost recovery.
Preferred Themes:
• Regulating for sustainability
• Re-thinking environmental regulation
• Rights and regulation
Disclaimer
Any opinions expressed in this paper are those of the author and do not constitute policy of the Environment
Agency.
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1. Introduction
Water resources in England and Wales are under increasing pressures (EA, 2008), due to population increase
and impacts of climate change. Although overall England and Wales use only 10% of the available water
resources, water exploitation indexes1 in South East and Eastern England are similar to those of some south
European countries.
Current policy mix was introduced some decades ago and might not be able to tackle effectively future
pressures arising from population increases and climate change. This because it was designed to give
certainty to water abstractors on the amount of water they can use. It evolves overtime to take into
consideration environmental protection. As a result, water policies in England and Wales pursue a variety of
objectives - from reversing over abstraction to adaptation to climate change - through a mix of policy
instruments. Nonetheless, it remains a regulatory approach, with limited use of incentive-based instruments.
Recent reviews, commissioned by the Government, have reiterated how existing instruments should be
reviewed and new policy instruments introduced to face these challenges. The thrust of both the Cave and
the Walker reviews is that water, to be managed in a sustainable manner, should be priced to consider its
“true” value. It is believed that the current system, by making possible to abstract water at very low price,
gives a false presumption of water abundance. Both reviews conclude that, by pricing the resource to take
into account its availability, abstractors would use water more wisely.
Economic literature has extensively analysed the value of water concept, by discussing different its
components and how to assess them. Nonetheless, there is still a gap between theoretical findings and how
the concept could be applied in practice. Understanding how the value of water might help policy making is
important to analyse policy proposals. Also, anticipating how water abstractors would react to any reform in
the pricing system is key to assess effectiveness, efficiency and equity of the proposed measures.
This paper, by reviewing the concept of the value of water and its practical applications, discusses issues that
need to be tackled when implementing pricing policies to apply economic principles.
The paper is structured as follows: first, we will review current environmental water use to illustrate the
extent of water over-abstraction. Then, a review of current water policy and proposed reforms will be spelled
out. By using a working example, scarcity charging will be analysed against a set of criteria by considering
theoretical findings and empirical evidence. Their interaction with other policy instruments will be
considered. In its conclusions the paper will assess desirability, feasibility and effectiveness of pricing
policies in attaining regulators’ objectives.
2. Current water use
Looking at how water is used across water sectors, one notes different patterns on water use. On the one
hand, some sectors, such as agriculture, hold a great number of licences, but they use only a small proportion
of abstracted water volumes. On the other side, other ones, like public water supply, hold fewer licenses but
account for the greater proportion of water used in England and Wales. The following tables show the
distribution of abstraction licenses across different sectors (Table 1) and the percentage contribution of each
sector to actual abstracted volumes (Table 2).
Interestingly, currently between 50% and 60% of the licensed volumes is abstracted.
1 Water exploitation index is defined as the actual abstraction as a proportion of effective rainfall. South East and Eastern England
can be classified as an area ‘under stress from water abstraction’, with more than 22 per cent of freshwater resources abstracted.
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Table 1 - Abstraction licences in force by purpose: 2006/2007
Public Spray Agriculture Electricity Other Fish farming,
water irrigation (excl. spray supply industry cress growing,
supply irrigation) industry amenity ponds
EA Region
North West 11% 30% 15% 2% 34% 3%
North East 8% 39% 12% 1% 28% 3%
Midlands 5% 60% 9% 1% 19% 1%
Anglian 5% 70% 12% 0% 10% 1%
Thames 13% 33% 17% 1% 24% 4%
Southern 10% 48% 16% 1% 12% 7%
South West 8% 24% 25% 5% 22% 7%
Wales 11% 41% 11% 4% 24% 4%
England & Wales 8% 48% 14% 2% 19% 3%
Source: Source: Own elaborations on Water e-digest statistics – Inland water quality and use
Table 2 Estimated abstractions from all surface and ground waters by purpose and EA region: 2006
Public Spray Agriculture Electricity Other Fish
water irrigation (excl. supply industry farming,
supply spray) etc
EA Region
North West 14.9% 0.0% 0.0% 75.2% 8.9% 0.9%
North East 38.5% 0.3% 0.1% 39.2% 14.7% 7.1%
Midlands 40.3% 1.0% 0.1% 32.1% 25.9% 0.4%
Anglian 28.1% 2.0% 0.1% 56.2% 12.8% 0.8%
Thames 70.3% 0.2% 0.2% 21.9% 3.6% 3.6%
Southern 15.2% 0.2% 0.1% 57.2% 13.3% 13.6%
South West 24.2% 0.1% 0.2% 42.3% 4.2% 28.7%
Wales 18.7% 0.1% 0.0% 74.2% 5.1% 1.8%
England & Wales 28.5% 0.5% 0.1% 53.8% 10.9% 6.1%
Source: Own elaborations on Water e-digest statistics – Inland water quality and use2
Water resources availability is assessed through Catchment Abstraction Management Strategies (CAMS),
which consider how much freshwater resource is reliably available, how much water the environment needs
and the amount of water already licensed for abstraction. The first CAMS assessment, completed in 2008,
showed that there are many catchments (35% of the total, in blue in the map below) where there is no water
available for abstraction at low flows. In addition, some catchments are over licensed (18%, in orange in the
map below)3 or over-abstracted (15%, in red in the map below)
4.
2 http://www.defra.gov.uk/evidence/statistics/environment/inlwater/iwabstraction.htm
3 In overlicenced catchments current actual abstraction is such that no water is available at low flows. If the existing licenses were
used to their full allocation they could raise unacceptable environmental damage at low flows.
4 In over-abstracted catchments existing abstraction is causing unacceptable damage to the environment at low flows.
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Figure 1 – Water available for abstraction
Source: EA (2008)
It is estimated that over abstraction results in a deficit of 1,100 and 3,300 Ml per day (Aldrick, 2010). Hence,
in numerous catchments of England and Wales water resources are currently scarce as they do not satisfy all
competing demands (including the environmental one).
This problem might worsen in future. UKCP09 projections for England and Wales foresee that climate
change will result in hotter, drier summers and warmer, wetter winters. As an effect of these predicted
changes, natural river flows in summer are likely to be, on average, significant lower by 2050s.
In the next paragraph we will review how current policies tackle this issue. In the following one we will
illustrate proposals for changing the current system.
3. Current policy means
The current management system is a mix of regulatory control, with limited use of economic instruments.
Abstraction licenses are issued on a first-come, first-served basis and remain in force “until revoked”. The
current system was introduced during the 1960s, in a completely environment and economic outlook. At the
time, security of water supply to sustain economic production was the main policy objective for water
management policies. Since then, understanding of environmental pressures and public attitudes has changed
and as a result, at the end of 1990s, environmental demand entered the policy scene as a legitimate “use” of
water resources.
In 1999 the Environment Agency set up the Restoring Sustainable Abstraction programme. The programme
encompasses all work to investigate and address the environmental impacts of unsustainable licensed
abstraction. It aims at resolving the impacts of unsustainable abstraction on sites designated by statutory
drivers (e.g. Habitat Directive) identified through Government policies and other undesignated sites of
concern to local communities. The programme consists of an investigation phase, where the cause of over-
abstraction is identified. In some cases the outcome of the investigations, and subsequent options
identification and appraisal, could be that changes will need to be made to existing abstraction licences.
Where these cannot be agreed on a voluntary basis, the Environment Agency can make proposals to change
the licence under Section 52 of the Water Resources Act 1991. It will be necessary to develop a case for
changing current abstraction for each licence, then advertising proposals and justifying the approach through
a formal hearing. As a result, given the current regulatory framework, the process of revoking or amending a
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license is cumbersome from an administrative point of view. As water licenses have property rights status,
changes imposed upon them may be compensated for.
Besides this regulatory approach, pricing mechanism is also in place. However, the current charging system
does not give water abstractors incentives to use water efficiently, as abstractor charges are set up
administratively, to recover the EA costs and the costs of compensation payments for the RSA programme.
Abstraction charges consist of a one-off payment, due at the time of application5, and an annual variable
charge (the subsistence charge), calculated by taking into account annual licensed volume, source, and
season. The variable charge is made up of two elements, the Standard Unit Charge (through which the
EA recovers its costs of managing water abstractions and regulating abstractions, proportional to the
impact of that licence on water resources) and Environmental Improvement unit charge (EUIC), to recover
the costs of compensation payments.
The following table summarises annual variable charges for the current financial year (2010/11).
Table 3 – Abstraction charges in England and Wales (£/Ml)
Charging Region SUC 2009/10
(£/1000m3)
EIUC - :on Water Companies
(£/1000m3)
EIUC- Water Companies
(£/1000m3)
Anglian 26.71 4.26 4.26
Midlands 14.95 2.51 2.51
Northumbria 25.98 0.00 0.00
Yorkshire 11.63 0.62 0.00
North West 13.22 0.76 2.93
Southern 19.13 3.59 3.59
South West (inc Wessex) 19.71 4.80 1.46
Thames 13.84 0.83 2.75
EA Wales 13.89 2.42 0.00
Source: EA website6
4. The policy debate: proposed instruments and their ability to disclose value of water
Recently the policy debate has known an unprecedented rise in interest for pricing issues, following the
publication of two reviews commissioned by Defra:
• The Independent Review of Competition and Innovation in Water Markets (the Cave review,
(Cave, 2009) hereafter)
• The Independent Review of Charging for Household Water and Sewerage Services (the
Walker Review, (Walker, 2009) hereafter)
5 It is formed by two components (the application charge, due to the point of application) and an advertising administration charge,
to pay for advert on local newspapers as the administration process). 6 http://www.environment-agency.gov.uk/business/regulation/38809.aspx
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Although different in scope, these reviews have common premises: the current water resource management
regime England and Wales fails to ensure that water goes to those who value it most (including the
environment) or that it is used efficiently (Cave, 2009: 8). Current water use is not technically nor allocative
efficient, due to historical licensing regime and the low price of raw water. As “the current system of
abstraction charging does not reflect all the economic, social and environmental costs of abstraction” (Cave,
2009: p. 35) it is important to ensure that “the full value of water is taken into account in any investment
decisions, so we value water appropriately” (Walker 2009, p. 1).
It is also recommended:
- that Ofwat and the Environment Agency agree methods of reflecting the full value of water in their
regulation of the industry and they continue to work on methods of valuing water in a way that
reflects its full future value (Walker, 2009: 10; 49)
- reforming the current abstraction license regime for abstraction and discharge to ensure a more
appropriate value of water (Walker, 2009).
The Cave review, in particular, proposes a bunch of new policy instruments, essentially market based
instruments, to enhance water allocation, most notably to introduce a scarcity charge in over abstracted
catchments and to run reverse auctions where licensed volumes are unsustainable.
Before introducing a scarcity charge, the EA could facilitate negotiated agreements between abstractors. If
an agreement is reached and abstraction reduced, then the scarcity charge will not be applied. This charge
“could be applied to the total licensed volume or on the degree to which licensed volumes are unsustainable”
(Cave, 2009: 33). For instance, in the latter case the scarcity charge would be applied to the proportion of
water use which contribute to unsustainable abstraction (i.e. if a catchment is over abstracted by 10%), the
scarcity charge will be applied only to the last 10% of the licensed volume. The charge is applied to
consumptive uses only.
In order to ease implementation, Cave envisaged applying a single scarcity charge across all over abstracted
areas, and then increasing it slowly over time until the abstraction levels are sustainable. The idea is then to
introduce caps on scarcity charges (to reflect different value of water at different locations and times), as
soon as implementation reveals such information.
Implementation challenges include:
- considering the real used volumes (as normally licensed volumes differ from actual used volumes).
The Environment Agency does have data on actual used volumes, as opposed to licensed volumes.
- calibrating the tax with environmental damage avoided.
Cave also suggested holding reverse auctions as a way of tackling over abstraction. Reverse auctions could
be used to buy out excessive abstraction licences at minimum cost. Under a reverse auction system a single
buyer, usually the government, seeks bids from a number of potential suppliers for the delivery of specified
environmental outcomes. Abstractors would offer prices to hand back or amend their abstraction licences.
Cave indicated EA would select lowest bids which will make possible to achieve environmental outcomes
(i.e. by using a cost effectiveness selection criterion). He also advised employing a reserve price as a
maximum starting bid7.
Reverse auctions could potentially reveal the value of water to water abstractors, provided that these ensure a
competitive outcome. Therefore, they should be designed such that participants have an incentive not to
7 Cave suggested setting reverse price equal to the lower of a broad estimate of the value of water and the estimated compensation
costs that could arise if abstraction licences were removed. Generally speaking, reverse price should be commensurate to the benefits
that acquiring the water entitlement would bring.
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inflate their bid beyond the minimum price they are willing to accept. In order to ensure this, there should be
a large number of bidders, who cannot coordinate their bids (i.e. no collusion)8.
There are a number of implementation challenges that need to be tackled before rolling out any reverse
auction system, most notably:
o To ensure a competitive outcome given that in many situations there may be few bidders and the
potential for one dominant player (water companies). It has been suggested to overcome this
problem by holding reverse auctions across multiple catchments. There could be a trade-off between
competitive outcomes and environmental effectiveness could be overcome, as by increasing the
scale, it could become more difficult to target the licences causing environmental harm, and there is
the risk of dealing only with licences which are cheaper to claw back.
o How the auction process could be run to help capturing price information (the value of water) over
time. Cave suggested holding reverse auctions regularly, e.g. every 3 months.
o How reverse auctions could be designed to target licences which cause environmental harm. One
needs to distinguish between used and unused licences, and over licensed and over abstracted
catchments. This because historically some licences have been unused or under-used; therefore they
do not contribute directly to environmental damage. It could be then that some catchments are over
licensed but not actually over abstracted because not all licensed volumes are currently used. We
want to avoid paying money out in catchments that are over licensed by removing paper water.
o How reverse auctions would address issues about complexity of abstraction licences and their
conditions. For instance, removing Licence A via a reverse auction could have a very different
environmental benefit to removing licence B. Price signals could not give this information, but this
would need to be taken into account.
Cave finally suggested making more extensive use of water trading in areas water is used sustainably. Water
rights trading is the transfer of rights to abstract water from one person to another. It has been used widely as
a mean to encourage more efficient allocation of water resources, as it helps revealing private information on
the value of water and allocates water to the most beneficial uses. In Cave’s proposal, trading could be used
to ensure “licences go to those abstractors who value them most” (p. 42), therefore enhancing water
allocation within a catchment.
5. What is the value of water?
In order to give a definition of the value of water let’s recall the definition of value in economic theory. This
goes back to Adam Smith, who distinguished between value in use (to indicate the value people put on an
item) and value in exchange (to indicate the purchasing power of a good, i.e. its price, as resulting from the
intersection between demand and supply curves). This distinction is useful as economic value is different
than price, and there are goods that, even without being traded, have a positive economic value. After
acknowledging that, he associated the true value of an item largely with its cost of production. Instead, the
modern economic theory of value (first formulated by Dupuit and Marshall) focuses on value in use, by
defining value as what is a good is worth to the individual (Hanemann, 2005).
Water, like other goods, has a value which is dependent on the satisfaction people derive by using it. Water
is used for human consumption or as an input in production processes. It also makes possible to enjoy
8 Economic literature suggested limiting potential for collusion by: keeping the reserve price secret, announcing identity of the
bidder, not her offer; collecting sealed-bids.
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amenities. Hence it has a non-use value, as people value positively protection of natural aquatic environment
for future generations (“option value”) or obtain satisfaction from the knowledge that water is protected
(“existence value”, first introduced by Krutilla, 1967).
Therefore, water has a positive value. This principle has been recognised by the 1992 International
Conference on Water and the Environment in Dublin, where it was concluded that “Water has an economic
value in all its competing uses and should be recognised as an economic good”. This statement is contested
by some scholars, on the ground that water is perceived as sacred and essential for preserving life (Shiva,
2002, Gleick, 1999). European legislation, namely the Water Framework Directive, reconciles these two
points of views. Although it states that “water is not a commercial product like any other but, rather, a
heritage which must be protected, defended and treated as such”, it introduced economic analysis as a
milestone in the water resource planning process. It also promotes economic principles to guide policy
decisions. The Common Implementation Strategy issued a guidance (Wateco, 2002), which illustrates how to
take into account the value of water.
In fact, the concept of value (intended as value in use) is helpful to understand and define the value of water.
If water was traded, then its price (value in exchange) would reveal its true value.
According to the value-in-use concept, the value of water is defined according to its current use. Private
water demand varies as a result of different sectoral uses (agriculture, power generation, industry, public
water supply etc). Water is used differently across sectors (which have different requirements for certainty of
supply) and shows seasonality patterns, as its demand is concentrated in different periods of time. Water is
an input for production processes, and the way it is used in productive processes affects the ability of users to
adapt to different supply conditions. There is a variety of adaptation responses to changes in water
availability (adopting water saving technologies, looking for alternative sources, changing production
patterns) and the costs of such responses are site-specific. Although, generally speaking, different uses
compete for the same amount of water, in some cases there can be several sequential uses (provided that
upstream users do not affect water quality such that downstream users cannot use it).
The demand curve shows the marginal (extra) benefit obtained from consuming an extra unit of water and,
subsequently, the willingness to pay by users for additional units of water.
As recognised by Hanemann (2005), water is both a private and a public good. Its private component is
linked with private consumption, in all situations where the same water used by one individual cannot be
enjoyed by another one. The public component, instead, emerges in water supply or is linked with the
environmental benefits of preserving water. For instance, the storage capacity of a reservoir is a public good.
Ditto for navigation or an aquatic habitat, where several people can enjoy it simultaneously.
Looking at water availability, one might identify several specificities, which make water management
extremely complex. As noted by Young and Haveman (1985), water moves around, as it flows and
evaporates, and its availability varies in time and space, as it unevenly distributed geographically, and annual
precipitations are concentrated in winter months.
By considering the marginal costs of supplying an additional unit of water the private supply curve could be
sketched. This has an increasing trend as cheapest sources are usually exploited first and supplying
additional water involves increased extra costs per unit supplied (Morris, 2004). Social supply curve is given
by private supply curve plus the external impacts on other water users. The Wateco guidance suggests these
external costs should be included in the assessment of water supply costs.
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Figure 2 – Water demand and supply
Source: Morris (2004)
Therefore, matching supply and demand is currently one of the main challenges of water systems
(Hanemann, 2005). In order to do that, infrastructure is needed to store and transport water. Water services
are extremely capital intensive, and their assets are long-lived. Moreover, there are significant economies of
scale in water supply and sanitation provision. This implies that total costs are dominated by fixed costs, and
that short-run marginal costs are relatively low (Massarutto, 2008).
Let’s now consider two users (e.g. private water supply and agriculture) and how an allocative problem
might arise due to a change in water availability (see Figure 3 below). Curve DD shows WTP of the water
users. This curve represents a negative value, i.e. the value of additional product that can be obtained by
using water. It has a negative slope to take into account diminishing benefits of additional water use. Curve
NN represents the opportunity cost of this water use, intended as the foregone benefits of a competitive use
(Massarutto, 2004). One of the two users might also be the environment.
Each user will use water up to a point where the marginal benefits will become zero, i.e. point Q for user 1
and point Q’ for user 2. In cases where the total available quantity is OO’, they will do that and no scarcity
issue arises. If the available quantity decreases, say to O’’, then the two uses use all the resource available,
but still there is not a scarcity issue. It is only when the available quantity drops to an amount greater than
O’’, say O’’’, that a scarcity problem arise. For instance, this could be a situation that can be experienced in
summer, when, as we pointed out above, river flows will be lower.
Then, when the water available is smaller than OO’, the scarcity threshold, the optimal allocation (Q*) will
be determined by the intersection of DD and NN: according to the economic optimum, user 1 should use the
quantity OQ*, whilst user 2 should use Q*O’’’. With a complete knowledge of private demand curves and
the scarcity threshold, the regulator will be in a position to identify Q*.
Theoretically, this optimal allocation can be achieved by a scarcity charging system, through direct
bargaining between users (e.g. trading) or through a reverse auction system.
From the consideration above it could be concluded that the value of water is a useful concept for policy
making when it helps matching demand with supply, when it ensure water is available at right location and
time of the year, and at a cost that people can afford and are willing to pay (Hanemann, 2005).
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Figure 3 – Optimal allocation of water and scarcity
Q O’O’’O’’’O Q’Q*
€
Available water quantity
DD
NN’
NN’’
NN’’’
Q’’’
Source: Massarutto (2004)
6. A working example
The discussion above concludes that effectiveness in achieving environmental goals (by reducing excess
demand), efficiency in water use and equity could be some of the evaluation criteria to analyse any proposed
policy intervention. In order to understand the policy implications of the above considerations, let’s consider
a working example. This has only illustrative purposes and does not use real data.
A catchment is over-abstracted by 10%, i.e. at low river flows current water demand is 10% higher than the
amount water bodies can support. There are 11 water users in this catchment, namely:
- 10 farmers (using 2 Ml9 each, i.e. total use for the agricultural sector is 20 Ml, from May to August only)
- 1 public water supply (abstracting 240 Ml – monthly consumption is on average 20Ml, but from May to
August water consumption increases to 25 Ml).
Hence, total water abstraction in this catchment is 260 Ml/year. Low flows are normally experienced in July
and August, where total abstraction should be reduced by 10% (i.e. 12 Ml)10. So would the value of water
concept useful to deal with this problem (i.e. would it help to resolve the excess demand problem in
summer)? Would a scarcity charge ensure that value of water is revealed? What information do water
abstractors base their decisions on?
9 1 Ml (Mega litre) = 1,000 cubic metres = 1,000,000 litres.
10 Total water use from June to August is 120 Ml (5Ml x 4 + 25Ml x4), therefore water reduction target is 12 Ml.
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Generally speaking, to face this problem there are two possibilities. On the one hand, one could reduce
summer water use to sustainable level (in this example total water abstraction in the catchment should not
exceed 120 Ml in summer). On the other hand, water supply could be increased, e.g. by building a winter
storage reservoir or by transfer raw water from neighbour catchments. Therefore the choice is between water
demand or supply management solutions.
In the short term all assets are fixed and water abstractors will end up paying scarcity charges. In the long
run, though, they could adapt and put in place actions to reduce their water use or secure alternative sources.
Let’s consider first the demand management option. As shown above, currently the EA set abstraction
charges to cover administrative costs. By knowing the water demand elasticity for each sector, it could be
possible to identify abstraction charging increases that will be necessary to get the desired environmental
objective. In this working example, we consider the following data:
- for public water supply, we assumed price elasticity is in line with the findings of a UKWIR’s study
(2003), which estimated price elasticity associated with uniform metered tariffs using data on
households who has opted for metered charging in England and Wales. By referring only to
customers who opted for metering, this study concludes price elasticity is -0.14. This result might
underestimate the overall price elasticity, as one could expect that customers who choose metered
charges have low water consumption.
- For agriculture sector, following Schoengold et al. (2006) we assumed a water demand elasticity of
0.4211.
Let’s assume that a scarcity charge is introduced and set equal, say, to 10% of current abstraction charge.
That is, for any consumption level greater than the allowed target, than the water abstractor would pay an
additional charge to its standard rate. For example, in the Anglian region, water abstractors would have to
pay £3/Ml if they exceed the sustainable level of abstraction. In this case, a 10% scarcity charge, with
demand elasticity of -0.14 and -0.42 for public water supply and agriculture, respectively, will entail water
saving of 0.4 Ml only12, not sufficient to reach the 10% sustainability reduction target at catchment level.
With perfect information on water demand elasticities, the regulator could anticipate abstractors’ response
and setting scarcity charges at level that will produce the desired reduction. The following table summarises
the scarcity charge necessary to achieve the desired environmental outcomes, assuming that real demand
elasticities in our catchment are equivalent to those suggested by economic studies. By at the table below, in
order to get a sustainability reduction of 10% across the catchment (evenly distributed across users), scarcity
charge would have to increase by 300% for public water supply and 240% for agriculture.
Table 4 – Sectoral Water Consumption and Water Abstraction Charges
Water User Water Demand
Price elasticity
Current use
(Ml/Year)
Current Water
Price (£/Ml)
Future Use
(Ml/Year)
Scarcity Charge
(£/Ml)
PWS -0.14 240 31 230 124
Agriculture -0.42 20 31 18 105
Note: Scarcity charges are calculated by assuming linear water demand. It is also assumed that the consumption decrease is
apportioned proportionally to current level of consumption. For water companies the effect of a scarcity charge on final consumers
will depend on how this is translated in water tariffs. Abstraction charges are considered as operating expenditures and the effects of
11 Schoengold et al. (2006) use econometric analysis to decompose water use by crop and irrigation technology. They find a price
elasticity of demand of -0.79, with -0.42 attributable to direct price effect, whilst -0.37 is indirect price elasticity (i.e. changes in
capital investments and land allocation).
12 I.e. 0.3 Ml/d for PWS and 0.1 Ml/d for agriculture.
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water tariffs will depend on the degree of allowed cost pass-through Ofwat allow water companies to retain incremental out-
performance in Opex. Hence the level of cost pass-through depends on how Ofwat set output expectations and on total Opex. For
simplicity let’s assume a complete cost pass-through. In this case, households will reply to a water price increase according to their
water demand elasticity.
Even without knowing water demand elasticity, the regulator could anticipate abstractors’ reaction by
looking at the marginal adjustment costs of different water demand and supply options and abstractors’
flexibility in adopting adjustment options (e.g. water saving devices, increase in water supply, or even
business shut down). Water users will choose whether to pay a scarcity charge or to implement any
adjustment option. They will pay in two cases:
a. The scarcity charge is smaller than the cost of implementing any other adjustment option; If these
costs are smaller than the scarcity charge, then water users will decide to implement these actions. If
more than one option is cheaper than paying the scarcity charge, the least cost solution will be
chosen. Hence, it is crucial to compare the least cost solution for each user to see how they will
respond to the roll out of scarcity charges.
b. They cannot change production processes. In this case they will pay up to the point where the
scarcity charge equals the private net benefits of using water. If the scarcity charge is greater than the
net private benefits, water abstractors will cease using water (by, e.g., shouting down their business).
Therefore, knowing the private value of water is important to identity this extreme “adjustment”
option. In the case of shouting down, the adjustment cost is the foregone net benefit and the amount
of water available is the water previously used.
In this case, the adjustment options for the two sectors could be described as follows:
- Farmers:
o Implement water efficiency measures, to be able to produce the same yield with a smaller
amount of water; this option will have a cost of 380 £/Ml (38 p/m3) and will reduce water
used by 4 Ml.
o Seek alternative source of water, e.g. by building a winter storage reservoir; this option will
have a cost of 600 £/Ml (60 p/m3) and will reduce water used by 6 Ml/d.
- Water Industry:
o Increase water supply by using alternative sources (water transfers); this option will have a
cost of 350 £/Ml and will reduce water used by 2 Ml.
o Reduce water leakage; this option will have a cost of 450 £/Ml and will increase water
availability by 5 Ml.
Benefits for environmental uses (i.e. the opportunity costs of these uses) are estimated in 120 £/Ml (and total
benefits would be £ 1,440).
With this information, we can draw a hypothetical water availability curve13 (McKinsey, 2009).
In this example, the cheapest option at the catchment level will be to reduce water leakage but this will not
be enough to reverse over-abstraction. Other interventions will be needed, namely increasing efficiency of
water used for irrigation purposes and to increase local water supply. It is important that adjustment options
13 Water availability curve describes a range of existing technical measures to balance demand and supply (and
associated costs). Each of these technical measures is represented as a block in the curve, where the width of the block
represents the amount of additional water that becomes available from the adoption of the measure. The height of the
block represents its unit costs.
13
are implemented according to their cost effectiveness, up to the point where private adjustment costs are
below social benefits of reversing over-abstraction.
Figure 4 – Water availability curve
Water availability
Cost/Benefits
5 Ml
90£
9Ml 15Ml
95£
175£
17Ml
100£
12 Ml
120 £
Reduce
leakage
Water
efficiency
Increase Local
Water supply
Water
Transfer
So far we have discussed the importance of comparing marginal abatement costs with scarcity charges. Is
this information sufficient to solve the excess demand problem we flagged up above? Will water abstractors
implement any adjustment options at all?
Marginal abatement costs information is not sufficient per se to understand whether people will invest to
secure water use when water becomes scarcer. They will do so only when the (marginal) benefits are greater
than (marginal) costs. In other words, the satisfaction they derive by using water will be greater than they
costs they incur to have it. In the agricultural sectors, benefits of using water will equal the marginal value of
water, i.e. its contribution to the total net revenue. Morris et al. (2003) suggested that this ranges from 3
p/m3 (30 £/Ml), when water is not scarce, to 2 £/m3 (2000 £/Ml), when water is not available at all. This
could be a measure of farmers’ WTP for water (i.e. its value in use). This value should then be compared
with adjustment costs and the available adjustment options, to see whether the existence of a positive value is
sufficient to guarantee the matching between demand and supply. In this working example, farmers will be
in a position to adjust.
The considerations above assumed that water abstractors can adapt to different resource availability
scenarios. In fact, any adjustment options require time, and whilst some options can be introduced relatively
quickly, other ones require years to be put in place.
Therefore, there is no guarantee that water abstractors will change their water demand following the
introduction of a scarcity charge. This has to do with the nature of private decision making, where water
abstractors compare marginal adjustment costs with their private value of water.
What about the other policy instruments discussed above?
A reverse auction system, if properly designed, would have the advantage to indirectly compare private
marginal adjustment costs with public benefits of reversing over-abstraction. In this example the reserve
price would be 120 £/Ml (i.e. public benefits are used to set the reserve price). All bids below this price
14
would be selected. If the bids revealed the true adjustment cost, then reversing over-abstraction would be
attained at the lowest cost. In this example, total cost of reversing overabstraction would be 930 £.
In a quota system, where water abstractors are asked to reduce their volumes evenly, total costs would be
970£, but the target would not be met, as public water supply might reduce its water consumption only by 7
Ml. With trading, the overall target might be achieved at a cost of £1130, like in the reverse auction example.
Obviously the distributional impacts will change in the two cases. For what concerns scarcity charging, its
distributional impacts will depend on the elasticity of demand. When this is smaller (most notably for the
public water supply) charges will need to increase more to get the desired outcome. Reverse auctions’
distributional impacts will depend on how the budget to finance buying back licences is financed. The impact
of scarcity charges could be mitigated if their receipts are ring-fenced and used to fund ex gratia payments or
a reverse auction system.
7. Concluding remarks and research directions
The interest for the value of water concept has increased considerably recently. In this paper we have
recalled this concept, by reviewing related economic literature. We that the value of water, following the
economic definition of value, describes the net benefits water abstractors enjoy by using water.
We have also shown by using a simple working example that water users, when deciding whether to
implement water conservation actions, will compare these net private benefits with the costs of adjusting to a
desired level of water consumption. Therefore the value of water is a helpful concept for policy making, but
it is not sufficient to give regulators all the information they need to set policy targets or to choose among
policy instruments. Information on adjustment costs is a crucial part of the information needed to anticipate
policy outcomes and effects on water abstractors.
This finding is in line with the developments of carbon valuation research. In a recent paper, Dietz and
Fankhauser (2009) concluded that “estimates of the marginal cost of environmental protection, […], will
often provide the more consistent and robust prices for achieving targets”. Nonetheless information on net
benefits (i.e. the value of water), will be helpful to:
- understand the ability to pay of water users for different adjustment options
- allocate water between competitive uses, namely between consumptive uses and environmental
protection.
This paper emphasises the distinction between the value of water and its price. It made clear that increasing
water prices to reflect the true value of water could not, per se, be a sufficient condition to attain policy
objectives. Feasibility of different adjustment options and their relative cost are crucial elements to be
considered when rolling out different policy instruments and by setting environmental objectives. This
information will help policy makers anticipating price increases needed to reduce water consumption.
Distributional impacts would have to be considered.
More research is needed to estimate marginal adjustment costs for different water sectors and to sketch the
water availability curve for England and Wales.
8. Acknowledgments
15
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