[1500 Words; 10 Minute Read] This article looks at ‘environmental resource’ issues in connection with water. We look at ‘externalities’ as the third-party costs and benefits are analysed using water pollution as an applied example. This external cost is then examined in relation to the introduction of water pollution control. In doing so we can begin to understand how perceived ‘free’ natural resources such as water incurs costs to clean, can have a market price attributed, and incentivised by various economic instruments.
Externalities can be more broadly defined as the spillover or third-party effects arising from the production and/or consumption of goods and services in the marketplace. In order to improve the capture of full costs in using water resources that are produced or consumed within urban areas, models can be used to conceptualise and value the external costs in using water resources. The degree of cost will depend on the sustainability in the production and consumption of water as a good or service. A more sustainable water provision would be one that has less external costs at a higher volume of output.
Socially Optimal Level of Output for Water
The socially optimal level of output model (Figure 1) considers the assimilative capacity of external water costs, such as water pollution costs, to determine the point at which water resource costs stop being assimilated by the environment and society by beginning to detrimentally impact upon it.
In using Figure 1 as a model, and the example of chemicals, at a global level the optimum amount of chemical by-products generated by the chemical plant that can be assimilated and absorbed by the water system are at quantity Q1, with a level of pollution emitted at a level of A1. This point is regarded as the socially optimal level of output – any further output would be directly affecting society through environmental degradation. If there is any further production beyond Q1, this would take the amount of water pollution beyond the finite assimilative capacity (expressed as a straight line) of the water system, and as a result, generate a surplus external cost that is the difference between the total released pollution and the assimilative capacity.
Pollution Control (of Water Resources at a Market or Zero Price)
The firm could internalise some of these external costs of pollution if some intervention is applied by governing authorities. This means that incentives provided within the marketplace can alter and direct change in production and consumption patterns. For environmental goods and services, price incentives centre around restricting and regulating production and consumption, as at their most basic the price of inputs for water resources (without extraction and processing costs) are zero. Water resources are, in essence, zero- priced or free goods and services, such as the price of fresh drinking water (prior to collection and distribution) being free at source (depending on the ownership of the land from which it is being sourced). Without market incentives and regulation, an unfettered or uncontrolled price mechanism will use too much of zero-priced goods.
In the freshwater example, a zero source cost of water will mean an overproduction of the product if it is to be turned into a commodity and sold, as the cost to produce is a noncontrolling factor, or, more simply, the zero price provides no incentive to produce less of the good. If a surplus and oversupply of free goods is produced there will be a cost to society above the private internal cost to the firm producing the freshwater for consumption. This excess cost and divergence away from the private cost is referred to as the ‘social cost’ and/or ‘environmental cost’.
Market inefficiency of zero-priced goods can be reduced if individuals and organisations control their behaviour though some nonprice incentives. Behaviour can be considered a nonprice determinant of demand function with regards to changes in tastes and preferences, altering the level of demand at the same price point. An example of nonpriced determinants of demand that alter the behaviour (tastes and preferences or fashion) of zero-priced goods is through education. Unfettered markets could have improved water quality if consumers change demand through education, awareness and choice of less-polluting products.
Incentives to environmental goods and services can therefore shape markets or correct market failure. These incentives can be viewed as either direct or indirect in the way in which they operate. Complete allocation control to the free market can be created via direct full privatisation. In most countries, the supply of water utility has been in control of the government. In a process of privatisation this relaxation of governmental control has meant that competing water companies can lease parts of the infrastructure and sell water as a commodity at a price determined by the quantity of units consumed by the end-user. The movement in viewing water provision from a public good to one that is private mirrors the transformation of value of the environmental resource as zero-priced to one that has a price attached to it.
Other direct regulatory changes could see a shift in the opposite direction from a deregulated free market to that of a command and control approach to water distribution. For instance, the government approach could be to decide what can and cannot be produced and polluted with respect to water. For instance, water standards can be directly commanded and enforced via legislation, such as setting and enforcing water purity standards for firms that are operating near water outlets.
As well as direct regulation as an enforced incentive to value water resources, indirect incentives are another mechanism that can alter their functioning. Indirect incentives could be regulations such as taxes and charges that financially incentivise the value and allocation of water as a good and service. A higher service charge for water for residential use may discourage the quantity of water used by the households subject to the service charge. As a result of such indirect manipulation of the market, this will adjust the price in existing markets for water goods and services.
A radical intervention into the market for water, which will change their economic functioning, is by creating ‘new markets’. Governments can create new markets for environmental services by direct regulation and creation of new tradeable entities that act as a new ‘currency’ in the marketplace. A classic example is the creation of environmental carbon credits that are traded and regulated. Water credits could similarly run if water scarcity becomes an even more pressing issue.
Pollution Control: Charges, Permits and Deposits for Environmental Use
Indirect economic mechanisms can therefore shape and influence the market price and resultant value of water resources that are used and produced in urban areas. Table 1 consolidates five key instruments that can be used to influence the price of water resources on the market.
Firstly, emission charges can be used to ensure that the emitter has to pay for any polluting activity, so with the charge they are encouraged to pollute less and thus be charged less. The charge is often related to the quantity (and quality) of pollutant damage. Therefore, in the case of water pollution by a firm in proximity to a water source, the cubic feet of water polluted could be charged, plus the intensity of pollution affecting its regenerative capacity to return to pure water will equally be charged more intensely.
Secondly, user charges are another instrument to influence the price of environmental goods. As they are different from emission charges, a user charge is one where the more of a resource is used the greater the charge allocated. For instance, the more units of chemicals used in a chemical plant the greater the charge attached to the use of the input materials.
Product charges are the third instrument, and are based upon the particular product that is being produced in order to gauge how much pollution is caused and hence charged by a regulatory force. The harm to a water system in producing cars may be more polluting than the creation of bicycles (if compared at equivalent values, e.g. one car and ten bicycles), and therefore the charge will be more heavily felt in the former product.
Marketable permits are the fourth instrument and draw on the carbon emissions trading example discussed earlier. Here a certain quota of water for a firm or nation could be set and any production under the set quota will generate a surplus water credit that can be traded to firms or nations that overproduce goods and services that pollute water.
The fifth and final instrument that can affect the price of water resources, particularly in affecting price in controlling their pollution discharge, is the use of deposit-refund systems. A deposit–refund system is where a firm pays a deposit up-front to an authority if they are potentially likely to emit pollutants in their process. At a certain point, the authority will return the deposit if no pollution has occurred or retain part of the deposit if there are partial pollution emissions. An example could be a drinking water bottling firm that pays a deposit to extract a certain amount of water, and if at a point of audit they have over-extracted, they will lose part of the initial deposit.
Conclusions
The commodification of water has enabled the natural resource to become an economic good and service in itself, as well as providing significant input into the production and consumption process. Water at source is ‘in theory’ at a zero (or free) price and could be considered a public good where it ‘in theory’ is nonexcludable to everyone on the basis of price and is nonrivalrous to everyone – in that the use of water by one person does not affect the use of another.
The use of water in economic terms can be both internalised into the market mechanism and, due to any third-party ‘spillover’ effects in water resource use, many external costs and benefits are generated. Negative externalities are those such as water pollution, where the socially optimum level of absorption by the environment is exceeded. Water pollution costs can be measured, valued and conceptualised in economic terms – and pollution controls can consider economic benefits if intervention provides an improvement of the factors that are measured and valued (e.g. the benefit value of clean water in the productive process as opposed to polluted drinking water).
Pragmatic economic tools and instruments can play some part in incentivising economic behaviour and direct water use to pollute less or internalise the external costs (and generate benefits). Instruments include; water permits, water emission charges, water user charges, product charges and water deposits.
This is an updated excerpt from the original text which can be cited as : Squires, G. (2014) ‘Chapter 4: Urban water economics’ in Booth, C.A.& Charlesworth, S.M. (Editors) Water Resources in the Built Environment: Management Issues and Solutions. Wiley-Blackwells, Oxford