Olmstead (2010) - Economics of Water Quality

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The Economics of Water QualitySheila M. Olmstead∗

Introduction

Water quality concerns were a major source of support for the establishment of the U.S.Environmental Protection Agency (EPA) in 1970. The infamous Cuyahoga River fire occurredin 1969, though in truth it was the tenth such fire that had occurred since the mid-1800s,and not the worst. The days of major river fires are likely over in the United States, due inpart to the significant improvements in surface water quality since the passage of the FederalWater Pollution Control Act, commonly known as the Clean Water Act (CWA), in 1972. Inthe industrialized countries, concern over industrial point source pollution has diminished,while attention has shifted to the effects of agricultural and urban runoff, such as their rolein the development of aquatic “dead zones” from the Gulf of Mexico to the Baltic Sea. Starkindustrial water pollution problems persist in many developing countries, however. Forexample, about one-half of the monitored urban river waters in northern China do not meetthe country’s lowest ambient standards, making these rivers unsuitable even for irrigation(World Bank 1997a).

Drinking water supplies are also a serious global concern. Approximately 1.1 billion peopleworldwide lack access to safe drinking water, causing millions of deaths annually, especially ofvery young children (United Nations 2003). The United Nations Millennium DevelopmentGoals include reducing by half the proportion of people without sustainable access to safedrinking water by 2015.1 Access to safe drinking water is approaching 100 percent in mostindustrialized countries. Thus, the relevant economic and policy questions in these countrieshave more to do with the setting of regulatory standards than providing drinking wateraccess. However, that there was controversy over a new standard for arsenic in U.S. drinking

∗Associate Professor of Environmental Economics, School of Forestry and Environmental Studies, YaleUniversity, 195 Prospect Street, New Haven, CT 06511, USA. Telephone: 203-432-6247; Fax: 203-436-9150;e-mail: [email protected]; and Visiting Scholar, Resources for the Future.

I am grateful to Hilary Sigman and Karen Fisher-Vanden for comments on an earlier draft, and for thehelpful suggestions of an anonymous referee. All remaining errors and omissions are my own.

1In September 2000, the United Nations convened the Millennium Summit, where nations adopted theUN Millennium Declaration. The Declaration committed nations to a new global poverty-reduction effort,including a schedule for achieving specific targets by 2015. The overarching group of eight goals (the waterand sanitation target mentioned above is part of Goal #7: Ensure Environmental Sustainability) has cometo be known as the Millennium Development Goals. See http://www.un.org/millenniumgoals/.

Review of Environmental Economics and Policy, volume 4, issue 1, winter 2010, pp. 44–62doi:10.1093/reep/rep016Advance Access publication on November 12, 2009C© The Author 2009. Published by Oxford University Press on behalf of the Association of Environmental and Resource

Economists. All rights reserved. For permissions, please email: [email protected]

The Economics of Water Quality 45

water in the early days of the George W. Bush administration suggests that concerns aboutthe safety of drinking water persist even in some of the wealthiest countries.

What do economists have to say about water pollution policies? While water quality hasreceived significant attention from environmental economists, especially in the voluminousliterature on nonmarket valuation, for several reasons it has received less attention thanair quality in the general economics literature. First, ambient air pollution has significantand direct human health impacts, which can be monetized and compared with the costs ofregulation. By contrast, most of the benefits of controlling surface water pollution (whereraw water is not consumed) have to do with recreational use and ecosystem health, and themagnitude of these benefits may be dwarfed by those of air quality regulations, in whichhuman health impacts dominate. Second, policymakers in both industrialized and develop-ing countries have implemented many market-based approaches to air quality regulation,such as tradable permits and emissions taxes, and economists have set the stage for suchapproaches in theory and evaluated their performance in practice. Policymakers have imple-mented far fewer market-based approaches to water pollution control, leaving little roomfor empirical work on cost effectiveness and policy instrument choice (though many issues,such as the design of market-based policy instruments for water pollution, have been con-sidered in theory). Finally, although the introduction of basic drinking water treatment andsanitation provides among the highest net benefits of any environmental policy intervention,the majority of populations in most industrialized countries had received these services longbefore environmental economics existed as a field of study. Thus, there is little demand forprospective benefit–cost analysis of such interventions in industrialized countries.2 However,the economics literature on drinking water interventions in developing countries is growing.

This article surveys selected contributions of economics to the literature on water pollutionand the regulation of water quality, one of the many issues concerning water to whicheconomists have made significant policy contributions. While not comprehensive, this reviewof the literature highlights many of the most important topics that economists have addressedin this area, as well as the key topics for future research. The remainder of the paper is organizedas follows. In the next section, the efficiency of drinking water provision and regulation isaddressed. This is followed by a discussion of the efficiency of general water quality regulation.Next, I examine the issue of policy instrument choice in general water quality regulation.A summary and conclusions are presented in the final section.

The Efficiency of Drinking Water Provision and Regulation

The economics literature has addressed two major issues concerning the efficiency of drink-ing water provision and regulation. First, many studies have quantified the human healthimplications of water and sanitation interventions that improve drinking water access, qual-ity, and service reliability. Second, research has compared the effectiveness of the specifictypes of interventions, and assessed regulatory mechanisms to reduce exposure to drinkingwater contaminants.

2However, there are now some good retrospective studies. See, for example, Cutler and Miller (2005).

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Drinking Water Quality, Human Health, and Welfare

Reducing human illness and deaths by providing clean drinking water sources, throughchanges in drinking water and sanitation infrastructure, is a policy intervention with verysignificant net benefits. Most of the benefits of such policies are attributable to reduced infantand child mortality. More than 3 million children, most of them under five years of age,die from preventable water-related diseases annually (World Bank 2002). The provision ofpiped, treated drinking water in major American cities during the early twentieth centuryresulted in large reductions in urban mortality, with an estimated social rate of return toinfrastructure investments of 23 to 1 (Cutler and Miller 2005). Improvements in the ac-cess to piped drinking water and sanitation in Brazil between 1970 and 2000 resulted in acombined welfare gain of $10,300 per capita, explaining 22 percent of within-municipalityvariation in life expectancy over the period (Soares 2007). By one estimate, an individualborn in Brazil in 1970 would have been willing to pay almost 3.5 times a single year’s incomefor the drinking water and sanitation improvements achieved through 2000 (Soares 2007).Piped water service expansion in Argentina during the 1990s, through private investment,reduced child mortality by 8 percent (Galiani, Gertler, and Schargrodsky 2005). Federal pro-vision of sanitation infrastructure on Native American reservations between 1960 and 1998reduced infant mortality on reservations by 2.5 percent, through reductions in waterbornegastrointestinal disease and infectious respiratory disease, at a cost per life saved of $217,000,with significant positive spillovers to neighboring white populations (Watson 2006). Whilemost published work on this topic finds very significant net benefits (in the form of reducedmorbidity and mortality) from the provision of piped water and sanitation, others estimatethat these interventions have had little impact on mortality (Lee, Rosenzweig, and Pitt 1997).There is also new evidence suggesting that reduced childhood exposure to pathogens indrinking water may improve long-run health and educational outcomes (Venkataramani2009).

Where households must fetch water from outside of the home, the benefits of pipeddrinking water supplies include the opportunity cost of the time previously spent gatheringand/or treating water (valued, in many cases, at the local wage rate for unskilled labor), as wellas health improvements. Numerous contingent valuation (CV) studies have demonstratedthat poor households in developing countries lacking safe drinking water sources are willingto pay significant sums for their provision (Whittington et al. 1990; Pattanayak et al. 2006;Akram and Olmstead 2009). These studies amount to ex ante estimates of the benefitsof piped water provision, which can be compared with the costs of public infrastructureinvestment. Economists have also used the averting-expenditure methods to estimate suchbenefits (McConnell and Rosado 2000; Pattanayak et al. 2005).

A comprehensive summary of research using both the CV and revealed-preference methodssuggests that the most important determinants of willingness to pay for improved waterservice include education, income, family size, and other demographic characteristics; cost,quality, and reliability of households’ current supply, compared with those of the proposedalternative; and household attitudes toward government policy and public investment inwater services (World Bank Water Demand Research Team 1993). Studies also suggestthat households in developing-country cities that are not connected to piped water systemsmay pay very high prices for water from the informal sector, providing further evidence


of willingness to pay for water service (Whittington, Lauria, and Mu 1991; Bhatia andFalkenmark 1993).

Economists have also estimated potential welfare gains from improvements in the qualityof water service – reducing variability or interruptions in the water delivery schedule, forexample – in both developing (Baisa et al. 2009) and industrialized countries (Hensher, Shore,and Train 2005). While the estimated benefits of such service improvements are significant,households in developing countries may be willing to pay less for these improvements thanfor improvements in drinking water quality (Akram and Olmstead 2009).

Willingness to pay for sanitation infrastructure in developing countries is less well studiedthan drinking water supply. The results of a CV study of one thousand two hundred house-holds in Kumasi, Ghana, suggest that the local willingness to pay is approximately the samefor conventional sewage treatment as it is for improved ventilated pit latrines (Whittingtonet al. 1993). Since on-site sanitation is much cheaper than conventional sewage treatmentinfrastructure, the subsidies required to support improved latrines for all local householdsare markedly smaller than those that would be required to support conventional treatment(Whittington et al. 1993).

Effectiveness of Specific Drinking Water Interventions

How should increased access to safe drinking water be achieved? In many cases, water supplyinterventions in developing countries are funded by national governments, multilateralfinancial institutions, or donor agencies, which may seek evidence of the effectiveness ofthese interventions. The epidemiological literature provides substantial evidence that point-of-use disinfection of drinking water reduces diarrheal incidence and mortality in developingcountries (see, e.g., Fewtrell et al. 2005). However, there is much less evidence on the causaleffect of other water and sanitation interventions on morbidity and mortality, especially inrural areas (Zwane and Kremer 2007).

In particular, the relationships among specific interventions, household and communitybehavior, and health outcomes are poorly understood. A recent randomized field exper-iment assesses the impact of spring protection on household water quality and health inrural Kenya (Kremer et al. 2006). While protecting springs is found to be very effective inimproving both water quality at the source and home water quality (after collection andstorage) among households collecting exclusively from sample springs before protection, theauthors find no substantial effects on diarrheal incidence, child weight, or child height; nopositive spillovers to neighboring communities; and a declining willingness to pay for sourceprotection over time (Kremer et al. 2006). Emerging research suggests that household behav-ioral changes such as reductions in in-home treatment and sanitation behavior can reduce,or even negate, the benefits of providing safe drinking water sources (Jessoe 2009; Bennett2009).

The role of communities that may invest in, and maintain, small-scale water and sanitationinfrastructure has also been examined. More than 40 percent of borehole wells dug in ruralwestern Kenya between 1981 and 1992 using external development aid were in disrepair by2000 (Miguel and Gugerty 2005). Ethnic diversity within these communities has a negativeimpact on water well maintenance, suggesting collective action failures in sustaining drinkingwater infrastructure (Miguel and Gugerty 2005). The composition of political bodies that

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make decisions regarding public good investment may also affect access to safe drinkingwater. For example, village councils in rural India headed by women (who bear a dispro-portionate share of the burden of water collection) may be more likely to invest in publicdrinking water infrastructure improvements (Chattopadhyay and Duflo 2004). More studiesof the interplay among drinking water and sanitation interventions, household and com-munity behavior, and health outcomes are necessary to design better drinking water supplyinterventions.

Another important area for future research is the design of water quality improvements incases where most households will continue to obtain water from raw sources or the informalsector. Studies have demonstrated that regulated drinking water providers reduce violationsof drinking water standards in the United States when they are required to disclose violationsto their customers (Bennear and Olmstead 2008). Recent work in developing countriessuggests that information disclosure may also result in consumption of safer drinking waterby developing-country households accessing unregulated sources, by encouraging them toswitch to safer wells (Madajewicz et al. 2007) or prompting increases in in-home drinkingwater treatment (Jalan and Somanthan 2008). Lack of awareness of the adverse health effectsof unsafe drinking water consumption has been identified as a significant barrier to theadoption of home water purification practices in urban India, providing additional supportfor the provision of information (Jalan, Somanathan, and Chaudhuri 2009). There is asubstantial literature in economics on information provision and disclosure, more generally;for example, the drinking water quality examples discussed above are linked to empiricalwork on nutritional and food safety labeling (Brown and Schrader 1990; Shimshack, Ward,and Beatty 2007) and tobacco warnings (Fenn, Antonovitz, and Schroeter 2001; Sloan, Smith,and Taylor 2002).

Some populations in industrialized countries still lack access to safe drinking water andsanitation, and significant net benefits may result from their provision (Olmstead 2004;Watson 2006). However, because most of the low-hanging fruit in drinking water qualityregulation has already been harvested in industrialized countries, barring new scientificevidence on the human health effects of existing and emerging drinking water contaminants,increased stringency of standards may in some cases have net costs. In the United States,for example, since 1996 the Safe Drinking Water Act (SDWA) has required that the EPAperform a benefit–cost analysis for all new drinking water contaminant standards. The firsttwo standards promulgated under this requirement, more stringent standards for arsenicand radon, were found to have net costs (USEPA 1999; Abt Associates 2000; Burnett andHahn 2001).

This has given rise to a discussion of whether drinking water standards in the United Statesshould be set at the national or local level. The benefit of national drinking water standards isthat all water systems meet minimum health standards (though across communities exposureto contaminants may vary significantly below the standard). However, uniform standards,as in other contexts, are likely not efficient. The U.S. Congressional Budget Office (1995)estimates that the average cost per cancer case avoided due to SDWA standards, across allsystem sizes, ranges from $500,000 for the pesticide ethylene dibromide and co-contaminantsto more than $4 billion for the pesticide atrazine and the herbicide alachlor. Due to significanteconomies of scale in drinking water treatment, the cost per cancer case avoided by manystandards increases dramatically as system size decreases. For example, for the largest size class


of the regulated U.S. water systems (approximately 370 systems serving more than 100,000people each), the cost per cancer case avoided by the SDWA standard for adjusted gross alphaemitters, which reduces exposure to a group of radioactive elements (mostly from naturalsources) in drinking water, is about $600,000. For the smallest size class (approximatelythirty thousand systems serving 25–500 people each), the cost per cancer case avoided by thisstandard is more than $1 billion (U.S. Congressional Budget Office 1995; Tiemann 2006).Thus, for many contaminants, it may be more efficient to set local standards, which reflectlocal preferences for the trade-off between risk reduction and control costs (Dinan, Cropper,and Portney 1999).

The appropriate administrative level for setting drinking water standards is one of manyaspects of fiscal federalism explored by economists.3 Theory suggests that interjurisdic-tional competition may be welfare-enhancing (Oates and Schwab 1988). Strategic interac-tion among neighboring communities, as in the case of free-riding in ambient water quality(discussed in the next section), is an important exception. But, unlike the case of ambientwater quality, drinking water quality imposes a few externalities that might cross local orstate boundaries.4 The downside risk of decentralized standards is the possibility of a “race tothe bottom,” in which communities enact excessively lax environmental standards to attractbusinesses or households. However, the empirical evidence suggests that interjurisdictionalcompetition in environmental quality does not result in a race to the bottom, and may evenresult in a “race to the top” (List and Gerking 2000; Millimet 2003). The welfare implicationsof uniform national drinking water standards are an important area for future research.

Efficiency of Ambient Water Quality Regulation

Ambient water quality standards, when raw water is not directly consumed, have low humanhealth benefits relative to drinking water standards. Most of the benefits of such policies arerelated to recreational use and ecosystem health. Ambient water quality is also associatedwith more significant externalities and public goods than the quality of piped drinkingwater, because water resources may be shared by multiple jurisdictions and may providegoods such as recreation, flood control, and navigation in addition to private goods. Thesemarket failures pose more significant barriers to achieving efficient levels of water quality intransboundary settings. With these issues in mind, this section first assesses what is knownabout the efficiency of national water quality standards, particularly in the United States, andthen considers transboundary water quality.

Estimated Benefits and Costs of National Water Quality Standards

The U.S. CWA, encompassing the Federal Water Pollution Control Act of 1972 and thelater amendments, implements controls almost exclusively for industrial point sources andmunicipal wastewater treatment. Freeman (1982) estimates recreational benefits from theCWA’s point source controls (freshwater fishing, marine sports fishing, boating, swimming,

3An overview of this literature is offered by Oates (1999).4There is, however, an important caveat here, which is that without sufficient microbiological standards, theexternalities from waterborne disease through person-to-person transmission could be significant.

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and waterfowl hunting), indirect use benefits (aesthetics, ecology, and property value), bene-fits to commercial fisheries, and cost reductions for water treatment in municipal, industrial,and residential settings. He reports a “best estimate” of total benefits (in 1996 dollars) of $22.6billion per year. Carson and Mitchell (1993) perform a single comprehensive CV analysis,asking a national random sample of U.S. households to value the change in water quality thatresults when moving from no pollution control to “swimmable” water quality nationwide.5

Their best estimate of annual benefits (in 1990 dollars) is $29.2 billion. Lyon and Farrow(1995) build on these studies, as well as others in the literature, to assess the incrementalbenefits of additional water pollution control investments (i.e., the marginal benefits of ad-ditional abatement) beyond 1990. In sum, these three studies suggest that the CWA hadsignificant net benefits between 1972 and the late 1980s, but that at some point around 1990,incremental costs began to exceed incremental benefits.

There are also many estimates of the value of water quality improvements on a smaller scale.For example, economists have shown that residential waterfront land prices increase withreductions in fecal coliform contamination (Leggett and Bockstael 2000), and that consumershave significant willingness to pay for the improvements in coastal water quality resultingfrom reductions in nutrient runoff (Morgan and Owens 2001) and for improvements inbeach water quality (Bockstael, Hanemann, and Kling 1987; Hanley, Bell, and Alvarez-Farizo2003). Recreational fishing benefits of water pollution abatement have also been assessedat individual sites (Kaoru 1995; Montgomery and Needelman 1997; Massey, Newbold, andGentner 2006). About three-quarters of published estimates of the economic value of non-market goods and services in the United States that are provided by water quality are travelcost studies, suggesting that most measured benefits are recreational (Van Houtven, Powers,and Pattanayak 2007).

The literature contains an increasing number of developing country applications. Forexample, Day and Mourato (2002) use a CV survey to estimate the value of improvements inriver water quality in China, and Choe, Whittington, and Lauria (1996) estimate the benefitsof reducing surface water pollution in the Philippines using both CV and travel cost models.However, the value of water quality improvements in developing-country settings deservesmuch more study.

Recent work has also combined the valuation of multiple ecosystem services with spatiallyexplicit models of the links between water quality and other environmental goods and services,using the ecological production function approach (National Research Council 2005). Forexample, land use and land cover changes may cause shifts in final ecosystem services,including hydrological services. One study that integrates the impacts of such changes onwater quality with other services also quantifies the effects of different land use changescenarios on nutrient runoff and storm-related flooding, though it does not value thesechanges (Nelson et al. 2009). The ecosystem services literature that combines economics andecology in this way is in its infancy, and advances in this area will improve water qualityvaluation in the future.

5Note that this is a larger water quality improvement than what is valued by Freeman (1982).


Water Quality in Transboundary Settings

Shared water resources present classic externalities and public goods. Polluting entities,bearing only a portion of the benefits of water pollution abatement but all of the costs, will tendto free-ride, passing pollution downstream across political borders. Several transboundarywater resource management examples have been addressed from a game-theoretic perspectiveas problems of international environmental cooperation (see Barrett 2003).

Empirical analyses of pollution spillovers in transboundary settings have confirmed thehypothesis that countries (and even states and counties) free-ride in this manner. In a globalanalysis, Sigman (2002) finds that pollution levels at monitoring stations just upstream ofinternational borders may have pollution levels elevated by 40 percent or more. Less free-riding occurs among countries within the European Union, suggesting a possible importantrole for international institutions in mitigating strategic behavior. Turning to states andcounties, in a panel analysis of water quality spillovers in the United States under the CWA,free-riding was found to cause a 4 percent decrease in water quality downstream of statesthat are authorized by federal law to implement and enforce the CWA, relative to statesin which the EPA plays this role (Sigman 2004). Water pollution emissions by U.S. pulpand paper plants appear to be higher when out-of-state residents receive a greater share ofpollution control benefits (Gray and Shadbegian 2004). Using panel data from counties inBrazil, Lipscomb and Mobarak (2008) quantify the spillover effects of free-riding; they showthat pollution increases by 2.3 percent per kilometer as a river approaches the border exitinga county, and that this effect jumps to 18.6 percent per kilometer within five kilometers ofa downstream border. Water pollution spillovers also intensify as the number of politicaljurisdictions managing the same river increases (Lipscomb and Mobarak 2008).

Policy Instrument Choice for Water Quality Regulation

Independent of whether the levels of particular water quality standards are efficient, policy-makers can choose policy instruments that cost-effectively achieve those standards. Followingthe remarkable success of permit trading under the U.S. Acid Rain Program’s sulfur dioxide(SO2) emissions trading system, the phase-down of lead in gasoline, the European Union’snascent market for carbon emissions under the Kyoto Protocol, and other applications ofmarket-based approaches to air quality, expectations have been high for the successful trans-fer of these policy instruments to the regulation of water quality. However, for several reasons,market-based policies for water pollution control have been slow to emerge and succeed.

Unlike most of the air quality problems that have been addressed through market-basedpolicies, the marginal damages from water pollution may vary dramatically with the locationof emissions, depending on the characteristics of receiving waters and other factors. This“nonuniform mixing” of most water pollutants makes it difficult to design cost-effectivepolicies for pollution control.

In industrialized settings, the primary remaining water pollution problem is generally notpoint source pollution, since the primary means for achieving water quality goals over thepast three decades has been the requirement that point sources (mostly industrial facilities)obtain permits delineating maximum discharge quantities, based on the performance ofknown pollution abatement technologies. Thus little remains to be gained by focusing only

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on increasing the stringency of point source water pollution control. For example, even ifall U.S. point sources of water pollution were to achieve zero emissions, only 10 percentof U.S. river and stream miles would rise a step or more on EPA’s water quality ladder(Bingham et al. 2000). It is nonpoint source (NPS) pollution that is the major source of waterquality impairment in U.S. water bodies, and, unlike point source pollution, it is currentlyunregulated by the CWA. Common nonpoint sources of water pollution include agriculturaland urban runoff, atmospheric deposition, and runoff from forests and mines, all of whichenter water bodies over diffuse areas. NPS pollution from agricultural activities is the primarysource of impairment in U.S. rivers and streams (U.S. Environmental Protection Agency2009). NPS pollution has a significant stochastic component, depending on fluctuations inweather and other environmental factors. There is also considerable uncertainty over boththe actual sources of NPS pollution and the impact of control measures (Stephenson, Norris,and Shabman 1998).

Since point sources have been the only targets of water pollution control policies formany decades, there are significant cost savings possible through point–nonpoint tradingor differentiated taxes. However, if these policy instruments are poorly designed, they couldeasily reduce rather than improve social welfare. The remainder of this section assessesthe current state of economic research on market-based policy instruments for controllingwater pollution, which hold the potential to improve water quality at a lower cost thantechnology standards and other common command-and-control approaches. These market-based instruments include both point source–point source and point source–nonpoint sourcewater quality trading, water effluent taxes, and liability rules.

Water Quality Trading

Only a few successful point source–point source water quality trading programs have beenestablished. One example is the salinity trading program in Australia’s Hunter River, whichwas created as a pilot program in 1995. Under this program, tradable permits are issuedto coal mines and power plants to discharge saline water into the river during periods ofhigh flow, when dilution is greatest. The permits entitle polluters to emit a share of the totalallowable discharge. Flow conditions change rapidly, so trading takes place online in realtime, through a central Web site. The salinity targets at the system’s two river-monitoringpoints have not been exceeded by participant discharges since trading began (Kraemer,Interwies, and Kampa 2002). Though no cost-effectiveness analysis has been conducted, themore costly alternative for the participating point sources of pollution would have been theconstruction and maintenance of saline water reservoirs that are larger than those that existedwhen trading began.

One of the barriers to the establishment of successful water quality trading programs hasbeen accounting for the spatial distribution of nonuniformly mixed water pollution. Thischallenge has largely been absent from tradable permit programs for air quality, though ithas been addressed in the environmental and resource economics literature. The literaturesuggests that establishing trading ratios that vary by each potential trading partner pair, inthe manner of exchange rates, is an efficient approach (Oates, Krupnick, and Van de Verg1983; Tietenberg 1985; Rodrıguez 2000; Farrow et al. 2005; Hung and Shaw 2005).


Regulators have typically constructed trading ratios between classes of polluters, ratherthan source-specific ratios. For example, the Rock River Basin Pilot Trading Program inWisconsin employs trading ratios calculated as the sum of a base trade ratio plus additionalincrements of 0.125 each if the trade is: (a) not in a “target area”; (b) not generating abatementwithin the same watershed; (c) not within 20 miles of the source receiving credits; and(d) made downstream from the source receiving credits (Rock River Watershed Group 2000).The trading ratio increments (a) through (d) are clear attempts to address the importance ofthe location of emissions.

Farrow et al. (2005) develop a system of source-specific trading ratios for the eight largestsources of combined sewer overflows in the Upper Ohio River Basin. The marginal damagesamong these sources vary significantly with the characteristics of receiving waters at thesource and exposed populations. The analysis suggests that trading among these municipalsources could achieve the same level of social damages from pollution as a uniform 85 percentremoval standard, at 25–61 percent lower cost, depending on the shape of the control costfunction.

The widening gap in marginal abatement costs between point and nonpoint sourcesmeans that enhanced participation of nonpoint sources in water pollution abatement effortscould reduce total costs very significantly (Freeman 2000). For example, EPA estimatesthat expanded use of water quality trading between point and nonpoint sources couldreduce compliance costs associated with total maximum daily load (TMDL) regulations by$1 billion or more annually between 2000 and 2015 (U.S. Environmental Protection Agency2001). In point–nonpoint source trading programs, point sources may be allowed to reducetheir internal pollution abatement requirements if they finance an equivalent amount ofpollution abatement by nonpoint sources. Typical programs involve industrial point sourcesor municipal wastewater treatment plants paying farmers for changes in agricultural landmanagement practices that reduce the runoff of nutrients and other pollutants to sharedwaterways.

The form of credit or offset trading common in most U.S. water quality trading programsis different from the allowance markets that have been so successfully implemented for airquality, such as the market for SO2 emissions from U.S. power plants (Shabman, Stephenson,and Shobe 2002; Woodward and Kaiser 2002). In most water quality trading programs,regulators must approve each credit purchase by point sources by modifying their existingNational Pollutant Discharge Elimination System permits, raising transaction costs verysignificantly and stifling the cost-effectiveness potential of this approach (Schary and Fisher-Vanden 2004).

While nearly three dozen point–nonpoint source pollution trading programs have beenestablished in the United States since the 1980s, many have seen no trading at all, and feware operating on a scale that could be considered economically significant (Breetz et al.2005). The lack of systems of trading ratios to address the spatial distribution of pollutionand the cumbersome structure of trading are two important reasons for thin water qualitymarkets in the United States. Economists have suggested other reasons, as well. On thesupply side, nonpoint sources, especially agriculture, are unregulated. They are not issuedpollution permits and are not required to monitor reductions in runoff (King and Kuch2003; Schary and Fisher-Vanden 2004). Many federal and state agricultural policies requireor pay farmers to engage in the same nutrient management practices that would generate

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credits for a willing point source buyer, suppressing supply (King and Kuch 2003). Pointsources, as the permitted parties, are liable for any permit violations, including any that maystem from invalid credits from nonpoint sources – a “buyer beware” policy that suppressesdemand (Schary and Fisher-Vanden 2004).

One of the most successful water quality trading programs in the United States is a nutrienttrading program established in the early 1990s in North Carolina’s Tar-Pamlico River Basin.Point sources and municipalities purchase agricultural nutrient reduction credits (as well aswetland and riparian buffer restoration) through an intermediary, the Tar-Pamlico BasinAssociation. The credit price set by the Association for these transactions in 1999 was $29per kilogram of nitrogen or phosphorous. In comparison, the estimated marginal costs forreductions by individual point sources ranged from $55 to $65 per kilogram. By 2002, thetotal phosphorous and nitrogen concentrations in the basin had been reduced significantly.

To deal with the considerable uncertainty over the effectiveness of NPS controls in reducingwater pollution, regulators have typically required more than one unit of NPS abatement inexchange for each unit of credit toward a total required point source emissions reduction.For example, in the Rock River case discussed above, the base trading ratio is 1.75 (that is,a point source must purchase 1.75 units of emissions reductions from nonpoint sources foreach unit of credit toward its own emissions reductions). All the existing U.S. water qualitytrading programs require a ratio greater than 1:1 (Horan 2001). The estimated amount ofNPS pollution that may reach the edge of a farmer’s field should not be equated to pointsource emissions that enter a water body directly through a pipe, so a 1:1 trading ratio islikely not optimal. But high trading ratios suppress demand on the part of point sources andmay be inefficient.

Three sources of uncertainty have been used to justify high trading ratios: the stochasticnature of NPS pollution, moral hazard on the part of unregulated farmers, and an imperfectunderstanding of the relationship between changes in land management practices and theamount of pollution that reaches water bodies (Horan 2001). Economists have focusedsomewhat on the first source of uncertainty, and research suggests that the optimal tradingratio could be either greater than or less than 1:1 in the presence of stochastic pollutantloading (Shortle 1990; Malik, Letson, and Crutchfield 1993). If society is risk averse withrespect to pollution damages, and increasing NPS pollution loads increases the variability ofambient water quality, the optimal ratio would be less than, not greater than, 1:1 (Horan2001). The prevalence of high trading ratios could be explained by assuming that regulatorsseek to maximize abatement, rather than minimize pollution damages (Horan 2001). It isalso possible that high trading ratios could be optimal in a second-best setting in whichtrading ratios are set independent of allowable emissions; in an efficient setting, these wouldbe jointly determined (Horan and Shortle 2005).

Effluent Taxes

Water pollution taxes are much more common than tradable permits for water pollutioncontrol, and many countries have implemented them. Water pollution taxes studied byeconomists include those in the Netherlands for heavy metals and organic discharges (WorldBank 2000); French water pollution charges, with revenues earmarked for pollution controland water infrastructure (Cadiou and Duc 1994); the Chinese pollution levy system (Wangand Wheeler 2005); Malaysia’s effluent charge system for the palm oil industry (World Bank


1997b); and Colombia’s effluent charge system for industrial polluters in the Rio Negro basin(Sterner 2003). Most such policies do not tax emissions at levels that would approach thelevel of marginal damages from emissions at the efficient level of abatement (the Pigouviantax), though some have reduced pollution (Stavins 2003).

Like tradable water pollution permits, efficient water pollution taxes must take into accountthe spatial distribution of emissions, so long as the pollutant is nonuniformly mixed (whichis true for essentially all water pollutants). In this situation, a uniform tax on water pollutionmight actually result in welfare losses, relative to a technology standard. When high abatementcost facilities also have high benefits of abatement (i.e., high damages from emissions), thiscan cancel out and even reverse any potential gains from a market-based approach (Boyd2003). While source-specific taxes may be difficult to achieve, this problem might be mitigatedby setting up trading zones.

Taxing NPS pollution is considerably more complicated than taxing point source pollution.Estimating firm-level emissions (let alone the damages from emissions) may be prohibitivelycostly, due to the presence of multiple small polluters in a single water body, informationasymmetries, complex processes that govern where and how fast a pollutant travels, andstochastic environmental factors, such as weather (Suter et al. 2008). Economists have focusedon regulating emissions proxies for some sources (such as estimates of field losses of fertilizeror pesticide residuals), regulating inputs (such as fertilizers, pesticides, urban impervioussurfaces, and particular farming or forestry practices that affect runoff), and regulatingambient concentrations of water pollutants (Shortle and Horan 2001).

Taxes on inputs and other NPS emissions proxies may be relatively straightforward, butsomewhat removed from the actual damages from pollution (through concentrations andexposure). Segerson (1988) developed a theoretical policy instrument for NPS pollutioncontrol that assigns penalties for pollution damages (or rewards for abatement) to firms basedon ambient water quality. This work has motivated much subsequent research that extendsSegerson’s analysis (e.g., Xepapadeas 1991, 1992; Herriges, Govindasamy, and Shogren 1994;Hansen 1998; Horan, Shortle, and Abler 1998). Further work on the economics of NPSpollution control, including both taxes and point–nonpoint pollution trading, is a criticalarea for further research.

Liability Rules

Liability rules that internalize the external costs of water pollution are also quite common.However, transaction costs may be high relative to administrative regulations such as stan-dards, taxes, and permits (Acton and Dixon 1992; Dixon, Drezner, and Hammitt 1993).Liability rules are often designed to support a “polluter pays principle,” though due to theeconomic incidence of liability funding, polluters may not really pay (Probst et al. 1995).In theory, a mix of administrative regulation and liability rules for pollution control maybe optimal (Shavell 1984; Kolstad, Ulen, and Johnson 1990). Joint-and-several liability rulesfor NPS pollution, with implications similar to those of ambient pollution taxes, have beenconsidered in theory (Miceli and Segerson 1991).6

6Under joint-and-several liability, losses may be pursued from any single party. Polluters held liable (de-fendants in such cases) can pursue payment from other defendants, but a harmed party may recover alldamages from any single defendant, regardless of their individual share of the liability.

56 S. M. Olmstead

The 1977 Amendments to the CWA established strict liability of polluters for the dischargeof oil and other hazardous substances into U.S. navigable waters. The liability limits weresubsequently raised and responsibility for natural resource damages expanded by the 1980Comprehensive Environmental Response, Compensation, and Liability Act (known as Su-perfund), the 1990 Oil Pollution Act, and the 2000 National Marine Sanctuaries Act (Boyd2004). Liability for oil spills in U.S. waters is potentially unlimited under the Oil PollutionAct, which was passed in the aftermath of the Exxon Valdez oil spill off the Alaskan coast (Kim2002). This unlimited liability has resulted in avoidance behavior among regulated firms,such as the formation of single-vessel corporations, so as to reduce the potential costs of aspill. Much work has been done in the area of law and economics on the effects of liabilityrules under Superfund and related state laws, though not with respect to water resources perse (Kornhauser and Revesz 1994; Sigman 1998; Chang and Sigman 2000, 2007; Alberini andAustin 2002). There is some evidence that strict liability regimes reduce unexpected pollutionreleases to the environment. Firms have, in some cases, developed behavioral responses toavoid liability, though at least one study has demonstrated that, unlike under the Oil Pollu-tion Act, divestiture into smaller firms is not the mechanism through which this is achieved(Alberini and Austin 2002).

This law and economics research has recently become even more policy-relevant with theEuropean Union’s adoption of the Environmental Liability Directive (ELD) in 2004 (withmember states incorporating the directive into national law in subsequent years). The ELDholds polluters strictly responsible for the environmental damage they cause to water, soil,and protected species and habitats, and requires public authorities to ensure that pollutersrestore damaged natural resources. The focus on natural resource damage remediation is newto many member states (Winter et al. 2008). Repairs may be done either by the polluter, orby public agencies that can then attempt to recover costs from polluters. Whether a polluteror the public sector actually does the repairs may be an important distinction; in the UnitedStates, the EPA tends to choose less extensive environmental remedies under Superfundwhen firms are expected to bear a greater share of the costs (Sigman 1998).

Conclusion

This paper has reviewed the economics literature on water quality and water pollution control,highlighting water quality issues to which economics has made important contributions, aswell as areas in which further research might illuminate critical questions from the perspectiveof theory, empirics, or applied policy analysis. Several conclusions can be drawn from thisreview.

The literature finds that the provision of piped drinking water has very high net economicbenefits, due to its potential to reduce acute illness and death, particularly among youngchildren. Benefits of improved access also include reductions in the time required to collectand treat drinking water supplies. Improved sanitation also has high economic benefits,through its impact on reducing exposure to waterborne contaminants.

Recent economic studies have estimated the causal effects of rural water supply interven-tions other than centralized, piped service. However, the interplay among drinking waterand sanitation interventions, household and community behavior, and welfare is poorly


understood, and further research by economists in this area may have high value in theglobal effort to reduce the fraction of people without access to safe drinking water.

In industrialized nations, the stringency of drinking water standards has increased dramat-ically over time. Early interventions, such as chlorination, had very significant net benefits,but more recent contaminant standards may have had net costs. The literature suggests thatlocal or regional standards, based upon local preferences for the trade-off between healthrisks and treatment costs, may be appropriate for some types of contaminants.

The issue of ambient water quality presents significant externalities and public goods, whichthe literature finds to be particular challenges in transboundary settings. A large literature onnonmarket valuation of water quality has found that society is willing to pay significant sumsfor specific local water quality improvements that affect recreation, property values, andother goods and services. National water quality standards have demonstrated significant netbenefits, although in the United States (and perhaps other industrialized countries), marginalcosts may now exceed marginal benefits.

The relatively high cost of national standards may have to do, in large part, with policyinstrument choice. Point sources have been the primary targets of national water quality reg-ulation, with command-and-control regulations such as technology standards and uniformemissions standards continuing to predominate. There are many challenges to the develop-ment of cost-effective water quality policies such as water quality trading and effluent taxes.These challenges include nonuniform mixing of pollution, which requires the developmentof systems of trading ratios or differentiated taxes; the current exclusion from regulation ofnonpoint sources such as agriculture, where low-cost abatement opportunities abound, par-ticularly for nutrients; and the cumbersome nature of the existing offset and credit programs,which raises transaction costs for regulated point sources and stifles the potential cost-effectiveness advantage of the market-based approach. Further contributions of economiststo research in the important area of policy instrument choice for water quality regulation willrequire working closely with water quality modelers to develop welfare-improving pollutioncontrol policies.

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