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The Economics of Water Quality

Sheila 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 re occurred in 1969, though in truth it was the tenth such re that had occurred since the mid-1800s, and not the worst. The days of major river res are likely over in the United States, due in part to the signicant improvements in surface water quality since the passage of the Federal Water Pollution Control Act, commonly known as the Clean Water Act (CWA), in 1972. In the 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 role in the development of aquatic dead zones from the Gulf of Mexico to the Baltic Sea. Stark industrial water pollution problems persist in many developing countries, however. For example, about one-half of the monitored urban river waters in northern China do not meet the countrys 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 people worldwide lack access to safe drinking water, causing millions of deaths annually, especially of very young children (United Nations 2003). The United Nations Millennium Development Goals include reducing by half the proportion of people without sustainable access to safe drinking water by 2015.1 Access to safe drinking water is approaching 100 percent in most industrialized countries. Thus, the relevant economic and policy questions in these countries have more to do with the setting of regulatory standards than providing drinking water access. 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, Yale University, 195 Prospect Street, New Haven, CT 06511, USA. Telephone: 203-432-6247; Fax: 203-436-9150; e-mail: sheila.olmstead@yale.edu; 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 the helpful suggestions of an anonymous referee. All remaining errors and omissions are my own.

In September 2000, the United Nations convened the Millennium Summit, where nations adopted the UN Millennium Declaration. The Declaration committed nations to a new global poverty-reduction effort, including a schedule for achieving specic targets by 2015. The overarching group of eight goals (the water and sanitation target mentioned above is part of Goal #7: Ensure Environmental Sustainability) has come to 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. 4462 doi:10.1093/reep/rep016 Advance Access publication on November 12, 2009
C 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: journals.permissions@oxfordjournals.org

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water in the early days of the George W. Bush administration suggests that concerns about the 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 has received signicant attention from environmental economists, especially in the voluminous literature on nonmarket valuation, for several reasons it has received less attention than air quality in the general economics literature. First, ambient air pollution has signicant and direct human health impacts, which can be monetized and compared with the costs of regulation. By contrast, most of the benets of controlling surface water pollution (where raw water is not consumed) have to do with recreational use and ecosystem health, and the magnitude of these benets may be dwarfed by those of air quality regulations, in which human health impacts dominate. Second, policymakers in both industrialized and developing 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 such approaches in theory and evaluated their performance in practice. Policymakers have implemented far fewer market-based approaches to water pollution control, leaving little room for 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 considered in theory). Finally, although the introduction of basic drinking water treatment and sanitation provides among the highest net benets of any environmental policy intervention, the majority of populations in most industrialized countries had received these services long before environmental economics existed as a eld of study. Thus, there is little demand for prospective benetcost 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 pollution and the regulation of water quality, one of the many issues concerning water to which economists have made signicant policy contributions. While not comprehensive, this review of the literature highlights many of the most important topics that economists have addressed in this area, as well as the key topics for future research. The remainder of the paper is organized as follows. In the next section, the efciency of drinking water provision and regulation is addressed. This is followed by a discussion of the efciency 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 nal section.

The Efciency of Drinking Water Provision and Regulation

The economics literature has addressed two major issues concerning the efciency of drinking water provision and regulation. First, many studies have quantied the human health implications of water and sanitation interventions that improve drinking water access, quality, and service reliability. Second, research has compared the effectiveness of the specic types of interventions, and assessed regulatory mechanisms to reduce exposure to drinking water contaminants.

However, 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, through changes in drinking water and sanitation infrastructure, is a policy intervention with very signicant net benets. Most of the benets of such policies are attributable to reduced infant and child mortality. More than 3 million children, most of them under ve years of age, die from preventable water-related diseases annually (World Bank 2002). The provision of piped, treated drinking water in major American cities during the early twentieth century resulted in large reductions in urban mortality, with an estimated social rate of return to infrastructure investments of 23 to 1 (Cutler and Miller 2005). Improvements in the access to piped drinking water and sanitation in Brazil between 1970 and 2000 resulted in a combined welfare gain of $10,300 per capita, explaining 22 percent of within-municipality variation in life expectancy over the period (Soares 2007). By one estimate, an individual born in Brazil in 1970 would have been willing to pay almost 3.5 times a single years income for 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 provision of sanitation infrastructure on Native American reservations between 1960 and 1998 reduced infant mortality on reservations by 2.5 percent, through reductions in waterborne gastrointestinal disease and infectious respiratory disease, at a cost per life saved of $217,000, with signicant positive spillovers to neighboring white populations (Watson 2006). While most published work on this topic nds very signicant net benets (in the form of reduced morbidity and mortality) from the provision of piped water and sanitation, others estimate that 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 in drinking water may improve long-run health and educational outcomes (Venkataramani 2009). Where households must fetch water from outside of the home, the benets of piped drinking water supplies include the opportunity cost of the time previously spent gathering and/or treating water (valued, in many cases, at the local wage rate for unskilled labor), as well as health improvements. Numerous contingent valuation (CV) studies have demonstrated that poor households in developing countries lacking safe drinking water sources are willing to pay signicant 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 benets of piped water provision, which can be compared with the costs of public infrastructure investment. Economists have also used the averting-expenditure methods to estimate such benets (McConnell and Rosado 2000; Pattanayak et al. 2005). A comprehensive summary of research using both the CV and revealed-preference methods suggests that the most important determinants of willingness to pay for improved water service include education, income, family size, and other demographic characteristics; cost, quality, and reliability of households current supply, compared with those of the proposed alternative; and household attitudes toward government policy and public investment in water services (World Bank Water Demand Research Team 1993). Studies also suggest that households in developing-country cities that are not connected to piped water systems may pay very high prices for water from the informal sector, providing further evidence

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of willingness to pay for water service (Whittington, Lauria, and Mu 1991; Bhatia and Falkenmark 1993). Economists have also estimated potential welfare gains from improvements in the quality of water service reducing variability or interruptions in the water delivery schedule, for example in both developing (Baisa et al. 2009) and industrialized countries (Hensher, Shore, and Train 2005). While the estimated benets of such service improvements are signicant, households in developing countries may be willing to pay less for these improvements than for improvements in drinking water quality (Akram and Olmstead 2009). Willingness to pay for sanitation infrastructure in developing countries is less well studied than drinking water supply. The results of a CV study of one thousand two hundred households in Kumasi, Ghana, suggest that the local willingness to pay is approximately the same for conventional sewage treatment as it is for improved ventilated pit latrines (Whittington et al. 1993). Since on-site sanitation is much cheaper than conventional sewage treatment infrastructure, the subsidies required to support improved latrines for all local households are markedly smaller than those that would be required to support conventional treatment (Whittington et al. 1993).

Effectiveness of Specic Drinking Water Interventions

How should increased access to safe drinking water be achieved? In many cases, water supply interventions in developing countries are funded by national governments, multilateral nancial institutions, or donor agencies, which may seek evidence of the effectiveness of these interventions. The epidemiological literature provides substantial evidence that pointof-use disinfection of drinking water reduces diarrheal incidence and mortality in developing countries (see, e.g., Fewtrell et al. 2005). However, there is much less evidence on the causal effect of other water and sanitation interventions on morbidity and mortality, especially in rural areas (Zwane and Kremer 2007). In particular, the relationships among specic interventions, household and community behavior, and health outcomes are poorly understood. A recent randomized eld experiment assesses the impact of spring protection on household water quality and health in rural Kenya (Kremer et al. 2006). While protecting springs is found to be very effective in improving both water quality at the source and home water quality (after collection and storage) among households collecting exclusively from sample springs before protection, the authors nd no substantial effects on diarrheal incidence, child weight, or child height; no positive spillovers to neighboring communities; and a declining willingness to pay for source protection over time (Kremer et al. 2006). Emerging research suggests that household behavioral changes such as reductions in in-home treatment and sanitation behavior can reduce, or even negate, the benets of providing safe drinking water sources (Jessoe 2009; Bennett 2009). The role of communities that may invest in, and maintain, small-scale water and sanitation infrastructure has also been examined. More than 40 percent of borehole wells dug in rural western Kenya between 1981 and 1992 using external development aid were in disrepair by 2000 (Miguel and Gugerty 2005). Ethnic diversity within these communities has a negative impact on water well maintenance, suggesting collective action failures in sustaining drinking water 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 drinking water. For example, village councils in rural India headed by women (who bear a disproportionate share of the burden of water collection) may be more likely to invest in public drinking water infrastructure improvements (Chattopadhyay and Duo 2004). More studies of the interplay among drinking water and sanitation interventions, household and community behavior, and health outcomes are necessary to design better drinking water supply interventions. Another important area for future research is the design of water quality improvements in cases where most households will continue to obtain water from raw sources or the informal sector. Studies have demonstrated that regulated drinking water providers reduce violations of drinking water standards in the United States when they are required to disclose violations to their customers (Bennear and Olmstead 2008). Recent work in developing countries suggests that information disclosure may also result in consumption of safer drinking water by developing-country households accessing unregulated sources, by encouraging them to switch to safer wells (Madajewicz et al. 2007) or prompting increases in in-home drinking water treatment (Jalan and Somanthan 2008). Lack of awareness of the adverse health effects of unsafe drinking water consumption has been identied as a signicant barrier to the adoption of home water purication practices in urban India, providing additional support for the provision of information (Jalan, Somanathan, and Chaudhuri 2009). There is a substantial literature in economics on information provision and disclosure, more generally; for example, the drinking water quality examples discussed above are linked to empirical work 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 and sanitation, and signicant net benets may result from their provision (Olmstead 2004; Watson 2006). However, because most of the low-hanging fruit in drinking water quality regulation has already been harvested in industrialized countries, barring new scientic evidence 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 EPA perform a benetcost analysis for all new drinking water contaminant standards. The rst two standards promulgated under this requirement, more stringent standards for arsenic and radon, were found to have net costs (USEPA 1999; Abt Associates 2000; Burnett and Hahn 2001). This has given rise to a discussion of whether drinking water standards in the United States should be set at the national or local level. The benet of national drinking water standards is that all water systems meet minimum health standards (though across communities exposure to contaminants may vary signicantly below the standard). However, uniform standards, as in other contexts, are likely not efcient. The U.S. Congressional Budget Ofce (1995) estimates that the average cost per cancer case avoided due to SDWA standards, across all system sizes, ranges from $500,000 for the pesticide ethylene dibromide and co-contaminants to more than $4 billion for the pesticide atrazine and the herbicide alachlor. Due to signicant economies of scale in drinking water treatment, the cost per cancer case avoided by many standards increases dramatically as system size decreases. For example, for the largest size class

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of the regulated U.S. water systems (approximately 370 systems serving more than 100,000 people each), the cost per cancer case avoided by the SDWA standard for adjusted gross alpha emitters, which reduces exposure to a group of radioactive elements (mostly from natural sources) in drinking water, is about $600,000. For the smallest size class (approximately thirty thousand systems serving 25500 people each), the cost per cancer case avoided by this standard is more than $1 billion (U.S. Congressional Budget Ofce 1995; Tiemann 2006). Thus, for many contaminants, it may be more efcient to set local standards, which reect local 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 many aspects of scal federalism explored by economists.3 Theory suggests that interjurisdictional competition may be welfare-enhancing (Oates and Schwab 1988). Strategic interaction 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 ambient water quality, drinking water quality imposes a few externalities that might cross local or state boundaries.4 The downside risk of decentralized standards is the possibility of a race to the bottom, in which communities enact excessively lax environmental standards to attract businesses or households. However, the empirical evidence suggests that interjurisdictional competition in environmental quality does not result in a race to the bottom, and may even result in a race to the top (List and Gerking 2000; Millimet 2003). The welfare implications of uniform national drinking water standards are an important area for future research.

Efciency of Ambient Water Quality Regulation

Ambient water quality standards, when raw water is not directly consumed, have low human health benets relative to drinking water standards. Most of the benets of such policies are related to recreational use and ecosystem health. Ambient water quality is also associated with more signicant externalities and public goods than the quality of piped drinking water, because water resources may be shared by multiple jurisdictions and may provide goods such as recreation, ood control, and navigation in addition to private goods. These market failures pose more signicant barriers to achieving efcient levels of water quality in transboundary settings. With these issues in mind, this section rst assesses what is known about the efciency of national water quality standards, particularly in the United States, and then considers transboundary water quality.

Estimated Benets and Costs of National Water Quality Standards

The U.S. CWA, encompassing the Federal Water Pollution Control Act of 1972 and the later amendments, implements controls almost exclusively for industrial point sources and municipal wastewater treatment. Freeman (1982) estimates recreational benets from the CWAs point source controls (freshwater shing, marine sports shing, boating, swimming,
3 4

An overview of this literature is offered by Oates (1999). There is, however, an important caveat here, which is that without sufcient microbiological standards, the externalities from waterborne disease through person-to-person transmission could be signicant.

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and waterfowl hunting), indirect use benets (aesthetics, ecology, and property value), benets to commercial sheries, and cost reductions for water treatment in municipal, industrial, and residential settings. He reports a best estimate of total benets (in 1996 dollars) of $22.6 billion 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 that results when moving from no pollution control to swimmable water quality nationwide.5 Their best estimate of annual benets (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 incremental benets of additional water pollution control investments (i.e., the marginal benets of additional abatement) beyond 1990. In sum, these three studies suggest that the CWA had signicant net benets between 1972 and the late 1980s, but that at some point around 1990, incremental costs began to exceed incremental benets. 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 with reductions in fecal coliform contamination (Leggett and Bockstael 2000), and that consumers have signicant willingness to pay for the improvements in coastal water quality resulting from reductions in nutrient runoff (Morgan and Owens 2001) and for improvements in beach water quality (Bockstael, Hanemann, and Kling 1987; Hanley, Bell, and Alvarez-Farizo 2003). Recreational shing benets of water pollution abatement have also been assessed at individual sites (Kaoru 1995; Montgomery and Needelman 1997; Massey, Newbold, and Gentner 2006). About three-quarters of published estimates of the economic value of nonmarket goods and services in the United States that are provided by water quality are travel cost studies, suggesting that most measured benets are recreational (Van Houtven, Powers, and Pattanayak 2007). The literature contains an increasing number of developing country applications. For example, Day and Mourato (2002) use a CV survey to estimate the value of improvements in river water quality in China, and Choe, Whittington, and Lauria (1996) estimate the benets of 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 deserves much more study. Recent work has also combined the valuation of multiple ecosystem services with spatially explicit models of the links between water quality and other environmental goods and services, using the ecological production function approach (National Research Council 2005). For example, land use and land cover changes may cause shifts in nal ecosystem services, including hydrological services. One study that integrates the impacts of such changes on water quality with other services also quanties the effects of different land use change scenarios on nutrient runoff and storm-related ooding, though it does not value these changes (Nelson et al. 2009). The ecosystem services literature that combines economics and ecology in this way is in its infancy, and advances in this area will improve water quality valuation in the future.

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

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Water Quality in Transboundary Settings

Shared water resources present classic externalities and public goods. Polluting entities, bearing only a portion of the benets of water pollution abatement but all of the costs, will tend to free-ride, passing pollution downstream across political borders. Several transboundary water resource management examples have been addressed from a game-theoretic perspective as problems of international environmental cooperation (see Barrett 2003). Empirical analyses of pollution spillovers in transboundary settings have conrmed the hypothesis that countries (and even states and counties) free-ride in this manner. In a global analysis, Sigman (2002) nds that pollution levels at monitoring stations just upstream of international borders may have pollution levels elevated by 40 percent or more. Less freeriding occurs among countries within the European Union, suggesting a possible important role for international institutions in mitigating strategic behavior. Turning to states and counties, 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 states that are authorized by federal law to implement and enforce the CWA, relative to states in which the EPA plays this role (Sigman 2004). Water pollution emissions by U.S. pulp and paper plants appear to be higher when out-of-state residents receive a greater share of pollution control benets (Gray and Shadbegian 2004). Using panel data from counties in Brazil, Lipscomb and Mobarak (2008) quantify the spillover effects of free-riding; they show that pollution increases by 2.3 percent per kilometer as a river approaches the border exiting a county, and that this effect jumps to 18.6 percent per kilometer within ve kilometers of a downstream border. Water pollution spillovers also intensify as the number of political jurisdictions 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 efcient, policymakers can choose policy instruments that cost-effectively achieve those standards. Following the remarkable success of permit trading under the U.S. Acid Rain Programs sulfur dioxide (SO2 ) emissions trading system, the phase-down of lead in gasoline, the European Unions nascent market for carbon emissions under the Kyoto Protocol, and other applications of market-based approaches to air quality, expectations have been high for the successful transfer 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-based policies, the marginal damages from water pollution may vary dramatically with the location of emissions, depending on the characteristics of receiving waters and other factors. This nonuniform mixing of most water pollutants makes it difcult to design cost-effective policies for pollution control. In industrialized settings, the primary remaining water pollution problem is generally not point source pollution, since the primary means for achieving water quality goals over the past three decades has been the requirement that point sources (mostly industrial facilities) obtain permits delineating maximum discharge quantities, based on the performance of known 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 if all U.S. point sources of water pollution were to achieve zero emissions, only 10 percent of U.S. river and stream miles would rise a step or more on EPAs water quality ladder (Bingham et al. 2000). It is nonpoint source (NPS) pollution that is the major source of water quality impairment in U.S. water bodies, and, unlike point source pollution, it is currently unregulated by the CWA. Common nonpoint sources of water pollution include agricultural and urban runoff, atmospheric deposition, and runoff from forests and mines, all of which enter water bodies over diffuse areas. NPS pollution from agricultural activities is the primary source of impairment in U.S. rivers and streams (U.S. Environmental Protection Agency 2009). NPS pollution has a signicant stochastic component, depending on uctuations in weather and other environmental factors. There is also considerable uncertainty over both the 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 for many decades, there are signicant cost savings possible through pointnonpoint trading or differentiated taxes. However, if these policy instruments are poorly designed, they could easily reduce rather than improve social welfare. The remainder of this section assesses the current state of economic research on market-based policy instruments for controlling water pollution, which hold the potential to improve water quality at a lower cost than technology standards and other common command-and-control approaches. These marketbased instruments include both point sourcepoint source and point sourcenonpoint source water quality trading, water efuent taxes, and liability rules.

Water Quality Trading

Only a few successful point sourcepoint source water quality trading programs have been established. One example is the salinity trading program in Australias Hunter River, which was created as a pilot program in 1995. Under this program, tradable permits are issued to coal mines and power plants to discharge saline water into the river during periods of high ow, when dilution is greatest. The permits entitle polluters to emit a share of the total allowable discharge. Flow conditions change rapidly, so trading takes place online in real time, through a central Web site. The salinity targets at the systems two river-monitoring points have not been exceeded by participant discharges since trading began (Kraemer, Interwies, and Kampa 2002). Though no cost-effectiveness analysis has been conducted, the more costly alternative for the participating point sources of pollution would have been the construction and maintenance of saline water reservoirs that are larger than those that existed when trading began. One of the barriers to the establishment of successful water quality trading programs has been accounting for the spatial distribution of nonuniformly mixed water pollution. This challenge has largely been absent from tradable permit programs for air quality, though it has been addressed in the environmental and resource economics literature. The literature suggests that establishing trading ratios that vary by each potential trading partner pair, in the manner of exchange rates, is an efcient approach (Oates, Krupnick, and Van de Verg 1983; Tietenberg 1985; Rodr guez 2000; Farrow et al. 2005; Hung and Shaw 2005).

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Regulators have typically constructed trading ratios between classes of polluters, rather than source-specic ratios. For example, the Rock River Basin Pilot Trading Program in Wisconsin employs trading ratios calculated as the sum of a base trade ratio plus additional increments of 0.125 each if the trade is: (a) not in a target area; (b) not generating abatement within 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 of the location of emissions. Farrow et al. (2005) develop a system of source-specic trading ratios for the eight largest sources of combined sewer overows in the Upper Ohio River Basin. The marginal damages among these sources vary signicantly with the characteristics of receiving waters at the source and exposed populations. The analysis suggests that trading among these municipal sources could achieve the same level of social damages from pollution as a uniform 85 percent removal standard, at 2561 percent lower cost, depending on the shape of the control cost function. The widening gap in marginal abatement costs between point and nonpoint sources means that enhanced participation of nonpoint sources in water pollution abatement efforts could reduce total costs very signicantly (Freeman 2000). For example, EPA estimates that expanded use of water quality trading between point and nonpoint sources could reduce compliance costs associated with total maximum daily load (TMDL) regulations by $1 billion or more annually between 2000 and 2015 (U.S. Environmental Protection Agency 2001). In pointnonpoint source trading programs, point sources may be allowed to reduce their internal pollution abatement requirements if they nance an equivalent amount of pollution abatement by nonpoint sources. Typical programs involve industrial point sources or municipal wastewater treatment plants paying farmers for changes in agricultural land management practices that reduce the runoff of nutrients and other pollutants to shared waterways. The form of credit or offset trading common in most U.S. water quality trading programs is different from the allowance markets that have been so successfully implemented for air quality, 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 existing National Pollutant Discharge Elimination System permits, raising transaction costs very signicantly and stiing the cost-effectiveness potential of this approach (Schary and FisherVanden 2004). While nearly three dozen pointnonpoint source pollution trading programs have been established in the United States since the 1980s, many have seen no trading at all, and few are operating on a scale that could be considered economically signicant (Breetz et al. 2005). The lack of systems of trading ratios to address the spatial distribution of pollution and the cumbersome structure of trading are two important reasons for thin water quality markets in the United States. Economists have suggested other reasons, as well. On the supply side, nonpoint sources, especially agriculture, are unregulated. They are not issued pollution permits and are not required to monitor reductions in runoff (King and Kuch 2003; Schary and Fisher-Vanden 2004). Many federal and state agricultural policies require or 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). Point sources, as the permitted parties, are liable for any permit violations, including any that may stem from invalid credits from nonpoint sources a buyer beware policy that suppresses demand (Schary and Fisher-Vanden 2004). One of the most successful water quality trading programs in the United States is a nutrient trading program established in the early 1990s in North Carolinas Tar-Pamlico River Basin. Point sources and municipalities purchase agricultural nutrient reduction credits (as well as wetland and riparian buffer restoration) through an intermediary, the Tar-Pamlico Basin Association. The credit price set by the Association for these transactions in 1999 was $29 per kilogram of nitrogen or phosphorous. In comparison, the estimated marginal costs for reductions by individual point sources ranged from $55 to $65 per kilogram. By 2002, the total phosphorous and nitrogen concentrations in the basin had been reduced signicantly. To deal with the considerable uncertainty over the effectiveness of NPS controls in reducing water pollution, regulators have typically required more than one unit of NPS abatement in exchange 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 for each unit of credit toward its own emissions reductions). All the existing U.S. water quality trading programs require a ratio greater than 1:1 (Horan 2001). The estimated amount of NPS pollution that may reach the edge of a farmers eld should not be equated to point source emissions that enter a water body directly through a pipe, so a 1:1 trading ratio is likely not optimal. But high trading ratios suppress demand on the part of point sources and may be inefcient. Three sources of uncertainty have been used to justify high trading ratios: the stochastic nature of NPS pollution, moral hazard on the part of unregulated farmers, and an imperfect understanding of the relationship between changes in land management practices and the amount of pollution that reaches water bodies (Horan 2001). Economists have focused somewhat on the rst source of uncertainty, and research suggests that the optimal trading ratio could be either greater than or less than 1:1 in the presence of stochastic pollutant loading (Shortle 1990; Malik, Letson, and Crutcheld 1993). If society is risk averse with respect to pollution damages, and increasing NPS pollution loads increases the variability of ambient water quality, the optimal ratio would be less than, not greater than, 1:1 (Horan 2001). The prevalence of high trading ratios could be explained by assuming that regulators seek to maximize abatement, rather than minimize pollution damages (Horan 2001). It is also possible that high trading ratios could be optimal in a second-best setting in which trading ratios are set independent of allowable emissions; in an efcient setting, these would be jointly determined (Horan and Shortle 2005).

Efuent Taxes
Water pollution taxes are much more common than tradable permits for water pollution control, and many countries have implemented them. Water pollution taxes studied by economists include those in the Netherlands for heavy metals and organic discharges (World Bank 2000); French water pollution charges, with revenues earmarked for pollution control and water infrastructure (Cadiou and Duc 1994); the Chinese pollution levy system (Wang and Wheeler 2005); Malaysias efuent charge system for the palm oil industry (World Bank

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1997b); and Colombias efuent charge system for industrial polluters in the Rio Negro basin (Sterner 2003). Most such policies do not tax emissions at levels that would approach the level of marginal damages from emissions at the efcient level of abatement (the Pigouvian tax), though some have reduced pollution (Stavins 2003). Like tradable water pollution permits, efcient water pollution taxes must take into account the spatial distribution of emissions, so long as the pollutant is nonuniformly mixed (which is true for essentially all water pollutants). In this situation, a uniform tax on water pollution might actually result in welfare losses, relative to a technology standard. When high abatement cost facilities also have high benets of abatement (i.e., high damages from emissions), this can cancel out and even reverse any potential gains from a market-based approach (Boyd 2003). While source-specic taxes may be difcult to achieve, this problem might be mitigated by setting up trading zones. Taxing NPS pollution is considerably more complicated than taxing point source pollution. Estimating rm-level emissions (let alone the damages from emissions) may be prohibitively costly, due to the presence of multiple small polluters in a single water body, information asymmetries, complex processes that govern where and how fast a pollutant travels, and stochastic environmental factors, such as weather (Suter et al. 2008). Economists have focused on regulating emissions proxies for some sources (such as estimates of eld losses of fertilizer or pesticide residuals), regulating inputs (such as fertilizers, pesticides, urban impervious surfaces, and particular farming or forestry practices that affect runoff), and regulating ambient concentrations of water pollutants (Shortle and Horan 2001). Taxes on inputs and other NPS emissions proxies may be relatively straightforward, but somewhat removed from the actual damages from pollution (through concentrations and exposure). Segerson (1988) developed a theoretical policy instrument for NPS pollution control that assigns penalties for pollution damages (or rewards for abatement) to rms based on ambient water quality. This work has motivated much subsequent research that extends Segersons analysis (e.g., Xepapadeas 1991, 1992; Herriges, Govindasamy, and Shogren 1994; Hansen 1998; Horan, Shortle, and Abler 1998). Further work on the economics of NPS pollution control, including both taxes and pointnonpoint pollution trading, is a critical area 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 standards, 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 the economic 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 may be optimal (Shavell 1984; Kolstad, Ulen, and Johnson 1990). Joint-and-several liability rules for NPS pollution, with implications similar to those of ambient pollution taxes, have been considered in theory (Miceli and Segerson 1991).6
6

Under joint-and-several liability, losses may be pursued from any single party. Polluters held liable (defendants in such cases) can pursue payment from other defendants, but a harmed party may recover all damages 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 discharge of oil and other hazardous substances into U.S. navigable waters. The liability limits were subsequently raised and responsibility for natural resource damages expanded by the 1980 Comprehensive Environmental Response, Compensation, and Liability Act (known as Superfund), the 1990 Oil Pollution Act, and the 2000 National Marine Sanctuaries Act (Boyd 2004). Liability for oil spills in U.S. waters is potentially unlimited under the Oil Pollution Act, which was passed in the aftermath of the Exxon Valdez oil spill off the Alaskan coast (Kim 2002). This unlimited liability has resulted in avoidance behavior among regulated rms, such as the formation of single-vessel corporations, so as to reduce the potential costs of a spill. Much work has been done in the area of law and economics on the effects of liability rules under Superfund and related state laws, though not with respect to water resources per se (Kornhauser and Revesz 1994; Sigman 1998; Chang and Sigman 2000, 2007; Alberini and Austin 2002). There is some evidence that strict liability regimes reduce unexpected pollution releases to the environment. Firms have, in some cases, developed behavioral responses to avoid liability, though at least one study has demonstrated that, unlike under the Oil Pollution Act, divestiture into smaller rms 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 the European Unions adoption of the Environmental Liability Directive (ELD) in 2004 (with member states incorporating the directive into national law in subsequent years). The ELD holds polluters strictly responsible for the environmental damage they cause to water, soil, and protected species and habitats, and requires public authorities to ensure that polluters restore damaged natural resources. The focus on natural resource damage remediation is new to many member states (Winter et al. 2008). Repairs may be done either by the polluter, or by public agencies that can then attempt to recover costs from polluters. Whether a polluter or the public sector actually does the repairs may be an important distinction; in the United States, the EPA tends to choose less extensive environmental remedies under Superfund when rms 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, as well as areas in which further research might illuminate critical questions from the perspective of theory, empirics, or applied policy analysis. Several conclusions can be drawn from this review. The literature nds that the provision of piped drinking water has very high net economic benets, due to its potential to reduce acute illness and death, particularly among young children. Benets of improved access also include reductions in the time required to collect and treat drinking water supplies. Improved sanitation also has high economic benets, through its impact on reducing exposure to waterborne contaminants. Recent economic studies have estimated the causal effects of rural water supply interventions other than centralized, piped service. However, the interplay among drinking water and sanitation interventions, household and community behavior, and welfare is poorly

The Economics of Water Quality

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understood, and further research by economists in this area may have high value in the global effort to reduce the fraction of people without access to safe drinking water. In industrialized nations, the stringency of drinking water standards has increased dramatically over time. Early interventions, such as chlorination, had very signicant net benets, but more recent contaminant standards may have had net costs. The literature suggests that local or regional standards, based upon local preferences for the trade-off between health risks and treatment costs, may be appropriate for some types of contaminants. The issue of ambient water quality presents signicant externalities and public goods, which the literature nds to be particular challenges in transboundary settings. A large literature on nonmarket valuation of water quality has found that society is willing to pay signicant sums for specic local water quality improvements that affect recreation, property values, and other goods and services. National water quality standards have demonstrated signicant net benets, although in the United States (and perhaps other industrialized countries), marginal costs may now exceed marginal benets. The relatively high cost of national standards may have to do, in large part, with policy instrument choice. Point sources have been the primary targets of national water quality regulation, with command-and-control regulations such as technology standards and uniform emissions standards continuing to predominate. There are many challenges to the development of cost-effective water quality policies such as water quality trading and efuent taxes. These challenges include nonuniform mixing of pollution, which requires the development of systems of trading ratios or differentiated taxes; the current exclusion from regulation of nonpoint sources such as agriculture, where low-cost abatement opportunities abound, particularly for nutrients; and the cumbersome nature of the existing offset and credit programs, which raises transaction costs for regulated point sources and sties the potential costeffectiveness advantage of the market-based approach. Further contributions of economists to research in the important area of policy instrument choice for water quality regulation will require working closely with water quality modelers to develop welfare-improving pollution control policies.

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