Director, ICS Consulting Presentation to WSUG Meeting :diagnostics/ :transformation/ :investment planning/ :portfolio optimisation/ :investment economics/ :regulation and economics/ :training/ Willingness to Pay, Surveys and Application of Results Lies, damned lies and statistics Scott Reid Director, ICS Consulting Presentation to WSUG Meeting Edinburgh, 27th February 2014

Introduction Customer is finally king in Water But if you know your history… Customer engagement, customer affordability, customer value If your PR14 business plan doesn’t demonstrate all of these then good luck The term Willingness to Pay is much used, more abused What is it, how do we measure it and how do we use it are the themes I will try to outline for you today

Willingness to Pay What is it?

In a market setting, customers make choices based on: The regulator’s view In a market setting, customers make choices based on: Price of the product or service The level of service (quantity/quality) Attitude towards supplier Factors such as brand loyalty, trends, etc Choices made by customers ‘reveal’ their preferences Companies respond to customer behaviour to make decisions about investment, new products, customer service, etc

The water sector Water companies not yet subject to competition and customer choice ‘signals’ Ofwat continues to set price limits and monitors performance to protect customer interests Post 2017 prospect of some retail competition Customer engagement needed to demonstrate to Ofwat that what customers are required to pay for reflects what they want in terms of service

Justifying business plans Ofwat has long advocated cost-benefit analysis (CBA) to support investment planning Demonstrate benefits alongside costs of investments Challenge design solutions Set priorities CBA is a tool that enables companies to select investments that maximise benefits relative to costs So called ‘economic efficiency’ / ‘value for money’

Cost-benefit analysis Application of CBA follows from economic theory Costs and benefits have precise definitions Costs = reductions in wellbeing (utility/welfare) Benefits = increases in wellbeing Costs and benefits are measured in monetary terms Enables a consistent comparison of investment impacts; e.g. comparing CAPEX and OPEX to service improvements Mention also that CBA is the cornerstone of the HM Treasury Green Book and applies to all public spending / other investments requiring public funds, not just water companies. CBA is also in Maastrict Treaty etc. The concept of willingness to pay expresses the value of benefits in monetary terms

Willingness to pay (WTP) is a measure of economic value: Based on the trade-off between money and the consumption of goods and services Represents what is ‘given up’ to secure a change in provision of a good Relevant to market and non-market goods Can be estimated by a range of methods Total expenditure 10 20 30 Quantity Consumer surplus £6 £8 £10 Price Demand for market good Quantity Consumer surplus Price Demand for non-market good £0 Use flipchart / practical demonstration of WTP for increasing quantity of a market good.

Willingness to Pay How can it be measured?

Economic valuation Actual market data Surrogate market data: RP methods Hypothetical market data: SP methods Market prices - markets exists and prices reflect opportunity costs Shadow prices - market prices observed but need to be adjusted (taxes and subsidies) Revealed preference methods - market prices do not exist but ‘surrogate’ markets and prices observed Stated preference methods - Market prices and surrogate markets do not exist

Economic valuation Actual market data Surrogate market data: RP methods Hypothetical market data: SP methods Market prices - markets exists and prices reflect opportunity costs Shadow prices - market prices observed but need to be adjusted (taxes and subsidies) Revealed preference methods - market prices do not exist but ‘surrogate’ markets and prices observed Stated preference (SP) methods - Market prices and surrogate markets do not exist

Development of SP methods SP methods are comparatively new to the water industry, but the techniques are well established Essentially a form of market research survey Understand customer preferences Attempt to model choice behaviour using statistical methods Predict how customers will react Very flexible methods that are the cornerstone of consumer behaviour analyses

Note – may also be referred to as ‘conjoint analysis’ Methods Choice modelling – umbrella term for a set of methods: Contingent rating – score alternative options Contingent ranking – rank alternative options Paired comparison – choose preference option and score Choice experiments – choose between alternative options Contingent valuation value changes in provision of a non-market good Note – may also be referred to as ‘conjoint analysis’ This can be confusing since over time this term has been applied to rating, ranking and choice exercises Terminology Underlying theory

Choice Experiments & Contingent Valuation Choice experiments (CE) and contingent valuation (CV) are the methods relevant for valuing benefits: Consistent with CBA framework (economic theory) Respondents are presented with a hypothetical/simulated market via a questionnaire (‘survey instrument’) This creates something closer to experimental data Choice Experiment: infer WTP values from choice exercises Contingent Valuation: directly ask for WTP from respondent CE or not CV – that is the question… Define non-market good in terms of its characteristics (‘attributes’) Describe non-market good and change in its provision

Example: choice experiment Attributes Example: choice experiment Choices (‘alternatives’) Preview of practical exercise – that will familiarise participants with how CE is put together – attribute descriptions. Option Defined in terms of attribute levels

Example: contingent valuation ‘Dichotomous’ choice format Attribute / non-market good Difference between Option 1 and 2 defines the change in provision of good

Implementing an SP study UKWIR diagram Purpose is to show rel. complexity of study implementation. Detailed guidance is provided in the UKWIR Practitioners Guide (Part 1)

Implementing an SP study 1. Commissioning Objective Valuation framework 3. Implementation Main survey fieldwork 1 – 2 months 1 – 2 months 2. Design & testing Asset planning info Qualitative testing Pilot survey Peer review 4. Analysis Econometric analysis Validity testing Interpretation Peer review 2 – 3 months 1 – 6 months

Analysis in a SP study Model Formulation Estimation Methods Model of utility: Discrete choices: Probability of observing choices made: Task is to estimate the β’s Conditional Logit (CL) Most restrictive specification for utility model, e.g. does not allow for correlation across choices made by same individual Error Component Models (EC) Allows for a random error term in specification of utility associated with alternatives to status quo options Random Parameter Models (RPL) Allows for randomness in the parameters of the choice models Purpose is to show rel. complexity of study implementation. Detailed guidance is provided in the UKWIR Practitioners Guide (Part 1)

Econometric models of choice The models help us quantify how each attribute influences the choices we observe in the experiments Sample 1 Sample 2 Variable Coefficient z-value Unexpected interruptions to supply -0.460*** -4.09 -0.83*** -3.94 Taste, smell and colour of tap water -0.326*** -6.41 -0.3554*** -4.64 River water quality 0.0816*** 6.81 0.1502*** 4.68 Bill -0.0496*** -9.65 -0.0037 -0.73 Status Quo ASC 1.125*** 13.46 1.9565*** 8.11 Observations 1988 600 Pseudo R-squared 0.213 0.2995 AIC 3457 942 Use results from TW staff survey? Sign & Magnitude Model fit Significance

Further information DTLR (2002) Economic Valuation with Stated Preference Techniques: Summary Guide Bateman et al. (2002) Economic Valuation with Stated Preference Techniques: Manual UKWIR (2010) Review of CBA and Benefit Valuation: Practitioners Guide Part 1 UKWIR (2011) Carrying Out Willingnesss to Pay Surveys

Willingness to Pay How does it get used?

The use and mis-use of WTP studies? Good practice Calibrate the benefits of options to change/improve level of individual service measures Input to cost benefit analysis and investment optimisation Test ranges of WTP for packages of service improvements not just individual areas of service Input to testing trade-offs within an overall portfolio of investments Understand differences in value For improvements in service versus reduction in service For different levels of improvement in service What to avoid Interpret WTP as the bill change/increase customers should pay WTP is about value, not about bills Its an input not the output

Example output from a SP study

Dr. Scott Reid Director, ICS Consulting scott@icsconsulting.co.uk :diagnostics/ :transformation/ :investment planning/ :portfolio optimisation/ :investment economics/ :regulation and economics/ :training/ Willingness to Pay, Surveys and Application of Results Lies, damned lies and statistics Dr. Scott Reid Director, ICS Consulting scott@icsconsulting.co.uk