1. 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

2. 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

3. Willingness to Pay
What is it?

4. 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

5. 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

6. 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’

7. 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

8. 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
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.

9. Willingness to Pay
How can it be measured?

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

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

17. 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)

18. 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

19. 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)

20. 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
***
-4.64
River water quality
0.0816***
6.81
0.1502***
4.68
Bill
***
-9.65
-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

21. 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

22. Willingness to Pay
How does it get used?

23. 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

24. Example output from a SP study

25. 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