Why does not this xss work?

It does not work because the payload is encoded in URL.

If you browse to

https://example.com/?foo= <> "

You'll watch the literal characters <> " in your URL bar, but the browser has requested

https://example.com/?foo=%3C%3E%22

. That is, your browser always encodes some characters in the query string in URL, including quotes and angle brackets.

So, if you access location.href through JS, the payload in your example will be returned as

test% 3C / option% 3E% 3Cimg% 20src = x% 20onerror = alert (1) /% 3E

. This does not produce any HTML tag unless you first decode it with URL.

Note: As far as I know, all modern browsers behave that way, but historically, some implementations have URL decoded values ‚Äč‚Äčimplicitly for the Location Interface. In these browsers, your attack would have worked.