Environmental Externalities: what they are, why they matter, and how to fix them

The First Welfare Theorem of neoclassical economic theory suggests that, so long as there are certain market conditions, rational, self-interested agents will produce socially optimal outcomes. Because the atmosphere is an open-access resource, however—a public good that is non-rivalrous and non-excludable across borders—there are several opportunities for externalities, inefficient allocations of resources, and market failures. Climate change stands out as the chief market failure of human history.

Greenhouse gas emissions are an example of negative externalities. An externality describes a market transaction in which a third-party is impacted, either positively or negatively. In the case of GHG emissions, social costs are external to the transaction between the buyers and sellers of oil, gas, or coal and their byproducts. Third-party members—those who must breathe in polluted air or live with the ramifications of anthropogenic climate change—are not compensated for the negative impacts that he or she may suffer. As such, absent of intervention, free markets cannot efficiently or equitably manage our atmosphere.

To provide an example, The United Nations has begun to portray climate change as a public health issue. Climate change is contributing to health risks by increasing heat-related mortality, pregnancy complications, and cardiovascular disease. Climate change also has large impacts on water quality, food security, and the spread of disease. Given these trends, the World Health Organization has projected that “between 2030 and 2050, at least 250,000 additional deaths will occur every year as a result of climate change.” These health impacts, or the social cost of carbon, are not included in the price of fossil fuels.

This social cost of carbon—calculated as the cost of damages from the release of one ton of carbon dioxide into the atmosphere—is a measure of the financial harm caused by the effects of air pollution. The impacts of these decisions cost society billions of dollars, not only in rising health care costs, but also in property damages and food prices. In only considering private costs, we are creating socially suboptimal outcomes.

As it now stands, political leaders may recognize that climate change is a threat, but their actions are insufficient. In fact, governments are subsidizing the activities that cause climate change, allowing polluters to pose unabated risks to our public health and environment. According to the International Monetary Fund, “Coal, oil, and natural gas received $5.9 trillion in subsidies in 2020 — or roughly $11 million every minute.” This underpricing leads to excess consumption of fossil fuels, the acceleration of anthropogenic climate change, and adverse public health impacts.

Greenhouse gasses power our world, and have contributed to economic flourishing in the last several decades. It is hard to fathom a world without carbon emissions, in that fossil fuels are inextricably linked to our everyday lifestyles. With that said, while we do benefit from the luxuries of fossil fuels—air conditioning, driving, etc.—society is not benefiting from greenhouse gasses as much as we may think. When we pay utility bills, for example—our own private costs—these market transactions have conspicuous, unintended and uncompensated social costs that are absent from our transactions. Because there is no punishment for imposing negative effects on society, producers and consumers of fossil-fuel-generated energy are not discouraged from their carbon-intensive activities. As such, markets continue to produce too much greenhouse gas emissions, with inadvertent consequences for people all over the world, for generations to come.

Every decision in economics must consider the incentives to an individual or firm when he/she/they choose how to produce or consume his/her/their energy. Carbon taxes—fixed prices per ton of CO2 emitted, whose rates are determined by the net benefits associated with reduced emissions—aim to remedy the externality of greenhouse gas emissions. By creating a monetary punishment for generating negative effects to society, households and firms will pollute less, resulting in less production of GHG emissions and more socially optimal outcomes for society. With a carbon tax, the external, social costs of carbon emissions will be internalized and borne by the polluter, rather than the third parties. By completing the market for greenhouse gas emissions, both producers and consumers will better understand—and avoid—the ramifications of their transaction.

While the point of taxation can be found anywhere across the supply chain, from suppliers, to refiners, to electric utilities, to households, vehicles or industries, for the purpose of this demonstration, I will focus on utilities. This is because taxing utilities will hasten the energy transition, force innovation, and ultimately remove the green premium on clean energy.

The graph below illustrates the demand for greenhouse gasses, for example, natural gas consumption in the utility sector. The demand curve represents consumers’ private marginal benefit, or their willingness to pay for the advantages of electricity, such as the ability to heat their homes. In economics, the efficient allocation of goods can be found at the intersection of the marginal cost and marginal benefit curve. With the further subsidization of cheap fossil fuels, the private marginal cost for firms to emit carbon dioxide is artificially low. As such, in a free market, we find overconsumption of Qm, leading to adverse health and climate impacts.

With a carbon tax, the supply curve moves to the left, as consumers are exposed to the full cost of their actions. Quantity falls to what is socially optimal, yielding a more efficient outcome at the intersection of the social marginal cost and the social marginal benefit.

Beyond reducing greenhouse gas emissions, the primary advantage of carbon pricing is that it contributes to a dynamically efficient economy. Economists at the London School of Economics report that “Empirical evidence suggests indeed a positive relationship between higher energy prices and the development of (green) innovation technologies.” Through market-based incentives, carbon pricing would discourage the consumption of fossil fuels, and instead encourage investment and research into a wide array of cleaner, cheaper alternatives. According to the think tank Resources for the Future, carbon taxes are the most efficient policy tool for emissions reductions, as it incentivizes reductions “that cost as much as or less than the carbon price, but discourages reductions that are more expensive.” Ultimately, this helps to identify the most cost-effective levels and methods of reductions overall. Because utilities are the cornerstone of the economy, taxing them would create ripple effects; as more clean technology is produced, it will lower in price, and ultimately reduce green premiums for the rest of society.

Carbon pricing stands out amongst its policy tool competitors as the most effective tool, both economically and environmentally. Compared to emission standards,for example, carbon pricing has a higher economic incentive to increase abatement capabilities above a baseline requirement, thereby encouraging greater innovation. With regard to carbon pricing’s chief competitor, Cap and Trade systems, taxes remain the better policy option. This is because carbon taxes provide a stable and transparent price for carbon emissions, whereas the price on carbon in Cap and Trade systems tends to be volatile. It is also easier to understand, and has fewer bureaucratic hurdles.