We ended our last discussion on climate change on “I’m not sure I want to give up electricity or stop buying anything made in a factory!”. Well if we’re smart in the way we mitigate climate change – that’s solving it – and we act fast, you won’t have to. As we have defined the problem, we need practical and executable solutions without creating imbalances in the economy. A tough line to tread.
We need to switch to low emissions technologies, which are available and affordable to produce. Many countries (25 countries including EU, Canada, Singapore, Japan, Ukraine and Argentina) are putting a price on carbon and the other greenhouse gases, to take into account the environmental damage caused by fossil fuels.
But should fossil fuels be punished for being the cheapest energy source?
Common Sense says that we shouldn’t punish fossil fuels, but we are in dire need to transition away from them pretty much immediately. Here is where we need to expand our perspective and look at the bigger picture. While cheap in terms of dollars, the ramifications of prolonged use of fossil fuels on climate change have not been taken into account at all.
If the true cost had been included – fossil fuels would be much more expensive! One way to factor in this cost is to introduce a price on carbon-intensive technologies. That way, we would speed up the transition to clean, renewable energy sources, like solar and biofuels. But there’s been a lot of debate about this… is carbon pricing the best policy approach to dealing with climate change? We will discuss this later.
Now, let’s dig into one of the most important concepts to find true cost – externalities.
If I play loud music while you’re trying to study for an exam, does this have an impact on you? You’re probably feeling quite distracted and annoyed by now, which may mean you lose valuable study time and even possibly fail that exam. In effect, you’re being indirectly and adversely impacted by my activities.
The decisions of individuals and organisations to produce, consume and invest have indirect impacts on people who are not directly involved in these activities and these Indirect, un-costed impacts are what economists call “externalities”.
Externalities can be both positive and negative. Positive externalities can be good for society. For example, if a sufficiently large proportion of the population is vaccinated against a disease, the entire population gains what is called “herd immunity.”
Negative externalities, on the other hand, are often problematic. Sometimes, negative externalities are relatively inconsequential in the grand scheme of things, such as Smokers ignore the harmful impact of toxic ‘passive smoking’ on non-smokers. But, when negative externalities are more widespread, they can become costly for the wider community.
The classic example of a negative externality is air pollution generated by industry (reminds me of the perennial air pollution in our so-called “Pollution Capital – New Delhi”). Most business enterprises make decisions based only on their direct cost of inputs and profit expectations.
A power plant or even a printing press, for instance, may operate without factoring in the indirect costs caused by pollution, because the firm does not bear these costs. However, these costs, or externalities, are real for other people and organisations in the economy. For example, a homeowner living near the polluting power plant may suffer higher healthcare costs. Or, the local tourism industry may lose revenue due to pollution from the plant causing environmental damage.
Now, if you consider the costs incurred due to the indirect damage caused by the power plant to its balance sheet, its production decisions would probably change. The point is, since the indirect costs are not borne by the power plant, the actual social cost of production is greater than the power plant’s private costs of production.
This is known as a market failure and is one of the main reasons why governments intervene as public policy. The 2007 Stern Review on the Economics of Climate Change regarded greenhouse gas emissions as negative externalities and labelled climate change as the greatest and widest-ranging market failure ever seen.
The review emphasized that the cost of this will be borne mostly by civil society. It estimated that the potential impacts of climate change on water resources, food production, health and the environment could result in a loss of between 5% and 20% of GDP globally. Today, years after the Stern Review was published, these potential impacts are likely to be much greater due to our careless approach towards its mitigation.
In climate economics, we use a metric known as the social cost of carbon. According to the US Government, the social cost of carbon can be defined as an “A monetized estimate of the damages associated with an incremental increase in carbon emissions in a given year.”
Simply put, the social cost of carbon represents the economic damage done to society by each additional ton of carbon dioxide. So how much is this in dollar terms?
Well, depending on the expert you talk to, the computer model and the discount rate used, the social cost of carbon varies widely. The US government puts the social cost of carbon at between 11 and 109 US dollars per ton of carbon dioxide emitted.
While this is interesting, does this metric have any practical application beyond informing governments of the economic consequences of climate inaction? The answer is yes; the social cost of carbon is being increasingly used in public policy. The US and UK governments have, in recent years, integrated it into their economic decision-making process for large infrastructure projects. Just google “Keystone XL Pipeline and social cost impacts” to understand how the decision on this project was impacted by social costs & externalities.
So, what can governments do to address the externalities of greenhouse gas emissions? The social cost of carbon provides an important part of the answer. Governments can enact public policies to ensure that the social cost of CO2 emissions is paid by the people and businesses responsible for those emissions.
In the terminology of economics, negative externalities need to be internalized by adjusting the price of the polluting activity to reflect the monetary value of that externality. This may, for instance, include putting a price on carbon emissions or requiring emitters to buy a tradable permit.
Look at our industry and think about how we deal with our externalities – how we handle (or sometimes just dump) our waste, use harmful chemicals and inefficient old equipment, manage finite resources like water, energy etc. If negative externalities are calculated and factored in the balance sheet – how will it reflect on our daily lives? Let’s ponder until we meet again!