A Semi-Annual Publication of Manomet

The Externality
By: John M. Hagan, Ph.D.

An externality is a by-product of economic activity that causes "damages" to others who had no part whatsoever in the transaction. We are all subject to externalities—people from all nations, rich and poor alike. Some externalities we know about. Some we don't know about. Some we don't want to know about. Nature—especially nature—can be on the receiving end of economic externality.

THE GOOD

To be fair, externalities can be positive—a benefit to innocent bystanders of an economic activity. A positive externality is one where there is a social benefit in excess of the private benefit of the economic transaction.

For the most part, we are unaware of economic externalities, positive or negative. We are affected, but we do not usually notice because the impact of an externality is just too subtle—or it is too complicated to figure out. We are all busy, and we have more important things to deal with every day than figuring out how we are impacted by economic externalities.

What are some examples of positive externalities? Quality healthcare systems and education systems.

When the local or state healthcare system is effective and well-run, people are healthier, less likely to spend time in hospitals, more likely to be happy, and more likely to be productive artists, scientists, businessmen and women. Over and above the immediate care you receive as an individual, all of society benefits from a quality health care system—a positive externality.

Education is the same. Everyone benefits from a well-educated citizenry. The economic transaction is between the individual and the college. But all of society ends up benefiting from each well-educated individual. The external value, or marginal benefit to society, thankfully is not included in the price of college.

Nature can be on the receiving end of negative externalities. Climate change may alter the distribution and potential impacts of insect pest species like Spruce Budworm. Photo: Paul Williams

THE BAD

Negative externalities are more troublesome because society is being harmed by a private economic transaction that includes the consumption or production of goods and services. People who had no part of the transaction incur damages from the transaction.

Consider the health impacts of burning coal to generate energy. Coal pollutants affect all major body organ systems and contribute to four of the five leading causes of mortality in the U.S.: heart disease, cancer, stroke, and chronic lower respiratory diseases. We need energy, and we willingly pay the low market price for its production. The human health impacts are not included in the price we pay for a kilowatt hour of coal-sourced electricity. If these impacts were embedded in the price, the cost of energy from coal would be much higher. The health impacts of burning coal for energy represent a negative externality. Those who voluntarily purchase only renewable energy have unilaterally decided to opt out of generating this negative externality.

In 2010, the National Research Council calculated the external cost of coal on human health, all the way from extraction to production of energy. The auspicious and diverse group of scientists, economists, and geologists estimated that the annual healthcare costs of coal in the U.S. were $120 billion (in 2005 dollars).1 This amount does not include the "value" of the estimated 50,000 lives lost in the U.S. to coal emissions.2 Nor does the figure include the climate impacts of the CO2 emissions from coal. More on that below.

Of course society does end up paying for the human health impacts of extracting and burning coal. Part of the cost is simply spread out over the whole population through health insurance premiums. If the price of a kilowatt hour of coal did include the cost of human health impacts, there would be a lot fewer kilowatts of coal energy sold. It would be too expensive. Solar and wind would be much more competitive.

In 1920, the British economist Arthur Pigou proposed a solution to the negative externality problem—impose a tax on the product approximately equal to damages. That is, raise the cost of the damaging goods so the demand for the damaging goods goes down. There is much debate about how to spend "Pigouvian Tax" revenues, but the main goal is to raise the price so as to reduce the demand, regardless of how the tax revenues are used.

THE EXTERNALITY

Climate change is shaping up to be the mother of all externalities.

The most recent report from the Intergovernmental Panel on Climate Change (IPCC) assessed the economic impacts of climate change throughout the remainder of the 21st century.3 This was a tough job because the assessment depended on predicting the greenhouse gas emissions throughout the rest of the century. Future emissions depend on estimating the growth of the human population, the growth rate of the global economy, and the degree to which humans switch away from fossil fuels. The IPCC focused on four different scenarios to demonstrate different possible futures for the remainder of the 21st century.

One of the four IPCC scenarios is Business-as-Usual, which assumes the human population keeps growing like we think it will (and no global plagues), the global economy keeps growing at about 2-3% per year, and we continue to rely mostly on fossil fuels for energy.

If we follow the Business-as-Usual emissions scenario the global average temperature will increase between 3.5 and 5.5º C (6.3 to 9.9º F) by 2100, resulting in serious economic hardship. This may not seem like much warming. One way to think about how such a seemingly small change can be so significant is to use human body temperature as an analogy. Our normal healthy temperature is about 98.6º F. Now add 6.3º F (3.5º C). That's 104.9º F, and life-threatening. It's the same with the global temperature; a few degrees translates into a big impact.

Pioneering economists, such a Nicholas Stern (London School of Economics), William Nordhaus (Yale), and Martin Weitzman (Harvard), have tried to predict the economic impact of climate change in the 21st century. They use an approach called Integrated Assessment Modeling. These models are incredibly complex and make predictions about the impacts of, say, a meter of sea level rise (a reasonable estimate based on the Business-as-Usual scenario). They calculate how many people will be displaced from coastal areas, and what it would cost for them to move; they calculate additional property damages from more intense coastal storms (over and above what would have occurred anyway); they calculate agriculture crop damages due to predicted drought (by region) and the cost of food; they calculate the costs of adaption measures, such as building sea walls around cities like Boston and New York. Then, they add it all up and discount the price to present day dollars.

"Every sector of our economy and our society will be impacted by climate change," said Andy Whitman, director of Manomet's Sustainable Economies Program. "Our farms and fisheries will have to adapt to higher temperatures, shifting precipitation, extreme weather and flooding. Somehow we are going to have to produce twice as much food for an increasingly affluent and growing human population right at the time when climate change is reducing crop yields around the world. It's not clear how this will work."

Essentially, the economists are trying to model global economics with and without climate change. The net difference is the cost of climate change. It's a quantitative estimate of the externality of greenhouse gas emissions. It's a horrendously complicated analysis, and the cost estimates could be low or high, but it's the best analysis we have right now.

Different economists have different models, and they have spirited debates especially about the discount rate—how much to discount (or to price) the wellbeing of, say, the people who will live in 2100.

Still, the various models all roughly estimate that holding global warming to no more than about 2º C (3.5º F) would cost 2-3% of global annual income, every year, for the rest of the century. Keep in mind there will be significant economic impacts even with 2º C of warming, but the damages would be far less than 3, 4, or 5º C of warming.

Although 2-3% of global income might not seem like much, the total global income today is about $75 trillion (in 2013 U.S. dollars), so 2-3% would amount to a $1.5-2.3 trillion annual global investment in addressing climate change. If not all nations participate the cost burden will increase for those that do participate. The difficulty in getting all nations to participate is one reason an effective global climate policy has been so hard to achieve.

In their calculations economists do not include the cost of the loss of biodiversity because they don't know how to price biodiversity. We expect the Business-as-Usual climate change pathway to result in the 6th major extinction in the earth's history. This loss is not captured in the economic modeling.

All of this helps to explain why climate change is the mother of all externalities. The greatest damages will be incurred by the next two generations, not by the generation engaged in the economic transactions today that are causing the problem. While it is true that this generation is also now coping with the emissions of all previous generations, but there are two very important points here: one, the most serious impacts of climate change have not kicked into high gear yet, so we will not have to experience them ourselves. And two, this generation is the first one that understands the consequences of the problem, and its actions.

So what is our responsibility to the next several generations? We have a reasonably clear sense of the future climate damages if we follow the IPCC Business-as-Usual scenario. There is not yet any serious indication that we will depart from that scenario.

As evidence of our fossil fuel inertia, ExxonMobil recently conducted an analysis of its long-term business vulnerability to climate change policy, at the request of an investor.4 ExxonMobil concluded that the demand for cheap fossil fuel is just too great to put their business at material risk. No nation's economy will be able to resist cheap fossil fuel. And unless everyone resists, no one will resist.

Maybe ExxonMobil is right. But many economists are making a compelling case for a Pigouvian tax on fossil fuels—i.e., a carbon tax. A carbon tax would begin to internalize the projected economic damages on future generations. Some economists such as William Nordhaus suggest that such a tax could be phased in over the coming decades so there is not such a shock to our present-day economy.5

Calculating the total financial cost of any given level of climate change can be derived from two components: (1) the abatement costs (the costs required to reduce emissions and build resilient infrastructure) for a specified level of warming (red line), and (2) the damages that will result from a particular level of warming (blue line). Keeping global warming at a low level will require a investment in abatement, but the damage costs will be low. By contrast, allowing warming to reach 5º C will take almost nothing in abatement costs, but will result in high damage costs. A purely economic approach to tackling climate change would be to add the two curves (=green line) and then encourage policy makers to shoot for the lowest point (lowest cost) on the green line to set their global warming policy goal (orange dashed line). (redrawn with permission from Nordhaus, 2013)

If we did impose a carbon tax, how might the revenue be used? The well-known climate scientist,James Hansen, would give the carbon tax revenue back to the people as a "dividend." 6 While it might make better sense to invest the revenue in alternative energy, the main point of a Pigouvian tax is to raise the price on a good so as to reduce the demand for the damaging good.

Hansen understands there are political realities to consider. Many people are opposed to new taxes, but some political leaders seem less opposed to a carbon tax (or what Hansen calls a "fee") if the revenues would go back into the pockets of people. In that sense, a Pigouvian carbon tax would be a redistribution of money driven by personal fossil fuel use and greenhouse gas emissions.

The underlying choice is, do we continue to externalize the cost of climate change to future generations, or do we figure out a way to internalize the projected longterm damages so as to avoid them on behalf of future generations? We could just let future generations pay for the problem themselves, except that we are causing their problem. The people of 2100 have no way of weighing in on our deliberations.

To date, humans have put enough greenhouse gases into the atmosphere to warm the earth by 1-2º C. In Copenhagen in 2009, global leaders decided that warming above 2º C would lead to "unacceptable" damages. They also knew we had virtually no chance of limiting warming to less than 2º C.

We can limit warming to any level we might like—2, 3, 4, 5, or 6º C, by the dawn of the 22nd century. To limit warming to 2º C in 2100 we are going to have to startinvesting significantly, soon. If we choose not to invest, it will cost us anyway. More in fact. It's just that the costs will come in the form of damages, mostly borne by those who follow us.

All the climate science and economic modeling is very instructive, but in the end, we each have to decide "how much risk are we willing to accept on behalf of future generations?" Who answers this question? Right now, nobody. The externality just keeps growing.


 

1 National Research Council. 2010. Hidden Costs of Energy: Unpriced Consequences of Energy Production. The National Academies Press. Washington, D.C. 506 pp. Available online: http://www.nap.edu/catalog.php?record_id=12794

2 Lockwood, A.H., et al. 2009. Coal's Assault on Human Health: A Report from Physicians for Social Responsibility. Physicians for Social Responsibility. 44 pp. Available online: http://www.psr.org/resources/coals-assault-on-human-health.html

3 Intergovernmental Panel on Climate Change. 2014. Summary for Policy Makers: Climate Change 2014: Impacts, Adaptation, and Vulnerability. Available on-line at http://www.ipcc.ch/report/ar5/wg2/

4 ExxonMobil. 2014. ExxonMobil reports to shareholders on managing climate risk. Available online: http://corporate.exxonmobil.com/en/environment/climate-change/managing-climate-change-risks/carbon-asset-risk

5 Nordhaus, W. 2013. The Climate Casino. Risk, Uncertainty, and the Economics of a Warming World. Yale University Press.


6 See Chapter 9 "An Honest, Effective Path," in Hansen, J. 2009. Storms of My Grandchildren: The Truth about the Coming Climate Catastrophe and Our Last Chance to Save Humanity. Bloomsbury, New York, NY. 303 pp

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