(A topical essay I wrote for an Energy Economics unit)
Cheap energy has been abundantly available for the last century. But is it really as cheap as it seems? Conventional energy trade carries external costs that neither the producer nor the consumer pays. Society at large must foot the bill for negative social and environmental by-products of energy production and consumption. This paper discusses the consequences of the failure to incorporate these externalities into the price of traded energy.
Externalities are defined as benefits or costs generated as an unintended by-product of an economic activity that do not accrue to the parties involved in the activity and where no compensation takes place[5]. In other words, any party (be it an individual, a group, a society or world-wide) external to an economic transaction may receive positive or negative impacts to which they had no intention or input in accruing.
Figure 1 illustrates the transactions involved in a voluntary economic exchange where externalities are present. An external cost or benefit may be created during production of a good, and/or during the consumption of that good. An example of a positive externality is that of education given to some individuals in a society leading to a greater prosperity for all in that society. A negative externality example is that of an individual consuming a cigarette in a crowded area where everybody else must passively smoke their cigarette and inherit the health risks.
Externalities are a form of market failure. Market failure describes a condition where the allocation of goods in a free market economy is not optimal. In practical terms, market failure is said to occur when individuals’ pursuit of self-interest leads to a negative result for society overall. This form of market failure can be addressed by internalising the externalised costs or benefits. In other words, any economic gains or losses received by third parties are captured and passed back to the parties involved in the originating transaction. There are a variety of economic mechanisms available to internalise externalities, such as command and control action or market-based methods like taxation, subsidies or assigning property rights.
Externalities in energy trade occur both in the production and the consumption ends of the transaction. These externalities, upon society, are typically negative - the details of why will be examined later. Initially, we will explore the underlying economic theory of negative externalities.
To fully understand the following theory discussion, some terms must first be defined. Marginal Private Cost (or MPC) is the willingness for a supplier to accept a price for goods produced as a function of quantity. Marginal Private Benefit (or MPB) is the willingness for a consumer to pay a price for goods to consume as a function of quantity. Pareto improvement is the act of reallocating the distribution of goods within an economy such that at least one individual is made better off without making any other individuals worse off. Deadweight loss denotes an inefficiency in goods allocation within an economy which could be made efficient using Pareto improvement.
Figure 2 illustrates the differences in marginal cost of goods production where externalities are accounted for. The MPC curve is the private cost of production to the supplier. The Marginal Social Cost (or MSC) adds the price of abatement of external social costs onto the MPC. In this instance, consuming goods does not carry any external social cost, and so MPB and Marginal Social Benefit (or MSB) are equivalent. The socially optimal trade occurs at quantity qs and price ps. Without accounting for externalities, the optimal trade occurs at q and p. The oversupply in quantity produced leads to a deadweight loss to society, however free market competition does not provide incentive for Pareto improvement towards social optimality. An example of a production externality in the energy context is a coal-fired electricity generator may sell electricity without abating emissions that impress a cost onto society.
Figure 3 illustrates an alternative situation where an external cost to society is present in the consumption of goods. In this instance, producing goods does not carry any external social cost, and so MPC is equivalent to MSC. Again the socially optimal trade occurs at quantity qs and price ps, and the optimal trade with accounting for externalities is at q and p. There is a deadweight loss to society in the oversupply of quantities traded when externalities in consumption of goods are not costed into the transaction. An example of a consumption externality in the energy context is the use of petrol in a car, providing transport to the consumer, without the consumer paying for engine emissions impressing a cost onto society.
The topic of negative externalities is particularly relevant to the energy market due to the nature of available energy production methods. Fossil fuels, to date, have been inexpensive to obtain, process and use. Some fossil fuels such as oil and gas are highly flexible due to their ease of transportability and high energy to mass ratio. It so happens that those which are used to produce the cheapest energy (coal and uranium) also carry the highest social costs[2]. In general, with the present level of technology and infrastructure, methods boasting lower social costs also deliver higher private costs, and vice versa.
There are numerous reasons why externalities in the energy market have not been internalised in the past and the present. The cheap generation, sale and delivery of energy was seen as the clear path to rapid industrialisation during the 19th century[6]. Only during these last decades has society begun to take heed of the growing external social and environmental costs being created by energy markets – degradation to health and the environment is now clear and present. Even so, today, the formation of global energy markets has forced energy suppliers to de-prioritise social and environmental considerations in order to stay competitive with a world of fierce market players. Also, while the true costs of these externalities are still being fiercely debated in global forums, the economic devices necessary to grow a socially-optimal energy market have not yet been instigated.
The failure to incorporate negative externalities into the price of energy has several categories of consequences. Each of these will be discussed in turn.
Neglecting to accommodate the social cost of energy has led to overdevelopment and overconsumption. An artificially low price creates an incorrect market signal that results in greater production than is warranted. The global marketplace has now developed an unhealthy, increasing demand for energy that cannot be easily recessed or even slowed.
The most topical consequence of energy use is the degradation of social and environmental public goods. A public good is a non-excludable, non-rival good, and thus is not owned by any particular party. The lack of property rights on the environment has enabled society at large to produce and consume energy with very limited knowledge or consideration of the external costs. The use of fossil fuels for energy is largely to blame for environmental damages, which can be divided into two categories; emissions related to climate change, and emissions not related to climate change.
Climate change is, by far, the most threatening and most wide-reaching result of failing to internalise the negative externalities of energy trade. The production and consumption of hydrocarbon based energy has made a major contribution to the quantity of carbon dioxide gas entering the atmosphere, which is the catalyst for many knock-on effects such as atmospheric warming, rising sea levels, and destabilised and intensified weather patterns. Further effects include glacial retreat, species extinctions, disease propagation and overall decreases in agricultural yields[2]. While the heavily inertial nature of global climate change has made externalities difficult to quantify, the consequences of failing to abate these external by-products will result in profound costs for society the world over.
A multitude of other environmental and social costs are associated with the unabated externalities of energy trade. Emissions from fossil fuel energy suppliers affect the health and well-being of people in their vicinity, as well as the natural and built environment. Along with carbon dioxide, coal power stations emit sulphur dioxides, nitrous oxides, particulate matter and other toxic material which has a range of detrimental effects such as acid rain that decays structures and poisons crops, and invokes respiratory disease in people[2]. Large cities of motor vehicle commuters create similar effects, along with haze, smog and noise. Oil spills and effluent leaks damage ocean sea life and in turn the yield from fishing. The transmission and consumption of electricity creates strong magnetic fields, which have been linked to cancer development and other health effects. Accidental explosions from power plants cost lives, with the fallout from nuclear incidents slowly killing thousands to date[1]. Energy trade, without care, can be responsible for many non-trivial social and environmental costs.
Consuming finite resources without accounting for depletion creates inter-temporal consequences. To say an economic transaction is inter-temporally inefficient is to indicate that it is unsustainable in current form, and future transactions will have less value or no longer be possible. This is true to say of fossil fuel energy resources, as there is a fixed amount of coal, oil, gas and uranium worldwide. As stockpiles are exhausted, energy suppliers must spend more to access more technically or politically challenging sources. To this end, fossil fuel based energy tomorrow will ask a higher price than today. However, this scenario is not internalised in today’s transactions, and thus becomes a growing externality to tomorrow’s energy trader parties.
Failing to reflect the total social costs in free-market energy prices has resulted in alternative energy technologies to remain commercially underdeveloped. Alternative stationary electricity generation techniques such as solar or wind attempt to compete in the open market and are largely unsuccessful. The same can be said for transportable fuel systems such as hydrogen or electric engines. The cause of this failure is two-fold. Firstly, decades of improvement and infrastructure development have seen fossil fuel based energy systems inherit an underlying subsidy in today’s marketplace. De-centralised systems that cannot provide baseload energy are more challenging to integrate into conventional grids[6]. Similarly for transportable fuels, petrol is available anywhere yet no hydrogen or electricity stations exist to refill alternative engines. Alterative energy systems have not had the same investment historically, leaving them with room for improvement and the contracts with the conventional fossil-based energy suppliers. The playing field may be evened for these alternative energy suppliers by a subsidy that recognises the social benefits in comparison to conventional stationary energy supply.
The second cause of failure for competitive alternative energy supply is in the failure to internalise the social and environmental costs of fossil-based energy suppliers into their energy price. If the costs of abatement and damage control (as discussed earlier) were entirely factored into the cost of fossil fuel energy, alternative fuel sources would not only be competitive, but in fact the preferred choice[4].
Increased geopolitical risk is also an outcome of the failure to promote a competitive market for alternative energy systems. As fossil fuel resources continue to diminish, and consumer demands fail to reshape without incentive, the need to capture and secure more fossil resources will become a vast and costly political and military exercise. Energy security has been a vital concern since the oil crises in the 1970s[2]. While Australia is a net energy exporter, the same cannot be said for most other developed nations, whose failure to negate their fossil fuel inter-temporal inefficiencies has resulted in growing import dependence.
This paper has covered the economic theory of externalities, detailed the externalities associated with energy production and discussed the consequences of failing to incorporate externalities into the cost of energy. The past and present show us that the trade of energy has many significant social and environmental externalities that must be abated or controlled to prevent greater consequences than those already on the horizon.
References
[1] Damien, M., 1992. Nuclear Power: The ambiguous lessons of history. Energy Policy July.
[2] Hohmeyer, O. 1992. Renewables and the Full Costs of Energy, Energy Policy April: 365-375.
[3] McHugh, A. 2007. Energy Economics Course Notes: Externalities. Murdoch University.
[4] Nicklas, M. 1993. Energy Politics: Can we achieve a sustainable energy path? Solar Energy Vol. 50, No. 4.
[5] Owen, A. 2004. Environmental Externalities, Market Distortions and the Economics of Renewable Energy Technologies. The Energy Journal Vol. 25, No. 3.
[6] Shlapfer, A. 2007. Energy Economics Course Notes: The Structure of Energy Supply Systems. Murdoch University.
[7] Wikipedia contributors. 2008. Externality. http://en.wikipedia.org/wiki/Externality (accessed 18 March 2008).
Tags: Economics, Energy, Essay, Externalities