My wise - and thrifty! - grandmother never took an economics course, but she had a firm grasp of economic theory. She also had a pithy saying for every occasion.

When I would lament not being able to afford to buy the latest fashion, she would whisper, “The best things in life are free.”  But she also often reminded me “there’s no such thing as a free lunch.”  And when I would laugh and point out the obvious contradiction between the two sayings, she would wink and remind me, as she so often did, “someday I’d understand.” Even if I didn’t, my grandmother clearly understood basic economic theory.  

Economics tells us how to price goods and services to produce an optimal outcome for both the purchaser and the seller. But often transactions have indirect impacts on people who aren’t parties to it. Economists call these indirect impacts “externalities.” They are the benefits or costs associated with producing a product or service that are not accounted for in the price. 

Positive externalities: nature’s gifts

The benefits are “positive externalities.” Classic examples include the self-renewing services that nature provides. Clean air and clean water to sustain us.  Fertile soil to grow food. Shade to keep us cool and protected from the blistering sun. We all derive great benefit from these (some of the “best things in life”). 

The problem is, since they’re considered “free,” we fail to properly value them.  And if we don’t ascribe value to the services that nature provides, they become vulnerable, at risk of being damaged or destroyed. 

Negative Externalities: The Hidden Costs

When companies make pricing decisions based only on the direct cost of and profit opportunity from production, and exclude the costs to those indirectly harmed by the production, they have hidden those  “negative externalities.”  The purchaser doesn’t pay the costs; they are passed on to the society to bear.  

Examples abound, but the poster child for negative externalities is industrial pollution. The toxic wastes of the 19th and most of the 20th centuries were they by-products of industrial processes. Preventing them would have cost money; dumping the by-products and waste was far cheaper (hint: free).  The damage done to the air and water quality (and the resulting human health damage) was not included in the “price” of the products produced. Instead, the costs of addressing and remediating the damage were passed on (because there is, after all, no such thing as a free lunch). And too often, it has been the local community where the pollution has occurred that has shouldered much of the burden.

GHG emissions: the most disastrous externalities ever

Today, the most pressing and complex externality problem are the greenhouse gas (GHG) emissions that are the byproduct of burning fossil fuels. GHG emissions cause the average global temperature to heat up. As a result, they are altering the global climate system. But in most places, the disastrous consequences are not captured in the pricing of the fossil fuels that release these GHG emissions.

Put the negative externalities on the balance sheet

How can we correct the externalities?  Economic theory tells us that the most efficient way to remove the distortions that externalities create in the market is to internalize them. Accounting for the true costs of production and impacts provides a revealing look at what someone should pay for the product. For GHG emissions, this means putting a market price on carbon. There are two approaches that currently dominate the conversation:

  • A carbon tax. This is a direct tax on the carbon content of fossil fuels. One great recent example of this approach is the British Columbia carbon tax. That tax is also revenue neutral, meaning all of the revenue generated by the tax is used to reduce other taxes.
  • A “cap and trade” system. This system assigns a price to carbon so that a limited and decreasing number of permits for GHG emissions can be purchased and traded. For a great example of a successful cap-and-trade system, take a look at the nine-state Regional Greenhouse Gas Initiative that operates in the northeast of the U.S.

In either approach, setting a price for (monetizing) carbon is the foundation. And that can be tricky. Industry groups, NGOs and governments have all tried to develop methods for pricing carbon, and the results are inconsistent. Many are narrowly drawn and too low (the EU Emissions Trading System), failing to account for all the costs associated with indirect impacts. The result is that the market is not adequately corrected for the externality.

Consistent measures need to be developed, complete with legitimate valuation and agreement among experts. It’s clear that the cost is something more than zero, but that’s the current price in most places. And everyone knows that there’s no such thing as a free lunch. We simply cannot ignore enormous costs stemming from climate change impacts around the globe. Those costs are real, and they will have to be paid. The question is, by whom?

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