Module 3

Environmental
Economics

Topics

Environmental Economics
Externalities
How to value externalities
Application in relation to Climate Change

Environmental Economics
I. What is Environmental Economics?
Economics is the study of the allocation of scarce
resources.
Note that the theories of economics can be applied to
any scarce resource, not just traditional commodities.
Economics is not simply about profits or money. It
applies anywhere constraints are faced, so that choices
must be made.
Economists study how incentives affect peoples
behaviour.

Environmental Economics
Environmental and natural resource economics is the
application of the principles of economics to the
study of how environmental and natural resources
are developed and managed.
Natural resources resources provided by nature that
can be divided into increasingly smaller units and
allocated at the margin.
Environmental resources resources provided by nature
that are indivisible.
Natural resources serve as inputs to the economic
system. Environmental resources are affected by the
system (e.g. pollution).

Environmental Economics
Why do we use economics in environment policy?
The main reason is that in our society the
environment has become a scarce resource. Since
economics is about how to deal with scarce
resources, it can often be useful when tackling
environmental problems.
Economic and environmental objectives are often
perceived as being contradictory. It is believed that a
choice must be made between one and the other and
that both cannot be achieved concurrently

Environmental Economics
One way of using economics is to ensure that the
costs and the benefits of environmental measures are
well balanced. Although it is difficult to estimate costs
and benefits, there is an increasing demand that this
is done before environmental policy is decided on a
European level. With the use of market-based
instruments, environmental goals can sometimes be
reached more efficiently than with traditional
command and control regulations.
Method of application of environmental economics is
to value externalities
Value the full lifecycle of a product
And express it all in terms of money

Externalities
What are externalities?
An externality is a consequence of an industrial or
commercial activity which affects other parties
without this being reflected in market prices, such as
the pollination of surrounding crops by bees kept for
honey.
Air pollution is an externality
Spraying insecticides or herbicides both have external
consequences
Externalities can be negative or positive

Negative Externalities
A negative externality (also called "external cost" or
"external diseconomy") is an economic activity that
imposes a negative effect on an unrelated third party.
It can arise either during the production or the
consumption of a good or service.
Examples of negative externalities include:
Air pollution from burning fossil fuels.
Water pollution by industries that adds effluent,
which harms plants, animals, and humans.
Noise pollution during the production process, which
may be mentally and psychologically disruptive.

Negative Externalities
Negative effects of Industrial farm animal production,
including "the increase in the pool of antibioticresistant bacteria because of the overuse of
antibiotics; air quality problems; the contamination of
rivers, streams, and coastal waters with concentrated
animal waste; animal welfare problems, mainly as a
result of the extremely close quarters in which the
animals are housed.
The depletion of the stock of fish in the ocean due
to overfishing. This is an example of a common
property resource, which is vulnerable to the Tragedy
of the commons in the absence of appropriate
environmental governance.

Negative Externalities
The cost of storing nuclear waste from nuclear plants for
more than 1,000 years (over 100,000 for some types of
nuclear waste) is included in the cost of the electricity the
plant produces, in the form of a fee paid to the
government and held in the nuclear waste superfund.
Conversely, the costs of managing the long term risks of
disposal of chemicals, which may remain permanently
hazardous, is not commonly internalized in prices. The
USEPA regulates chemicals for periods ranging from 100
years to a maximum of 10,000 years, without respect to
potential long-term hazard.

Positive Externalities
A positive externality (also called "external benefit"
or "external economy" or "beneficial externality") is
an economic activity that imposes a positive effect on
an unrelated third party.
Examples include:
A beekeeper who keeps the bees for their honey. A side
effect or externality associated with such activity is
the pollination of surrounding crops by the bees. The
value generated by the pollination may be more
important than the value of the harvested honey.

Positive Externalities
The construction and operation of an airport. This will
benefit local businesses, because of the increased
accessibility.
A industrial company providing first aid classes for
employees to increase on the job safety. This may
also save lives outside the factory.
A foreign firm that demonstrates up-to-date
technologies to local firms and improves their
productivity.

Externalities in Climate Change

While it is relatively straightforward to assess the
social costs of activities that affect marketable goods
directlyfor example, the social cost of a factory
whose smoke emissions harm the business of a
nearby laundryit is much more difficult to
determine social costs if there is uncertainty about
the physical extent of the externality and the amount
of harm that a specified extent of the externality
causes.

Externalities of Climate Change

As an example, while there is considerable agreement
that todays emissions of CO2 have social costs that
deserve attention, there is much less agreement
about the magnitude of these costs, partly because of
uncertainty about the impact of emissions of CO2 on
climate and partly because of uncertainty about the
economic costs of Climate Change.

Externalities of Climate Change

The economic cost of climate change is high: an
annual $12 billion increase in electricity bills due to
added air conditioning; $66 billion to $106 billion
worth of coastal property damage due to rising seas;
and billions in lost wages for farmers and
construction workers forced to take the day off or
risk suffering from heat stroke or worse.
By the end of the century, these costs and others put
a combined price tag of hundreds of billions of dollars
on climate change in the United States alone.

Externalities of Climate Change

This is not the case in the worlds poorest countries where
climate change is projected to dramatically reduce incomes
for the most affected. As just one measure, research has
shown that the effect of very hot days on mortality in India
is nearly 20 times as greater as in the United States where
people simply turn up the air conditioning on hot days.
Other developing countries, like Bangladesh, are expected
to lose substantial fractions of their land mass due to rising
water levels. For these people, confronting climate change
is quite literally a matter of life or death.

Externalities of Climate Change

We know the looming costs of climate change will weigh heavily
on every country around the world in the coming decades.
The question is, what do we do about it?
How do we rationalize making investments to prevent future
threats to society when so many investments need to be made
to prevent current threats?
While complex politically, the economic case for reducing
greenhouse gas emissions has always been simple: put a higher
price on things that cause harm.
As previously discussed we now know what negative
externalities are.
Climate change is the ultimate negative externality. That is,
when someone anywhere in the world drives their car or turns
on their lights they are causing damages for everyone else in the
world.

Possible Solution
A very simple solution to this problem, which
economists recognize and teach, is to penalize
activities that cause damages to others.
To date, lawmakers around the world have largely
chosen to ignore this basic economic insightthe
result is that we are subsidizing the activities that
cause climate change by failing to put a price on
carbon emissions.
As a consequence, polluters all over the world are
causing the climate to change in ways that pose risks
to the well-being of our children, their children, and
on and on.

Carbon Pricing
Fortunately, in the last several years, the United
States has taken significant steps in the right
direction, most notably through the U.S.
Environmental Protection Agencys recent carbon
rules.
Other countries are also signalling their willingness to
take climate change seriously, such as, importantly,
China, which has incorporated pilot cap-and-trade
programs into their next five-year plan.
Finally there is a price on carbon.

Carbon Pricing
Carbon pricing the method most favoured by
economics for reducing global-warming emissions
charges those who emit carbon dioxide (CO2) for their
emissions.
That charge, called a carbon price, is the amount that must
be paid for the right to emit one tonne of CO2 into the
atmosphere.
Carbon pricing usually takes the form of a carbon tax or a
requirement to purchase permits to emit (also called
"allowances").
Because such permits are privately tradable and emissions
are limited to the total number of available permits (the
cap), this system is known as cap-and-trade.

Cap and Trade

A classic cap-and-trade design works in one of two ways.
First, the government establishes an emissions cap, for
example 1000 tons/year, and prints 1000 permits to emit 1
ton.
Then it either (1) gives the permits to stakeholders in some
politically or administratively determined way, or (2)
auctions them off to the highest bidder.
After the permits have been distributed one way or the
other, they can be traded privately.
Since emitters must have permits to cover their emissions
(or face a penalty that would cost more than buying
permits), emissions will be limited to the cap.
If the cap is low, permits will be in short supply (scarce)
and the price of permits will be high

Cap and Trade

Like a carbon tax, a cap is generally applied to fossil
fuel in proportion to its carbon content.
Generally, coverage is partial, for example it may be
limited to the electric industry.
The main difference between the two systems is that
the market for permits automatically adjusts the
carbon price to a level that insures that the cap is
met, while under a carbon tax, the government and
not the market sets the price of carbon.

Conclusion
There is a very real need to accurately value the true cost
of climate change.
A way of doing this is to value the externalities of climate
change.
The carbon price and cap and trade mechanisms certainly
go towards that end.
But, it is dependent on market mechanisms
Will that be a true reflection of the damage of climate
change?
If the market floods with carbon credits, the price reduces.

Further Reading
Carbon Pricing: Early Experience and Future Prospects,
edited by John Quiggin, David Adamson, Daniel Quiggin
Carbon Emissions Pricing Policy: Technical Backgrounder.
Canada Government.
Building a Low-carbon Economy: The Uk's Contribution
to Tackling Climate Change, Committee on Climate
Change, Great Britain.