Let’s imagine I decide to start a small manufacturing operation. I want to make small flowerpots, so I research the market and discover that a fair price for an unpainted flowerpot is $5, while the price for a nice, artistically painted one is $10. I check on the price of the materials which would go into the pots, (clay, paint, glazing, etc.) and the allocated direct and indirect costs (transportation, equipment, kiln rental and heat for the kiln, license fees for artwork, sales costs, etc.) and determine that I can produce the unpainted pots for $3; the painted pots for $5. Naturally, I choose to produce the painted pots, because I make $5 per pot sold rather than $2. And off I go, selling 500 pots and making $2,500 per month!!
Now – let’s add a complication. Let’s say that the paint I choose is beautifully bright and long-lasting, making for a durable and lovely flowerpot. Unfortunately, it also contains lead and other toxic materials – which I do not realize. Over the years, I make those pots and dispose of the paint spills, broken pieces of flowerpot, old brushes, etc. in a pit behind the production facility. And there is a point in time when people start buying my beautiful flowerpots to grow herbs or lettuce in their kitchens.
Somewhere along the line, the pit behind my production facility is tested – and found to contain enough toxic materials that it must be cleaned up, at significant cost. And decades later, people who have purchased my wonderful flowerpots begin to get sick.
These unexpected costs represent “externalities”, costs and benefits which are very real (even if they are possibly unknown at the time) and paid by third parties not involved in the transaction. In the example above, the costs of cleanup would probably be borne by the building owner, the owner’s insurance company; institutions such as the Environmental Protection, and all of us who pay taxes locally and nationally. The medical costs for those who got sick because of the toxic flowerpots would be borne by the purchasers and their families, medical insurance companies, and again by taxpayers. I, on the other hand, have done well with my flowerpots, and yet face few costs because I did not intentionally use toxic paint.
In the energy field, we aim to understand the costs and benefits of energy we use or generate. There is an ongoing debate regarding the “true cost” of all types of energy (see http://www.groundtruthtrekking.org/Issues/OtherIssues/True-Cost-Electricty-Generation.html ), with most recent studies finding that some renewables cost about the same as standard generation. Greenhouse gas emissions are also important, because the task of reducing emissions and coping with the effects of climate change rests upon us all. Policy-driven approaches led by governments and international organizations are beginning to address the global situation, and although we believe our shared future depends on success, our clients are more concerned with their own “externalities”.
A large factory must have reliable, uninterrupted electricity 24 hours a day, 365 days a year. The factory expects that power to be available, and rarely plans for the risk of it not being so; in addition, the industry’s volume discounts make its’ price per kWh less than that paid by a residential customer: the factory receives an externalized benefit, paid for by the utility and smaller ratepayers, and avoids the cost of providing back-up power.
Water is one of the most scarce and valuable commodities in the world – none of us could live without it – and we in the southwestern US act as if we consider it to be a right. We pay only a small fraction of even the known costs incurred by cities and small municipal water systems to provide clean, potable water – and we certainly don’t cover the externalized costs for sinking new wells as rivers and aquifers dry up. We’re only beginning to use water more conscientiously, installing low flow appliances and remembering we don’t need to run the water while we brush our teeth. Would we do better if we paid the “true cost” of water, and would our water infrastructure crisis (storage tanks and water pipes in desperate need of replacement, and few funds with which to do so) be lessened? Would we reduce energy use if we paid a kWh price that included the cost of cleaning up power plants and pollution, but not subsidies for generation and transmission?
In business, we like to make decisions by analyzing costs and benefits of different possible approaches, like installing an energy efficient boiler or letting the old one limp along for another few years. If we don’t know the true cost of the new boiler and the fuel to run it, and we don’t know the cost of maintaining, repairing, and fueling the old one – how can we make a reasonable decision?
Externalities (both costs and benefits) are real; we need to include them in our decisions.