a]: Summarize at least one example of an externality presented in the report? mWhat are some of the possible remedies to externalities discussed in the report? a What are some of the externalities associated with electric power generation? 8:37 .Ill 70 Electricity-Gen... . .. 2. Economic Foundations of Environmental Externalities: An Overview To assist the reader in understanding the origins of the perfect competition, unrestrained factor mobility, and economic idea of "externalities," this chapter provides free trade) to provide a rigorous formulation of con- a brief conceptual overview of the term within the ditions under which a state of maximum social welfare framework of the theory of welfare economics and its (or some variation thereof) becomes attainable.'s extension into the environmental field. The background discussion with respect to externalities is extended to Among the conditions deemed necessary and sufficient electric power generation with a brief reference to to attain maximum social welfare, the single most criti- overall regulatory approaches. cal requirement is the existence of perfect competition in all economic activities in all markets so that the Economic Foundations of Externalities value at the margin of any class of factor (i.e., I labor, and capital) is the same in all occupations in Welfare economics may broadly be viewed as a study which it is employed. ' of the social desirability of alternative arrangements of economic activities and the allocation of resources-that Welfare economics essentially aims to "test the effi- are scarce and have alternative uses-toward a deter- ciency of economic institutions in making use of the mination of efficient states in which no individual can productive resources of a community."" Achievement be made better off without making some other indi- vidual worse off." Economic theory on the subject based on the equivalence between marginal costs and starts with a number of simplifying assumptions (e.g., prices." Product prices based on this equivalence are "Dr. EJ. Mishan of the London School of Econom s "that branch of study which endeavors o formulate propositions by which we may rank, comic situations open to the society. (1960). pp. 197-256. Note that for the me . 1939-1959." Econo vestigative attempts in this direction despite chanisms Critics Bikes meory does not fully take into account welfare for what was thought nonmeasurable, " For further details, see Kenneth J. Arrow and Tibor Scitovsky, A.E.A. Readings Wellare Economics (Richard D. Irwin, Inc.. Homewood, II. 1969), pp. 6-7. "The earliest exposition on this subject is attribut ublished in 1896-1897. Pareto developed the fan nslations of his major economic works are not available. Note that perfect ver or seller/firm have no effect on the price of a product. This requires a large number of buyers and profit-maxim ssumption of products being homogenous. In addition, entry and exit for the firms is assumed to be costless, implying mobility of ces and complete knowledge. Product prices under these conditions are equal to marginal costs. ad product substitution necessary to maximize social welfare Note that fumesmarathon does not ensure that the welfare of a community is at a maximum, but the nonfulfillment of any one does indicate that welfare is not For a complete discussion of the conditions sufficient and necessary to attain maximum social welfare, see Mark Blaugh, "Economic Theory in retrospect. Chapter 15. G onemics (Richard D. Irwin, Inc., Homewo 13. General Equiparum she welfare economics (Richard D. lewin, Inc. Homewood, II, 1969), pp. 575-614. "Tibor Scitovsky, "A Note on Welfare Propositions in Economics." A. E.A Readings in Welfare Economics tings in Welfare Economics, Eds. Kenneth J. Arrow and bor Scitovsky (Richard D. Irwin, Inc., Homewood. IL, 1969). pp. 390-401. elopment of the welfare theory (and its subsequent refinement) represents a departure from the earlier notions of welfare being ent underpinnings of welfare theory (attributable to Vilfredo Pareto in Cours d'Economie Politique published in 1896-1897 and Manuel ublished in 1906) reflect a radical departure from the notion of cardinality of utility functions and are independent arisons. In addition, Pareto's approach to welfare permitted the separation of efficiency from considerations of equity with respect to the distribution of incomes. Energy Information Administration/ Electricity Generation and Environmental Externalities: Case Studies instrumental in the determination of rewards to factors of production (which are land, labor, and capital). principal causal factor contributing to this divergence." Both the terms-external economies and Within the framework of welfare economics, it is into what are commonly called "externalities" or the hat demand represents the marg arginal social val- uation or the marginal social benefit derived from an alternative term "spillover effects." additional unit of a commodity in question. Since the Generally speaking, external economies are realized if additional units are all p hits are all priced at marginal cost, the the expansion of an industry's outp price represents the marginal cost society must incur to of on moustry s output lowers the total cost curve of each firm. Similarly, external diseconomies have an additional unit produced. The "marginal" are realized if the expansion of an industry's output argument is extended to include the proposition that raises the total cost curve of each firm." In both cas social welfare maximization occurs when marginal social costs equal marginal social benefits." however, market failures cause their emergence (i.e., external economies or diseconomies) s costs and so sts differ, leading to e onomic inef- Nonmarket Interdependence and ficiency and misallocation of resources in production. se concepts have been instrumental in initially chan- Externalities ling economic analysis into areas that focus on welfare maximization concepts. Subsequent theoretical Marginal conditions envisaged in the derivation of developments provide tools for performing cost-benefit social welfare maximization analyses and their real world." As a result, divergences from the ideal- mental policy." ized equivalence between social costs (which include a valuation for the impacts of externalities in addition to References to the concept of external economies or private costs) and private costs (which broadly include diseconomies (together with undertaking an econ appear in the writings of Marshall ity) and social and private benefits emerge, casting a nomy occurs when an action taken by an economic unit tion. Other things being equal, non-market interde- results in uncompensated benefits to other firm(s) such pendence with its associated attributes of external as an increase in its output." As an illustrative economies or external diseconomies is identified as the example with respect to an external economy, assume "For additional comments on this topic, see C.E. Ferguson, Microeconomic Theory (Richard D. Irwin, Inc., Homewood, IL, 1972), pp. ncome distribution as a given, conditions necessary and sufficient to ensure optimal allocation of resources can be briefly ratio of marginal utilities of two commodities must be the same for any two customers buying the same commodity. Second, the ratio of the marginal products of the two inputs must be the same for any pair of producers using both inputs. Finally. the omics-Principles, Problems and Decision (W.W. Norton and Co., New York, NY, 1974), pp. 721-735. "Nonmarket interdependence is said to exist when the various production functions and preference functions are interdependent and spillover effects" or briefly "spillovers" first appears in Alfred Marshall's writings (The Principles of Economics, published 1890) in connection with a competitive industry's downward sloping supply curve. ternal effects may not be unambiguously economies or diseconomies. For further details, see James M. Henderson and Richard comic Theory: A Mathematical Approach (McGraw Hill Book Company. New York, NY, 1980). pp. 143-145. 302-304. Initial purpose of a cost-benefit analysis is to undertake the appraisal of a project to include all social and financial costs and cruing to the project. Thus, in addition to employing the usual financial analysis approach, undertaking the valuation in money the social or welfare costs and benefits presents special problems. For further details, see Ezra J. Mishan, Cost-Benefit Analysis ger Publishers, New York, NY, 1976) for a discussion of the problems in this area. tomist to dwell on the subject of external economies and diseconomies. For further details, see red Marshall. The Principles of Economies (1890). Pigou, a prize student of Marshall at Cambridge made a clear-cut economic case for bal costs. For further details, see Arthur C. Pigou. The Economics of Welfare (Macmillan, 1920), While a number of eminent economists gouvian conce puntainhead for eco and it's policy conclusions to be in error: The Pigouvian tax, subsidy doctrine still remains the dings. Eds. Robert Dorfman and Nancy S. Dorfman (W.W. Norton and Co., Inc. Economics (Richard Di irwin, Inc. Home also Mark Blaugh, "Economic Theory in Retrospect." Chapter 13, General Equilibrium and Welfare 26 Edwin Mansfield, Micro-Economics: Theory and Applications, 3rd ed. (W.W. Norton and Co., Inc., New York, NY, 1979). pp. 456-458. Energy Information Administration/ Electricity Ger and Environmental Externalities: Case Studies the simultaneous existence of apple-growing and bee- externalities lies in the absence of fully defined keeping activities in a given region. An increase in the property rights. Take a activities of the apple-growing farmers to augment their Take a typical common-property produce (apples) by an increase in factor utilization source liked like where everyone has fishing nights. (land, labor, or capital) provides an unexpected increase everyone else. A redefinition of property rights or the in apple blossoms, which, in turn, tends to increase the imposition of some charges may cor the situation. production of honey. Here, the apple farmer provides Such prescriptions, however. do not apply to air or with additional benefits at n to charge. It water where ownership rights are difficult to estab can thus be argued that the apple-growing farmer Somewhat similar difficulties arise in the case of a receives less than the value of his marginal social net resource for which there are competing but conflicting product while the bee-keeper gets more than the value uses, like a body of water that is useful for recreation of his marginal social net product." Consider now the purposes as well as for dumping city sewage. ase of an external diseconomy where the output of one production activity adversely affects the production activity of an classic example involves a poor It is not necessary to provide a further elaboration in widow supporting herself by hand laundry (which is classifying externalities given the subject matter of this hung outside to dry), and a factory next door emitting smoke that blackens her laundry. definition of the term "externality" beyond its generic description is lacking. Some economists contend that The above two externalities arise due to ownership ex- rigorous definitions of "externality" are difficult to ternalities and focus on production activities. Economic provide and that the "definitions of external economies literature also differentiates between pecuniary and are few and unsatisfactory."" More recent attempts to technological externalities. P externalities. Pecuniary externalities result provide a definition continue to prove elusive. Some from a change in the prices of some inputs or outputs economists note that they are aware of the implications in the economy. For example, a change in the demand (of externalities), but attempts to define the notion still for leather shoes affects the price of leather and hen fail to capture all its ramifications." More recent the welfare of extensions of the definition of externalities indicate that essence, the production function for the handbag the effects of the externality should be appreciable and remains unchanged." Stated simply, it means that t should fall on a third party or parties that are or were factor inputs used in producing a product do not not part of the transaction." hange. Such changes do occur, however, in the case of a technological externality. In the case of hand-operated laundry operation, more soap and labor, for example. Definitional problems aside, the impacts resulting from the presence of externalities are not in dispute. Market a more or less direct effect. other than price changes, the divergence between social imposed by one decision unit on another that prevents costs/benefits and private costs/benefits lead to an the efficient functioning of the market mechanism. likely to generate too much of an activity where liseconomies prevail and too little where economies In cases of "common-property resources," environ- prevail. To counteract these tendencies (which are not al externalities are concerned primarily with reflected in market prices or in valuation of relative property rights, on the assumption that the source of goods) or to mitigate their impacts, some degree of "The example cited here has been adopted from the writings of James Meade. See James E. Meade, "External Economies and Diseconomies in a Competitive Situation." in A.E.A. Readings in Welfare Economics (Richard D. Irwin, Inc., Homewood. IL., 1969). pp. 185 198. "This example appears in C.E. Ferguson. Microeconomic Theory (Richard D. Irwin, Inc.. Homewood. IL., 1972). pp. 496-497. "A production function is a mathematical relationship between the output of a firm (or the economy) and the inputs used to produce see William J. Baumol and Wallace E. Oates, The Theory Environmental Policy (Cambridge University Press. New York, NY. 1993 " James M. Buchanan and Wm. Craig Stubblebine, "Externality." A.E.A. Readings in Welfare Economics, Eds. Kenneth J. Arrow and Tibor citovsky (Richard D. Irwin, Inc.. Homewood. IL., 1969), pp. 199-212. #2William J. Baumol and Wallace E. Oates. The Theory of Environmental Policy (Cambridge Univ mbridge. U.K. 1993). pp. " Richard Comes Press, Cambridge. MA, 1986). Energy Information Administration/ Electricity Gener rental Externalities: Case StudiesF Electricity-Gen... . . . intervention is called for." Policy tools designed to bility of welfare economics to more dynamic conditions achieve these ends include taxes, user fees, subsidies, of economic growth and development may be limited. and clarification of property rights." Problem areas still remain. Given that externalities Environmental Externalities and Electric cause distortions in resource use primarily because Power Generation' society fails to pay the price (positive or negative) charged for a good (or a bad), the real problem is how Discussion in the preceding paragraphs makes it pos- to configure the price to be charged since the normal sible to take into account environmental externalities in price mechanism does not usually work. In everyday. the context of electric power generation. Power genera- normal transactions, prices are generally symmetrical tion involves a process in which t he actions of the in nature between the supplier and the consumer, but electricity producer may not be appropriately reflected this symmetry is difficult to sustain where externalities in the market prices charged for their product. True are involved." It is thus pointed out that assumptions resource costs should include both the private costs of asymmetry are necessary to induce efficiency. incurred to provide power and the external costs of damage (or deterioration in quality) to the environment Problems resulting from the existence of pecuniary caused by power generation. Because of this market externality caused by market interdependence may not failure, the price charged for electric power is lower be easy to resolve. Consider, for example, the advent of than it would be if the costs of externalities were competition (due to passage of the Energy Policy Act of internalized, i.e., included in the price charged to 1992), which is likely to cause such structural changes consumers for electric power. Consumption of electric in the domestic electric utility industry a number power is thus encouraged, leading to a misallocation of of generating assets (still in operation but with higher resources (in terms of their most efficient use), together costs of production) may have to with an ass assets." Such results are due to pecuniary externalities and arise due to changes in some in output prices The correct way, in terms of the Pigouvian teachings, is in the economy. Even though pecuniary externalities do to tax the producers by an amount equal to the mag- not cause inefficient allocation of resources under nitude of damages caused. The Pigouvian prescription conditions of pure competition, it is necessary to draw is embedded in the notion that economic efficiency attention to this aspect. would be increased by government inter vention. How- ever, this simplified version conceals many problems Limitations to the theory of welfare economics (with or associated with its implementation. Challenges to the without the considerations of externalities) also need to Pigouvian concept have since been vocal. Some econ- be noted. These limitations arise not from the lack of omists contend that government intervention to inter- rigor and elegance in the development of its theoretical nalize should focus on property rights instead of taxing construct, but rather from the essentially static nature producers and that there may be options that are less of its conceptualization and with its treatment of expensive (than imposing taxes on producers) which income distribution as a given. As a result, the applica- should be explored and used." "Following Pigou's analysis in his book The Economics of Welfare, most economists have struggled with a conceptual formulation to mitigate impacts resulting from the presence of externalities. Most prescriptive arrangements postulate that the costs of external damages be recovered. Consensus building continues on who should pay thes "Economic Report of the President, 1994 (U.S. Gove ington, DC, 1994), pp. 179-181. Note that taxes or subsidies are not to be viewed as costs and benefits but rather as a transfer of resources from one segment of the economy to the other. "The notion of symmetry implies that the seller receives the same monetary value (expressed in terms of market price) as the buyer pays. In the cas e surrounding atmosphere may be subjected to a tax or a subsidy (in the manner suggested by Pigou) to provide the required incentive to the supplier of the externality (the factory in this case) while leaving the nearby residents with a zero price. Thus, the price treatment (required to induce efficiency) loses its intrinsic symmetrical nature. For additional discussion, see William J. Baumol and Wallace E. Oates, The Theory of Environmental Policy (Cambr Press, Cambridge, U.K., 1993). pp. 29-32. 37Stranded assets or investments may generally be defined as investm recovery schedule initially approved by egulatory action that subsequent action has rendered not practically recoverable. "This section focuses on externalities and electric power generation to the exclusion of other segments of the energy sectors. For a further discussion, see Anthony C. Fisher and Michael H. Rothkopf, "Market Failure and Energy Policy: A Rationale for Selective Conservation, " Energy Policy (August 1989). pp. 397- "Ronald H. Coase, "The Problem of Social Cost," The Journal of Law and Economics (October 1960), pp. 1-44. Energy Information Admin Externalities: Case Studies Other economists recommend-in the tradition of It is possible to provide a different or an enlarged Pigou-that externalities associated with power gener- version of externalities' classification based on the ation be internalized. The term internalizing an choice of criteria used in the process." Note that the externality implies the creation of social conditions types of electric facilities and their functional roles where the damages (or benefits) from production and differ considerably from one to the other. Consider, for consumption are taken into account by those who pro- example, the impacts caused by a hydroelectric power duce the effects. These social conditions can be created plant in comparison to a pumped storage facility or, for by government regulation, a tort system, bargaining that matter, two identical plants located in areas with between private parties, or other policy and insti- different population densities or social infrastructures. tutional arrangements. A taxonomy of alternative methods, including, for example, some form of tradable The environmental problems posed by each of these emission permit system, will be discussed in the next power plants differ and so will their impacts. The task chapter. Note, however, that benefits and damages can of classifying externalities is further complicated by the exist even when all externalities have been internalized. absence of a complete checklist of applicable Federal, State, and local environmental laws that relate to all Classification of Externalities in Power aspects of the electric power industry." For these reasons, a simplified classification scheme is desirable. Generation Externalities attributable to electric power generation The Economists' Approach may be classified in the following categories:" Economists' interests focus on the creation of a social arrangement that (in the presence of externalities) can . Air pollutants including sulfur dioxide, nitrogen be relied upon to bring about an optimal allocation of oxides, particulates, and heavy metals with im- resources and thus a maximization of welfare. While pacts on human health, flora and fauna, building some adjustments may be cost free and are a pos- materials, and on other social assets like recreation sibility, it is the "common-property resources" that do and visibility not lend themselves to simple solutions. The prescrip tion to embody a set of Pigouvian taxes (subsidies) on . Greenhouse gases including carbon dioxide, the generators of externalities to indu methane, and chlorofluorocarbons suspected of into account the full range of social costs (benefits) may contributing to global climate change and thus to not necessarily be an ideal solution that can be univer- potential impacts on agriculture and human sally applied. The general consensus seems to be that health no single device such as a tax will eliminate the diver- gences caused by externalities in private and social Water use and water quality affected by elec- costs." Moreover, the application of even well-defined tricity production, principally through thermal economic principles often faces problems in practice. pollution or hydroelectric projects that affect Moving away from theory into the realm of policy- aquatic populations making, there are many approaches that have been adopted. Regulatory framework may first involve Land use values affected by power plant sitings setting environmental standards or targets for different and by waste disposal including solid, liquid, and pollutants and then proceeding to install implemen nuclear wastes. tation strategies similar to the provisions of the Clean Federal Energy Regulatory Commission, Report on Section 808: Renewable Energy and Energy Conservation Incentives of the Clean Air Act Amendments of 1990 (Washington, DC, December 1992). "A recent publication lists 12 categories of environmental categories impacting on: (1) agricultural crops, timber, and livestock. if) catastrophic accidents, (ill) ecosystems and biodiversity, (iv) environmental-cultural icons, (v) global climate change, (vi) human morbidity and mortality, (vil) land use, (vill) materials, (ix) recreational opportunities, (x) regional economic structure, (xi) visibility, and (xil) visual and audio aesthetics. See National Associat n of Regulatory Utility Com sioners, Environmental Externalities and Electric Utility Regulation (Washington, DC, September 1993), p. 10. It is even possible to enlarge this listing if the classification scheme is based on the criteria of impacts. "Congressional Research Service, Electricity: A New Regulatory Order, A Report Prepared for the Use of the Committee on Energy and Commerce, U.S. House of Representatives (U.S. Government Printing Office, Washington, DC, 1991), p. CRS-213. "Ronald Coase, "The Problem of Social Cost," Economics of the Environment: Selected Readings, Eds. Robert Dorfman and Nancy S. Dorfman (W.W. Norton and Co., New York, 1977), pp. 142-171. Energy Information Administration/ Electricity Generation and Environmental Externalities: Case Studies Air Act Amendments of 1990. In some cases, a tax/ There is, however, a lack of consensus regarding what subsidy approach could be an option to promote the really constitutes a coherent cost-benefit accounting entry of certain technologies like renewables. These and framework that could facilitate the adoption of some other approaches are discussed in the next chapter. To common approach. These problems are discussed else- conclude, there exists an increasing awareness of the where in this report. environmental problems caused by power generation