Energy Economics and Energy Systems 1

External Cost
Sustainability as one of the goals of energy policy

Security of supply

Affordability Sustainability

Slide 2 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Definition of external effects

External effects (also called externalities): Negative or positive impacts of

an activity performed by an economic agent on other agents without
compensation

Zweifel et al. (2017)

Summary of the definition of external effects

• Can be negative or positive
• Activity of an economic agent has impacts on an uninvolved third party
• The impact goes without compensation

Question: What are examples of external effects regarding energy and

sustainability?

Slide 3 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Possible types of damages

• Economic damages in the narrow sense: destruction of physical assets that

cause income losses, cleanup and repair costs

• Losses to human life and health: number of concerned persons, number of

years of life lost, duration and degree of medical treatment

• Losses of environmental assets and environmental quality as far as not yet

captured by category “economic damages”

• Losses of quality of life: exposure to noise and vibration, but also fear of
catastrophes, reduced autonomy and self-fulfillment

• Social institutions that are temporarily prevented from normal functioning

(civil protection, health system, …): number of days times number of
concerned persons

Question: How can theses damages be quantified?

Slide 4 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Example for external effects

plant
fuel electricity Goal: maximize profits
operator

emissions

home property Emissions impact

owner value property value

Question 1: How can society intervene to reduce emissions?

Question 2: Are zero emissions optimal for society?

Question 3: What is the optimal amount of emissions?

Slide 5 Prof. Dr.-Ing. Aaron Praktiknjo
Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Coase theorem

If trade in an externality is possible, bargaining will lead to an efficient

outcome regardless of the initial allocation of property.

plant
company profit
operator

negotiate
emissions

home
property value losses
owner

Slide 6 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Coase theorem

company profit property value losses

emissions emissions
additional profit per additional losses per
additional emission additional emission

emissions emissions

Slide 7 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Coase theorem

additional profit per additional losses per

additional emission additional emission

emissions emissions

marginal profits,
marginal losses

emissions
Em* Em0

Slide 8 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Coase theorem

marginal profits,
marginal losses

emissions
Em* Em0
Allocation of the right to the environment to Allocation of the right to the environment to
the injured party (homeowner) the polluter (company)

• The company needs consent of the
homeowner for emissions (no emissions)
• But the company could use part of the profits
to compensate the homeowner
• Negotiations would continue until
marginal profit = marginal losses
• The company initially emits in order to
maximize profits (maximum emissions)
• But the homeowner could offer a part of the
avoided losses to compensate the company
• Negotiations would continue until
marginal profit = marginal losses

The optimal amount of emissions is independent

from the initial allocation of the property right!
Slide 9 Prof. Dr.-Ing. Aaron Praktiknjo
Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Emission trading (cap and trade)
Company 1 Company 2

marginal foregone profits marginal foregone profits

(marginal cost of abatement) (marginal cost of abatement)

mc2

mc1

emission emission
reductions reductions

avoided emission avoided emission

emissions cap emissions cap

Slide 10 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
 Emission trading (cap and trade)

marginal cost
of abatement

Cap and trade system

• Initially, company 1 can reduce emissions at

lower cost compared to company 2
• But company 2 can increase its emissions by
mc2 negotiating an emission reduction of equal
magnitude with company 1
pem • Company 2 acquires some of company 1’s
mc1 right to emit (emission allowances)
• The total sum of avoided emissions remains
constant but the trade allows both
companies to save cost
initially avoided initially avoided
emissions 1 emissions 2

final emissions final emissions

avoided 1 avoided 2

Slide 11 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Excercise: Emission trading

The island of Lummerland wants to reduce its CO2

emissions by 100,000 tons per year. The industry on the
small island consists basically of two main types: (A) castle
construction and (B) the production of steam engines.
The government decides that (A) castle construction needs to reduce CO2 emissions
by 40,000 tons while (B) steam engine production needs to reduce emissions by
60,000 tons.

The cost for CO2 abatement C (1,000 EUR) for both industries are given below per
avoided unit of CO2 Em (1,000 tons of CO2).

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

a) What are the abatement cost for (A) and (B) per ton CO2?
b) The government allows the cap and trade system. What is the volume of
certificates traded and at what price are they traded?
c) What are now the overall abatement cost for (B)?
Slide 12 Prof. Dr.-Ing. Aaron Praktiknjo
Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Solution: Emission trading (1)

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

a) What are the abatement cost for (A) and (B) per ton CO2?

𝐶𝐶𝐴𝐴 40 0.02 � 402 + 0.002 � 403

= = 4 EUR/t
40 40
𝐶𝐶𝐵𝐵 60 5 � 60 + 0.2 � 602 + 0.003 � 603
= = 27.8 EUR/t
60 60

Slide 13 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Solution: Emission trading (2)

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

b) The government allows the cap and trade system. What is the volume of
certificates traded and at what will be their price?

We know that the total reductions in CO2 emissions from industry A and industry B
together need to amount to 100,000 tons.

𝐸𝐸𝐸𝐸𝐴𝐴 + 𝐸𝐸𝐸𝐸𝐵𝐵 =100

If we allow trading of emission rights between industry A and B, it will continue until
marginal cost of abatement are equal.

𝑑𝑑𝐶𝐶𝑎𝑎 𝐸𝐸𝐸𝐸𝐴𝐴 𝑑𝑑𝐶𝐶𝑏𝑏 𝐸𝐸𝐸𝐸𝐵𝐵

=
𝑑𝑑𝐸𝐸𝐸𝐸𝐴𝐴 𝑑𝑑𝐸𝐸𝐸𝐸𝐵𝐵

0.04𝐸𝐸𝐸𝐸𝐴𝐴 + 0.006𝐸𝐸𝐸𝐸𝐴𝐴 ² = 5 + 0.4𝐸𝐸𝐸𝐸𝐵𝐵 + 0.009𝐸𝐸𝐸𝐸𝐵𝐵 ²

Slide 14 Prof. Dr.-Ing. Aaron Praktiknjo
Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Solution: Emission trading (3)

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

b) The government allows the cap and trade system. What is the volume of
certificates traded and at what will be their price?

With this, we have two equations with two unknowns

𝐸𝐸𝐸𝐸𝐴𝐴 + 𝐸𝐸𝐸𝐸𝐵𝐵 =100

0.04𝐸𝐸𝐸𝐸𝐴𝐴 + 0.006𝐸𝐸𝐸𝐸𝐴𝐴 ² = 5 + 0.4𝐸𝐸𝐸𝐸𝐵𝐵 + 0.009𝐸𝐸𝐸𝐸𝐵𝐵 ²

𝐸𝐸𝐸𝐸𝐴𝐴 = 66.12 [1,000 tCO2]

𝐸𝐸𝐸𝐸𝐵𝐵 = 33.88 [1,000 tCO2]

The traded volume will be

66.12 − 40 = 26.12 [1,000 tCO2] or 60 − 33.88 = 26.12 [1,000 tCO2]

Slide 15 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Solution: Emission trading (4)

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

b) The government allows the cap and trade system. What is the volume of
certificates traded and at what will be their price?

Negotiations between industry A and B will continue until the market price for CO2
allowances is equal to the marginal cost of abatement for both industries.

𝐸𝐸𝐸𝐸𝐸𝐸
𝑝𝑝 = 0.04 � 66.12 + 0.006 � 66.122 = 28.88 [ ]
𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝐸𝐸𝐸𝐸𝐸𝐸
or p = 5 + 0.4 � 33.88 + 0.009 � 33.88² = 28.88 [ ]
𝑡𝑡𝑡𝑡𝑡𝑡𝑡

Slide 16 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Solution: Emission trading (5)

𝑪𝑪𝑨𝑨 𝑬𝑬𝑬𝑬 = 𝟎𝟎. 𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

𝑪𝑪𝑩𝑩 𝑬𝑬𝑬𝑬 = 𝟓𝟓 � 𝑬𝑬𝑬𝑬 + 𝟎𝟎. 𝟐𝟐 � 𝑬𝑬𝑬𝑬² + 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎 � 𝑬𝑬𝑬𝑬³

c) What are now the overall abatement cost for (B)?

On its own, industry B reduces its emissions by 33.88 [1,000 tCO2]

and buys 26.12 [1,000 tCO2] certificates from industry A.

𝑇𝑇𝑇𝑇𝐵𝐵 = 𝐶𝐶𝐵𝐵 33.88 � 1,000 + 26.12 � 28.88 � 1,000 = 1,270,000 [EUR]

(Cost for Industry A)

As for industry A, it reduces it emissions by 66.12 [1,000 tCO2]
and sells 26.12 [1,000 tCO2] certificates to industry B.

𝑇𝑇𝑇𝑇𝐴𝐴 = 𝐶𝐶𝐴𝐴 66.12 � 1,000 − 26.12 � 28.88 � 1,000 = −89,000 [EUR]

Industry A has negative abatement cost after the cap and trade system has been
introduced and is thus making a profit by selling certificates to industry B.

Slide 17 Prof. Dr.-Ing. Aaron Praktiknjo

Juniorprofessur für Energieressourcen- und Innovationsökonomik
apraktiknjo@eonerc.rwth-aachen.de
Thank you for your attention!