Understanding Externalities

Externalities occur in an economy when the production or consumption of a specific good or service
impacts a third party that is not directly related to the production or consumption of that good or
service.
Almost all externalities are considered to be technical externalities. Technical externalities have an
impact on the consumption and production opportunities of unrelated third parties, but the price of
consumption does not include the externalities. This exclusion creates a gap between the gain or loss
of private individuals and the aggregate gain or loss of society as a whole.
The action of an individual or organization often results in positive private gains but detracts from the
overall economy. Many economists consider technical externalities to be market deficiencies, and this
is the reason people advocate for government intervention to curb negative externalities through
taxation and regulation.
Externalities were once the responsibility of local governments and those affected by them. So, for
instance, municipalities were responsible for paying for the effects of pollution from a factory in the
area while the residents were responsible for their healthcare costs as a result of the pollution. After
the late 1990s, governments enacted legislation imposing the cost of externalities on the producer.
Many corporations pass the cost of externalities on to the consumer by making their goods and
services more expensive.

Types of Externalities
Externalities can be broken into two different categories. First, externalities can be measured as good
or bad as the side effects may enhance or be detrimental to an external party. These are referred to as
positive or negative externalities. Second, externalities can be defined by how they are created. Most
often, these are defined as a production or consumption externality.

Negative Externalities
Most externalities are negative. Pollution is a well-known negative externality. A corporation may
decide to cut costs and increase profits by implementing new operations that are more harmful to the
environment. The corporation realizes costs in the form of expanding operations but also generates
returns that are higher than the costs.
However, the externality also increases the aggregate cost to the economy and society making it a
negative externality. Externalities are negative when the social costs outweigh the private costs.

Positive Externalities
Some externalities are positive. Positive externalities occur when there is a positive gain on both the
private level and social level. Research and development (R&D) conducted by a company can be a
positive externality. R&D increases the private profits of a company but also has the added benefit of
increasing the general level of knowledge within a society.
Similarly, the emphasis on education is also a positive externality. Investment in education leads to a
smarter and more intelligent workforce. Companies benefit from hiring employees who are educated
because they are knowledgeable. This benefits employers because a better-educated workforce
requires less investment in employee training and development costs.
Production Externalities
A production externality is an instance where an industrial operation has a side effect. This is often the
type of externality used as example, as it is easy to envision an environmental catastrophe caused by
improperly stored chemicals by a chemical company. Because of how the company produced its goods
or protected its waste, an externality occurred.
Consumption Externalities
Externalities may also occur based on when or how a consumer base utilizes resources. Consider the
example of how you get to work. Those who choose to drive are creating a pollution externality by
driving their own car. Those who choose to take public transit or walk are not causing the same
externality. Instead of a side effect occurring because something is being produced, an externality is
caused because of an item being consumed.
These four types of externalities above are often combined to define a single externality. For example,
an externality may be a positive production, negative production, positive consumption, or negative
consumption externality.

Externality Solutions
There are solutions that exist to overcome the negative effects of externalities. These can include those
from both the public and private sectors.

Taxes
Taxes are one solution to overcoming externalities. To help reduce the negative effects of certain
externalities such as pollution, governments can impose a tax on the goods causing the externalities.
The tax, called a Pigovian tax—named after economist Arthur C. Pigou—is considered to be equal to
the value of the negative externality.
This tax is meant to discourage activities that impose a net cost to an unrelated third party. That means
that the imposition of this type of tax will reduce the market outcome of the externality to an amount
that is considered efficient.

Subsidies
Subsidies can also overcome negative externalities by encouraging the consumption of a positive
externality. One example would be to subsidize orchards that plant fruit trees to provide positive
externalities to beekeepers.
This nudge has the potential to influence behavioral economics, as additional incentives one way or
another way dictate the choices that are made. The subsidy is often placed on an opposing item to
detract from a specific activity as well. For example, government incentives to upgrade to more energy-
efficient renovations subtly discourages consumers against options with more externalities.
Other Government Regulation
Governments can also implement regulations to offset the effects of externalities. Regulation is
considered the most common solution. The public often turns to governments to pass and enact
legislation and regulation to curb the negative effects of externalities. Several examples include
environmental regulations or health-related legislation.
The primary issue with government regulation of externalities is the need for consistent and reliable
information to track the externality is being managed or overcome. Consider regulation against
pollution. The government put forth resources to ensure that the legislation put in place is actually
being followed, including holding bad actors accountable for not properly addressing their externality.
Real-World Examples of Externalities

Many countries around the world enact carbon credits that may be purchased to offset emissions.
These carbon credit prices are market-based that may often fluctuate in cost depending on the
demand of these credits to other market participants.

One program within the United States is the Regional Greenhouse Gas Initiative (RGGI). The RGGI is
made up of 12 states: California and 11 Northeast states. RGGI is a mandatory cap-and-trade program
that limits carbon dioxide emissions from the power sector.1

Different agencies are imposed a cap on externalities, though they can trade resources to change what
their cap is. Agencies that struggle managing their externality (i.e. pollution) may need to purchase
additional credits to have their cap increased. Other agencies that conquer their externality may sell
part of their cap space to recover capital likely used to overcome their externalities.
How Do Externalities Affect the Economy?
Externalities may positively or negatively affect the economy, although it is usually the latter.
Externalities create situations where public policy or government intervention is needed to detract
resources from one area to address the cost or exposure of another. Consider the example of an oil
spill; instead of those funds going to support innovation, public programs, or economic development,
resources may be inefficiently put towards fixing negative externalities.

What Is the Most Common Type of Externality?

Most externalities are negative, as the production process often entails byproducts, waste, and other
consequential outcomes that do not have further benefits. This may be pollution, garbage, or negative
implications for worker health. Many externalities are also related to the environment, as the
mechanical nature of manufacturing and product distribution has many detrimental impacts on the
environment.

How Can You Identify an Externality?

Companies must be mindful of their entire production process when assessing production
externalities. This includes not only implications of the final product but residual impacts of
byproducts, disposal of items not used, and how antiquated equipment is handled. This also includes
projecting outcomes of items yet to occur, such as waste yet to be properly disposed of.
Consumers can identify consumption externalities by being mindful of the inputs and outputs that go
beyond what they are attempting to achieve. Consider an example of an individual consuming alcohol.
A consumer must be mindful that excessive drinking may lead to noise pollution, an unsafe
environment, or adverse health effects.

How Do Economists Measure Externalities?

Economists use two measures to evaluate an externality. First, economists use a cost-of-damages
approach to evaluate what the expense would be to rectify the externality. As we may be seeing with
greenhouse gas emissions, some externalities may extend beyond the point of repair.
Another method of measuring externalities is the cost of control method. Instead of fixing the
externality, economists measure what preemptive and preventative steps can be taken to stop the
externality from occurring. Similar to how an actuary assesses a financial value to an event, economists
may assign multiple financial measurements to an externality.

The Bottom Line

An externality is a byproduct of a primary process. This side effect may be good or bad and may be
caused by a production process or consumption process. Many externalities relate to the environment
due to the nature of company and individual actions, though there are many ways governments,
companies, and people can take responsibility to both prevent and rectify externalities.

Discount rates and climate change

- Sandsmark and vennemo – 2007 – argue that beta < 0 – mitigation of emissions hedges
catastrophic macroecnomic risk
Explanation
The concept of emissions abatement hedging catastrophic macroeconomic risk leading to a negative
beta to discount climate change impact implies that actions taken to reduce greenhouse gas emissions
can serve as a form of risk management against the potentially severe economic consequences of
climate change. Here's how this linkage might work:

1. Emissions Abatement Reduces Economic Risk: By implementing emissions abatement measures,

societies aim to mitigate the drivers of climate change, such as carbon dioxide emissions from burning
fossil fuels. These measures can include policies promoting renewable energy, energy efficiency,
reforestation, and emissions trading systems. By reducing emissions, societies can potentially limit the
extent of climate change-related impacts, such as extreme weather events, sea-level rise, and
disruptions to ecosystems and agriculture. As a result, the economic damages and costs associated
with these impacts may be lower than they would otherwise be without emissions abatement efforts.

2. Hedging Catastrophic Macroeconomic Risk: Climate change presents significant macroeconomic

risks, including damage to infrastructure, loss of productivity, increased healthcare costs, and
disruptions to supply chains. These risks can have far-reaching and potentially catastrophic effects on
economies, both at the national and global levels. By undertaking emissions abatement measures,
societies can hedge against some of these macroeconomic risks by reducing the severity and frequency
of climate-related events and their associated economic consequences.

3. Negative Beta to Discount Climate Change Impact: In financial terms, beta measures the sensitivity
of an asset's returns to changes in the overall market. A negative beta implies that the asset's returns
move in the opposite direction to the market. In the context of climate change, if emissions abatement
measures effectively reduce the economic impacts of climate change, investments or policies
associated with emissions abatement could exhibit a negative beta to discount the impact of climate
change on economic outcomes. This suggests that these investments or policies may provide a form
of diversification or risk reduction in portfolios or economic decision-making frameworks, particularly
in environments where climate-related risks are significant.

In summary, the concept of emissions abatement hedging catastrophic macroeconomic risk leading to
a negative beta to discount climate change impact highlights the potential for emissions reduction
measures to contribute to economic resilience and risk management in the face of climate change. By
reducing emissions and mitigating climate-related risks, societies can potentially lower the economic
costs associated with climate change impacts, leading to more favorable economic outcomes over the
long term.

In finance, beta is a measure of the sensitivity of an asset's returns to changes in the overall market. A
beta greater than 1 indicates that the asset's returns tend to amplify movements in the market, both
upward and downward. A beta less than 1 suggests that the asset's returns are less volatile than the
market, while a negative beta implies that the asset's returns move in the opposite direction to the
market.

Let's clarify the implications of positive and negative betas:

1. Positive Beta: A positive beta indicates that the asset's returns tend to move in the same direction
as the overall market. If the market goes up, assets with positive betas are expected to increase in
value, and vice versa. Stocks of most companies typically have positive betas because they tend to
perform better when the economy is doing well.

2. Negative Beta: A negative beta suggests that the asset's returns move in the opposite direction to
the overall market. When the market goes up, assets with negative betas are expected to decrease in
value, and vice versa. Assets with negative betas are often considered "defensive" investments
because they tend to perform well during economic downturns or periods of market volatility.
Examples of assets with negative betas might include certain types of bonds, gold, or certain types of
utility stocks.

In the context of climate change, if emissions abatement measures or investments are seen as
providing a hedge against the economic impacts of climate change, they might exhibit a negative beta.
This would imply that as climate change-related risks increase, the value of investments associated
with emissions abatement could rise, providing a counterbalance to potential economic losses from
climate change impacts. However, it's important to note that assigning beta values to complex
environmental factors like climate change can be challenging and may involve significant uncertainty.

If there is a negative beta associated with hedging macroeconomic risk, it implies that the asset or
strategy being utilized serves as a counterbalance to economic downturns or adverse market
conditions. In the context of climate change mitigation, this suggests that investments or actions taken
to reduce greenhouse gas emissions and adapt to climate change could provide a form of economic
resilience, potentially offsetting losses or reducing the severity of economic impacts resulting from
climate-related events.

Regarding the discount rate and its effect on spending for bearing costs today for mitigating climate
risk:

1. Lower Discount Rate: A negative beta associated with climate change mitigation efforts may warrant
a reassessment of the discount rate used in economic analysis. Typically, a lower discount rate reflects
a greater emphasis on the value of future benefits relative to present costs. In the context of climate
change, where the benefits of mitigation efforts may be realized over long time horizons (e.g., reduced
damages from extreme weather events, preserved ecosystems, avoided healthcare costs), using a
lower discount rate could justify greater investment in mitigation measures today.

2. Effect on Spending: With a lower discount rate, the perceived value of future benefits from climate
change mitigation increases compared to using a higher discount rate. This could lead to a greater
willingness to spend on bearing costs today for implementing mitigation measures, such as
transitioning to renewable energy, improving energy efficiency, investing in resilient infrastructure, and
implementing policies to reduce emissions. Organizations, governments, and individuals may be more
inclined to allocate resources towards climate change mitigation projects and policies, recognizing the
long-term economic and environmental benefits they provide.

In summary, a negative beta associated with hedging macroeconomic risk through climate change
mitigation suggests that investments in such efforts may provide economic benefits that outweigh
their costs over time. Using a lower discount rate in economic analysis could justify increased spending
on mitigation measures today, reflecting the higher value placed on future benefits and the importance
of addressing climate change for long-term economic sustainability.

Certainly. Ebenstein et al. (2017) exploited China's 1950 Huai River Policy to conduct a natural
experiment and study the long-term effects of sustained exposure to air pollution on human health
and economic outcomes. Here's a summary:

1. Background: The Huai River Policy, implemented in 1950, provided free coal for heating during the
winter to areas north of the Huai River but not to areas south of it. This policy was aimed at addressing
heating needs in northern China but inadvertently led to substantial air pollution due to increased coal
consumption.

2. Natural Experiment: The policy created a natural experiment by effectively dividing China into two
regions: a treated area (north of the Huai River) and a control area (south of the Huai River). The
treated area experienced higher levels of air pollution due to increased coal use for heating, while the
control area had lower pollution levels.
3. Study Design: Ebenstein et al. analyzed data from China's 1990, 2000, and 2010 censuses to compare
long-term health and economic outcomes between the treated and control areas. They focused on
outcomes such as life expectancy, infant mortality, education levels, and income.

4. Findings: The study found that individuals living in the treated area (with higher air pollution
exposure) experienced significantly shorter life expectancy, higher infant mortality rates, and lower
levels of education and income compared to those living in the control area (with lower pollution
exposure).

5. Implications: The findings of the study suggest that sustained exposure to high levels of air pollution,
as a result of the Huai River Policy, had detrimental effects on human health and economic well-being
over the long term. The study highlights the importance of environmental policies and regulations in
mitigating the negative impacts of pollution on public health and economic development.

In summary, Ebenstein et al. utilized China's Huai River Policy as a natural experiment to investigate
the consequences of long-term exposure to air pollution on human health and economic outcomes,
providing valuable insights into the effects of environmental policies on public welfare.

In the context of Ebenstein et al.'s study using China's Huai River Policy as a natural experiment, here's
how exogenous variation, independent variables, and dependent variables are defined:

1. Exogenous Variation: Exogenous variation refers to the natural or external factors that cause
variation in the independent variable (the factor being studied) but are not influenced by the
dependent variable or any other factors of interest. In this study, the exogenous variation arises from
the implementation of the Huai River Policy in 1950, which provided free coal for heating to areas
north of the Huai River but not to areas south of it. This policy created a natural dividing line between
regions with different levels of air pollution, leading to exogenous variation in pollution exposure
across the treated (north of the river) and control (south of the river) areas.

2. Independent Variable: The independent variable in this study is the level of air pollution exposure
resulting from the Huai River Policy. Specifically, it is the geographical location relative to the Huai
River: areas north of the river (treated area) experienced higher levels of air pollution due to increased
coal use for heating, while areas south of the river (control area) had lower pollution levels.

3. Dependent Variables: The dependent variables in the study are various health and economic
outcomes that are hypothesized to be influenced by long-term exposure to air pollution. These
include:
- Life expectancy: The average number of years a person is expected to live.
- Infant mortality: The rate of death among infants under one year of age.
- Education levels: Measures of educational attainment, such as years of schooling completed.
- Income: Measures of economic well-being, such as household income or per capita income.

By comparing these dependent variables between the treated and control areas, researchers can
assess the impact of sustained exposure to air pollution on human health and economic outcomes.

In summary, the exogenous variation in this situation arises from the natural implementation of the
Huai River Policy, which creates differences in air pollution exposure across geographical regions. The
independent variable is the level of air pollution exposure resulting from this policy, while the
dependent variables are various health and economic outcomes affected by pollution exposure.
The economics of externalities

Classic econ perspective: govt should intervene to control market failures

Market failures occur when there are externalities present

GHG emissions present a clear externality – firms and consumers don’t internalise the consequences
of their carbon consumption

First best response is through government response

In economics, the "first-best solution" refers to the optimal outcome that would be achieved
in a perfectly competitive and frictionless market environment, where all relevant factors are
taken into account and there are no distortions or inefficiencies present.
Efficiency: The first-best solution maximizes economic efficiency, meaning that resources are
allocated in a way that maximizes total societal welfare or utility. This occurs when the
marginal benefits of production and consumption are equal to the marginal costs.
Perfect Competition: The first-best solution assumes perfect competition, where firms are
price takers and individuals have perfect information. This ensures that prices accurately
reflect the true costs and benefits of production and consumption decisions.
No Distortions or Externalities: There are no distortions in the market, such as taxes, subsidies,
or regulations, that would lead to inefficient outcomes. Additionally, all externalities (both
positive and negative) are internalized, meaning that the costs and benefits of production and
consumption are fully borne by the parties involved.

In real-world markets, achieving the first-best solution is often challenging due to various market
imperfections, government interventions, and informational constraints. However, economists often
use the concept of the first-best solution as a benchmark for evaluating the efficiency of actual market
outcomes and designing policy interventions to move closer to the ideal outcome.

• For a variety of reasons, the first-best response may be unattainable or incomplete

• Sustainable Finance & Impact Investing provide an alternative to this first-best
• Study first-best solution to understand Sustainable Finance & Impact Investing alternative

Assessing Public Finance Solutions to Climate Change

Curbing Global Warming: Kyoto Treaty
- International Conferences to address climate change began in 1988; the first UN Climate
Change Conference of the Parties (COP) was held in 1995 in Berlin
- Kyoto 1997 (COP 3): 35 industrialized nations (but not US) agreed to reduce their GHG
emissions to 5% below (depends on country) 1990 levels by the year 2012
- Industrialized countries are allowed to trade emissions rights among themselves, as long as
total emissions goals are met quantity regulation with trading permits
- Developing countries are not in the treaty even though likely cheaper in the long run to use
fuel efficiently while developing an industrial base than to “retrofit” an existing industrial
base

Curbing Global Warming: Paris Agreement

- Paris 2015 (COP 21): Significant step of adding developing countries to a worldwide plan
- 195 nations agreed to work together to keep the temperature rise to well below 2°C
 - 186 countries submitted plans for how they would limit their emissions by 2025 or 2030
- US pledged to reduce GHG emissions by 26-28% of 2005 levels
- Trump left agreement, but Biden rejoined, promising a higher reduction of 50-52% from
2005 levels
- China pledged to cut coal consumption, reduce carbon intensity by 60% of 2005 levels, and
draw 20% of the country’s energy from non-fossil fuels by 2030
- Recently increased targets to 65% and 25% respectively as well as pledged to reach peak
carbon emissions by 2030 and become net zero before 2060

Curbing Global Warming: Future

- In principle, reducing CO2 emissions could generate Pareto improvement because losers
from global warming lose more than what emitters win from emitting
- Challenge: in practice, remedies (such as carbon tax) create losers who oppose change
- Disagreement between rich and developing countries on who should bear the cost of
curbing greenhouse gas emissions
- In the US, Obama directed EPA to regulate CO2 emission (a carbon tax or cap-and-trade
requires a Federal law passed by Congress) but directive was undone by Trump
- Bottom-line: A higher carbon price, through taxes or trading permits, where the US and
other large countries (China, India) participate is critical to a global warming response
o See Nordhaus (2013) and Wagner and Weitzman (2015)

Can Diplomacy Solve the Free-rider Problem

- The benefits of reducing emissions are broadly shared but the costs (e.g. lost fossil fuel
profits) are nationally borne → countries want to free-ride
- Not all free-riders are created equal
- Nearly 50% of emissions since the Industrial Revolution have come from the US and the EU
(Chinese share roughly 10%)
- G20 accounts for 80 percent of the world’s yearly emissions
- Since 2006, China has been the world’s largest emitter (31% in 2020), followed by US, EU,
and India
- Per capita rankings rather different
- Calls for “loss and damage” transfers from richer countries historically responsible for climate
change to poorer countries for damages caused by rising temperature
emissions

Carbon Pricing as of 2023

- Carbon pricing helps individuals, firms, and jurisdictions internalize the cost of greenhouse
gas (GHG) emissions and enable a shift to a low-carbon economy
o Carbon Tax
o Emissions Trading System
▪ Cap-and-trade
▪ Baseline-and-credit
- Some progress, but the potential of carbon pricing is largely untapped
- Carbon pricing instruments generated USD 95 billion in global revenue
- Prices of USD 61-122/tCO2 by 2030 (in 2023 USD) needed to meet 2°C goal
- The World Bank estimates that less than 5% of emissions covered by carbon prices above
USD 61/TCO

An Alternative Approach?
As result of political failures either at the national or international level, an externality such as global
warming may not be well-controlled via regulation or taxes
If a firm has a comparative advantage relative to individuals in addressing externalities (e.g.,
producing a public good or avoiding a public bad),
Shareholders may want the firm to pursue social goals such as reducing carbon emissions at the
expense of profit
Consumers and workers may be willing to pay a price for a firm to act in a socially responsible way

Important Questions
What are the ways in which stakeholders might affect firm decisions?
Are these ways effective?
Can this pressure achieve the first-best outcome that government intervention via tax or regulation
would generate?