cigarette (besides breaking the law in most states) creates an externality for others in the restaurant.

  • The activities that produce negative externalities usually also produce benefits for someone in society. The electricity that is produced by the coal-fired power plant provides value to the consumers who purchase that electricity. The externalities arise from the side-effects of that benefit-producing activity that are not reflected in its market price.

How Externalities Are Characterized in This Study

Most of the externalities associated with the production and consumption of energy have been addressed, or corrected, to some degree, through public policies. Coal mining and oil and gas extraction are subject to federal, state, and local regulations that are intended to limit the environmental damages from fuel extraction. Air pollution emissions by power plants are regulated under the Clean Air Act, and tailpipe emissions from motor vehicles are regulated at the federal and state levels. Indeed, regulations designed to correct externalities have substantially reduced their magnitude over the past 30 years. What the committee evaluates in this study are the externalities that remain in 2005—and the externalities that are predicted to remain in 2030—after such regulations have been implemented.

To make clear what we evaluate in this study, consider Figure 1-1, which shows the marginal damage associated with SO2 emissions and the marginal cost of emitting SO2 for a hypothetical power plant in a particular year. According to the graph, the damage from emitting each additional ton of SO2 is $1,000. The cost of emitting another ton of SO2 declines as more is emitted—equivalently, the marginal cost of reducing SO2 emissions (moving from right to left on the horizontal axis) increases as less SO2 is emitted. If Firm 1 (the hypothetical power plant) in 2005 is emitting E1 tons of SO2, the external damages that we quantify equal the shaded area in Figure 1-1—that is, we quantify the total damages associated with the firm’s current level of emissions.1 If the firm were emitting E* of SO2, the external damages that we evaluate in the study would correspond to the rectangle 0ABE*. We also express these damages per kilowatt-hour of electricity produced and quantify the marginal damage of each ton of SO2 produced by the plant for a specific year.

It is important to note that, from the viewpoint of economic efficiency,


We calculate aggregated damages by estimating the damages per ton of SO2 (the horizontal line in Figure 1-1) and multiplying by the number of tons of SO2 emitted in 2005, to which we add similar calculations for NOx and directly emitted PM. We therefore calculate the marginal damage per ton of SO2 (and per ton of NOx and PM) at each plant, which are reported in Chapter 2.

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