BOX 5-1
The NRC (2010) Definition of Externality

The NRC (2010) report defined externality as follows: “an externality, which can be positive or negative, is an activity of one agent (for example, an individual or an organization, such as a company) that affects the well-being of another agent and occurs outside the market mechanism.” Assuming that people respond to prices and nothing else, a logical extension of that definition is, as stated in the report, “In the absence of government interaction, externalities associated with energy production and use are generally not taken into account in decision making.”

SOURCE: NRC, 2010, p. 29.

Identifying Internalized Externalities

One key component of the statement of task was to evaluate key externalities “that are not or may not be fully incorporated into the market price … or into the federal tax or fee.” Without knowing whether an externality has been internalized or not, it is impossible to know whether a policy change could improve the situation. According to Hammitt, this component of the task was especially challenging because of the difficulty in determining, in some cases, whether an externality is internalized or not. It is not always clear.

For example, the following scenario was used in the report to illustrate the concept of externality: “A coal-fired electricity-generating plant, which is in compliance with current environmental regulations, releases various pollutants …. The damage from this pollution is … a ‘social cost.’ If these social costs were not adequately taken into account in selecting the plant’s site or the air pollution control technology that it uses, the true costs … have not been reflected in these decisions.” Hammitt observed that while damage from this pollution is clearly a social cost, whether that cost has been internalized is not clear. If the social cost was not considered during selection of the plant location or when deciding which air pollution control technology to use, then it has not been internalized. But how does one know if that cost was adequately taken into account at the time those decisions were made? That it is a very difficult phenomenon for a committee to judge. Compounding the challenge is the likelihood that science has evolved since that time, so knowledge about harm from pollution is different than it was when those decisions were made. So in that case, the committee was able to estimate both total damages (compared with zero emissions) and marginal damages (the damage that arises from the last unit of emission



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