Paradigm Shifts: Internalizing the Externalities

In the fields of energy and environment, I have seen paradigm shifts take place on several important occasions during my career. Paradigm shifts dramatically change the conversation about how to deal with problems. For example, economists have recognized the concept of externalities since the 19th century, when they began to understand how unrelated third parties could be affected, unwillingly and unwittingly, by the voluntary exchanges of two other people.

In the field of environmental pollution, negative externalities occur when, let’s say, a factory dumps its waste into the air or water and causes harm or extra costs to other people, such as a municipal waterworks that has to spend more to treat river water used for a town’s water supply because it has been polluted by someone upstream.


Understanding this paradigm led environmentalists and government agencies to require pollution control devices on factory effluents, effectively internalizing the costs of emitting pollutants into air and water, thereby causing changes in production methods by industry to avoid such costs. The same reasoning has been applied to mandating seat belts and catalytic converters in motor vehicles so that the costs of preventable injuries and air pollution don’t have to fall on the public, while the profits from vehicle sales accrue solely to the manufacturers. "Public pain, private gain" is now a widely recognized issues in all fields of modern life, one that can usually be dealt with by changing economic incentives..

In 1989 and 1990, I served on the board of the Coalition for Clean Air, the largest such citizens’ group in California. While I was on that board, we developed the first “emissions trading” program in the county, with the rationale borrowed again from the concept of “internalizing the externalities.” In this approach, rather than regulating emissions from smokestack, air pollution control boards would set an overall limit for the emissions of a certain pollutant from industry. Then, whenever it made sense for companies that could control their emissions more cheaply than others in their industry to buy the “rights to emit/pollute” from companies that couldn’t reduce emissions as cheaply, they would. That helped compliance, cut overall compliance costs, and worked in the short run to keep the less efficient companies in business by selling their emission permits ("right to pollute") to more efficient companies. This approach also helped to some degree to get industry support for air quality regulation.

To reduce carbon dioxide emissions, we must now require companies and industries to purchase permits for generating such emissions, as a way to force them to reduce or eliminate those costs. By 2017, more than 100 of the 500 largest global companies were doing this pricing internally and adjusting their operations to reduce carbon emissions, showing the power of such paradigms.[1]

We still haven't figured out how to charge for carbon emissions induced by electricity use in buildings, green or otherwise. Do you have good ideas how to do this, beyond requiring every new home or building to be "net zero"?


[1], accessed February 4, 2018.