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The Economic Concept of External Effects


The different definitions and interpretations of external costs relate to the principles of welfare economics, which state that economic activities by any party or individual making use of scarce resources cannot be beneficial if they adversely affect the well-being of a third party or individual (see, for example, Jones 2005).

From this, a generic definition of externalities is 'benefits and costs which arise when the social or economic activities of one group of people have an impact on another, and when the first group fails to fully account for their impacts' (European Commission, 1994).

By definition, externalities are not included in the market pricing calculations and, therefore it can be concluded that private calculations of benefits or costs may differ substantially from society's valuation if substantial external costs occur. Externalities can be classified according to their benefits or costs in two main categories:

  • Environmental and human health externalities: These can additionally be classified as local, regional or global, referring to climate change caused by emissions of CO2 or destruction of the ozone layer by emissions of CFCs or SF6; and
  • Non-environmental externalities: Hidden costs, such as those borne by tax-payers in the form of subsidies, research and development costs, or benefits like employment opportunities, although for the latter it is debatable whether it constitutes an external benefit in the welfare economics sense.

If an external cost is recognised and charged to a producer, then it is said to have been 'internalised'.


By definition, markets do not include external effects or their costs. It is therefore important to identify the external effects of different energy systems and then to monetise the related external costs. It is then possible to compare the external costs with the internal costs of energy, and to compare competing energy systems, such as conventional electricity generation technologies and wind energy.

As markets do not intrinsically internalise external costs, internalisation has to be achieved by adequate policy measures, such as taxes or adjusted electricity rates. Before such measures can be taken, policy-makers need to be informed about the existence and the extent of external costs of different energy systems. Analysing external costs is not an easy task. Science (to understand the nature of the impacts) and economics (to value the impacts) must work together to create analytical approaches and methodologies, producing results upon which policymakers can base their decisions for appropriate measures and policies.

Valuation procedures are needed, for example putting a value on a person becoming ill due to pollution, or on visual intrusion caused by a wind turbine, or on future climate change damage caused by a tonne of CO2. Such evaluations of externalities have uncertainties due to assumptions, risks and moral dilemmas. This sometimes makes it difficult to fully implement the internalisation of externalities by policy measures and instruments (for example emission standards, tradable permits, subsidies, taxes, liability rules and voluntary schemes). Nevertheless, they offer a base for politicians to improve the allocation processes of the energy markets.

Subsequently, the question arises whether the internalisation of externalities in the pricing mechanism could impact on the competitive situation of different electricity generation technologies, fuels or energy sources. As Figure 4.1 illustrates, a substantial difference in the external costs of two competing electricity generating technologies may result in a situation where the least-cost technology (where only internal costs are considered) may turn out to be the highest-cost solution to society if all costs (internal and external) are taken into account.


Figure 4.1: Social Cost of Electricity Generation

Figure 4.1 Social cost of electricity generation, source Auer

Source: Auer et al. (2007)


Serious study of external costs began in the late 1980s, when the first studies were published attempting to quantify and compare the external costs of electricity generation. The most important early studies are listed in the references. These studies seeded public interest in externalities, since they indicated that external costs could be of the same order of magnitude as the direct internal costs of generating electricity. Since that time more research and different approaches, better scientific information, and constant improvement of the analytical methodologies used have advanced the study of externalities, especially in Europe and the US.

This development has resulted in a convergence of methodologies, at least for calculating the external costs of fossil-fuel based electricity generation and wind energy. Despite the uncertainties and debates about externalities, it can be stated that, with the exception of nuclear power and long-term impacts of GHGs on climate change, the results of the different research groups converge and can be used as a basis for developing policy measures aimed at a further internalisation of the different external costs of electricity generation.




>> Externalities of different types of electricity generation technologies


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