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Friedman Talks about Externalities – No Drill Baby Drill

I love it when someone talks about externalities.  I’m twisted that way.  It gets me going.

As long as I’ve been reading his column, Friedman has continually hit the drum beat for us to recognize the true costs in our use of energy.   The price we pay for our carbon based energy is not fully loaded.  In his article today, he gives us some examples of how we miss these externalities, while he talks about the energy and conservation policies of one of our neighbors to the south.

[I]f a chemical factory sells tons of fertilizer but pollutes a river — or a farm sells bananas but destroys a carbon-absorbing and species-preserving forest — this is not honest growth. You have to pay for using nature. It is called “payment for environmental services” — nobody gets to treat climate, water, coral, fish and forests as free anymore…Right now, most countries fail to account for the “externalities” of various economic activities. So when a factory, farmer or power plant pollutes the air or the river, destroys a wetland, depletes a fish stock or silts a river — making the water no longer usable — that cost is never added to your electric bill or to the price of your shoes.

In fact, there are hidden costs in almost every market.   Many items in a our markets have significant positive and negative externalities.  Friedman provides examples of negative externalities above: the classic example of pollution needing to be recognized in the ‘true’ cost of a product.  But there are also positive externalities.  Accessible public eduction, for example, is the most profound one that has reshaped the United States and our civilization.  If not subsidized through taxes, far fewer would receive education to the detriment of society as a whole.  Tax payers paid more today for a benefit that paid dividends a decade or a generation later.

The bottom line of all this is that if you do not recognize the real cost or benefit of goods and services in a market you will over utilize certain goods and under utilize others.  So, what are we to do if energy markets contain significant externalities?  Well, you and I can’t do much.  We, individually, are  incapable of recognizing these true costs since they are spread out to everyone and energy costs are bundled into just about every downstream derivative product or service we utilize.  Oh sure, a many of us can take actions such as “recycling” and using canvass bags and, maybe, use those lousy fluorescent bulbs to a point.   Stuff that makes us feel good — and it might help to a point.   But externalities have to be addressed systemically — because they are a systemic market problems.

Please do not misunderstand me.  No one should be taking the position that individuals or energy corporations are acting irresponsibly.  Quite the contrary.  They are acting rationally.  It’s the market that’s out of whack.  The objective of a corporation is to maximize return to shareholders within legal constraints.  They have no requirement to identify the true cost of an item to others unless there is some legal contraint that they do so, be it tort law or some regulatory regime.   In fact, if they can arbitrage by exploiting unrecognized externalities, then not only will they, but they must due to their legal directive to shareholders.  And if they do not and their competitors do — they’ll risk being driven from the market.  And you and me, while individuals are as diverse as can be, number in the billions.  In the aggregate and in the longer term, we react en mass to price signals that a market provides more than any other factor.

So, what’s to do?  Well, identifying significant distorting externalities is a core responsibility of government. Friedman gives the example of Costa Rica in his article.

More than any nation I’ve ever visited, Costa Rica is insisting that economic growth and environmentalism work together. It has created a holistic strategy to think about growth, one that demands that everything gets counted.  So it did something no country has ever done: It put energy, environment, mines and water all under one minister… [W]hen Costa Rica put one minister in charge of energy and environment, “it created a very different way of thinking about how to solve problems,”…‘Look, [the minister was able to say,] if you want cheap energy, the cheapest energy in the long-run is renewable energy.  So let’s not think just about the next six months; let’s think out 25 years.’”… [A]nd today it gets more than 95 percent of its energy from these renewables.

So does this mean taxes?  Sure.  Be it direct or a cap and trade system, it’s about taxes.  See Friedman’s article earlier in the week.  We tax a lot of things due to their externalities.  We already tax gas in part because of this in order to maintain roadway infrastructure — which use of gas impacts.  The important point that, if done correctly, and that’s a big ‘if’, the net cost to everyone is far less over time than the cheaper fuel today.

To pay for these environmental services, in 1997 Costa Rica imposed a tax on carbon emissions — 3.5 percent of the market value of fossil fuels … If government policies don’t recognize those services and pay the people who sustain nature’s ability to provide them, things go haywire. We end up impoverishing both nature and people. Worse, we start racking up a bill in the form of climate-changing greenhouse gases, petro-dictatorships and bio-diversity loss that gets charged on our kids’ Visa cards to be paid by them later. Well, later is over. Later is when it will be too late.

I think we’ve finally moved away from the question of whether there are significant externalities in the energy products sector.   You don’t really have to look to ‘global warming’ for this.  You need only realize that carbon based fuels are a finite supply and a critical resource.  The demand/supply curve very possibly will not price the commodity in gradual manner to encourage the infrastructure development to move away from it.  So it’s a pay me now or pay me a lot more later question if sudden price distortions hit the market and then stick around, unlike the 1970s and last year.   So, in any event, we’re finally onto the policy questions:  (a) how big are these unloaded costs and (b) what mechanism or mechanisms do you use to incorporate the true price into these products.

The first is a function of policy choices relying upon terribly incomplete data.  How big is the global warming problem?  What is the probabilities related to loss of GNP in the future due to global warming?  What’s the potential costs of politically fragile regions holding so much of the word’s supply of carbon based fuels?  Carbon based fuels are finite — what is the realistic time frame that they will remain economically cost effective?  Will pricing really gradually rise to encourage alternative development or is the infrastructure costs so huge that we have to encourage significant R&D and infrastructure alternatives earlier?  What effects would major disruption have on supply, the cost of oil and related GNP growth stability?  These are really meaty questions without hard answers.   But we have to make policy judgements on these types of unknows all the time.   Insurers do this every day — they figure out potential costs and probablities of poutcomes and attribute premiums accordingly.  (AIG’s credit swaps, perhaps, excluded. )

And practically, what mechanism is politically possible to pass through Congress?  Can we articulate why we are choosing those mechanisms and the underlying issues.  These are really difficult policy decisions.  And vested interests (and you and me who might not understand why higher prices today mean for much lower overall cost tomorrow) have the ability to block rational policy making.  Still, like Friedman, I remain hopeful.

via Op-Ed Columnist – (No) Drill, Baby, Drill – NYTimes.com.

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