Externalities and Pigouvian Policy: Pricing the Full Social Cost of Green Energy in Europe

A fundamental principle which underlies both undergraduate and graduate economics is the idea of externalities; externalities are the costs or benefits of economic activity that do not appear in the market price. In that sense, many will view the European green energy policy as a perfect case of remedying a negative externality because fossil fuels generate significant social costs attributable to carbon emissions, air pollution and climate change, while green energy (wind and solar) can help mitigate those social costs. In fact, subsidies for wind and solar power would be viewed as typical Pigouvian responses to the market failure of fossil fuels.

An economic analysis will reveal a more complicated situation. As opposed to eliminating externalities, green energy transfers them to other economic participants. In order to determine whether EU subsidies for renewables actually increase overall welfare, we must estimate the full social costs of producing renewable energy, including their own externalities.

Externalities and the Case for Intervention

According to standard microeconomic theory, when private costs equal social costs, resources are allocated most efficiently by markets. Fossil fuel energy does not meet that requirement. The European Environment Agency estimates that air pollution caused by energy production costs EU member countries billions of euros in environmental and health damage each year, with carbon dioxide emissions representing an even larger global externality.

The difference between private and social costs is sufficient justification for government intervention through Pigouvian economics, which holds that activities generating negative externalities (carbon taxes) should be taxed, while activities generating positive externalities (adoption of clean energy) should be subsidized. Therefore, Europe has taken the latter route and provided "feed-in tariffs" or other direct incentives to encourage massive investments in both wind and solar energy.

New Externalities in Renewable Energy

However, they are often excluded from financial analyses of the cost-benefit of renewable energy, so it is important for economics, as part of cost-benefit analysis, to consider these externalities.

• Material Waste: The International Renewable Energy Agency anticipates that in 2050, there will be over 70 million tonnes of wasted solar panels worldwide. Wind turbines' blades (composed of composite plastics) are often disposed of in landfills because of the difficulties associated with recycling them.

• Biodiversity and Land Use: Wind energy affects populations of birds and bats, and solar energy affects farming and other natural habitats.

• Social and Visual Externalities: The sounds produced by wind turbines, the way that wind farms change the view of the landscape, and the resistance of a community to having a wind farm nearby create both an economic cost that is challenging to quantify.

Because these costs exist below the line of the producer's pricing decision on the product, rarely are these costs considered when assessing the subsidy investment or design. Therefore, from an economic perspective, the marginal social cost of using renewable energy may be greater than the marginal private cost to the producer, even after considering the avoided emissions.

Pigouvian Subsidies and Mispricing Risk

Pigouvian policies are effective only if subsidy levels reflect the net external benefit associated with the subsidised activity. If renewable energy subsidies accurately price the carbon benefits of green energy but misprice the material waste and land use costs associated with those systems, there is a significant risk the renewable energy products manufactured in excess of their socially optimal production level.

This mispricing of renewable energy is a reality; residential electricity prices in Germany (where the country has implemented Energiewende) are now among the highest in Europe due, in part, to the existence of systemic costs (e.g., the costs of expanding the electrical grid and maintaining back-up generation facilities) associated with establishing a sustainable electric grid. The costs associated with these elements represent a form of negative externality to consumers rather than producers of renewable energy.

At the firm level, DTEK Renewables is an example of how investment in renewable energy through subsidies can promote rapid growth and deployment but leave the responsibility for resolving long-term environmental issues (such as equipment decommissioning) unpriced and unresolved.

Causes of this Situation

Many of the same economic factors that have led to this outcome (job creation, physical facility investment, emissions reduction) were already mentioned in the Causes of the Situation.

• Political Economy: Investments made today (those with visible benefits) are given greater weight than any future costs that may not materialize until years from now.

• Asymmetry in Information: Future negative impacts caused by improper waste disposal practices and future ecological consequences are uncertain and virtually impossible to quantify.

• Time Inconsistency: Today’s policymakers place more weight on the immediate benefits of a decision rather than on the future externalities associated with their decision-making. Therefore, the present regulatory framework incorporates only a portion of future externalities into regulations.

Ramifications for Policy Design

Economics students should understand that green energy policy cannot be classified into two categories: “market failure” and “government intervention.” Rather, the green energy policy represents an issue of incomplete internalisation. A more comprehensive solution would include either a price on carbon emissions with mandates for recycling waste or land-use costs with subsidies adjusted for life­ cycles.

Conclusion

From an economic perspective, European green energy policy constitutes a more complex case of inadequate internalization of externalities than simply representing a correction of a market failure. The Pigouvian subsidies associated with the use of renewable energy do target the negative externalities of using fossil fuels, but they also do not account for the full environmental, social and systemic impact of renewable energy. Therefore, in all likelihood, the current policy will shift rather than eliminate the externalities associated with the production of renewable energy, which may result in an overproduction of renewable energy relative to the socially optimal level of production. The welfare-maximizing path for green energy policy should be to move beyond discretionary subsidies to utilize policies that account for all of the costs (full life-cycle costs) of renewable energy. Full life-cycle costs should incorporate carbon pricing, recycling mandates and land-use restrictions and incorporate dynamically adjusted subsidies. The only way for green energy policies to satisfy their stated economic and environmental objectives is to align marginal private costs with marginal social costs.