Pop quiz: What is the socially optimal level of pollution? (Hint: the correct answer is not ‘zero’.)
This is from environmental economics professor (and blogger) Tim Haab :
Each fall, I start my undergraduate environmental economics class by asking students “What is the socially optimal level of pollution?” The class consists of about 1/2 economics majors and 1/2 natural resource/ecology/treehugging (a joke!) majors. Inevitably I get a critical mass of students that think zero pollution is optimal. I tell them “If you learn one thing in this class, learn that zero pollution is not an option.” Well, I gave the final exam in that class yesterday and asked “What is the socially optimal level of pollution? Explain.”
Here’s an answer that received full credit (read the post for examples of answers that did not):
From an economic perspective the socially optimal level of pollution occurs when the marginal benefit of the last unit of pollution exactly equals the marginal cost of pollution. At this level the net benefits to society are maximized. If all of the externalities of pollution are accounted for, the resulting level of pollution will be optimal.
Environmentalists don’t need to be reminded that pollution generates costs—although some do seem to need to be reminded from time to time that pollution is not actually a mortal sin. But sometimes they forget that polluting activities also bring benefits. If the gain from an extra unit of pollution is greater than the environmental cost, then society is better off with the extra pollution.
The marginal benefit equals marginal cost condition applies to a very broad set of problems. But the presence of externalities complicates things. An activity generates a negative externality if part of the costs of production are borne by third parties who don’t benefit from and who didn’t participate in the exchange. If people receive all of the benefit of an extra unit of pollution but only bear part of the extra cost, there will be too much pollution.
So the issue isn’t that pollution is costly—every activity has a cost. The problem is that when people weigh the costs and benefits of pollution, they don’t take into account all of the costs of their actions. The simplest solution is to make sure that the prices individuals face actually reflect the costs faced by society—and the simplest way to do that is to impose a tax that reflects the externality. If prices reflect the true costs, then markets will produce the social optimum.
Which brings me to the oil sands.
Like almost all resource extraction activities, the oil sands operations pose risks to the local environment. What makes them a reason for global concern is their role in the climate change file. The oil sands are a significant source of greenhouse gases, but I’m not sure it’s widely understood just why they are. It has little to do with the fact that they produce oil (or synthetic crude or diluted bitumen) per se, it’s that the available technology for doing so requires enormous amounts of energy—and producing that energy creates greenhouse gases. Producing oil from the oil sands creates costs that are not fully borne by those who purchase it.
But producing oil also creates benefits – high oil prices generate higher incomes for all Canadians (see here for an explanation for how and why the benefits extend well beyond Alberta’s borders). So the question is: do the extra benefits from oil sands production outweigh the costs?
I don’t know the answer to that question, and I’m pretty sure that the people who want to shut down the oil sands—or even those who would target them for special treatment—don’t know either. But the great thing about markets is that no one has to make that decision. As Andrew Leach once put it,
Supporting carbon pricing means that you hand control of who wins, who loses, and where emissions come from in the economy to the market. True carbon pricing also likely means, sin of sins, that environmentalists might have to give the oil sands a pass.
Pricing carbon will mean that certain GHG-generating producers will shut down—but not necessarily the ones that are attracting the most attention. Low-value GHG-emitting activities will be most vulnerable, and it is by no means obvious that the oil sands produce the lowest value per tonne of GHG. As Andrew says,
if you believe in carbon pricing, you also have to accept that it is not a market failure when the activities you do not like keep going in the face of a carbon charge.