Energy in Ontario: The Strange Case of the Inverse Externality

Arthur Lightstone, www.green-neighbour.ca, January 21, 2011

           In economics, we refer to any cost born by a third party resulting from an economic transaction between two other parties as a “negative externality.” A positive externality, on the other hand, would describe a benefit enjoyed by a third party that initially arose from a transaction between two other parties. For example: when a smoker consumes cigarettes, the bystander who breathes second-hand smoke is experiencing a negative externality. The bystander neither purchased nor sold the cigarettes, yet the bystander experiences a direct cost associated with the transaction between the cigarette smoker and the cigarette manufacturer. Negative externalities result in a misallocation of resources because they interfere with the natural market signals that lead to an allocatively efficient market equilibrium. In other words, given that the costs to third parties are not taken into account by either the seller or the buyer, the market forces of supply and demand do not take these costs into consideration, and therefore produce an equilibrium price and quantity that do not truly reflect all of the social costs associated with the product. In the case of negative externalities, the market is producing too much of the good simply because the market is not recognizing that the overall marginal costs associated with the good are in fact greater than the marginal benefit associated with the good. A cardinal rule in economics (not just text-book economics, but indeed the common sense behaviour of rational people everywhere) is to stop doing something once the additional cost associated with the behaviour exceeds the additional benefit.

In theory, a government can restore the socially optimum equilibrium by imposing a tax on the good or service generating the negative externality. If the tax is equivalent to the cost associated with the negative externality, then the equilibrium resulting in the market after the tax is imposed should produce an allocatively efficient equilibrium. The reverse is true for positive externalities. In the case of a positive externality, a government could attempt to restore the socially optimal equilibrium by subsidizing the good or service generating the positive externality. If the tax is equivalent to the benefit associated with the positive externality, then the equilibrium resulting in the market after the subsidy should produce the socially optimum equilibrium.

Fossil fuel is, without a doubt, a product that generates negative externalities. Even if one were to deny the extreme costs associated with global warming, anyone would have to concede that the burning of fossil fuel produces pollution, and pollution generates a host of negative externalities ranging from acid rain to cardiopulmonary disease. Now here is where economic theory (as well as common sense) and government policy have historically parted ways: it turns out that energy produced in Ontario from the burning of fossil fuel has not historically been taxed in the manner that one might expect of a negative externality. Rather, under the Harris government it was subsidized in the manner that one would normally expect of a positive externality. In recent decades, Ontarians have enjoyed price caps on electricity that were well below the actual market rates. Since 2004, the McGuinty government has tried to ease these caps to more accurately reflect the true costs of energy production. However, initial attempts to do so were met with intense resistance from Ontarians who had grown used to their cheap subsidized energy. 

Thus, years ago when the Harris government should have been correcting an over-allocation of resources being directed toward the production of nuclear and fossil fuel-based energy, it was in fact encouraging even greater allocation of resources into the production of this commodity. This invariably resulted in a tremendous misallocation of resources, and encouraged consumers to purchase far more energy than they would have if they were to bear the true costs (internal and external) of energy production. Needless to say, this was indeed strange behaviour. I will resist the temptation to comment on the political, financial, or social forces that may have led to this behaviour. I will simply dub this rather eccentric policy an “inverse externality,” and I will leave it to politicians, bureaucrats, and conspiracy theorists to explain its existence.

The good news is this: the Ontario government’s current long-term energy plan is now moving in a direction that will see increased energy costs, a reduction in fossil fuel-based energy, and an increase in the production of renewable energy – a form of energy that is not associated with anything close to the negative externalities generated by fossil fuels. Finally, economic sense and government policy are starting to converge. The question is, will Ontarians have the political will and the economic sense to pay the true costs of energy production, pay back the debt created by the Harris government's subsidization of energy (i.e. "buy now - pay later" energy policy) while also investing in the production of our future renewable energy capacity? To be sure, this is all a rather expensive proposition. My fear is this: If the average debt-laden Ontarian expects the same behaviour of his government that he practices at home, he will likely resist the demise of “buy now - pay later” energy policies. The sad fact of the matter is that our economy and our environment are both currently suffering because the average Canadian feels entitled to take more than he contributes. That is why we buy more than we can afford, drive huge cars, live in huge houses, and consume more energy per capita than any other nation on the planet. The problem with this style of behaviour, however, is that it will always make a bad situation worse. We should always force ourselves to ask the hard question: If I can’t afford this right now, what makes me think I’ll be able to afford it in the future, especially after taking the cost of interest into account? Moreover, buy now - pay later logic is  inherently selfish, as it places the burden on future generations to pay for the standard of living that is being enjoyed in the present.

Let us never forget that the pollution generated from oil refineries and from nuclear energy production is part of the uncalculated costs of energy production. The average energy consumer does not likely realize thatone third of all oil refined becomes waste that is burned, buried, or dumped into the ocean, and radioactive waste is buried in concrete vaults for thousands of years in the hopes that future generations will develop a way to deal with it. These are the negative production externalities that are not captured in the current price we pay for a kilowatt hour of energy. Thus, the damage to our health, the damage to our environment, and the damage to our lifestyles are all part of the costs of non-renewable energy production that market forces simply do not take into consideration. For the sake of our environment, and for the sake of our children, Ontarian's need to shake off the stupor of buy-now, pay later logic, and get behind the Ontario government’s current long-term energy plan.