We ended our last discussion on climate change on “I’m not sure whether I want to give up electricity or stop buying anything made in a factory.” Well, if we’re smart in the way we mitigate climate change - that© s solving it – and if we act fast, you won’t have to. As we have defined the problem, we need practical and executable solutions without creating imbalances in the economy.

A tough line to tread. We need to switch to low emission technologies, which are available and affordable to produce. Many countries such as Canada, Singapore, Japan, Ukraine and Argentina among others are putting a price on carbon and the other greenhouse gases, to take into account the environmental damage caused by fossil fuels. But should fossil fuels be punished for being the cheapest energy source?

Common-sense says that we shouldn’t punish fossil fuels, but we are in dire need to transition away from them pretty much immediately. Here is where we will have to expand our perspective and look at the bigger picture. While cheap in terms of dollars, the ramifications of the prolonged use of fossil fuels on climate change have not been taken into account at all.

If the true cost had been included – fossil fuels would be much more expensive. One way to factor in this cost is to introduce a price on carbon-intensive technologies. That way, we would speed up the transition to clean, renewable energy sources such as solar and biofuels. But there’s been a lot of debate about this. Is carbon pricing the best approach to deal with climate change? We will discuss this later. As of now, let©s dig into one of the most important concepts to find true cost – externalities.

If I play loud music while you study for an exam, will this have an impact on you? You will probably feel quite distracted and annoyed. This may cause you to lose your valuable study time and even possibly fail that exam. In effect, you’re being indirectly and adversely impacted by my activities.

The decisions of individuals and organisations to produce, consume and invest have impacts on the people who are not directly involved in these activities and these indirect, un-costed impacts are what economists call externalities. Externalities can be both positive and negative. Positive externalities can be good for society. For instance, if a sufficiently large proportion of the population is vaccinated against a disease, the people gain what is called herd immunity. Negative externalities, on the other hand, are often problematic.

Sometimes, negative externalities are relatively inconsequential in the grand scheme of things. For example, smokers ignore the harmful impact of toxic passive smoking on non-smokers. When these negative externalities are more widespread, they can become costly for the wider community.

The classic example of a negative externality is air pollution generated by industry (reminds me of the perennial air pollution in our so-called pollution capital – New Delhi). Most business enterprises make decisions based only on their direct cost of inputs and profit expectations. A power plant or even a printing press, for instance, may operate without factoring in the indirect costs caused by pollution, because the firm does not bear these costs.

However, these costs, or externalities, are real for other people and organisations in the economy. A resident living near a polluting power plant may suffer higher healthcare costs; the local tourism industry may lose revenue due to pollution causing environmental damages.

Now, if you consider the costs incurred due to the indirect damage caused by the power plant to its balance sheet, its production decisions would probably change. The point is, the indirect costs are not borne by the power plant, the actual social cost of production is greater than the power plant’s private costs of production.

This is known as a market failure and it is one of the main reasons why governments intervene with public policies. The 2007 Stern Review on the Economics of Climate Change regarded greenhouse gas emissions as negative externalities and labeled climate change as the greatest and widest-ranging market failure ever seen.

The review emphasised that the cost of these externalities will be borne mostly by the civil society. It estimated that the potential impacts of climate change on water resources, food production, health and the environment could result in a loss between 5% and 20% of GDP globally. Today, years after the Stern Review was published, these potential impacts are likely to be much greater due to our careless approach towards its mitigation. In climate economics, we use a metric known as the social cost of carbon.

According to the US government, the social cost of carbon can be defined as "a monetised estimate of the damages associated with an incremental increase of carbon emissions in a given year." Simply put, the social cost of carbon represents the economic damage incurred by the society from each additional tonne of carbon dioxide (CO2). So how much is this in terms of dollars?

Well, depending on the expert you talk to, and the computer model and the discount rate used, the social cost of carbon varies widely. The US government puts the social cost of carbon at between USD 11 and USD 109 per tonne of CO2 emitted. While this is interesting, does this metric have any practical application beyond informing governments of the economic consequences of climate inaction? The answer is yes; the social cost of carbon is being increasingly used in public policies.

The US and UK governments have, in recent years, integrated it into their economic decision-making process for large infrastructure projects. Just type “Keystone XL Pipeline and social cost impacts” in your browser to understand how the decisions are impacted by social costs and externalities.

So, what can governments do to address the externalities of greenhouse gas emissions? The social cost of carbon provides an important part of the answer. Governments can enact public policies to ensure that the social cost of CO2 emissions is paid by the people and businesses responsible for the emissions.

In the terminology of economics, negative externalities need to be internalised by adjusting the price of the polluting activity to reflect the monetary value of that specific externality. This may, for instance, include putting a price on carbon emissions or requiring emitters to buy a tradable permit.

Look at our industry and think about how we deal with our externalities – how we handle (or sometimes just dump) our waste, use harmful chemicals and inefficient old equipment, manage finite resources such as water, energy and so on. If negative externalities are calculated and factored in the balance sheet – how will it reflect on our daily lives? Let’s ponder until we meet again