Table of Contents
Understanding Externalities
In energy economics an externality is a cost or benefit from an activity that affects people who did not choose to be part of that activity. When a coal plant emits pollution that harms health downwind, the plant owners and electricity buyers create costs for others that are not reflected in the electricity price. These are negative externalities.
In conventional markets only private costs and revenues are counted. Private costs include fuel, equipment, wages, and maintenance that appear on a company’s balance sheet. External costs fall on society in the form of poorer health, damaged crops, climate change, and degraded ecosystems. When these costs are not included in market prices, fossil fuels appear cheaper than they really are.
Key idea: The market price of fossil fuel energy is lower than its true social cost because many environmental and health damages are externalized and not paid by producers or consumers.
This hidden gap matters when comparing fossil fuels with renewable energy. A fair comparison must consider both private and external costs, sometimes called the full social cost.
Types Of External Costs From Fossil Fuels
Fossil fuels create externalities at every stage of their life cycle, from extraction to end use. Although details differ across coal, oil, and gas, several categories of hidden costs recur.
A major category is health damage from air pollution. Burning fossil fuels produces fine particulate matter, nitrogen oxides, sulfur dioxide, and ground level ozone. These pollutants increase respiratory and cardiovascular diseases and contribute to premature deaths. Hospitals, families, and health systems bear these costs, not the power plant operators.
Another set of externalities comes from climate change. Carbon dioxide and other greenhouse gases trap heat in the atmosphere and contribute to rising temperatures, more severe heatwaves, changing rainfall patterns, sea level rise, and more frequent extremes. The costs show up as damaged infrastructure, lost agricultural yields, disruptions to water supplies, and forced migration. The emitters typically pay none of these costs directly.
Local environmental degradation during extraction also creates externalities. Coal mining can cause land subsidence, contaminated water, and destruction of landscapes. Oil and gas extraction can lead to spills, methane leaks, and ecosystem damage. Communities near extraction sites bear many of these burdens through loss of livelihoods, lower property values, and increased health risks.
There are also hidden safety and security costs. Oil dependence can contribute to geopolitical tensions and military spending to secure supply routes. Large accidents such as major oil spills impose sudden, high damages on fisheries, tourism, and coastal ecosystems. These risks are part of the broader social cost of fossil fuel dependence.
Finally, there are distributional externalities. Pollution and climate impacts often fall disproportionately on low income communities, Indigenous peoples, and countries that have contributed least to emissions. These unequal burdens represent a social cost that is rarely accounted for in the market price of energy.
Valuing External Costs
To bring hidden costs into economic analysis, researchers estimate monetary values for different types of damage. This process is imperfect, but it allows fossil fuels and renewables to be compared on a consistent basis.
One key concept is the social cost of carbon. This is an estimate of the present value of all future climate related damages caused by emitting one additional ton of carbon dioxide today. It includes impacts on agriculture, health, property damage from flooding, and other climate effects. The social cost of carbon is expressed in currency per ton of CO₂, for example dollars per ton.
Although the exact value is uncertain and depends on assumptions, the principle is simple. Each ton of CO₂ imposes a real cost on society that is not captured by the private cost of burning fossil fuels. Ignoring this cost makes fossil fuels artificially cheap compared with low carbon alternatives.
Health externalities from air pollution can also be monetized. Epidemiological studies link pollutant concentrations to illnesses and mortality. Economic methods then estimate the medical costs, lost work days, and willingness to pay to reduce health risks. These values are usually expressed as a cost per unit of pollutant emitted or per kilowatt hour of electricity produced from a given fuel.
Environmental damages to ecosystems, crops, and buildings are similarly valued using market data, such as lost agricultural revenues, and non-market valuation techniques, such as surveys on willingness to pay for cleaner environments. While these methods are subject to debate, they consistently show that external costs from fossil fuels are large compared with their market prices.
Important statement: When external health and climate costs are added, fossil fuel electricity can be more expensive to society than many renewable options, even if its market price per kilowatt hour is lower.
Hidden Subsidies To Fossil Fuels
Because external costs are unpaid by producers and consumers, they function as an implicit subsidy. Society, rather than the energy company, bears part of the true cost of production.
In addition to these implicit subsidies, many countries provide explicit financial support to fossil fuels through tax breaks, price controls, and direct budget transfers. However, the hidden subsidy from unpriced externalities is often larger than the explicit support.
This situation distorts competition between fossil fuels and renewables. Renewable projects must usually pay most of their social costs up front, such as land, materials, and grid connection, while many of the damages from fossil fuel use are postponed and borne by others. As a result, investment and consumption decisions are biased toward fossil fuels, even when they are not the least costly option for society as a whole.
In some analyses, “fossil fuel subsidies” are defined broadly to include both explicit budgetary support and the failure to price externalities like air pollution and climate change. Under this broader definition, the total support to fossil fuels becomes very large, making clear how far market prices are from reflecting full social costs.
Correcting For Externalities
To address hidden costs, policymakers use instruments that bring externalities into economic decision making. One approach is to put a price on emissions equal or close to the estimated external cost. This can be done through a carbon tax, which imposes a fee on each unit of greenhouse gas emitted, or through emissions trading systems, where a cap on total emissions is combined with tradable allowances.
In simple form, if $C_p$ is the private cost of producing one unit of energy, and $C_e$ is the external cost per unit of energy, then the social cost is
$$C_s = C_p + C_e.$$
Corrective policies aim to make the price paid by producers and consumers closer to $C_s$ rather than $C_p$. In principle, if the tax per unit of pollution is set equal to the marginal external cost of that pollution, the socially optimal level of production can be achieved.
Core rule: Efficient pricing requires that the marginal cost of pollution faced by firms equals the marginal external damage caused by that pollution.
Besides pricing instruments, governments can use regulations, such as emission standards and performance requirements, that limit pollutants directly. While these do not place an explicit monetary value on external costs, they still reduce the gap between private and social costs by restricting damaging activities.
Information tools can also play a role. Public disclosure of pollution levels, health impact studies, and comparisons of full social costs across technologies help citizens and decision makers understand that low prices at the point of sale may hide substantial costs elsewhere.
Implications For Renewable Energy
Once externalities and hidden costs are considered, the economic position of renewable energy often improves significantly. Many renewable sources, such as wind and solar, have very low air pollution and greenhouse gas emissions during operation. Their external costs per kilowatt hour are therefore much smaller than those of fossil fuel plants.
Some external costs still exist for renewables, for example related to land use, material extraction, and end of life management. However, life cycle assessments generally find that these impacts are much lower than the combined climate and health damages from fossil fuels. When health savings and avoided climate damages are counted, investments in renewable energy can deliver large net benefits to society even if their private costs appear similar or slightly higher.
This understanding also affects how “cheap” or “expensive” technologies are perceived. A fossil fuel plant that sells electricity at a low market price may, after including health and climate damages, cost society more than a renewable plant with a higher market price but much lower externalities. Policy support for renewables can then be seen not only as a climate measure, but also as a correction for long standing distortions created by unpriced external costs of fossil fuels.
Recognizing externalities and hidden costs is therefore central to any rigorous economic assessment of the energy transition. It shifts the focus from narrow price comparisons to a broader evaluation of who pays, when they pay, and how costs are distributed between current and future generations.