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Pollution, Economics, and Personal Responsibility

Over the last few years I have written a number of posts on economics.  I had written down in my book of future post ideas that I owed you the reader a post on pollution out of these discussions.  Particularly the economics of pollution, the intersection with personal finance, and of course personal responsibility.  I will attempt to do this while avoiding politics and ask commenters to also do so.

Supply and Demand Intersection with Polution

Any study of pollution begins with the concept of Supply and Demand.  If you recall we price things in society based on the supply of something and its intersections with the amount demanded.   The problem with this framework is a supplier will price only based on the costs they directly incurred at that level.    Why?  Because indirect costs do not impact an individual company’s profitability. Since pollution is not directly incurred their profitability is not directly impacted by producing additional units.

Externalities, Free Riders, and Pollution

This is similar to the free rider concept we talked about early on.  Essentially the cost of pollution created by a single company adds to other pollution in the environment.  Then the cost of that pollution is equally felt by all of us rather than solely born by the polluter.  Even worse, pollution is cumulative.  As such the cost of company X’s pollution to society on its own might be negligible.  But the costs of millions of company Xs to society may be catastrophic.  This means pollution is often known as an Externality.    There can be both positive and negative externalities of any action.

Resolving Pollution Externalities

So the question of fixing these externalities in economics is always how do you account for the cost of the free rider item in the supply and demand curve.    How do you essentially charge back the cost of the externality to the supplier?    

Option: Ban

One way to do this is to simply legally outlaw the pollution.  The cost of any penalty for failure to comply would, in essence, add a type of cost to the company’s supply curve as cost avoidance.    The problem is how to set the fine value?  Too high and we produce less of something then the optimal point.  Too low and we produce too much pollution.    It’s really anyone’s guess what the right level of cost is.    If it’s a criminal penalty it might stop the activity altogether, which also may not be a good thing.

Option: Cap

A variation of this might allow some amount of pollution instead of an outright ban with a fine.  This adds some flexibility by limiting the number.  This is often called a cap.  The problem with applying these to individual companies is determining the applicable cap to each individual company.  Each company may through the nature of their business need to produce differing levels of pollution.  As such too high for a given company and they won’t bother to reduce pollution even though they could.  Too low for a given company and it will drive them out of business even if that is not what’s best for society.    

Cap: Many Down Sides

A cap on its own is generally considered a poor method of dealing with pollution.  At the risk of sounding a little political, CAFE is a type of cap.  CAFE says that the average fuel economy of an automaker needs to be above a certain number or a company is fined.  The problem with this type of measurement is obvious.  Even if we assume they set the top-level cap of the allowable pollution at a doable rate, it still measures all companies equally against the standard. 

The issue is every company delivers a different mix of products.  Is it fair to hold say Ferrari to the same pollution standards per car as say Hyundai?  One company specializes in economy cars and the other in high-end low volume sports cars.  And yet an outright cap like CAFE treats them the same (we’re throwing out special characterizations like SUV versus car as out of the scope of discussion).   

Today, Ferrari just pays the fine and passes it on to their customers.  There is no way they can improve below the cap. So will Ferrari even try?   A financial incentive to improve pollution doesn’t really exist.  Ferrari just charges more than its fair share of pollution costs to its customers.  Hyundai meanwhile may have more opportunities to reduce emissions it may not pursue given they are already below the cap.  As such we all lose an opportunity to optimize pollution in the economy.

Cap and Trade: A Superior Way to Deal with Pollution

Which leaves us with really the best option we have, cap and trade.  Still, the cap or total max amount for the economy is set by a governing body.  We can only hope they set it to such a level that it is obtainable for society as a whole, minimizes damage to the environment, and does not overly harm the economy.   Too high a cap and improvement won’t occur, too low and the economic costs will exceed the pollution. Along with what I describe in the next paragraph the total allowable amount defines the cost of pollution born by suppliers.  As such it is incredibly important.   Analysis of data might guide the cap portion and is also the true point where politics might come into play.   Since this is a financial blog we’ll leave that to someone else to discuss.

The trade aspect of cap and trade is the ideal economic way to distribute the costs of pollution.  The reason is those customers with pollution below the cap can then sell their extra credits (the portion below the cap) to another company who may not be able to make it under the cap otherwise.  In this way, you get an optimal distribution of pollution across all organizations.

Who Bears The Cost of Pollution Under Cap and Trade?

The cost of the pollution is born out by the supplier in the form of the opportunity cost of selling their credits (or buying more) regardless of level.  The open market essentially defines the cost based on the cost of those credits in the free market.  Ferrari still has the incentive to decrease their pollution at a marginal level rather than all or nothing. Hyundai now has the incentive to continue to improve despite being well below the cap to start. The economic incentive to improve pollution remains for all.

Essentially you get a supply and demand curve for pollution that affects the supply and demand of other items in the economy.  Pretty cool.  In theory, you can do this with any type of negative externality.

Personal Responsibility and the Environment: Determining Your Impact

So what does this all have to do with personal finance?  Well as a human being we pollute the environment as well.  That cost is not born out by us directly as well.  By understanding the above you can see how it is important for you to pay attention to your own impacts on society you may not directly pay for.  We all owe it to society to throw away our trash, recycle, and not wastefully consume.  You won’t directly pay for just your solution, but if everyone does these things we will all suffer.

You might even be able to come up with a framework to measure your impact on society from the pollution you create.  Perhaps monitoring the costs of credits for the pollution you might individually create.  Or maybe accounting for the cost of trash you ship off to your local landfill at the price of the land it may render unlivable rather than just the cost of trash pickup.    IE. You can use your knowledge of externalities to apply a cost to yourself encouraging your own behavior.

Carbon Credits, All Trade No Cap

Finally, you can understand more about existing carbon credits and other such private cap and trade equivalents.  You see them all the time from airlines and other organizations for purchase.  The problem of course is, there is no regulator limiting the number of credits for sale.  That means these are not cap and trade.  They are just a company selling you something at a profit.    

For example, the price of the carbon credit in the US today has nothing to do with the real cost of the carbon you are creating.   Most don’t bill it as such thankfully.   Most commonly they are stated as an offset, say plant a tree to offset carbon output of a flight.  One can hope they really are using the money as some sort of offset.    One can also hope they are doing it in a way to not just replace one tree with another (not really an offset then is it?).   In either case, realize they are just selling you someone somewhere you don’t know planting a tree.  They are not really selling you anything that will reduce your targeted pollution or that of those around you.

 Remember You Impact Pollution

Where does that leave us?  With the final point of this piece.  It is each of our moral responsibility to reduce our pollution and other externality impacts on society to ensure our children live as well as us.     However, there is a real intersection here with personal finance. Not wasting resources or polluting lines up well with the personal finance ethos of not buying things only to toss them aside immediately.    It’s also another step needed in ensuring your average level of happiness rises in the future.  After all, how could all of us be happier if we live in a landfill with acid rain.  

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