THE INTERNALIZATION OF NEGATIVE EXTERNALITIES
Businesses do not exist in a vacuum. It exists in an increasingly complex world where it interacts with the biosphere and other actors to provide goods or services. There is a relationship between the producer and consumer, the so-called producer-consumer relationship. This relationship is self-serving; thus, the consumer wants to buy at the lowest price, and the producer wants to make a profit. Ultimately, they meet at an equilibrium price, and a transaction occurs.Now, it is possible to have a situation where the market fails to price products accurately. Thus, a market failure occurs. Externality is one of the causes of market failure. An externality is an action by either a consumer or producer that affects other producers or consumers yet is not accounted for in the market price. These effects are called externalities because they occur external to the market. An externality can be negative – when the action of one party imposes a cost on another – or positive – when the action of one party benefits another party.
According to the Corporate Finance Institute, negative externalities occur when the product and/or consumption of a good or service negatively affects a third party independent of the transaction. An ordinary transaction involves two parties, i.e., a consumer and the producer, referred to as the first and second parties. Any other party unrelated to the transaction is referred to as a third party.
In sustainability science, pollution is a well-known negative externality. For example, a company emitting pollutants into the air is affecting our shared atmospheric resources or what can be referred to as the “Common”. So, negative externalities take place outside the producer-consumer relationship.
So, if the activities of companies affect the “commons”, the argument is companies have to take responsibility for that. If company A emits GHGs contributing to climate change, it exacts a social cost on the population, then company A should do more to internalize those costs. This brought about the concept of internalization of negative externalities.
Dealing with externality:
The government, as the regulator, has served as a check on the private sector over the years and uses several mechanisms to address the negative externality imposed on citizens by corporations. The three approaches governments use are Command control regulations, Taxes, and Trading systems.
Regulators set a standard. It monitors compliance, and then it penalizes noncompliance. The standard is set to limit the level of pollutants that can cause health and safety issues and negatively affect the environment. In Nigeria, the NESREA sets standards for pollutants and monitors compliance. If implemented correctly, regulations can be effective. It can be expensive as it does not consider the organization’s context of the business.
Cap And Trade System:
The government sets the Cap, the maximum quantity of emissions allowed. A country can develop a form of carbon budget, the total quantity of emissions for a particular year; that’s the Cap. An allowance is set for each emission unit, which is given to companies for free or through auction. So, the number of permits equals the allowance limits. Subsequently, the government reduces the emission cap yearly, reducing the allowance limits for companies.
To provide more context, if company A is given 50ppm as its allowance limit, it can only emit up to 50PPM. However, if, due to its operation, it emits more than this or the allowance does not allow the company to meet client needs, it has to pay a levy or charge to emit beyond the allowance. Company A could also decide to invest in technology that would allow it to meet its demand within the emissions allowance limits. Changing to a cleaner energy source to reduce its emissions is also possible.
Lastly, it could buy emission allowance from other companies. This aspect constitutes the trading part of the cap-and-trade system, where companies with excess allowances can sell off those allowances to other companies to increase their emission cap.Thus, this offers a business opportunity for the company. If a company has improved its technology and now emits lower than its allowance, it can sell off the excess credit.
A cap and trade sets a quantity for total emissions. It encourages companies to find the lowest-cost method to achieve an emission target. The trading of an emissions allowance creates a source of revenue. While Cap and trade set the emissions quantity, the allowance price can vary.
Carbon credits, also known as carbon offsets, permit the owner to emit a certain amount of carbon dioxide or other greenhouse gases. One credit permits the emission of one ton of carbon dioxide or the equivalent of other greenhouse gases. Carbon credit is an example of the cap-and-trade system (Investopedia).
Opportunities for political influence at the initial stage of emissions allowance allocation could affect the effectiveness of the cap-and-trade system. Also, the measurement of emissions and setting of emission caps could be subjective or politically influenced.
Another strategy for internalizing externalities is the internal carbon price. The organization can set an internal carbon price and use it in its NPV analysis. It is a form of self-imposed carbon tax. This allows the company to be proactive in the event of any carbon tax in the sector and boost its reputation. Companies worldwide are making net zero commitments and making pledges on when to stop emissions. The internalization of negative externality is generating much attention, and consumers are looking up to the private sector to behave like responsible citizens.
Taxes are a way for the government to direct the behavior of citizens and corporations. It technically distributes the social cost of the negative externalities. High tax on products means they will be more expensive, thus less consumer patronage, e.g. tax on alcohol and cigarettes.
Under a carbon tax, the government sets a price that emitters must pay for each ton of greenhouse gas emissions. The government can tax several things. Governments all over the world have gotten good at collecting taxes. As argued during the African climate summit, a carbon tax could be used to deal with climate change. The tax collected is typically used for public good. However, It doesn’t assure that the emission target will be met.
Ultimately, a tax imposed on carbon is passed down to the consumers and manifests as a high cost of products. This affects the company, too, as it shifts consumers’ preference to substitute goods. So, companies are affected by the carbon tax and are incentivized to reduce their CO2 emissions. According to Statista, as of March 2023, Uruguay has the highest carbon tax in the world at 156 USD per metric ton of CO₂ equivalent (USD/tCO₂e). The setting of a carbon tax should look at the social cost of carbon emissions.
So far, we have taken you through how companies can internalize externalities and the merits and demerits of each mechanism.