Why can’t we price for externalities?

Austin street art. Artist unknown. Photo by Nermin Judson

Last November, Austin lost Freddie’s Place, a funky bar, barbecue joint, outdoor music pavilion and children’s playground all rolled into one. The restaurant had been closed for several years, but I hadn’t been there for far longer. Its stone façade reflected the iconic look of Austin’s South First Street. When it was still in business, it was abuzz with people in a way that gave life to the neighborhood. I wonder what will become of Freddie’s. What will its replacement add to the neighborhood?

While I have an outsized, even sentimental interest in this particular building, I concede there is nothing particularly noteworthy about it as opposed to any other old building being knocked down to make way for something new. We all have our list of fabled Austin landmarks being cleared in the name of progress. Perhaps the stonework could have been preserved, but it’s not an occasion for public outcry. The city must grow and evolve.

But Freddie’s is still a great example of how what happens on private land has a real impact to the community around it. This is what economists refer to as externalities. Were a beautiful building to replace Freddie’s, it could make it more enjoyable to live nearby, even increase the value of a neighbor’s property, thereby having a positive externality on the neighborhood. Conversely, a post-Freddie’s structure could block a neighbor’s view or increase traffic, having a negative externality on them. It’s why you see signs all over Bouldin Creek opposing the Warren and Ramel Wildlife Gallery in the residential neighborhood. In this case, a former pentecostal church has been converted to a sprawling display of the intrepid work of big game hunter and venture capitalist Rick Warren.

Every decision that gets made privately has some, often negligible impact, on those around it. And while we have rules surrounding what can be done, we don’t reward or punish decisions within those rules.

Freddie’s Place or an entrepreneur’s hunting trophies are one thing. But the relevance of externalities is raised to a new and global dimension when we talk about environmental costs, with pollution as an example. Let’s consider naturally-occuring oil. As a nation, we have laws against some types of pollution, but although we can measure pollution, we fail to allocate a per unit cost. At a price of $60 per barrel, oil production in the Gulf of Mexico generates roughly $39 billion per year. For comparison, the cost of BP’s Deepwater Horizon spill in 2010 was $61 billion, which likely didn’t capture the full cost of the damage. Each barrel of oil, even without any spill, represents a real cost to our shared resources, but with few exceptions, like settlements after a massive spill, the cost of that oil production doesn’t bear that hidden expense. Fracking is known to pollute nearby water supplies but again that cost is borne solely by society and not by the individual or company producing that pollution.  No wonder it is difficult to get companies to take more responsible action; profit, which is what executives are required to maximize for their shareholders, demands that business leaders take advantage of this failure to attribute costs properly.

Moving from Freddie’s to fracking to the planetary economy, back in 2011 when the global GDP was $75 trillion Australian economist Robert Costanza estimated that on top of this Mother Nature contributed an additional $125 trillion. So out of a revised total GDP of $200 trillion, that increment from nature itself was 66 percent larger than that produced by human ingenuity, labor and financial capital. Further diminishing the human-produced share of the aggregate bounty, Costanza also calculated that the unrecognized costs to the environment – the externalities – was $23 trillion. For context, that’s a sum 50 percent larger than the entire U.S. GDP at the time of $16 trillion. All said differently, if back in 2011 we had traded the entire GDP of the United States for the cost of that year’s damage to the global environment, humankind would have been $8 trillion ahead.

These are 2011 estimates. The numbers in this exercise would be far larger if calculated today. So while we tout economic growth — which at 2.1 percent for the last U.S. quarter was precisely what the U.S. Commerce Department was doing as Urbānitūs went to press – we ignore the reality that we are simply trading nature (water, forest and air) for material things we can monetize. We don’t examine or debate the fact that we may actually be poorer each year than were at the start despite all the “goods” that we’ve produced that year.

As we have explored in this edition of Urbānitūs, if a private party drains or destroys an underground aquifer in the pursuit of commercial profit, their cost for that destruction is zero. To be fair, economists currently count in their GDP calculations either. Once these resources become scarce, and therefore more valuable to the market, perhaps we’ll start to value clean drinking water more than a smartphone or make the investment to use compostable instead of plastic bags.

Until then there is an elegant and just solution as introduced by English economist Arthur Pigou 100 years ago in his 1920 book the Economics of Welfare: shift the cost burden of externalities onto those that cause them. The implementation would be anything but simple as it would represent the largest redistribution of wealth in our history. This ‘radical’ notion of passing on the cost to those who negatively impact the environment, while rewarding those financially who find ways to improve the world for others, would undoubtedly have an impact. If that $23 trillion in negative impact to the environment was able to be charged to those that caused it, they would be making different decisions. Renewable energy use would go up, pollution would go down, and the free market might just operate as it was intended to: solving society’s challenges and promoting innovation. Instead, society rewards those who are best able to convert public goods to private ones; regardless of whether society is worse off from the conversion.

Already in Europe there is a movement of companies to plant trees to offset CO2 emissions. The amount of land that it would require make it a wholly impractical solution to the full problem of global warming, as it would involve essentially filling every empty square inch of the world with 1.2 trillion new trees. But it is a step in the right direction. As companies like Volterra Ecosystems offer services for multi-national oil and gas companies to offset emissions from oil production with the planting of trees, it’s an indication that with enough money, action can be taken to decrease the harm to the environment that companies are making and not force the whole of society to pay the cost for one company’s profits. And it will encourage innovation in a way that clearly won’t happen in today’s current environment.

From South First Street, of course, an effort to a more effective global reckoning of externalities might be a bit ambitious. But there’s no reason we can’t begin calculating this locally. In all the noise, anger and rancor surrounding the ongoing Land Development Code – aka CodeNext – debate in Austin, the math of externalities is what’s missing.

What is the public cost of private development in downtown or in gentrifying East Austin? What is the ultimate public burden of housing developments moving into areas at risk of Australia-like wildfires? What will be the cost for developing the water resources for a population set to grow by 20 percent just in the next decade?

Or down on 1st Street, what is the externality to be paid by Austinites for a replacement of Freddie’s or putting a museum of stuffed camels and buffalo in a residential neighborhood?

Until we can acknowledge and measure the true aggregate gains or losses from each of these, it’s nearly impossible to engage in a conversation on how we rightly spread those costs and benefits.

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