Hailey College of Banking & Finance Lahore

Apr 07 - 13, 2008

Externalities are actually the effects imposed on others but not taken into account by the person engaging in some action. The best examples are (1) pollution, a negative externality and (2) personal flower gardens at the front of a house, a positive externality.

In the case of negative externalities, people do too much of whatever it is because they don't consider at all the costs they are inflicting on others. In case of positive externalities, people do too little of whatever it is because they don't consider all the benefits conferred upon others.

Energy production and its externalities pose significant regulatory challenges that are simultaneously local, regional, national, and international in nature. The supply of nonrenewable energy sources continues to drop, the production process and usage of the final products result in significant pollution, and the burdens and benefits of the industry are inequitably divided. The relationship between government and energy corporations reinforces these intertwined problems. Governments chronically enforce environmental standards, and the structure of resource extraction often enmeshes corporations with armed conflict or dictatorial regimes that commit human rights violations.

Economic theory defines a market failure when competitive markets cannot reach an equilibrium maximizing social welfare. One of its most typical examples has proved to be the energy market. Exhaustible energy resources provide the limits to economic growth, at least in the short term. Thus an energy policy for countries like Pakistan has to be focused on minimizing the negative influences of external energy price shocks to the domestic economy.

The energy sector does not sit isolated from other spheres of activity in the modern society. In addition within the energy sector itself competition is not sufficient even to produce efficiency outcomes where problems of externalities are involved. Thus energy policy has to concern itself not just with economic efficiency, but also concerns associated with equity or fairness, and the issues associated with environmental impacts of energy use, as well as long-term sustainability of the energy resources available to the society. In addition, energy policy has to be made consistent with policies in other policy areas such as transportation policy, human settlement policy, industry policy, and taxation policies.


Energy policy objectives are the outcomes sought through the use of energy policy instruments.

There is a range of policy objectives and they include:

Economic efficiency in the supply of energy

Efficiency in the use of energy

Diversity in the sources of energy

Consistency between energy policies and other policy objectives e.g. environmental policy objectives

Energy security

Cost and availability of energy resources to low income earners

Conversion of energy resources

Research in energy supply technologies

Placing energy supply on a sustainable basis

In the recent past there have been a number of disruptions in supply and in the price of energy. This has led to more focused attention to the concept of "energy security". The term "energy security" has actually been used by Anil Markandya and Alistair Hunt, University of Bath, Bath, UK in their article titled "The Externalities of Energy Insecurity" where they have defined it as "a state in which consumers and their governments believe, and have reason to believe, that there are adequate reserves and production and distribution facilities available to meet their requirements in the foreseeable futures, from sources at home and abroad, at costs which do not put them at a competitive disadvantage or otherwise threaten their well-being. Insecurity arises as a result of physical failure of supplies or as a result of sudden and major price changes."

In understanding the nature of externalities associated with energy security it is useful to distinguish between two types of externalities that generate external costs: technological externality when the actions of an economic agent affect the welfare of another, other than by affecting prices; and a pecuniary externality when the actions of one economic agent affects the welfare of another through price changes. Even though energy shocks can involve physical disruptions, the impact of these also comes through dramatic effects on price. Therefore, the external costs associated with insecurity of energy supply are thought to be primarily pecuniary externalities.

The following are some measures of pecuniary externalities:

MACROECONOMIC COSTS OF ENERGY PRICE INCREASES: Historically, it has been observed that the link between energy (oil) price increases and economic performance are not linear functions, if they exist at all. This observation therefore signals that the confidence in which we can have in estimates of externalities based on macroeconomic costs is diminished. However, it is hard to quantify the degree of uncertainty surrounding the macro-economic estimates.

PRICE VOLATILITY: We define price volatility as being the standard deviation of return/price, which measures how widely actual values are dispersed from the average. The larger the difference between the actual value from the average value, the higher the standard deviation will be and the higher volatility.

MILITARY EXPENDITURE: Some have argued that military expenditure should be factored into the external cost of energy security given that without this type of expenditure (particularly in the Middle East) there would be a tangible threat to the secure supply of oil. These include the arguments that:

* Military expenditure is a cost of mitigating energy security rather than a cost of insecurity itself

* Other national security interests are being served, not just oil

* Military presence is potentially on behalf of many other countries too

CONCLUSIONS: Measurement of energy security externalities remains a complex and difficult exercise. Problems of definition as to what constitutes these externalities make agreement on what the policy issue is hazardous. Additionally, the range of assumptions that need to be made in order to calculate quantitative estimates of the size of these externalities means that these estimates should be viewed as indicative only.