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An externality occurs when somebody who is not directly involved in a transaction incurs a cost or enjoys a benefit as a result of that transaction.
These terms that may seem odd at first but are important when considering Whole Life Costs in a wider sense than just financial. The WLCF is considering extending its research and development to include the effects of externalities in the next rebuild of the WLCF Comparator Tool.
The often cited example of an externality is pollution. Car exhaust fumes do not distinguish between drivers and non-drivers, but enter everybody's lungs indiscriminately. Car drivers enjoy the benefits of using petrol, but part of the cost is borne by those whose quality of life is affected by pollution.
The term 'externality' refers to the fact that the effect in question is external to the market. In our car example, the market for petrol determines what price petrol sells at, but the effects and costs of the pollution that the petrol produces fall outside this market. Users of petrol do not, currently, pay for the privilege of being allowed to pollute, and the general public are not paid for suffering the effects of the pollution.
Types of externality
One of the most significant categories of externality is environmental impact and often the foremost is energy use. The evaluation of environmental externalities has been the subject of countless books and journal articles and how they can be considered is subject to further development by WLCF in the future.
Environmental effects of projects are mostly but not always negative. For example, a householder might decide to renovate and redecorate the outside of their house. Although only the householder pays for this, the whole neighbourhood benefits from the improvement in the building's appearance. Some of the benefits of the renovation and redecoration are therefore not reflected in its cost - they are external to the market.
In complex projects such as buildings externalities will be both negative and positive where the positive affects will reduce the negative impact. The example here is SuDs (sustainable drainage) where the positive environmental benefits reduce the environmental impact of the building. Lets not forget the other positive benefits of reducing the impact of externalities in the SuDs case they are financial in reduced costs of discharge and water use charges and positive public relations.
There are many forms externality that are non-environmental including consumer surplus, training and employment effects the majority of which are positive.
Dealing with Externalities
Governments try through fiscal and regulatory policy to internalise all externalities, (sorry about the language but it is the only way to describe it) by imposing taxes and charges to adjust prices to reflect true social and environmental costs.
However, this is difficult to achieve in reality (both from a practical and a political perspective), when it interferes with the free market which in turn generates even more externalities, and so in practice many externalities will remain.
Where a project is being appraised according to broader social criteria (rather than narrow financial criteria), it is necessary to take these into account using a Multi Criteria Appraisal. See http://www.dtlr.gov.uk/about/multicriteria/ for the UK Governments view on MCA.
It is generally believed that the private sector is not interested in including externalities in investment appraisals as they are concerned only with the 'bottom line'. However, there are at least three reasons why a private sector project sponsor should consider externalities:
if 'soft' finance is to be sought, it is very often a condition that projects should demonstrate a wider economic benefit, and externalities (either generating positive externalities or minimising negative ones) are one aspect of this.
over the lifetime of the project, there is a likelihood that the the UK Government or the EU will introduce or tighten regulatory or fiscal measures to control or internalise externalities, especially environmental ones. This outcome might have a significant effect on the viability of the project, and so should be taken into account in the initial appraisal.
a project that minimises externalities tends to be lower risk in a number of risk sectors.
many commercial banks are increasingly becoming aware of the issue of environmental liability. The regulatory regime in some countries (the USA is a good example) places a strong burden of responsibility on banks to ensure that the businesses to which they lend take reasonable steps to minimise their adverse environmental impacts. Therefore, unless the project developer incorporates environmental externalities into the project appraisal, it might prove difficult to persuade banks to provide finance.