The need for CBA applied to energy results from the existence of market failure. If there were no market failure and all energy suppliers were privately owned, there would be no need for CBAs of energy projects and policies. If market signals were appropriate, those activities and projects that are in the best interests of society would be implemented automatically and financial analyses by firms would simply replace any need for CBAs. However, the market does not work perfectly. Market failure necessitates CBA of energy projects, policies, and activities as a result of the existence of externalities, the associated need for environmental policy instruments, state ownership of energy generation and supply, assessment of sustainability, and ‘‘green’’ national accounting.
One of the most significant areas of environmental concern today relates to the environmental impacts of energy generation from fossil fuels, particularly acidification precursors, greenhouse gases, and localized air quality impacts. Much of these emissions result from power generation and the transport sector. These environmental impacts occur at local, national, regional, and global levels.
The environment can be defined as those parts of our physical and psychological endowment that we somehow share, which are ‘‘open access.’’ An economic analysis shows that it is precisely this shared nature of many environmental endowments that threatens their quality and character. In a market system, goods are allocated by the price mechanism. In a free market, the price of a good is determined by the demand for, and supply of, the good. Price is therefore a reflection of society’s willingness to pay for, or the valuation it places on, the good in question. However, the shared nature of many environmental assets, such as air, the atmosphere, and water resources, means that they are not owned and so do not have a price. When goods are seen as free they are overused. Thus, the market fails to protect environmental assets adequately.
This failure of the market can be best demonstrated with a simple example: If a power plant produces SO2 emissions resulting in acid rain, which causes forest damage and damage to buildings, in a free market these costs will not be reflected in the cost of power generation. Thus, the price of the energy will not reflect the true cost to society of generating it. In this case, more energy will be generated and more of the environmental asset depleted than is in the best interest of society. When a cost is imposed on those other than the person or business that produces the cost, this is known as an external cost. Of course, many energy projects will reduce such externalities, such as through renewable energy sources and improved heating and insulation systems.
When assessing the social efficiency of energy activities using CBA, it is necessary to include these externalities and other wider societal impacts. However, because by definition such costs and benefits are not traded in markets, there is no price to reflect their value. This provides the basis for the tools of environmental valuation.