(This is Part 9 of a series. Go back to Part 8.)
As discussed elsewhere, historically humanity has had a strong tendency to regard the benefits of nature as a "free good". Indeed, nature's benefits were not even recognized in most cases. Nature was nowhere on the balance sheet when economic calculations were being made.
But as population and industrialization have grown, nature's resources have become taxed to the limit, as evidenced in the severe threats to the planet's air, water, climate, species, etc. We can no longer afford to keep nature off the balance sheet; we must bring her onto it now if we are to survive.
Cap-and-trade systems, as we've seen, can be a valuable approach in harnessing the power of markets in using and protecting the "commons". But a market system is based upon accurate financial information, and that has been the obstacle up to now: How do we value nature's benefits?
How do we value the way that a wetland filters and purifies water? How do we value the way that a forest absorbs carbon dioxide? How do we value the way that the diversity of an ecological system lends it strength? How do we value the way that insects from a grassland pollinate an orchard of apples or a field of almonds?
In part at least, science advances on the strengths of its measurements. It's worth recalling that at one time we had great difficulty in measuring such things as temperature or time. Yet we learned how to do those things. Now we must learn how to measure the benefits of nature, so that she can be present as we make our economic calculations.
A first step in this direction has been made with the recent publication of the Millennium Ecosystem Assessment, which attempts for the first time to elucidate on a global scale how nature's ecosystems are working, what services are being delivered and in what quantity.
Also assisting in this effort are such things as satellite observations and the growing use of computers and the internet, contributing to The Little Green Data Book, now being published annually by the World Bank.
Putting a value on the benefits of nature does not deprive her of soul and mystery. On the contrary, nature cannot survive unless we do this, and neither can we. It is truly appreciating nature and her majesty to take intelligent steps to preserve her.
Another example of an externality is the phenomenon known as moral hazard. Moral hazard arises when the risk or consequences of some action are eliminated.
A simple example occurs in medical insurance. Research has shown that when medical insurance is offered with no deductible that ill-founded medical claims and excessive consumption rise dramatically. This makes sense because all the risk—all cost to the recipient—has been removed.
The same thing tends to apply in all kinds of insurance. Experience has demonstrated that keeping a reasonable deductible in auto insurance, for instance, helps to reduce the risk of auto accidents. We tend to drive more carefully if we know that we'll have to pay some portion of the cost of an accident.
In terms of overall benefit to society, it's actually better to retain a certain amount of "risk" in all such transactions. When we have to pay a reasonable cost or deductible in using some service we're far more likely to make careful and wise use of it. It could be summed up this way: When there is no cost, we tend to become too aggressive in taking risks—which often leads to disastrous outcomes.
Another example of moral hazard is the issuance of huge amounts of stock options to top executives. Corporate stock options carry no "downside"; they provide benefits with no risk. If the underlying stock goes down it costs the executive nothing; however, if the stock goes up the executive benefits enormously.
The granting of millions of stock options to top executives figured prominently in the corporate scandals of recent years. Since stock options carry no downside risk but only an upside benefit, a spectacular incentive is created to take the company on a riskier path than might otherwise be the case, in order to show higher earnings and thus lift the price of the stock.
In the most extreme examples, top executives engaged in fraud in order to show increased earnings. They became far more concerned with the price of the stock than with the underlying well-being of the company. The result was often the bankruptcy of the company, with grim outcomes for employees, investors and others.
The antidote to this is to restore a certain amount of risk, in this case to the executives themselves. For example, when executives purchase company stock from their own funds they share in both the upside and downside of the company's fortunes and thus are more likely to exercise some prudence in their efforts to maximize earnings.
In general, the negative effects of externalities come into play when some cost or risk is "off the balance sheet". A good solution to this source of suffering is usually to find some way to bring at least a portion of this cost or risk back into economic decision-making.
As one example, incorporating a carbon tax into certain products could have a good effect. Then, as we go about our business making self-interested economic decisions at the grocery store or the gas station or wherever we would automatically be helping to increase the well-being of the planet as well, because some of the hidden costs to nature would now be incorporated in our decisions.
(This is the end of Part 9. Go to Part 10.)
—jim sloman, 04.25.05
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