How do environmental policies aim to internalise external costs?

Environmental policies aim to internalise external costs by making those responsible for pollution bear the cost of their actions.

Environmental policies are designed to address the issue of external costs, which are costs that are not directly borne by the party responsible for causing them. These costs are often associated with pollution and other forms of environmental degradation. The aim of these policies is to 'internalise' these costs, meaning that they are incorporated into the cost of producing or consuming a good or service. This is achieved by imposing taxes, fines, or regulations that increase the cost of activities that cause environmental harm.

One common method of internalising external costs is through the use of 'Pigouvian taxes'. Named after the economist Arthur Pigou, these are taxes imposed on activities that generate negative externalities, such as pollution. The idea is to make the cost of these activities reflect their true social cost, including the cost of the environmental damage they cause. For example, a tax on carbon emissions would increase the cost of burning fossil fuels, encouraging businesses and consumers to reduce their carbon footprint.

Another approach is the use of tradable permits or 'cap and trade' systems. Under this system, a limit or 'cap' is set on the total amount of a certain type of pollution that can be emitted. Businesses are then issued permits allowing them to emit a certain amount of this pollution, which they can trade with other businesses. This creates a market for pollution permits, and businesses that can reduce their emissions more cheaply will sell their permits to those for whom reduction is more expensive. This ensures that the overall cap is met in the most cost-effective way, and the cost of pollution is borne by those who cause it.

Regulations and standards are another way of internalising external costs. These might involve setting limits on the amount of pollution that can be emitted, or requiring businesses to use certain technologies or practices to reduce their environmental impact. While these do not directly impose a cost on polluters, they can increase the cost of production, effectively internalising the cost of pollution.

In all these ways, environmental policies aim to ensure that the cost of environmental damage is reflected in the decisions made by businesses and consumers. This encourages more sustainable behaviour and helps to protect the environment for future generations.