Market prices of energy often diverge from the true cost to society of consuming that energy. Two of the most common reasons for that divergence are external costs and subsidies, both of which make consumers think that energy is less expensive to society than it really is, and hence lead to more consumption of energy than would be economically optimal.

External and Internal Costs

According to J. M. Griffin and H. B. Steele (1986), external costs exist when "the private calculation of costs differs from society's valuation of costs." Pollution represents an external cost because damages associated with it are borne by society as a whole, not just by the users of a particular fuel. Pollution causes external costs to the extent that the damages inflicted by the pollutant are not incorporated into the price of the fuel associated with the damages. External costs can...