Internalisation is the adjustment of prices to reflect social Costs and Benefits. This process aims to incorporate externalities into market prices so that the full societal impact of economic activities is captured in the cost of goods and services.
In welfare economics and Life Cycle Assessment, internalisation serves as a mechanism to achieve optimal resource allocation by ensuring that economic actors bear the costs and reap the benefits of their activities in proportion to the impacts they generate on society and the environment. When externalities remain external to market prices, market failures occur, leading to inefficient allocation of resources where activities with negative environmental or social impacts may be overproduced, whilst those with positive impacts may be underproduced.
Common policy instruments for internalisation include insurance schemes that spread risk and costs across populations, subsidies that support activities generating positive externalities, taxes on emissions that make polluters pay for environmental damage, and production costs that account for external benefits created by certain activities. For example, a carbon tax internalises the climate change costs of greenhouse gas emissions by making emitters pay per tonne of CO₂ equivalent released, whilst renewable energy subsidies internalise the social benefits of clean energy production.
The concept is particularly relevant in Environmental Life Cycle Costing, which includes externalities that are anticipated to be internalised in the decision-relevant future. This distinction is important to avoid double-counting in Life Cycle Sustainability Assessment, where internalised costs and benefits are captured in the Life Cycle Costing component, whilst remaining externalities are addressed in the Life Cycle Impact Assessment.
Achieving effective internalisation requires that the value assigned to externalities accurately reflects the damage costs or benefits to human wellbeing, which often involves challenging monetary valuation of environmental and social impacts.
