This paper discusses methodology of energy system modelling when reduction of local externalities such as damage to the human health from energy production-related air pollution, is in focus Ideally the local energy externalities should be analysed by adopting the impact pathway approach of ExternE study and following the pollutants from their release to the personal uptake and resulting health effects This would require inclusion of air pollution modelling and monetary valuation of the impacts into an energy system optimisation process However this approach Involves a complex study and generalisations are needed The way local externalities are included in the existing energy system models is identified and discussed in the paper Only a few studies include localisation aspects when internalising local externalities in an energy system optimisation The performed analysis of the Danish heat and power sector verifies that It is cheaper for the society to include externalities in the planning of an energy system than to pay for the resulting damages later Total health costs decrease by around 18% and total system costs decrease by nearly 4% when health externalities are included in the optimisation Furthermore including localisation aspects can reduce health costs of the heat and power sector in Denmark by additional 7% (C) 2010 Elsevier Ltd All rights reserved