The recent Frontier Economics proposal to treat emissions differently in electricity has been framed as being about whether price signals flow through to consumers or not. But there were no claims that the Frontier proposal might be favourable in encouraging low emissions generation in electricity. I thought that the CPRS and Frontier’s scheme would be equivalent in that regard.
According to a new paper released today by Stephen Holland there may be a difference. The abstract is over the fold. But the bottom line is this: if generators have significant market power in wholesale electricity markets, then an emissions intensity standard (similar to the Frontier proposal) dominates an emissions tax (equivalent in the model to a CPRS scheme).
The intuition of these results is relatively straightforward. The weakness of an intensity standard is that it relies more on substitution effects than output effects to reduce emissions. With incomplete regulation or market power, this disadvantage may be helpful since leakage may offset gains rom reducing output and since market power already inefficiently reduces output.
The reason is that with market power, output is restricted and carbon prices have less of an impact on it. Now, I didn’t see this in the Frontier report but they are the experts on electricity markets and, in light of this paper, I’d be happy to admit that their scheme may be superior in driving the optimal mix of emissions in electricity if they would provide clear statements and evidence about the existence of significant market power held by electricity generators in Australia. (The issue on price signals remains live, however).
[DDET Read the abstract]
This paper investigates whether an emissions tax (equivalent to an emissions cap) is the best policy in the presence of incomplete regulation (leakage) or market power by analyzing an intensity standard regulating emissions per unit of output. With no other market failures, an intensity standard is indeed inferior, although combining it with a consumption tax eliminates this inferiority. For incomplete regulation, I show that under certain conditions an intensity standard can dominate any emissions tax (including the optimal emissions tax). This dominance persists even with the addition of a consumption tax, which ameliorates output distortions and can sometimes help the intensity standard attain the ﬁrst best (when an emissions tax/consumption tax combination cannot). Comparing intensity standards to output-based updating shows that the latter dominates because of its additional ﬂexibility. Finally, I show that with market power an intensity standard can dominate the optimal emissions tax.