The Carbon Price and the Electricity Market
A government introduces a carbon price of $30 per tonne of CO2. Brown-coal electricity generators emit about 1.2 tonnes of CO2 per MWh; gas generators emit 0.5 tonnes; renewables emit almost nothing. Brown coal supplies 60% of electricity, gas 20%, and renewables 20%. Wholesale electricity prices rise 20%. Households spend 3% of their budget on electricity, but low-income households spend 8%. The government returns all revenue as a lump-sum payment to households. A neighbouring country has no carbon price and exports electricity into the market.
1. Calculate the carbon cost per MWh for each generator type and predict the effect on the generation mix.
Read the worked answer
Carbon cost per MWh:
- Brown coal: 1.2 × $30 = $36 per MWh.
- Gas: 0.5 × $30 = $15 per MWh.
- Renewables: approximately $0.
Effect on the mix: Brown coal's cost rises by $36 per MWh and gas by $15, while renewables are unaffected. Brown coal loses its cost advantage relative to gas and renewables. In the short run, dispatch shifts toward gas and renewables, and brown-coal output falls. In the long run, investment flows to renewables because their relative cost has fallen. The 60% brown-coal share should decline.
Complication: The neighbouring country's imports are not subject to the carbon price, so they undercut domestic generators. This limits the price rise domestic generators can pass on and may cause production to shift offshore rather than to cleaner domestic generation - carbon leakage. The predicted shift to renewables is therefore weaker than a closed-economy analysis suggests, unless a border adjustment is applied.
2. Evaluate whether the lump-sum rebate makes the policy fair, and whether it undermines the environmental objective.
Read the worked answer
Fairness: Low-income households spend 8% of their budget on electricity versus 3% for average households, so the price rise is regressive. A lump-sum rebate of equal size to all households gives proportionally more to low-income households relative to their electricity spending, which can offset the regressive effect. If the rebate equals the average cost increase, low-income households gain relative to the status quo, while high-income households lose slightly. Fairness is therefore improved, but the outcome depends on the rebate being at least as large as the average increase and on renters versus owners being treated equally.
Environmental objective: A lump-sum rebate does not weaken the price signal, because the marginal cost of emitting is unchanged. Households still face higher electricity prices at the margin and are still encouraged to conserve. This is the key advantage of lump-sum rebates over rebates tied to electricity use, which would blunt the incentive. The policy therefore preserves the environmental objective while addressing equity.
Conclusion: The rebate is defensible on both grounds, provided it is genuinely lump-sum and not linked to consumption.