Carbon policies: do they deliver in the long run?

Abstract

This chapter analyzes a hypothetical electricity sector, the effects of both instruments under realistic circumstances, such as policy uncertainty, risk aversion by investors, and long construction lead times. Carbon taxation and emissions trading are policy instruments for achieving significant CO2 emission reduction by inducing a shift in technology and fuel choice. Simulations with a quantitative agent-based model of a competitive electricity generation sector show that under both policies, CO2 emissions increase for 10-15 years due to the long life cycle of power plants. Dramatic reductions materialize after 20-40 years, when a tight cap or sufficient tax level is maintained. When taxes are set equivalent to trading prices, taxation induces earlier investment in CO2 abatement, a better balance between capital and operating costs, and lower long-run electricity prices. The pressure that carbon policies put on the power generation system is reflected in the electricity prices since power companies ultimately pass on their CO2 cost to consumers.