Tailoring carbon pricing designs to diverse power sector contexts

Carbon pricing instruments (CPIs) can be instrumental in the transition to low-carbon electricity systems, but they must be tailored to the specific institutional structure and challenges faced by a jurisdiction, particularly in low- and middle-income countries. 

These were the findings of a new report published by the World Bank, International Energy Agency (IEA) and International Carbon Action Partnership (ICAP), 'Carbon pricing in the power sector: Role and design for transitioning toward net-zero carbon development'. As the main consultant on the project, Ricardo was a co-author of the report alongside fellow experts from the three organisations. 

Electricity is a lynchpin for the modern economy. Yet electricity generated from fossil fuels is also one of the main sources of greenhouse gas emissions.

Across the world, there is substantial experience of applying CPIs – carbon taxes and emissions trading systems – to tackle emissions in the power sector. In the right context, well-designed CPIs have been effective in shifting power generation toward lower-carbon sources, changing the wholesale purchases and dispatch of electricity to prioritise cleaner power plants, and altering consumers’ energy use. Carbon taxes and auctions of emission allowances have also provided a welcome source of revenue for some governments to invest in low carbon infrastructure or mitigate the impact of higher energy prices on lower-income households. 

A growing number of low- and middle-income countries are now adopting or considering CPIs among a range of policies to decarbonise their power sectors. A lot can be learnt from advanced economies’ experience in applying CPIs. However, experience and evidence of CPIs in low- and middle-income contexts is much more limited. This report helps to fill that evidence gap. It provides a broad overview of the power sector context in low- and middle-income countries and in-depth case studies on the application of CPIs to the sector in China, Colombia, Kazakhstan and South Africa.

Power sectors in low- and middle-income countries commonly share a set of challenges that differ markedly from those faced by advanced economies. These include rapid growth in electricity demand, low levels of access and affordability, insufficient and insecure supply, and lack of affordable financing. Such challenges provide a different set of public policy priorities. 

The institutional structures of power sectors in low- and middle-income countries are also highly diverse. Countries vary in the degree to which they have adopted power sector reforms that introduce private sector participation, competitive wholesale and retail markets, independent regulation, merit order dispatch and cost reflective tariffs. As a result, the types of actors along the power sector value chain and incentives shaping decisions about investment, dispatch and consumption differ between countries.

The report illustrates that carbon taxes and emission trading systems are not deployed within a vacuum. Rather, they layer an additional price signal on top of an existing web of incentives, priorities, contractual obligations, and physical and political constraints. Governments must carefully consider these contextual factors into the design of CPIs. Failure to do so risks unintended and adverse outcomes, such as inducing higher electricity prices without achieving the targeted reduction in emissions. 

The report dives deep into the key elements of CPI design and their effects along the value chain in different contexts including fully liberalised, single-buyer and vertically integrated power sectors. It concludes with a framework to aid governments in the selection and design of CPIs for the power sector in low- and middle-income countries.

Ricardo has a wealth of experience advising governments on the design of emission trading systems and carbon taxes across a range of different countries including Argentina, Colombia, Guinea, the European Union, Indonesia, Mexico, South Africa, Thailand, Türkiye, United Arab Emirates and the United Kingdom, among others. To speak to one of our carbon pricing and power sector specialists, please get in touch here.