Differentiated Carbon Prices in the Electricity Sector: Towards a Cooperative Approach Based on Purchasing Power Parity

This blog was first published on the OECD Forum Network.

Everyone should have access to electricity. Disturbingly, this remains elusive. Worldwide, one in five persons lacks access to affordable and reliable power. Volatile prices and regular power outages undermine the wellbeing of millions of people, while the continued heavy use of dirty fossil fuels to generate electricity damages the environment.

Renewable electricity offers a pathway to address these challenges and build an affordable, secure, and clean energy future. Carbon pricing provides a key catalyst to increase momentum towards this goal. The pricing of carbon has a proven track record in the European Union to effectively stimulate investment in renewable electricity. However, carbon prices currently paid in the European Union by power producers – almost €100/tCO2 – are too high to be introduced in most developing countries. To account for various stages of development, governments should consider establishing carbon prices based on purchasing power parities, instead of market exchange rates. This would make economic sense and soften the impact of sharp price increases on vulnerable households. Upcoming international summits in New Delhi, Marrakech and Dubai would be good opportunities to discuss this cooperative approach.

More, secure, and clean power

The world needs more power. Households are fast adopting electric vehicles and heat pumps. Businesses are electrifying their manufacturing processes. The International Energy Agency forecasts unabated growth of electricity demand of around 3% annually.

The world needs more secure power. Russia’s invasion of Ukraine has demonstrated the perils of producing electricity with fossil fuels imported from regions with geopolitical tensions. Renewable energy sources, such as solar and wind power, are more secure.

The world needs cleaner power. Global emissions from the power sector reached a new all-time high in 2022, more than one-third of total emissions. Fossil fuels generate 61% of all electricity, predominantly coal. Many governments are planning to decarbonise their power sectors, but not enough is done.

The IEA estimates that renewable electricity production will need to increase by almost 9% every year until 2050 to achieve carbon neutrality. This requires historically-high levels of investment – the equivalent of more than 200 000 modern offshore wind turbines every year! Governments will need to provide strong incentives to make this happen.

Help from carbon pricing

Among the mix of available policy tools, Figure 1 shows that carbon pricing has been associated with lower emissions in the power sector. Successful progress in terms of decarbonisation and high net effective carbon rates in the electricity sector have often gone hand in hand (such as in Belgium, Greece, Netherlands, and Spain), while little progress has occurred in countries with low carbon prices (such as in the Russian Federation, South Africa and Türkiye).

This is in line with OECD research finding strong evidence to support carbon pricing. It is not the only useful instrument – governments can also make use of tax incentives, subsidies, feed-in tariffs, regulation, and public investments – but it sends powerful price signals.

Sources: Author’s calculation based on OECD and BP statistical review.

Note: This figure shows the relationship between net effective carbon rates on electricity and the percentage change in carbon intensity of electricity during 2015-2021 in a sample of 28 countries comprising G20 countries and other EU member states where data is available. The Effective Carbon Rate (ECR) is the sum of fuel excise taxes, carbon taxes and tradeable permits that effectively put a price on carbon emissions. The Net ECR equals the ECR minus fossil fuel subsidies that decrease pre-tax fossil fuel prices. The indicator excludes taxes and fees that are only partially correlated with energy use or GHG emissions.

The electricity sector is a good place to start with ambitious carbon pricing: clean electricity technology is widely available, there are few emitting firms to monitor, and risks of leakage overseas are limited. In addition, research finds that carbon pricing triggers the most significant response in the sectors of electricity and heating.

Emission trading systems (ETS) are the most common form of carbon pricing in the electricity sector. The general setup is simple: power plants are required to purchase permits corresponding to their projected emissions. They may sell these permits if they emit less than projected, reducing overall cost. It is therefore not a surprise that emission trading systems have gained momentum in the power sector:

• The European Union obliges all electricity producers to buy CO2 emission allowances for the emissions they cause.
• China has launched its national ETS for the power sector. Initially, China’s emission allowances are allocated freely up to a benchmark reflecting historical emissions.
• While the United States does not tax electricity at the federal level, regional initiatives require the purchase of emission permits, with a link to Quebec’s cap-and-trade system.
• Japan commenced a voluntary carbon market, with the major participants in the electricity sector.
• India also decided to establish a regulated carbon market in the power sector.
• Korea, New Zealand, and the United Kingdom operate emission trading systems.
• Vietnam has initiated arrangements for a carbon market for the power sector.

Using PPPs to differentiate carbon prices

The European Union ETS is the largest carbon market in the world, with prices trading close to €100 per tCO2 in mid-2023. Elsewhere, carbon prices remain low, at less than €30 per tCO2. Following the experience of the European Union, ETS regulators elsewhere could take steps to raise market prices such as eliminating emission allowances freely allocated, postponing or reducing the amount of emission allowances auctioned in the market, and establishing a market stability reserve to withdraw surplus allowances and transfer them in reserves.

However, the price currently prevailing in the EU ETS is too high for developing countries and emerging markets, if converted at market exchange rates. IMF simulations with a carbon price of US$50 per tCO2 converted in local currencies at market exchange rates find that this would result in large electricity price increases in South Africa (+66%), Türkiye (+59%), Indonesia (+57%) and China (+46%).

An alternative approach is to use purchasing power parity exchange rates (PPPs), instead of market exchange rates to determine carbon prices in each country. PPPs control for the differences in price levels between economies and better reflect the purchasing power of consumers than market exchange rates. PPPs have concrete applications in the multilateral system. They are used to determine eligibility to concessional lending from the World Bank. The quotas of IMF member countries depend on a formula that includes PPP-based GDP. The European Union determines with it the list of member states eligible to its Cohesion Fund.

Using PPPs rather than market exchange rates would determine the level of carbon prices compatible with each country’s purchasing power. The IMF has proposed differentiated carbon prices of US$75 per tCO2 (high-income economies), US$50 (middle-income economies), and US$25 (low-income economies), but did not provide a formula for these differentiated prices. Using the same benchmark of US$75 on average for high-income economies together with PPPs, Figure 2 shows differentiated carbon prices ranging from US$92 per tCO2 (United States) to US$28 per tCO2 (India). The differences reflect the purchasing power in each country.

Source: Author’s calculations using OECD data.

Even with differentiated carbon prices, electricity would become more expensive, especially in countries where the power sector is highly carbonised. Over time, the rising market share of renewable electricity would soften this price increase due to the lower levelized cost of renewable energy relative to fossil fuels. The IEA has estimated that EU electricity consumers are likely to save €100 billion during 2021-2023 due to newly installed solar PV and wind capacity.

If properly designed and together with other policy tools, differentiated carbon prices based on PPPs would be a giant step to deliver electricity  that is more affordable, secure, and clean. This approach should be the starting point of cooperative discussions at upcoming international meetings: the G20 Leaders’ Summit in New Delhi in mid-September 2023; the IMF and World Bank Annual Meetings in Marrakech in mid-October; and COP28 in Dubai during the first half of December.

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