The carbon tax is no longer a proposed financial tool to address an environmental problem. It’s now an ideological touchstone for the Greens, a political weapon for the LNP and a millstone around the neck of the Labor party. Typically, in all the political fisticuffs the facts about a carbon tax, what it can do and how effective it can be, are lost. The point of carbon tax is presumably to reduce carbon emissions by increasing the price of carbon intensive products - the underlying assumption being that increasing the price will decrease demand.

Most of the debate focuses on electricity, which makes sense because carbon emissions from electricity are almost double that of any other sector in Australia.

The problem with this theory though, is that it takes no account of the structure and operation of Australia’s electricity industry.

The National Electricity Market (NEM), which is actually a misnomer as it excludes Western Australia and the Northern Territory, buys and sells electricity at a uniform high price from a wholesale pool. The pool price can swing between -$1,000 and $12,500 per megawatt hour (MWh) making it one of the most volatile markets in the world. Extreme price events are rare however (maybe 3 or 4 times per year); prices usually fluctuate around $35/MWh.

The following is a simplistic scenario demonstrating how the wholesale market works and what would happen in the event of a $20/tonne carbon tax.

Generator A is an old brown coal fired generator, which sells at around $25/MWh and produces around 1.3tonnes of carbon per MWh of electricity.

Generator B is a newer black coal generator, which sells at around $35/MWh and produces around 1 tonne of carbon per MWh.

Generator C is a Combined Cycle Gas (CCG) generator with carbon capture technology, which sells at around $90/MWh and produces around 300kg carbon per MWh.

Generators sell to the pool in half hour lots at a uniform high price. This means that regardless of the bid price, everyone gets paid the highest bid required to meet demand. So when the market operator opens bidding for a particular time slot, Generator A might offer 1,000MW for $25/MWh, Generator B 1,000 MW for $35MWh and Generator C 1,000MW for $90/MWh.

If demand is only 1,000MW A wins and is paid $25/MWh. If demand is 2,000MW, A and B both sell their entire load for $35/MW. If demand is 3,000MW all three generators sell at $90/MW, regardless of their initial bid.

In the event of a $20/tonne carbon tax, Generator A will have to sell at $51/MWh, Generator B will have to sell at $55MWh and Generator C will have to sell at $96/MWh.

Generator A is selling at a much higher price now, but at peak demand, all the generators get $96/MWh. At less than peak demand, Generator A still sells first, gets windfall profits and the cleaner electricity is not used at all.

Energy infrastructure is at least a 30 year capital investment, which requires that the market has long term certainty on government policy. Coal generators at the moment make up about 80% of the capacity of the NEM; replacing that with cleaner generators like CCG (because there is no renewable energy at the moment that has the technology to generate at that capacity) would cost billions of dollars, take decades to build and still leave us dependent on fossil fuels, albeit at cleaner levels of consumption.

In the meantime, the market encourages coal generation to run at full capacity and rewards them with windfall profits for doing so.

This, of course, is not the full story.

Almost no consumers buy direct from the pool. Large users negotiate with electricity retailers for smoothed pricing at a contracted rate, usually 2 to 3 years ahead, but this rate only applies to the electricity consumed. Total delivered electricity costs also include market fees (< 2% of the total cost) network fees (30-50% of the total cost, depending on jurisdiction) and environmental imposts like the Large-scale Renewable Energy Target (LRET) and the Small-Scale Renewable Energy Scheme (SRES) (~10%). Electricity contracts are commercial in confidence, but the Sydney Futures Exchange trades electricity futures and these are a good indication of contract rates.

Queensland prices usually sit around the middle of the market, so it’s a useful microcosm to examine. Typical electricity costs for a large manufacturer in Queensland in 2011 would look like this:

Current Scenario

Retail electricity: $60 $/MWh

Network: $45 $/MWh

Environmental Imposts: $12 $/MWh

Market fees: $2 $/MWh

Total: $119 $/MWh

In the event of a $20/tonne carbon tax (average across the NEM is around 1 tonne/MWh), and assuming that the carbon tax replaces the current environmental imposts, electricity costs would increase by 6.7%.

$20 Carbon Tax Scenario (Imposts replaced)

Retail electricity: $60 $/MWh

Network: $45 $/MWh

Market fees: $2 $/MWh

Carbon Tax $20 $/MWh

Total: $127 $/MWh

% increase 6.7%

If the carbon tax was in addition to the current imposts, total price would increase by 16.8%.

$20 Carbon Tax Scenario (Imposts additional)

Retail electricity: $60 $/MWh

Network: $45 $/MWh

Environmental Imposts: $12 $/MWh

Market fees: $2 $/MWh

Carbon Tax $20 $/MWh

Total: $139 $/MWh

% increase 16.8%

How will this affect demand?

Electricity prices over the last 5 years have increased more than 50%; demand per person over that time has increased by around 3%.

Business only makes up about 12% of the market, demand is primarily domestic and driven by lifestyle factors that make electricity almost entirely inelastic to demand.

The ubiquitous plasma screen TVs, which use 3 times as much power as standard screens; the spread of McMansions with large windows, no verandas, ineffective insulation and reliance on power intensive air conditioners, and our increased dependence on personal electronic devices have all pushed up individual power needs. None of these are things we can roll back without costly efficiency measures or drastic lifestyle changes. Prices go up, and rather than reduce demand, we pay more for power and reduce our spending on other things.

Despite the manifested flaws of a carbon tax, the point of this is not to suggest that we shouldn’t attempt to reduce carbon emissions, but rather, to say that the action required is complex, long term and needs far more than just simple price pressures. It may well include some market mechanism (carbon tax or emissions trading system) but far more important will be how firm the structure of that mechanism is, how confident the market is in its robustness and how it plans for long term replacement of energy infrastructure.

Government needs to give the market firm 10 year schemas and clear indications of where they will go beyond that.

The new investment so desperately needed in the energy market is not going to happen while carbon solutions are political footballs for all concerned.

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This article was first published on ABC’s The Drum.

Many thanks to Key Energy & Resources for providing much of the market data. The conclusions and opinion, however are mine and are not necessarily endorsed by the much more knowledgeable folk at Key Energy.

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