Equilibrium Analysis of a Tax on Carbon Emissions with Pass-through Restrictions and Side-payment Rules

Chile was the first country in Latin America to impose a tax on carbon-emitting electricity generators. However, the current regulation does not allow firms to include emission charges as costs for the dispatch and pricing of electricity in real time. The regulation also includes side-payment rules to reduce the economic losses of some carbon-emitting generating units. In this paper we develop an equilibrium model with endogenous investments in generation capacity to quantify the long-run economic inefficiencies of an emissions policy with such features in a competitive setting. We benchmark this policy against a standard tax on carbon emissions and a cap-and-trade program. Our results indicate that a carbon tax with such features can, at best, yield some reductions in carbon emissions at a much higher cost than standard emission policies. These findings highlight the critical importance of promoting short-run efficiency by pricing carbon emissions in the spot market in order to incentivize efficient investments in generating capacity in the long run.