Understanding the interactions between carbon markets and electricity markets — the impacts of each on the other — is key to good design of both. International experience shows that designing power markets and carbon markets in isolated policy “silos” does not lead to best outcomes. Designing them in concert helps ensure that the markets are as economically efficient as possible and the carbon program is achieving its goals at lowest possible cost for both end-use customers and the power sector as a whole.

A price on carbon can cause emissions reductions in the electric sector by: (1) changing power sector dispatch (i.e., system operations), (2) affecting investment (and disinvestment) decisions regarding power plants and other sector resources, and (3) altering demand for energy. This paper examines these interactions and asks how power markets can be adapted to maximize the effectiveness of the carbon price. The authors offer observations and recommendations for policymakers in China, particularly those designing a carbon market. These findings can be summarized this way:

  • The effectiveness of carbon markets is greatly enhanced by economic (or merit order) dispatch, in which power plant operational decisions are based on their relative operating costs. One way to achieve economic dispatch is to implement well-designed electricity markets.
  • It is important to get other elements of electricity market design right to make the carbon market both effective and efficient. Those elements include generator compensation; market monitoring and oversight; and moderating the impacts of carbon prices on electricity consumers.
  • The influence of the carbon price can be greatly enhanced by the manner in which the resulting revenues are spent. Directing the revenue to investments in low-carbon assets (in particular, end-use efficiency and renewables) can multiply by many times the effect of the carbon price alone.
  • Even in parts of the world that have developed sophisticated electricity and carbon markets, power sector planning remains a critical component of energy and environmental policy. Planning must be integrated with both carbon market design and electricity market design.
  • Retail price reform will need to move forward across the country as electricity and carbon markets evolve. Retail prices that reflect the true underlying costs, including carbon costs, of electricity production will aid the carbon market’s ability to reduce emissions.

A Chinese language version of this policy brief is also available on our website.