Chile Economy-wide implications of a carbon tax in the Chilean electricity generation sector

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1 Chile Economy-wide implications of a carbon tax in the Chilean electricity generation sector A Policy Brief An output of the CDKN funded project on modelling the socio-economic implications of mitigation actions in developing countries September 2014 EXECUTIVE SUMMARY Chile has a relatively modest carbon emissions profile, in the global emissions context, coming mostly from the energy sector. The country has nevertheless committed to implementing measures that will reduce the country s emissions by 20% below the business as usual emissions growth trajectory by Certain mitigation actions will act as an economic shock to the country s gross domestic product (GDP) growth path. This policy brief examines the economy-wide implications of applying a carbon tax to the country s electricity generation section. The report evaluates carbon taxes of US$10, US$20, US$30, US$40 and US$50 per ton of carbon dioxide equivalents (US$/tCO 2 e). The results show that the effectiveness of this policy depends on factors beyond the control of policymakers, such as new investments in renewable energy, the cost of liquid natural gas (LNG), and the feasibility of exploiting hydroelectric resources. A tax on the Chilean electricity generation power system, of US$ 20 per ton of CO 2 e, will reduce Chile s emissions on average by between 1.1 and 9.1 million tco 2 e. But it will have a recessive effect: it will push up the average annual price of electricity by between US$ 8.3 and US$ 9.6 per megawatt hour (MWh), equivalent to a 7.4% and 8.5% increase relative to today s electricity price. This shock decreases the annual GDP growth rate but up to 0.15%. It means that the average yearly GDP growth rate will be 3.35%, compared with 3.5% of a business-as-usual scenario.

2 In addition, the carbon tax is compared to two other policies in this paper: introduction of renewable energy source and a sectoral cap. The results show that the same emission reduction can be achieved with these policies, but the macroeconomic impacts are lower. INTRODUCTION In spite of Chile being a minor contributor to global greenhouse gas (GHG) emissions, at only 0.2%, the country has seen a considerable growth in emissions of 232% in less than two decades (between 1990 and 2006). Emissions come mostly from the energy sector (76.3 million tco 2 e) and from electricity generation. At the United Nations climate summit in Copenhagen in 2009, Chile committed to implementing emissions reduction measures that aimed to achieve a 20% cut in emissions below the businessas-usual emissions growth trajectory by This would be done using mitigation measures that are regarded as nationally appropriate, at the same time as taking advantage of the associated environmental and social benefits, and the possible improvements in the quality of growth that these measures could bring. A carbon tax is an economic mechanism that governments can use to help reduce a country s carbon emissions. It is expected that a carbon constraint like this would reduce emissions in two ways: it would lower energy demand, as users respond to the price increases on electricity; and the energy sector would respond by switching to less carbon intensive fuels. Chile s electricity comes from two different power suppliers, the Central Interconnected System (Sistema Interconectado Central, SIC), and the Norte Grande Interconnected System (Sistema Interconectado del Norte Grande, SING). Historically SIC has produced most of its electricity using hydropower, contributing 76% of the electricity supply. However, it produces 57% of the electricity generation sector s emissions (19 million tco2e). One of the reasons of this is that additional 1266 MW of coal generation was installed between 2006 and SING is largely coal-produced electricity, explaining its 43% emissions (14.2 million tco 2 e) for the 24% power it supplies to the grid. The purpose of this study conducted by researchers from the Catholic University s Energy Centre and the Pontificia Universidad Católica (UCh-PUC) is two fold: to analyse how a carbon tax on electricity generation will shock the economic business-as-usual trend so that policy makers have more information with which to work. A new way of integrating the results of the two modelling tools used is proposed, so that modellers and researchers can be effective in their future work in this area. TWO TOOLS TO MODEL CHILE S ECONOMIC FUTURE This study investigates the broader economic implications of implementing a carbon tax on the Chilean electricity sector, analysing specifically the way it will have a substitution effect on the energy sector, allowing the country to adopt cleaner energy sources. The research team evaluated the likely impacts of five different carbon taxes on the Chilean electricity generation sector: US$10, US$20, US$30, US$40 and US$50 per ton of carbon dioxide equivalents (US$/tCO 2 e), applied between 2017 and 2030 to both the SING and SIC power systems. A sensitivity analysis was conducted on three parameters which are integral for optimising the energy system. 2 Economy-wide implications of a carbon tax in the Chilean electricity generation sector

3 The modelling tools Two models were used for this emissions and energy forecasting exercise. The first tool is an economy-wide analysis model that can, for instance, evaluate the macroeconomic impact of an energy price shock. The impact of electricity price shocks on the path of gross domestic product (GDP) as a result of these different carbon taxes was evaluated. The second tool is able to zoom in on individual sectors and evaluate the effects of a tax on various carbon emitting technologies in order to reduce CO 2 emissions. It also allows modellers to test the impact of, for instance, how energy generation companies might deal with planning problems in the context of renewable energy source incentives and mitigation policies (such as feed-in tariffs, quota obligation, emission trade, and carbon tax). The approach Four indicators were used to compare the possible impact of the carbon tax on the electricity generation sector, emissions and the broader economy. These are: Operation expenditure (OPEX) Present value of the additional operation expenditure in comparison to the baseline scenario Public income due to the carbon tax Present value of the total tax that is paid by the power plants which emit GHG emissions Capital expenditure (CAPEX) Present value of the additional capital expenditure in comparison to the cost of the baseline scenario Average annual emission reduction Average annual of GHG reduction in comparison of the baseline scenario A sensitivity analysis was conducted using the following three parameters: Investments cost in non-conventional renewable energy (US$/kW), specifically solar energy Changes in liquid natural gas (LNG) prices Whether or not hydroelectric resources in south Chile come online The UCh-PUC researchers lay out the results of this modelling in four different scenarios: Scenario 1: represents the less optimistic levels of solar technology costs, LNG fuel price, and without the development of hydro resources in the south Scenario 2: greater investment in solar power with lower capital cost projections Scenario 3: includes additional 2750 MW of hydro-electricity Scenario 4: adds a more optimistic scenario for liquefied natural gas (LNG) prices and access to LNG terminals The results This modelling approach shows that: as carbon taxes go up, the electricity sector s carbon emissions come down as operational costs come down, the total investment in new power plants increases and the cost of electricity rises the total investment increases as more renewable energy sources are introduced (these have a higher investment cost than coal plants) total operation costs decrease because the renewable energy sources have lower variable costs than a thermoelectric plant A Policy Brief 3

4 For a carbon tax of US$10 per tco 2 e: carbon emission reduce annually by between 0.8 and 1.5 million tco 2 e price of the electricity increases between US$3.9 and US$5.3 per MWh, which is equivalent to a 3.5% and 4.7% relative to currently electricity prices For a carbon tax of US$20 per tco 2 e: carbon emissions reduce annually by between 1.1 and 9.1 million tco 2 e. the price of the electricity increases by between US$8.3 and US$9.6 MWh, which is equivalent to a 7.4% and 8.5% relative to currently electricity price Scenario by scenario The highest emission reduction happens in Scenario 2, because investment in solar technology is more optimistic, and the carbon tax promotes the introduction of new non-conventional renewable energy sources earlier in comparison to Scenario 1. The impact of the carbon tax in Scenario 4 is low, because this scenario includes more hydroelectric sources than Scenario 2, and there is less thermoelectric generation with coal sources. In Scenario 3, there is more electricity generation with LNG sources compared with Scenario 1, and less with coal generation, because the impact on carbon tax is lower than Scenario 1. These results show that the effectiveness of the carbon tax depends on certain variables that are not controlled by policy makers. Impacts on the wider economy The results show that a carbon tax will decrease GDP growth. Assuming the GDP will grow by 3.5% in a business-as-usual scenario, imposing a carbon tax of US$10 per tco 2 e will produce an electricity price shock that will decrease annual GDP growth by up to 0.08%, while a carbon tax of US$20 per tco 2 e will decrease annual GDP growth by up to 0.15%. It means that the average yearly GDP growth rate will be 3.42% and 3.35%, respectively, versus 3.5% of baseline scenario. Comparison with other policies Policy makers have other mechanisms which they could use to bring about an emissions reduction. Two such policies include: one which introduces renewable energy sources; and one where a cap, or ceiling, is placed on how many emissions each sector is allowed to emit, a so-called sectoral cap. More renewables in the mix: Chile has a law which requires that 20% of energy sales must come from non-conventional renewable energy by This study considers the implications of increasing this percentage to 25% by 2030 (25/30) and 30% by 2030 (30/30). The emission reduction of the 25/30 case is similar to the emission reduction of a carbon tax of US$10 per tco 2 e (annual average emission reduction equals to 1.4 million of tco 2 e), and the emission reduction of the 30/30 case is similar to the emission reduction of US$20 per tco2e carbon tax case (annual average emission reduction equals to 2.4 million of tco 2 e). However, electricity price increase is lower in both cases (US$1 and US$2.4 per MWh, respectively). Therefore, the impact on GDP will be lower. Capping carbon on electricity generation: The research team analysed the carbon caps in the Chilean electricity generation sector, equivalent to tax levels of US$10, US$20, US$30, US$40, and US$50 per tco2 and calibrated emission caps to resulting emissions for that tax level. 4 Economy-wide implications of a carbon tax in the Chilean electricity generation sector

5 While the emissions reduction outcome is the same, the results show a lower increase in electricity prices compared to the carbon tax cases; therefore, the impact on GDP will be lower. For example, the increase of the electricity price is US$0.9 per MWh in the case with a cap equivalent to US$20 per tco 2 e, which is lower than the US$8.3 and US$9.6 per MWh of the case with carbon tax. CONCLUSIONS The purpose of this research is to analyse how a carbon tax on electricity generation will reduce emissions, and what the ramifications of that will be across the wider economy. The modelling process was also an opportunity for researchers to test the tools at their disposal for doing this kind of forecasting effectively. The results indicate that a carbon tax will reduce emissions over time. A tax of US$ 20 per ton of CO 2 e will reduce Chile s emissions on average by between 1.1 and 9.1 MM tco 2 e. In addition, it was estimated that it would push up the average annual price of electricity by between US$ 8.3 and US$ 9.6 per megawatt hour (MWh), equivalent to a 5.9% and 8.5% increase with respect to currently the electricity price. This shock decreases the annual GDP growth rate in a maximum value of 0.15%. It means that the average yearly GDP growth rate will be 3.35% versus 3.5% of baseline scenario. Nevertheless, it is important to note that in the case of carbon tax, recycling is not considered in the macroeconomic evaluation. However, this study was able to show that the effectiveness of a carbon tax depends on other variables that are beyond the control of policy makers, such as non-conventional renewable energy investment cost, the price of LNG, and how many hydroelectric sources are exploited. This was also an opportunity to test the modelling tools available, and allows the UCh-PUC research team to propose a novel approach to integrate results from two different tools, which would enable the forecasting of Chile s economic and emissions future in the presence of certain policy mechanisms that are designed to help reduce carbon emissions. To access the working paper on which this brief is based, please see or cabenavif@gmail.com Disclaimer: This document is an output from a project funded by the UK Department for International Development (DFID) and the Netherlands Directorate-General for International Cooperation (DGIS) for the benefit of developing countries. However, the views expressed and information contained in it are not necessarily those of or endorsed by DFID or DGIS, who can accept no responsibility for such views or information or for any reliance placed on them. This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, the entities managing the delivery of the Climate and Development Knowledge Network do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Management of the delivery of CDKN is undertaken by PricewaterhouseCoopers LLP, and an alliance of organisations including Fundación Futuro Latinoamericano, INTRAC, LEAD International, the Overseas Development Institute, and SouthSouthNorth. 5