The economics of carbon pricing 101: The carbon price and your electricity bill

By Adolf Stroombergen and Corey Allan

The electricity market is a complex beast; people spend their entire careers examining and analysing its inner workings. For most of us, our only interaction with the market is through our electricity provider. We get the monthly bill, try to pay it on time to get the prompt payment discount, and receive a letter almost every year telling us that prices are, surprise surprise, going up. We may occasionally ask ourselves “what’s happened this time to make prices go up?” Usually the price increase is blamed on the transmission companies, but since 2011 electricity prices have been influenced by a new price – the price of carbon.

But just how does the price of carbon affect the price you pay for the electricity you use? Two issues immediately come to mind when thinking about the impact of the carbon price on residential electricity prices: the ‘peakiness’ of residential electricity demand, and uncertainty about the future carbon price.

In 2013, households were responsible for about 32% of the electricity consumed in New Zealand. 75% of the electricity generated in that year came from low-carbon renewable sources, mainly hydro. That is surely more than enough to satisfy household electricity demand with low-carbon electricity, minimising the exposure of households to the carbon price. But the picture is a bit more complicated than that. One feature of household electricity demand is that it is characterised by two large peaks. Most household electricity is consumed during the hours of 6-9am and pm, basically when people are getting up and getting ready for the day, and when people come home and settle in for the night. Industrial demand, on the other hand, tends to be more stable throughout the day. Most of the renewable generation capacity is base capacity – the generation that is used to satisfy the more constant part of electricity consumption. This is also the cheapest electricity to supply, which is why base generation capacity is used first. To satisfy peak demand, generators need to bring on additional generation capacity. The marginal cost (the cost of producing an extra unit of electricity) for peak generation is higher than for base generation; this is one reason why residential electricity prices are higher than industrial prices. Peak generation is also more carbon intensive, meaning that the carbon price has a larger effect on the marginal cost of peak generation than base generation. Economists consider a market to be operating efficiently if the price is equal to the marginal cost of the last unit of output produced. For residential electricity, the last unit of electricity is likely generated using the more expensive and carbon intensive peak generation. If households are to face the true marginal cost of the electricity they consume, then we would expect the carbon price to have a larger effect on residential electricity prices.  Note that this does not mean that all household electricity needs to be priced at the high marginal price, but that is a discussion for another article.

Electricity prices are set in advance for a lot of residential contracts. Electricity companies have to set their price per kilowatt hour on the basis of what they think certain costs will be, such as the wholesale price, the distribution costs, and the carbon price. Companies have some expectation of what these costs will be, and build these expectations into the prices they set for the coming year. These expectations will very rarely be 100% accurate. With regards to the carbon price, some years it will be lower than the companies expect, meaning that less is paid for the right to emit than was thought. In other years, the opposite will occur. In years where the carbon price turns out to be lower than expected, it can create the impression that the electricity company is passing on a carbon price that is too high. But due to the forward-looking nature of electricity prices, what is built in is what the companies thought they would pay, which is unlikely to be what they actually pay. As long as electricity companies form their expectations about the future carbon price in a rational (taking into account all relevant information available at the time) way, then on average they will pass on the appropriate carbon price.

The whole point of a carbon price is to get people to take the environmental cost of their economic decisions into account. Unfortunately, it is not always obvious just how the carbon price is reflected in the prices of things we buy – it’s just another price increase. This is particularly true in complex markets like the market for electricity. Hopefully this piece has provided some insight into the inner workings of the electricity market and how the carbon price may be reflected in your electricity bill.