Carbon Taxation in an Imperfectly Competitive Power Sector

Power-sector decarbonisation necessitates variable renewable energy (VRE), viz., wind and solar. VRE's intermittency could be balanced by energy storage and fossil-fuelled generation. However, flexible plants may enjoy enhanced leverage, and carbon policy will have to adapt to mitigate economic and environmental distortions. Absent market power and storage inefficiency, the optimal carbon tax on fossil-fuelled generation equals its marginal cost of damage (MCD) from emissions. Departures from this idealised setting require reflecting an imperfectly competitive industry's attributes. In particular, a bi-level framework in which a policymaker anticipates industry’s Nash-Cournot equilibria distils a carbon tax that is lower (higher) than the MCD if fossil-fuelled generation (hydro storage) exerts market power. Intuitively, a fossil-fuelled plant (hydro storage) withholds output (conducts temporal arbitrage) to manipulate electricity prices, which alleviates (exacerbates) the environmental impact. We solve our problem instances by reformulating the bi-level model as a mathematical program with primal and dual constraints (MPPDC).