and solar PV are not. Solar PV, which was more expensive at the time the first auction was conducted, could produce energy during moments of high demand, avoiding the use of expensive “peaker” plants in the system and providing capacity value in the years following solar PV deployment.

It should be noted that these considerations about value and the LCOE of specific assets will change over time, in an uncertain way. Some technologies can reduce their costs faster than others. Also, the value provided to the system can change as the shape and size of demand evolve, or if too much of one technology is deployed in a single region.

The solution is a technology-neutral auction with a system that incorporates premiums and penalties in the bids, so that different technologies can make comparable bids.

These premiums and penalties are based on the expected value of energy over the next 15 years and are of two kinds:

Location – the country is divided into 51 power regions, and a penalty or bonus is calculated according to the average difference between the value of the energy in that region and the rest of the country.

Time of day – a penalty or bonus is included for energy being available at different times of the day.

The following features are incorporated to make the auction as flexible as possible:

Three different products are sold: energy, Clean Energy Certificates and dispatchable capacity. Generators are not obliged to sell all three, and they can choose to sell only one.

The auction is held three years in advance of the expected delivery date, although developers can propose different deliverable dates within certain limits.

Developers can make bids conditional on the acceptance of other bids, which allows for the development of large projects.

Projects do not have priority on the grid access just because they win the auction. However, in a congested area, those who have completed the interconnection procedures are given priority in the auction.

The auction compares all the bids and a replicable algorithm chooses the bids that minimise the “adjusted” cost to the buyers – including the value that the plants will generate. This allows “expensive” plants (on a cost basis) to be chosen if they produce more value (i.e. they are located in a region with expensive energy, or produce energy at an expensive time of day).

Pricing of externalities

Price-based instruments aim to internalise the societal costs of environmental degradation, climate change or air pollution – caused by energy production – in the planning and operation of electricity generators according to the polluter pays principle. Price-based instruments can achieve environmental targets in a cost-effective way. However, they should be part of a coherent policy package, including a pricing optimisation framework that harmonises incentives. Often this entails removing existing fossil fuel subsidies, which can increase the costs associated with the externalities that are targeted by price-based instruments.

Climate change policy can place a cost on CO2 emissions. Market-based approaches can be categorised into carbon taxes (direct CO2 tax; input or output charges) and emissions trading systems (ETSs). When optimally defined, both approaches have the same objective and impact.

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However, a carbon tax creates a predictable price of CO2, whereas an ETS38 puts a cap on emissions and hence creates certainty on the emissions reduction trajectory that is agreed upon in the decision-making process under fluctuating carbon prices.

A carbon tax is easier to implement, but an ETS has the advantage of creating abatement incentives where they are most cost-effective. As emission allowances can be traded for the market price of CO2, the allowance price sets the threshold below which it is economic for actors to invest in emission reduction options (resource efficiency, low-carbon generation or carbon capture utilisation and storage) (Hood, 2011). In other words, those with a marginal abatement cost below the market price of CO2 will sell permits (if any) and invest, and those with a marginal abatement cost above the market price of CO2 will buy permits up to the point that the market price of CO2 matches their abatement cost (Fan et. al., 2017).

Impact of CO2 pricing on daily and long-term operations in the power market

Carbon pricing has profound effects on power sector development. It increases the cost differential between lowand high-carbon generation assets by adding a marginal cost to the operation of the latter. In competitive electricity markets with a sufficiently high carbon price, this will incentivise a clean dispatch of the existing generation fleet, accelerated decommissioning of carbon-intensive assets, low-carbon investment, demand-side response and clean-technology innovation (Acworth et al., 2018).

The primary mechanism plays out in the daily (or hourly) dispatch of generation sources: the added marginal cost of CO2 pushes carbon-intensive generators down the merit order when passing on these costs to consumers. As a result, the capacity factor of high-carbon assets decreases to the benefit of low-carbon generators, who receive more generation hours based on their lower bidding price. The cost of CO2 pushes the wholesale price up during hours when fossil fuel plants are dispatched, partly offsetting the downward pressure on wholesale prices by low marginal cost (renewable) generation and increasing the returns on low-carbon assets. The immediate effects of carbon pricing are seen in a higher utilisation of low-carbon generation in the existing generation fleet. In the longer term, a deteriorating business case for operating high-carbon assets will accelerate the decommissioning of these generation plants.

Depending on the price level, carbon pricing creates a strong signal for low-carbon investment in the power generation fleet. Fossil-based generators are incentivised to shift production to low-carbon sources when their short-term marginal operating costs surpass the long-term marginal cost of investing in new assets (Guivarch and Hood, 2010). Moreover, new producers might opt to start investing in low-carbon electricity generation directly, especially when the policy framework indicates that the price of CO2 is going to rise further in the future.

Under an ETS, even with declining emission caps, allocation mechanisms can provide carbonintensive generators with time to adjust to new market conditions. As allowances are tradeable commodities with a market value, free allocation of allowances provides fossil fuel plants with implicit capacity payments (while ensuring clean dispatch effects due to the cost pass-through in short-term power markets). In the EU ETS, the share of free allocation in the power generation sector has gradually declined and allowances are fully auctioned since the start of Phase III in 2013.39

38ETSs discussed in this section are limited to cap-and-trade systems. Note that China’s national ETS, in its initial phase, differs and is more similar to a tradeable performance standard (TPS).

39An exception is made for the eight member states who have joined the European Union since 2004, and who can make use of a transitional period until 2019. (European Commission, 2018).

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Policy packages and interactions

At moderate levels, carbon prices can lead to shifts towards lower-carbon options in dispatch and a change in fuel inputs. If carbon prices remain moderate, complementary policies are needed to promote the retirement or (carbon capture and storage) retrofit of unabated fossilfuel generation and guide investment decisions to low-carbon technology development (IEA, 2017b). Policy options include efficiency performance standards, renewable portfolio standards or support measures, and government funding for clean technology research, development and demonstration, parallel with optimising pricing by removing fossil fuel subsidies. These policies can serve multiple functions besides emission reductions, such as increasing competitiveness in certain technologies and decreasing electricity costs in the long term.

Overlapping energy and climate policies have to be addressed in the design of ETSs. In principle, any energy policy that results in emission reductions should be accounted for in the ETS cap setting.

Electricity sector design

The effectiveness of carbon pricing depends heavily on the electricity market design. In general, more heavily regulated electricity sectors constrain the efficient functioning of a carbon price. However, additional regulatory measures can be implemented to imitate the effects a carbon price would have under competitive market circumstances.

In China, administratively set wholesale prices and the fair dispatch rule constrain an effective functioning of a carbon price by limiting cost pass-through and dispatch flexibility. In order to make the carbon price signal visible when market reforms are not feasible in the short term, additional regulatory measures would have to be implemented that have a comparable effect.

Box 18. ETSs in China

Having gained experience with ETSs since 2013 through several pilot programmes in seven regions (five cities: Beijing, Shanghai, Tianjin, Shenzhen and Chongqing; and two provinces: Guangdong and Hubei), China launched its national ETS in late December 2017 (NDRC, 2017). Allowance allocation rules are defined at a national level, will apply identically to all provinces and are currently in a drafting process. They are set to be adopted by 2019. The ETS covers only CO2 emissions, which make up more than 80% of China’s total greenhouse gas emissions.

In Phase I, the ETS covers only firms in the power and heat sectors that use more than 10 000 tonnes of coal equivalent each year (~26 million tonnes of CO2). According to these rules, roughly 1 700 power plants are obliged to participate in the system, together accounting for an estimated 3.3 gigatonnes of CO2 (GtCO2) emissions annually (37% of China’s total CO2 emissions in 2016), making the Chinese system the largest ETS in the world (ICAP, 2018).

During this initial phase, implementation efforts focus on developing the market infrastructure of the ETS (monitoring, reporting, and verification [MRV]). Simulation trading will commence for the electricity sector in Phase II, and a deepening and expansion of the ETS will follow in Phase III (post-2020). In the latter phase, eight sectors are to be included in the system (power and heat, construction, iron and steel, non-ferrous metal processing, petroleum refining, chemicals, pulp and paper, aviation) and emission standards are likely to become more

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