An Experimental Comparison of Carbon Pricing Under Uncertainty in Electricity Markets

We report on an economic experiment that compares outcomes in electricity markets subject to carbon-tax and cap-and-trade policies. Under conditions of uncertainty, price-based and quantity-based policy instruments cannot be truly equivalent, so we compared three matched carbon-tax/cap-and-trade pairs with equivalent emissions targets, mean emissions, and mean carbon prices, respectively. Across these matched pairs, the cap-and-trade mechanism produced much higher wholesale electricity prices (38.5% to 52.6% higher) and lower total electricity production (2.5% to 4.0% lower) than the “equivalent” carbon tax, without any lower carbon emissions. Market participants who forecast a lower price of carbon in the cap-and-trade games ran their units more than those who forecast a higher price of carbon, which caused emissions from the dirtiest generating units (Coal and Gas Peakers) to be significantly higher (15.2% to 33.0%) than in the carbon tax games. These merit order “mistakes” in the cap-and-trade games suggest an important advantage of the carbon tax as policy: namely, that the cost of carbon can treated by firms as a known input to production. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.