Seesaw with trees on one side and a smoking factory on the other, symbolizing the balance between policy and market forces.

Carbon Tax Conundrum: How Market Structure Impacts Emission Reduction

Soraya Malik in Climate & Environment August 2025 • 5 min read.

"Uncover the surprising ways carbon taxes can backfire, increasing emissions instead of reducing them, and how market dynamics play a crucial role."

In an era defined by the urgent need to combat climate change, governments worldwide are implementing various carbon pricing mechanisms to curb greenhouse gas emissions. These policies, including carbon taxes and cap-and-trade systems, aim to incentivize businesses and individuals to reduce their carbon footprint by making pollution more expensive. However, the effectiveness of these measures isn't always straightforward. Recent research reveals that the impact of carbon taxes can vary significantly depending on the structure of the market in which they are applied.

A groundbreaking study published in the Journal of Public Economics sheds light on this complexity, revealing instances where carbon taxes can paradoxically lead to an increase in carbon emissions. This counterintuitive outcome occurs when market dynamics and industry-specific conditions interact in unexpected ways, undermining the intended environmental benefits. To fully grasp these dynamics, we’ll delve into the intricacies of market structure and explore how it can influence the effectiveness of carbon taxation.

This article will break down the key findings of the study, examining the Western Australian electricity market as a case study. We will explore the conditions under which a carbon tax can backfire and highlight the importance of considering market structure when designing environmental policies. We will also discuss the implications of these findings for policymakers and businesses alike.

The Market Structure Effect: Why Carbon Taxes Sometimes Fail

Seesaw with trees on one side and a smoking factory on the other, symbolizing the balance between policy and market forces.

The study's central finding revolves around the concept of "market structure," which refers to the competitive landscape of an industry. In a perfectly competitive market, numerous buyers and sellers operate, and no single entity has the power to influence prices. However, many industries, including the electricity sector, are characterized by imperfect competition, where a few dominant players control a significant share of the market. In these concentrated markets, the behavior of a few key firms can have a disproportionate impact on overall market outcomes.

The study highlights that a carbon tax's impact is not just about making pollution more expensive. It's about how firms react to this added cost, and that reaction depends heavily on the competitive environment. In a perfectly competitive market, a carbon tax would likely lead to a straightforward reduction in emissions as firms switch to cleaner energy sources or adopt more efficient technologies. But in a market dominated by a few players, things get more complicated.

Dominant Firm Behavior: In markets with a dominant firm, the introduction of a carbon tax can lead to unexpected consequences. If the tax flattens the marginal cost curves without changing their order, the dominant firm may adjust its production strategy to maximize profits, potentially increasing production from dirtier sources.
Fuel Switching Challenges: The effectiveness of a carbon tax hinges on the ability of firms to switch to lower-emitting plants. However, if the tax is too small to make cleaner sources cheaper, the dominant firm may stick with its existing, more polluting plants.
Regulatory Frameworks: Regulatory frameworks, such as fixed retail prices, can also distort the impact of carbon taxes. When retail prices are regulated, vertically integrated firms may have less incentive to reduce wholesale prices, leading to a production mix that increases emissions.

The Western Australian electricity market provides a compelling example of these dynamics in action. The study found that the introduction of a carbon tax initially led to an increase in carbon emissions because the dominant firm, Synergy Energy, adjusted its production strategy in response to the tax. This increase was attributed to the tax flattening the marginal cost curves, prompting Synergy to favor its coal-fired generation over cleaner natural gas alternatives.

Policy Implications: A Nuanced Approach to Carbon Taxation

The study's findings underscore the importance of adopting a nuanced approach to carbon taxation, considering the unique characteristics of each market. Policymakers must carefully assess the potential impacts of carbon taxes on market structure and firm behavior to avoid unintended consequences. This may involve tailoring policies to specific industries, incorporating measures to promote competition, and addressing regulatory distortions. By taking a holistic view of market dynamics, policymakers can design more effective carbon pricing mechanisms that truly deliver on their environmental goals.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: 10.1016/j.jpubeco.2018.09.010, Alternate LINK

Title: Tax Induced Emissions? Estimating Short-Run Emission Impacts From Carbon Taxation Under Different Market Structures

Subject: Economics and Econometrics

Journal: Journal of Public Economics

Publisher: Elsevier BV

Authors: Gordon Leslie

Published: 2018-11-01

Everything You Need To Know

What is a carbon tax and what is it designed to do?

A carbon tax is a policy governments use to make pollution more expensive, aiming to encourage businesses and individuals to reduce their greenhouse gas emissions. The intent is to create an incentive to lower their carbon footprint. However, its effectiveness can vary depending on the market structure and how firms within that structure react to the added cost.

What is 'market structure,' and why is it important when considering the effects of a carbon tax?

Market structure refers to the competitive landscape of an industry. A perfectly competitive market has many buyers and sellers, none of whom can influence prices. However, many industries, like the electricity sector, feature imperfect competition, where a few dominant players control a large market share. In these concentrated markets, the actions of these key firms significantly impact overall market outcomes.

How can a carbon tax sometimes lead to an increase in carbon emissions, especially in markets dominated by a single firm?

In markets with a dominant firm, a carbon tax can lead to unexpected results. If the tax flattens the marginal cost curves without changing their order, the dominant firm may adjust its production strategy to maximize profits, potentially increasing production from dirtier sources. If switching to cleaner sources is not economically viable due to a small tax or other factors, the dominant firm might continue using its existing, more polluting plants.

Can you provide a real-world example of how a carbon tax has backfired and led to increased emissions? What factors contributed to this outcome?

The Western Australian electricity market serves as an example of how a carbon tax can have unintended consequences. When a carbon tax was introduced, carbon emissions initially increased because the dominant firm, Synergy Energy, changed its production strategy. This increase was due to the tax flattening the marginal cost curves, leading Synergy to favor its coal-fired generation over cleaner natural gas alternatives. Factors like fuel-switching challenges and regulatory frameworks, where fixed retail prices provide less incentive to reduce wholesale prices, can exacerbate this outcome.

What steps should policymakers take to ensure that carbon taxes effectively reduce emissions without unintended consequences?

Policymakers must adopt a nuanced approach to carbon taxation by considering the unique characteristics of each market. They need to assess how carbon taxes might impact market structure and firm behavior to avoid unintended consequences. Tailoring policies to specific industries, promoting competition, and addressing regulatory distortions are crucial. A holistic view of market dynamics helps design more effective carbon pricing mechanisms that achieve environmental goals. Further research into specific market dynamics, like the role of renewable energy subsidies or the impact of international carbon markets, could provide additional insights.