Differentiated products, increasing returns to scale and heterogeneous firms in a CGE model of the Australian coal sector

- Results of a carbon tax with an aggregated coal sector can be very misleading.
- Effects of a carbon tax on Australian black and brown coal sectors are very different.
- Increasing coal firm market power raises cost of achieving a given level of abatement.
- Carbon tax will reduce Australia's terms of trade and worsen welfare.

We use a Computable General Equilibrium (CGE) model to re-evaluate the effects of the introduction of a tax on CO2 emissions in Australia after incorporating a number of important aspects of Australian coal production. While other studies (for example, Commonwealth of Australia (2008a), Clarke and Waschik (2012)) model coal as a single aggregate sector, we disaggregate coal into black and brown coals. Brown coal is non-traded while most black coal is exported, and brown coal has a higher emission intensity than black coal. Coal is a differentiated product whose production is characterized by the existence of very large fixed costs and considerable differences in the ratio of capital expenditures to capacity between coal mines, so we use Balistreri and Rutherford (2012) and Melitz (2003) to incorporate increasing returns to scale production technology and heterogeneous productivities between monopolistically competitive coal firms. We find that while the aggregate effects of achieving a given level of abatement are largely unaffected by disaggregation of coal, the effects within the black and brown coal sectors are very different. The introduction of increasing returns to scale and heterogeneous firms does have important effects on the aggregate welfare costs of achieving a given level of abatement. When monopolistically competitive coal producers face more inelastic demand, welfare costs rise, firm exit falls, and the carbon price needed to achieve a given level of abatement falls.