The government on Wednesday said that it would contribute A$75 million towards the cost of the photovoltaic solar power plant.
The 154 megawatt power station will cost a total of A$420m ($318m) and will be built by Melbourne-based Solar Systems.
It is the first of a series of projects aimed at reducing the greenhouse gas emissions blamed for global warming.
The move comes as the government, which like the US has refused to sign the Kyoto Protocol on climate change, tries to contain the political impact of the worst drought in living memory.
Peter Costello, the minister of finance, said that the power plant near Mildura in the southern state of Victoria would be the biggest of its kind.
Costello told the Australian Broadcasting Corporation: "The project aims to build the biggest photovoltaic project in the world and this is by using mirrors which concentrate the sun's rays on a power plant."
The plant will generate clean electricity directly from the sun to meet the needs of more than 45,000 homes with zero greenhouse gas emissions, the company said in a statement.
It will use high performance solar cells originally developed to power satellites, with fields of mirrors focusing sunlight on the cells.
A company statement said: "Solar Systems has developed the capability to concentrate the sun by 500 times onto the solar cells for ultra-high power output."
A spokesman for the company told AFP that there was one bigger solar power station in the world, in the Mojave desert in California, but it used thermal solar technology.
"Thermal stations use concentrated sunlight to heat water to make steam and use steam to run a turbine," said technical director John Lasich.
The project will start in 2008 and reach full capacity by 2013.
Costello said the government would also put A$50m into an A$360m pilot project to reduce, capture and store carbon dioxide emissions from a coal-fired power station in the same state.
Danny Kennedy, a spokesman for environmental group Greenpeace, welcomed the announcement and said that the government was starting to bow to growing public pressure and concern about climate change.
With soaring temperatures and bushfires marking the start of another hot summer on the driest inhabited continent on earth, critics have stepped up their attacks on the government's environmental policies, blaming global warming for exacerbating the drought.
Last week Howard announced that A$500m would be spent on a series of clean energy projects, and on Wednesday Costello said he accepted the scientific evidence on global warming.
"I accept the scientific evidence, which is that global warming is taking place, that it is caused by carbon emissions, that restraining the increase in carbon emissions will counteract that process of global warming and that we should play our part."
Australia produces more carbon dioxide per person than any other country in the world and is a major exporter of fossil fuels, which produce the gases blamed for rising temperatures worldwide.