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The real cost of carbon pricing

23 September 2010

Although a price on carbon will mean real changes to parts of the Australian economy, write John Daley and Tristan Edis, its impact on most industries will be small


Marj Kibby/Flickr

Marj Kibby/Flickr

IN HARD TIMES, published in 1853, Charles Dickens wrote about industrialists who complained that “[t]hey were ruined, when they were required to send labouring children to school; they were ruined, when inspectors were appointed to look into their works; they were ruined, when such inspectors considered it doubtful whether they were quite justified in chopping people up with their machinery; they were utterly undone, when it was hinted that perhaps they need not always make quite so much smoke.” But even though the industrialists threatened to “pitch [their] property into the Atlantic,” wrote Dickens, they turned out to be “so patriotic after all” that they “had been kind enough to take mighty good care of it.”

Over 150 years later, no one is suggesting that child labour or workplace safety laws should be rolled back. But as the carbon-pricing debate heats up again in Australia, we are again hearing claims that if the Australian government puts a price on carbon pollution, Australian industry will become uncompetitive and production will shift to countries that don’t restrict pollution. We are again hearing claims that Australian industries, particularly exporters, should be shielded from carbon pricing.

Earlier this year, the Grattan Institute tested these claims to see whether a carbon price of $35 per tonne of CO2 would lead to the end of Australian industry as we know it, and whether it would result in production shifting to even more polluting locations offshore. The study, Restructuring the Australian Economy to Emit Less Carbon, found that the impact of a carbon price on the economy would generally be small. Even industries that have high carbon emissions and that export most of their production will generally remain very profitable and internationally competitive with a carbon price of $35.

The study also found that most of the $20 billion in assistance proposed under the Carbon Pollution Reduction Scheme, or CPRS, to deal with industry fears that production would move offshore, was unnecessary. Worse still, the proposed free permits were likely to retard the necessary and efficient restructuring of the economy that is in Australia’s long-term interests. Three facts underlie these findings:

1. Most Australian industries do not compete internationally or do not have high carbon emissions

Carbon pricing will only affect the viability of the small number of industries that compete internationally and have high carbon emissions relative to their revenue. These industries are sometimes known in the jargon as EITEs (emissions-intensive trade-exposed industries). Less than 10 per cent of Australia’s GDP falls into this category. The competitiveness of the remainder is not affected by carbon pricing.

This shouldn’t be a surprise. Most of Australia’s economy is service-oriented: retailing, healthcare, education, telecommunications, financial services and government activities. These industries don’t have many smokestacks. Light manufacturing, mining and agriculture are also important to the economy. While they are more emissions-intensive than services, they still don’t use much energy and don’t emit much carbon. Rio Tinto’s iron ore mining operations, for example, only emit 0.01 tonnes of CO2 per tonne of iron ore produced. At a carbon price of $35 it would pay an extra 38c for a tonne of iron ore that currently sells for over $100.

Then there are some industries that have high emissions or use a lot of electricity, but that aren’t exposed to competition from overseas. They will all face the same carbon price. While that might ultimately cause some high emissions power plants to shut down, they will be replaced by less polluting power stations also in Australia. And that, after all, is the aim of carbon pricing.

2. Most high-emissions trade-exposed industries will still be profitable and internationally competitive even if they pay a carbon price

Relatively few Australian industries compete internationally and have high emissions – less than 10 per cent of the economy. The Grattan Institute analysed seven of the biggest industries that make up the majority of this category and are collectively responsible for over 20 per cent of Australia’s greenhouse gas emissions. The analysis showed that coal mining, alumina refining and LNG production will continue to be internationally competitive even if they pay a carbon price of $35 per tonne of CO2. Because they have other structural advantages such as proximity to high quality mineral deposits, they will remain relatively low-cost producers even if they pay a carbon price and international competitors do not.

The findings on coal mining and alumina refining were based on an analysis of the costs of individual Australian facilities relative to the costs of international facilities. The data came from the international cost curves published by major resource companies in investor presentations, which indicated that Australian facilities had some of the lowest costs in the world. Even after adding the carbon cost for the emissions of each facility, they would remain very low-cost producers. They would stay profitable even if they received no industry assistance – yet the draft CPRS proposed A$3.5 billion in free permits from 2010 to 2020.

For LNG, the study looked at the economics of constructing new facilities. Oil and gas equity analysts estimate that a range of Australian LNG projects will make a 12 per cent return on capital provided the gas price is between US$6 and US$8 per mmBTU (the international standard for measuring gas volumes – equivalent to about 28 cubic metres of gas at room temperature and pressure). The Grattan Institute’s analysis showed that carbon costs would only change this price by around 20 to 30 cents. Meanwhile, presentations to investors by two of the major Australian LNG developers outlined their expectations of robust LNG pricing outcomes with long-term contracts at around US$12 per mmBTU, provided oil prices are around $80 per barrel. The 20 to 30 cents for carbon pricing was small relative to other uncertainties inherent in LNG development, including future oil prices and construction cost increases. On the industry’s own forecasts, the proposed LNG facilities would be very profitable even if they received no assistance. The draft CPRS proposed A$3.6 billion in free permits from 2010 to 2020 – assistance the industry does not need, for facilities that in general have not yet been constructed.

3. The emissions of many of the remaining industries would probably reduce in the medium term if production moved offshore

The study found that aluminium smelting and oil refining facilities might well shut down in Australia as a result of a carbon price. The cost increases due to a carbon price would leave them struggling to compete internationally. But this is environmentally desirable on balance, because their output is likely to be replaced by facilities overseas with substantially lower greenhouse gas emissions intensity. This should not be surprising. Electricity comprises 30 per cent of aluminium smelting costs. Predominantly powered by brown and black coal, Australia has some of the world’s highest emissions electricity. When production moves offshore, it is hard for emissions to get worse. The only halfway plausible scenario is that Australian facilities might be replaced by inefficient coal-powered Chinese production. This scenario is not likely in the medium term, however. Western producers have said that they are mainly planning low-emissions facilities, and it is reported that the Chinese government is restricting Chinese aluminium production because it consumes scarce and expensive Chinese electricity.

Keeping aluminium production in Australia would come at a high price. The CPRS proposed A$9.5 billion in free permits from 2010 to 2020, worth over $160,000 per employee per year. In the long run, with a global carbon price, the Australian facilities are unlikely to be internationally competitive. The Australian aluminium industry will only be sustainable if Australia starts producing low-emissions electricity at lower cost than the rest of the world. At best this is a long shot, given Australia’s current position with the highest emissions per capita and per unit of GDP in the developed world. In the meantime, keeping aluminium production in Australia would delay restructuring the Australian economy to be more competitive in the carbon-constrained world of the future.

The aluminium and oil refining industries are not major employers in Australia. They directly employ around 11,000 people, around one tenth of the jobs lost as Australia removed tariff barriers for manufacturing, and one tenth of the jobs lost as Australia restructured its electricity sector. Governments are well able to provide adjustment assistance for job losses on this scale. And it is better for government to support workers directly by assisting them to obtain alternative employment in workplaces with a more sustainable future. The alternative is to pay companies to continue employing workers in industries with a limited outlook.

“Moving forward” on carbon pricing

As the Australian carbon debate restarts, two industries require genuine consideration. A carbon price would make some Australian steel and cement clinker facilities marginal, and production from overseas would not have substantially lower emissions. Border adjustments would require steel and cement clinker importers to pay a carbon price based on Australian industry average emissions, effectively levelling the playing field. Importers would be able to reduce this payment by demonstrating either that their actual production emissions were lower, or that they had already paid a carbon price in their “home” country. Border adjustments would be better than free permits because they would increase the price of carbon-intensive materials to reflect the full cost of carbon, encouraging greater efficiency in their use, more use of lower emission substitutes, and lower-emissions production.

But there are major problems in providing border adjustments (sometimes described as a “consumption-based carbon price” or a “carbon tax export rebate”) for all industries. A general border adjustment would leave export-oriented facilities with little incentive to reduce emissions – and they are responsible for over 20 per cent of Australia’s carbon emissions, and growing. Furthermore, calculating the emissions intensity for every imported and exported product would be administratively expensive. It is better to confine border adjustments to the very small number of industries where there is a real possibility that carbon pricing might result in production moving offshore and result in higher emissions. As the Grattan Institute’s analysis shows, this “carbon leakage” is a rare phenomenon in reality. Similar industry analysis around the world is starting to come to similar conclusions: carbon leakage is a real issue for steel and cement, but not for other industries. Consequently, preventing carbon leakage should be treated as an exception to carbon scheme design rather than a driver of its architecture.

For most of the Australian economy, there is little to fear from a carbon price, even if some other countries move after Australia does. The impacts on most industries will be small. Most emissions-intensive, trade-exposed industries will continue to be internationally competitive. Aluminium smelting and oil refining face very significant challenges even with a uniform global carbon price. And the small number of exceptions can be adequately dealt with through targeted border tax adjustments.

This is just as well. It is looking increasingly unlikely that there will be a single, ideal, top-down global agreement on carbon pricing. More likely, countries will move crab-wise, looking over each other’s shoulders, and responding as much to domestic pressure as to international norms. The good news is that they can afford to do so when carbon pricing is unlikely to substantially reduce a country’s international competitiveness.

As a result, any legislation for a carbon price emerging from current discussions should be much less generous than the draft CPRS in providing industry assistance. Industry assistance will simply weaken the incentives for the Australian economy to adjust efficiently to produce lower emissions.

Carbon pricing will mean real changes to some parts of the Australian economy. They will be small changes relative to the overall economy. But they will cause relatively substantial changes to Australia’s carbon emissions. And this, after all, is the entire point of carbon pricing: to make the changes that will have the smallest impact on the economy, but the biggest impact on carbon pollution. •

To obtain a copy of the report visit the Grattan Institute.

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