Carbon prices and the economics of self-interest

The only thing holding up complaints by businesses about the carbon price is the self-interest of the firms making them.

“In any horse race, son, always back the horse called self-interest.”

 – NSW Premier Jack Lang advising a young Paul Keating

Last week I was chatting with a consultant who advises a range of large energy consuming companies on how to reduce their carbon footprint. He related an interesting and very revealing conversation he had with a financial analyst from a mining company:

Consultant: “It looks like the total carbon tax liability for the business will be $29 million per annum.......In light of that can I ask why Mitch Hooke (Head of the Mining Industry lobby group the Minerals Council) is on the television and radio claiming this carbon tax is going to sink the mining industry?”

Financial analyst: “Well $29 million is a lot of money!”

Consultant: “Yeah, but what’s the total annual expenditure of the business?”

Financial analyst: (sheepishly) “$1.8 billion dollars (long pause)..... Okay you’re right, Mitch is talking crap.  But by spending a couple of million dollars on an advertising campaign, we could end up saving $29 million per year in perpetuity. That’s a pretty good return on investment.”

Over the past few weeks, The Australian Financial Review has been prominently reporting claims by some business interests about how the carbon pricing scheme will negatively impact on the Australian economy. These include:

-- Macquarie Generation (owner of two large NSW coal power stations) complaining that unless it receives lots of free permits it will be forced to game the electricity market to drive up prices and recover lost profits;

-- Business lobby groups complaining that the carbon price should be determined through free trade of permits rather than a fixed price over the first three years. They claim that Australian industry competitiveness will be seriously harmed because Europeans face a lower carbon price.

If you apply just an ounce of scrutiny to these claims you’ll find that the only thing holding them up is the self-interest of the firms that are making them. 

Claim: Macquarie Generation will game the electricity market to recover lost profits from the carbon tax.

Macquarie, like Delta Electricity, has been guilty of strategic re-bidding of capacity to push prices to extreme levels in 2007 and 2009 when there was no carbon price in operation. The problem is not the carbon price. Rather it’s that the NSW Government structured its generation sector in a manner that suited NSW Treasury, instead of consumers’ interest in a competitive electricity market. Macquarie holds two very large coal power stations totalling 4640MW. This very large share of NSW generating capacity (nearly a third) provides it (and Delta’s with its third) with the capacity to manipulate the market at times when transmission links to other states are constrained.

Rather than giving Macquarie free permits in the hope that it won’t continue to exercise its market power, we should remove its market power. This could be done by forcibly splitting the company into two separate entities holding one power station each.

Claim: The Australian carbon price should be determined through trading rather than a fixed price. Otherwise Australian industry competitiveness will be seriously harmed relative to European competitors who pay a lower carbon price.

Let’s examine a real world example to see whether these lobbies have a point. To take an extreme case let’s use aluminium smelting, which is the most emissions intensive, trade-exposed sector in the Australian economy.

Current EU permits are trading at about €8.50 or about $10.50 in our currency. The Australian carbon price, at its highest fixed-price point, will be $25.40. That’s a difference of $14.90 per tonne CO2 emitted. On average about 17 tonnes of CO2 are emitted for each tonne of aluminium produced, however the smelter will receive 92.1 per cent of their permits for free. So that’s really only 1.34 permits they need to buy per tonne. 1.34 multiplied by $14.90 is about $20 per tonne of aluminium. This is less than one per cent of the sale price of aluminium. If a one per cent change is all it will take to destroy the Australian aluminium industry, then they were sunk already, irrespective of a carbon price.

When we look back at the past stances of these business lobbies you see that the only consistent thing in their argument is the self interest of their members. Five years ago, when the Europeans were paying a far higher carbon price than currently, these same lobby groups were saying that Europe was irrelevant because they weren’t significant competitors to Australia.  Back then they were very happy with Australia having a fixed carbon price for the first year, because it was only $10tCO2. Also while they were happy to have international trading of credits several years ago, they only wanted trade in one way. Importing of credits from overseas was fine, but they didn’t want export of Australian permits which would have lifted Australia’s carbon price to match Europe’s.

It seems they’re all in favour of free trade provided it only works to reduce the price paid for polluting.

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