Why Paul Howes is wrong and BHP is right

Propping up struggling industries like aluminium smelting with cheap energy is both ineffective for the economy and for reducing carbon emissions – there is a better way to capitalise on our mineral riches.

Paul Howes, the head of the Australian Workers Union, is misguided, as are many others who advocate for energy subsidies as part of a strategy of “value-adding” Australia’s minerals and energy.

Today, Paul Howes unveiled a five-point plan for saving Australia’s aluminium smelting industry involving:

1. Competitive energy supply contracts;

2. Stronger local content rules for major resource projects;

3. Co-investment from state and federal governments in more efficient plant and equipment;

4. Accelerated depreciation on capital stock investment for the aluminium sector;

5. Investment in ways to improve the energy efficiency of plants and process innovations.

While this might sound reasonable on face value, I suspect that what it means in practice is an extremely expensive job creation scheme with little lasting benefit after the subsidies are removed.

What exactly does competitive energy supply contracts mean?

At its core it is code for selling energy below its long-term market value. If you are an aluminium company I can tell you that means electricity supplied to your door at less than $25 per megawatt-hour because this is what other governments around the world are stupid enough to do.

This is well below the long-term price for electricity (ignoring the carbon price), which must ultimately be set by the cost of building and operating new power stations, which would be around $50 per MWh for dirt-cheap coal. 

This issue is not isolated to Paul Howes and aluminium.

We are confronting exactly the same problem with gas supplies. A number of energy-intensive businesses such as Rio Tinto, Alcoa and Incitec Pivot (a fertiliser company) want the government to force gas producers to provide gas to them at prices well below market value – which will now be set by Asian markets because it can be exported via liquefaction.

Of course these companies don’t put it in those terms, instead they talk about “domestic reservation” of gas supplies or “resource value-adding”, but it is a subsidy by another name.

As an example of this argument see this article by Robert Gottliebsen.

They also try to roll-out spurious scare tactics such as Rio Tinto claiming (as reported uncritically in The Australian) that they can’t secure a contract for gas supply in Queensland and that Australia is overstating its gas reserves.  The reality is there’s bucket-loads of gas, but Rio just isn’t prepared to pay the price that suppliers know the gas is worth now they can export it overseas.  

Intuitively you would think Australia could capture greater wealth by not just exporting raw materials, such as iron ore or gas, but further processing them into things like steel or fertiliser. It is true that this might end up generating greater export revenue and employ more people along the value chain. But the question is whether that additional revenue outweighs the additional cost, and what other value you could have created with those people you employed.

If you want to know whether this approach generates greater economic value have a look at BHP Billiton’s strategy since the late 1990s and early 2000s.

BHP realised the key to making money was to concentrate on those sections of the value chain in minerals and resources that others could not easily replicate. So when it came to making steel it realised it was extremely easy for anyone to build a new steel mill, but low cost, long-lived coking coal and iron ore mines were rather rare. It closed and sold-off its steel business and it has been a disaster for those who bought into Bluescope. And the only thing that rescued OneSteel was that it got into iron ore mining.

Also BHP, unlike Rio Tinto, has studiously avoided getting any deeper into aluminium smelting in the last 10 years, but has continued to invest in its existing upstream bauxite and alumina assets. That’s also because aluminium smelters can be readily built by the Chinese, but they can’t replicate Australia’s large-low cost Bauxite reserves.

The end result is that Rio Tinto lost huge amounts of money on its Alcan acquisition, and now every Western aluminium business talks up how it has excess bauxite and alumina for its own smelters’ needs.

Marketing 101 dictates that profit and therefore high paying jobs are captured by those sections of the production value chain that are difficult for others to replicate. Let’s not squander our mineral wealth and unnecessarily increase carbon emissions by subsidising energy supplies to prop up businesses who’s only future is ruinous competition and ultimately low wages.

Far better to direct our effort towards endeavours with greater growth prospects requiring human capabilities that can’t easily be copied by others.

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