026 Energy Report 22 April 2010

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Main Report

April 2010

John Daley and Tristan Edis

Restructuring the

Australian Economyto Emit Less Carbon:


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Restructuring the Australian economy to emit less carbon main report

GRATTAN Institute 2010 2

Founding members Senior InstitutionalAffiliates

National Australia Bank

Institutional Affiliates

Arup

Urbis

Grattan Institute Report No. 2010-2 April 2010

This report is accompanied by a publication: Restructuring the Australian economy to emit less carbon: detailed analysis . Theaccompanying publication provides supporting analysis and can bedownloaded from the Grattan Institute website

This report was written by John Daley, CEO, and Tristan Edis,Research Fellow. Katherine Molyneux, Helen Morrow, MarcusWalsh and Julian Reichl provided extensive research assistanceand made substantial contributions to the report.

We would like to thank the members of Grattan Institutes EnergyReference Group for their helpful comments, as well as numerousindustry participants and officials for their input. The opinions inthis report are those of the authors and do not necessarilyrepresent the views of Grattan Institutes founding members,affiliates, individual board members or reference group members.

Any remaining errors or omissions are the responsibility of theauthors.

Grattan Institute is an independent think-tank focused on Australian public policy. Our work is thoughtful, evidence-based,and non-aligned. We aim to improve policy outcomes by engagingwith both decision-makers and the community.

For further information on Grattan Institutes Energy programplease go to:

http://www.grattan.edu.au/programs/energy.php

To join our mailing list please go to:http://www.grattan.edu.au/signup.html

ISBN: 978-1-925015-02-7


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Table of Contents

Overview................................................................................................4

1. Carbon pricing and structural economic change................................5

2. Impact on emissions-intensive industries...........................................9

3. High emission industries that remain internationally competitive .....16

4. High emission industries that should be supported..........................19

5. High emission industries that should not be protected.....................22

6. Other industries and households .....................................................25

7. Glossary...........................................................................................28

8. References ......................................................................................30


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interactions between sectors, but require more complex workingsand assumptions. Both static and dynamic analyses areultimately valuable in understanding the impact of carbon pricing.

The report does not investigate:

The merits of pricing carbon through a tax rather than a capand trade scheme;

Dynamic interactions when carbon pricing causes an industryto reduce production, potentially reducing carbon prices forother industries;

The impacts of carbon pricing on capital costs;

Support for the electricity industry aimed at ensuringcontinuous supply.

These are all important issues, but beyond our core focus.

The report assumes a carbon price of $35/tCO 2 and an exchangerate of US$0.85/A$1. Further details about the scope andassumptions of this report are in the detailed analysis.


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3.2 LNG

The key business decision for Liquefied Natural Gas (LNG)producers in Australia is whether to proceed with substantialinvestment in new projects. If projects currently underinvestigation proceed, Australia could become the worlds largestLNG producer. 28

A carbon price is very unlikely to materially affect these decisions.The carbon price would only be a small percentage of theprojects lifetime costs (including capital investment), as shown inFigure 3.2. 29 Production costs (including a carbon price) are lessthan gas prices outlined by major Australian project developers. 30 At these prices, Australian projects would provide significantreturn on capital invested. Nor does a carbon price substantiallyincrease the uncertainty of LNG investment, which is subject to fargreater uncertainties from other variables. 31 And finally, even ifAustralian costs were higher than those of other countries,investment would probably proceed in Australia because it haslower risk for both developers and customers.

Consequently, it is not necessary to provide any free permits toLNG producers to avoid carbon leakage.

28 ABARE (2009a); Hirjee et al. (2009b); Ramsay and Hardie (2009)29 Greenwood et al. (2009); ABARE (2009c)30 Santos (2009); Woodside (2009b); Energy Information Administration (2009);International Energy Agency (2009)31 McLennan Megasanik & Associates and KPMG-Econotech (2009)

Figure 3.2 LNG price required for 12% return on projects (AUD$price per mmBTU)

$0

$2

$4

$6

$8

$10

$12

$14

QLD Curtis GLNG APLNG Gorgon Ichthys Pluto

Carbon costOther costs

$13.30Santos/Woodside price

if oil US$80/bbl

Free on Board basis. Incorporates offsetting revenue from oil condensate.Assumes $A:$US is 0.85; APLNG assumed to have same emissions intensity asGLNG given similar size and location; 12% WACC.Note: Pluto cost is inflated by pre-investment for future increases in capacity andwill be lower once new LNG trains are brought on-line.Source: Hirjee et al. (2009a) with Grattan Institute estimates of carbon costimpact.


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3.3 Coal

A carbon price would have only a minor impact on thecompetitiveness of 90% of Australias black coal mines. For theremaining 10% the impact on profitability is significant due tosubstantial emissions of methane, a potent greenhouse gas.

However, while their profitability might be significantly reduced,these emissions intensive mines are unlikely to close. Most ofthem primarily produce metallurgical coal that sells at a premium,at margins greater than $30 per tonne of coal, as shown inFigure 3.3.

Figure 3.3 Australian coal cash margins and carbon costs

0

10

20

30

40

50

60

70

80

0 50 100 150 200 250 300 350

Margins and Carbon Cost(USD/t coal)

High margin

Average margin

Carbon cost

Thermal coal Metallurgical coal

Production volume (mtpa)

Also, even if they did reduce production, it is likely that productionwould shift from these high emissions mines to lower emissionsmines in Australia. A carbon price will have a minor impact on theprofitability of other mines, but it is unlikely to noticeably changetheir international competitiveness.

It may be possible for some high emissions coal mines to reducetheir emissions, and this may be economically viable, 32 althoughwe have not obtained data on the precise costs and benefits.

For the coal industry, free permits, such as those provided underthe draft CPRS are not justified. Rather than acting to preventperverse carbon leakage or support a transition towards morecarbon efficient processes, they primarily serve to protect profitsof emissions-intensive mines and delay the movement ofproduction from high emissions mines to low emissions mines inAustralia, which is the very purpose of imposing a carbon price.Rather than providing free permits, it would be better to let thesemines restructure and, in the rare cases where closure mightoccur, target assistance to the affected communities and theindividuals who lose employment and income.

32 Climate Works Australia (2010)


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4. High emission industries that should be supported

Australian cement and steel production may become marginalwith a carbon price, and production may move offshore to higheremission locations. Australian cement and steel are primarilyproduced for domestic use. If their production costs become toohigh they would be vulnerable to imports from countries withhigher emissions.

4.1 Cement

Carbon pricing might cause Australia to use cement clinkerproduced offshore rather than in Australia. While relocation mightreduce greenhouse emissions, the improvements appear too

marginal to justify the change. However, relatively few freepermits are required to prevent declines in Australian clinkerproduction.

The question regarding carbon leakage in the cement industry isunusual: here the relevant question is whether imports wouldsubstitute for local production. This contrasts with many otherindustries considered in this report, where the question is whetherAustralian exports would remain internationally competitive.

There is a real possibility that Australia would substitute cementclinker produced offshore for locally produced cement clinker as a

result of carbon pricing. Figure 4.1 illustrates that the additionalcosts of carbon pricing would make domestic production marginalrelative to imported cement clinker, despite the additional costs of

freight for overseas production that usually make its internationaltrade uneconomic. 33

Figure 4.1 Cement prices and carbon price impacts

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

Cash Cost Carbon Price Depreciation Import Price

$127

$24

$17 $170

Margin

Offshore supply usually comes from South-East Asia and Japan. 34 These producers tend to be more energy efficient than smaller,older Australian plants and are likely to emit fewer greenhousegases even after incorporating the extra emissions from

33 Climate Strategies (2008)34 Australian Government Department of Industry, Tourism and Resources(2006); Grant-Taylor (2007); Kakoschke (2009); McNee and Hannam (2010)


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Figure 4.2 Impact of a carbon price on EBIT margins

Current EBIT

Carbon costEBIT with carbon cost

Port Kembla Whyalla Sydney Waratah Laverton

It is unlikely that emissions would become noticeably worse ifAustralian blast furnace steel mills were to close. Howeversubstantial improvements in emissions are equally unlikely. IfAustralian electric arc mills closed, then emissions wouldsubstantially improve if their output was replaced by OECDcountries electric arc mills (such as Korea, Japan or Taiwan), butemissions would substantially deteriorate if their output wasreplaced by blast furnaces (electric arc furnaces that recycle steel

use substantially less energy).

Considering the slight or indeterminate effect on global emissions,some level of assistance may be desirable to prevent perverseclosures. However the current method for provision of free permitsis not ideal, with potential for perverse outcomes in the Australian

market where most Australian steel production is consumed. Thedraft CPRS scheme provides more free permits per unit ofproduction to the emissions intensive blast furnaces than the lesspolluting electric arc furnaces, even though a substantialproportion of the Whyalla blast furnaces production is steel billet

the same product produced by the electric arc mills. 39 Also insome uses steel competes against less emissions-intensivesubstitutes such as plastic and wood. This substitution would beslowed if steel producers received free permits.

It would be better to rebate emissions permit payments ifproduction is exported, and to impose a carbon charge onimports. The quantity of rebated permits or import charge shouldbe set equivalent to the level of average global emissionsintensity. Australian producers would still have ample incentives toimprove their carbon efficiency given that most production is solddomestically. The import carbon change or border tax adjustmentwould be consistent with WTO rules provided that it treats importson an equal basis to domestically produced steel. 40 This regimewould distort the economy less, and reduce costs to theAustralian community.

39 OneSteel (2009) OneSteel Limited Operational Site Tour, 22 September 200940 Droge (2009)


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5. High emission industries that should not be assisted

5.1 AluminiumFull carbon pricing would probably result in most Australianaluminium production moving offshore. In the medium term thiswould probably reduce global carbon emissions.

A carbon price without free permits or exemptions, in conjunctionwith the expected expiry of subsidised state-governmentelectricity contracts, would make most Australian aluminiumplants marginal to unviable, as shown in Table 5.1. This illustratesthat Australian aluminium producers would move to high cost (4 th quartile), uncompetitive positions on the international aluminium

production cost curve.Based on the available evidence, as legacy electricity subsidiesfor the industry unwind, Bell Bay and Kurri Kurri will become veryhigh cost producers, and Point Henry will be vulnerable to swingsin Aluminium demand. This loss of competitiveness isindependent of a carbon price.

Table 5.1 Impact of carbon pricing and unwinding of electricitysubsidies on Australian aluminium production costs

Change in Alproduction cost(per tonne)

International cost curve position(Quartile)

Smelter

Marketelectricityprices(tAl)

Carbonprice

Current Marketelectricityprice

Carbonprice

MarketelectricityANDcarbonprice

Portland $307 $623 1st low 3rd low 4th High 4thPoint Henry $330 $623 up 1st

-low 2nd

mid 3rd mid 4th High 4th

L1&2 mid 2nd low 3rd mid 4th High 4thBoyne/Glad-stone

L3$210 $488

1st hi 2nd mid 3rd High 4th

Bell Bay $576 $110 mid 3rd hi 4th high3rd

High 4th

Tomago $266 $448 low 1st low 3rd low 3rd 4thKurri Kurri $293 $522 mid 3rd 4th high

4thHigh 4th

Source: See section 7 of the Detailed Sector Analyses Report


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In the very short run, Australian capacity may be replaced byhigher emission Chinese production. In the medium term,aluminium smelters that close in Australia (with the exception ofBell Bay) are likely to be replaced by smelters overseas that onaverage have lower greenhouse emissions. 41 Australian smeltersemit more greenhouse gases than the current InternationalAluminium Institute global average and new global capacity isalso likely to have lower emissions, as shown in Figure 5.1.

In the long run it is unlikely that Australia will have lower-emissions lower cost electricity which will be essential to sustaincompetitive advantage in aluminium smelting. Instead, aluminiumproduction is likely to move to stranded low-emissions electricitysources such as the Middle-East, Canada and Iceland, that arerelatively cheap because there are few alternative uses for theelectricity fuel source in these locations.

Protecting the Australian aluminium industry with carbon pricingconcessions will impose significant costs on the Australiancommunity and impedes the almost inevitable restructuring thatwill enable Australia to increase productivity and living standards.In addition to the already considerable electricity subsidies, thecost of free permits proposed under the December 2009 CPRSprovisions would average around $811m per year. 42 These costsamount to an annual subsidy of about $161,000 per personcurrently directly employed in the aluminium industry.

The most viable smelters if they are pay market electricity pricesare at Portland, Boyne-Gladstone and Tomago. Keeping them in

41 International Aluminium Institute (2007)42 See Section 2.3 of the main report for a discussion of the cost of freepermits.

production with free permits would effectively cost otherAustralians $582m per year on average over the next decade, or$183,000 per person directly employed by these plants.

Figure 5.1 Proportion of proposed new aluminium smelter capacityto 2020 by electricity fuel supply

Hydro19%

Gas31%

Coal40%

Nuclear8%

Geothermal2% Zero

emissions

Source: Brook Hunt and Grattan Institute Analysis.


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5.2 Oil refining

The current economics of Australias oil refineries are precarious.

Although they generate cash from their operations, they do notmake substantial returns on capital. New plants are not beingbuilt because these investments are unlikely to generateadequate returns.

Australian oil refineries are not internationally competitive oncosts, and in the long run, with or without a carbon price, manyare likely to close. More modern plants in Asia are substantiallylarger, more efficient, and better located. Australias refineriesonly compete today against imports because their freight costsare lower, many competitor Asian refineries do not yet complywith higher Australian fuel quality standards, and Asian demandhas tended to exceed supply in recent times. 43 These barriers arelikely to erode so that we are likely to see:

New overseas plants costs decrease further;

Asian fuel standards lift to be closer to Australian standards;

Asian supplies increase;

Opportunities for Australian plants to reduce costs remainlimited.

Carbon pricing would not result in immediate plant closures, but itis likely to bring them forward. Carbon pricing accelerates arrival

43 ACCC (2007b)

at the point where Australian cash costs are higher than importprices.

Should Australian refineries close, global carbon emissions arelikely to reduce . Overseas plants that are taking market share aresubstantially more efficient than Australian plants. 44

Free permits under the draft CPRS will delay industryrestructuring that is inevitable even without a carbon price and willincrease global emissions.

If it were believed that Australia needed some domestic oilrefining capacity to remain operational for energy security ordefence purposes, this would be best managed through a directand transparent subsidy for such purposes, not indirectly via free

permits or other exemptions from a carbon price.

44 http://solomonline.com ; Pers. Comms. (2010d)


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Figure 6.1 Carbon price impact on Australian average householdweekly expenditure (AUD)

$0 $40 $80 $120 $160

Gas & other heating fuelsTobacco

Non-alcoholic beveragesPersonal care

ElectricityAlcoholic beverages

PetrolClothing & footwear

Meals out & fast foodsMedical care and health expenses

Household furnishings etcHousehold services and operationMiscellaneous goods and services

FoodNon petrol transport costs

RecreationHousing

Average expenditure

Carbon price impact

Source: Australian Bureau of Statistics (2006). Carbon price impact based onGrattan Institute analysis

To put these cost increases from a $35 carbon price into historicalcontext:

petrol price rises experienced from 1999 to 2008 are nine timesgreater 50 than the increase in petrol prices induced by a $35carbon price (8c/litre) which will be offset by governmentreductions in excise taxes over the first 3 years of the scheme;

A carbon price of $35 could be expected to increase residentialelectricity prices on average by around 20% from currentlevels. This percentage increase is smaller than thatexperienced by all Australian capital cities over the priordecade, when prices increased in real terms by between 31%and 69% depending on the capital city. 51

50 Grattan Institute analysis of Australian Automobile Association (2009) Fueltracdata51 ABS (2009); Government of Western Australia Office of Energy (2009)


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Box 6.1: Restructuring then and now

Industry concerns at legislative change are not new. In Hard Times , first published in 1853, Charles Dickens wrote about the owners ofthe mills in the fictional Coketown of 19 th Century England:

Surely there never was such fragile china-ware as that of which the millers of Coketown were made They were ruined, when theywere required to send labouring children to school; they were ruined, when inspectors were appointed to look into their works; theywere 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.

Whenever a Coketowner felt he was ill-used - that is to say, whenever he was not left entirely alone, and it was proposed to hold himaccountable for the consequences of any of his acts - he was sure to come out with the awful menace, that he would sooner pitch hisproperty into the Atlantic. This had terrified the Home Secretary within an inch of his life, on several occasions. However, theCoketowners were so patriotic after all, that they never had pitched their property into the Atlantic yet, but, on the contrary, had beenkind enough to take mighty good care of it.

As Hard Times illustrates, what is thought to be difficult for industry when it is introduced, often becomes orthodox business practice withthe passage of time. Few, if any, people engaged in greenhouse emissions intensive businesses could have known when their industriesand facilities were established that the greenhouse gases they emitted would be likely to cause harm. When problems are uncovered itmay be difficult for businesses to imagine how they could do things differently. Nonetheless businesses (although not necessarily thesame businesses that were in place in the past) have repeatedly shown a capacity to innovate in response to environmental, health andsafety regulations in order to produce the goods that the market demands, while reducing the harm caused to others.


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7. Glossary

ABARE Australian Bureau of Agricultural and ResourceEconomics

ABS Australian Bureau of Statistics

ACCC Australian Competition and Consumer Commission

Al Aluminium

Alumina Aluminium oxide, the raw material produced from bauxiteand used to produce aluminium

AUD Australian dollars

Bauxite The principal ore of Aluminium metal

Billet A long, rectangular or cylindrical unfinished bar of iron or

steelBlack coal A lower water-content form of coal

BPD Barrels per day

Brown coal A higher water-content form of coal

BTU British Thermal Units

Carbon leakage The effect when a firm facing increased costs in onecountry due to an emissions price chooses to reduce,close or relocate production to a country with lessstringent climate change policies

Carbon price The cost of emitting carbon into the atmosphere. It can bea tax imposed by government, the outcome of an

emissions trading market, or a hybrid of taxes and permitprices

CIF In relation to cement: Cement Industry Foundation

CIF In relation to a price of a commodity: Price including cost,insurance and freight i.e. the price at the port wheregoods are imported compare to FOB

Clinker The precursor to cement, made by heating a mixture oflimestone, sand and clay

CO 2 Carbon dioxide

CO 2 equivalent A measure used to compare the emissions fromgreenhouse gases based upon their global warmingpotential

CO 2-e See CO 2 equivalent

Coking coal See metallurgical coal

CPI Consumer Price Index

CPRS Carbon Pollution Reduction Scheme the label thegovernment has applied to its emissions cap-and-tradescheme

EAF Electric Arc Furnace

EBIT Earnings Before Interest and Taxes profit taking intoaccount the amortised cost of capital equipment, althoughpositive EBIT may not provide sufficient return on capitalto justify investment

EBITDA Earnings Before Interest, Taxes, Depreciation andAmortisation pure cash profit of a business withoutregard to the cost of capital equipment

EIA Energy Information Administration

EITE Emissions Intensive Trade Exposed

Electric Arc Furnace Furnace for producing steel by recycling scrap iron andsteel by melting it with an electric arc

Emissions intensity The amount of greenhouse gas produced per unit ofproduction


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FOB Price for goods free on board i.e. the price at the portwhere goods are exported from, and excluding the costsof international insurance and freight compare to CIF

Free permit A certificate created under an emissions trading schemethat the holder does not pay for, and which entitles theholder to emit a specified amount of greenhouse gases

Garnaut Report An independent study conducted by economist ProfessorRoss Garnaut, commissioned by AustraliasCommonwealth, State and Territory governments in 2007

GDP Gross Domestic Product

GFC Global Financial Crisis

GJ GigaJoule

Greenhouse gas The atmospheric gases responsible for causing globalwarming and climate change

GST Goods and Services TaxIAI International Aluminium Institute

IBF Integrated Blast Furnace

IEA International Energy Agency

Integrated Blast Furnace Furnace for producing steel by converting iron oreand metallurgical coal into pig iron and then steel using aheat-intensive furnace

Kyoto Protocol an international agreement linked to the United NationsFramework Convention on Climate Change, adopted inKyoto, Japan on 11 December, 1997

LNG Liquified Natural GasMetallurgical coal Coal used in steel making

Methane A greenhouse gas, estimated to have a global warmingeffect twenty-one times that of the same weight ofcarbon-dioxide

Mtpa Million tonnes per annum

MWh Megawatt hour

OECD Organisation for Economic Co-operation andDevelopment

Sequestration The removal of atmospheric carbon dioxide, eitherthrough biological processes (eg. photosynthesis in

plants and trees) or geological processes (eg. storage inunderground reservoirs)

t tonne

Thermal coal Coal used in power generation

USD United States Dollars

Windfall gain A benefit accruing to a company without any effort ontheir part as a result of government regulation

WTO World Trade Organisation


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026 Energy Report 22 April 2010

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