Feature Stories | Mar 26 2007
By Greg Peel
Following on from “Investing In A Carbon-Traded World” (Sell&Buyology; 09/02/07), this article seeks to address some of the nuts and bolts and realities of carbon trading in Australia.
Where is Australia at?
If a federal election were held on Saturday, the polls suggest a Labor government would replace the longstanding Coalition government. While FNArena is not here to play politics, the reality is that the next federal election comes at a time when climate change is possibly the number one election issue. What path Australia heads down in towards controlling carbon emissions through a carbon trading system will depend to a great extent on who is in power.
The Coalition government recognised climate change as a problem only last year in the face of pressure from the electorate. To date, it has made two significant statements: (1) it will never introduce a carbon tax (as opposed to tradeable carbon credits) and (2) it believes an international system is the way to go. The latter came with acknowledgement, however, that an international system may be a long way off. Thus the government established a task force and invited submissions from interested parties as to how an interim national carbon trading system might work. That task force is due to report at the end of May. The election must be called anywhere between October and December, so the Coalition has its work cut out to come up with a system that will appease both Big Industry and the increasingly environmentally concerned voter in that time.
One thing is a given, and that is a Coalition scheme will be a lot more lenient towards carbon-heavy industry than a Labor scheme. However, given the timeframe, it is also likely the Coalition will announce a national scheme in spirit ahead of the election, while saving up the devil of detail for later.
Nor has the federal Labor party unveiled a specific scheme beyond a commitment to do so. The federal Labor conference is next month, so one presumes more detail might emerge as a result. It would not be beyond the bounds of Labor to introduce a carbon tax, but although the left wing will push hard for such, one doubts the right wing will risk the inevitable backlash from industry: job loss cries, economic destruction warnings etc. (A carbon tax could provide for an offset benefit, such as a lower corporate tax, but it would still be a system weighted against Australia’s most profitable and labour-intensive industries)
The reality is that the states – all Labor governed – have already introduced various carbon schemes of their own, albeit with little consistency. But as a united force, the premiers have offered to take the lead in combining to move towards a national system. This would offer Howard an easy way of introducing a national system, but there’s no way he would take it. Rudd, on the other hand, can easily build upon the framework established to date.
The state premiers have not been foolish enough, particularly in the resource-rich states, to suggest a carbon tax. Indeed they advocate concessions for heavy industry in the short term. It is quite possible that Labor and Coalition proposed schemes may end up looking fairly similar in fact, in order to easily segue into an international system for which the European system is currently providing a guide. However, on a concession basis, the Coalition will no doubt be more lenient in the short term than Labor.
(In keeping with the Howard government’s nuclear task force, which consisted of nuclear scientists, the carbon trading taskforce consists of representatives from Xstrata, International Power, Australian Pipeline Trust, Qantas, BHP Billiton, Alumina and the National Bank – staunch environmentalists one and all).
So the cost of carbon control for Australia’s listed companies will initially come down to who is in power in 2008.
Quantifying that cost under whichever scheme is adopted requires putting a cost on carbon. Carbon dioxide is not the only greenhouse gas, nor is it the most dangerous – it is simply the most abundant. For emissions-trading ease a convention has been established to equate all gases into equivalent amounts of carbon dioxide. Thus any cost applicable to carbon dioxide flows through proportionately to other pollutants such as methane and sulphur dioxide. On the flipside it provides a valuation to everything from trees (which absorb carbon dioxide) to windmills (which replace carbon-fuelled power sources).
What price carbon?
There are several precedents from which a price for carbon (carbon dioxide equivalent) – the basis of any trading scheme – can be determined. Citigroup analysts have recently undertaken this exercise. They noted: NSW Greenhouse Gas Abatement Certificates ($13/t increasing to $18/t in 2011); Australian National Renewable Energy Certificates ($27/t now, increasing to $35/t in 2011); European Trading Scheme Emissions Units ($27/t by 2012); a Western Australian government task force prediction of $25/t by 2020; and estimations of the cost of carbon capture and storage by both ABARE and the IEA which range from US$25-55/t but acknowledge the fledgling level of such technology at this stage.
Taking all into consideration, Citigroup settled on a benchmark cost of $20/t for now for the purpose of calculating financial impact. Citi notes that capitalising this cost at a price/earnings of 15x would lead to a range of cost to carbon-intensive Australian corporations of 5% to 45% of current valuation. Costs could be greater in the longer term.
BHP worth 45% less? That is not a comforting thought. But Citi quickly warns that this calculation does not take into consideration abatement solutions. Any such solutions pursued by carbon-heavy corporations will offset the carbon cost.
Australian companies have not had their heads in the sand. Many are already well underway with projects that will provide a carbon offset – for the nature of carbon credits is not just a price for reducing emissions, but a price for countering emissions, and even for not increasing emissions. Emission reduction in its simplest form might involve spending money on clean coal technology for example, or sourcing power from more expensive renewables, or retro-fitting office blocks with environmentally friendly functionality. These pretty much involve writing a cheque. However, companies can also invest in renewable energy, or forests, or low-emission cars, or anything that will in itself turn a profit as well as be carbon credit positive. Under some schemes (such as the UN Certificates of Emission Reduction), corporations can receive credits for NOT building another coal-fired smelter, for example, as planned. (China does very well out of that little scam).
So Citi’s 5% to 45% cost range is a calculation of the straight out cost of equivalent carbon credits corporations would have to buy to reach emission targets to stabilisation (not net reduction) levels while carrying on doing what they do now as a primary source of income.
Investors can be at least comforted that 75% of the ASX 100, in Citi’s calculations, will suffer only a small impact – less than 2% of capitalisation. The most exposed industries, making up the bulk of the other 25%, will be those of steel, aluminium, petroleum, cement, chemicals and mineral processing.
Glaringly missing from this list is power generation. The reason is that power generated in Australia is consumed in Australia – power is not an export. Thus power companies are free to pass on any carbon costs to their customers, be they heavy industry or you and me. This raises the important issue of the capacity of any industry to pass on costs.
Australia will introduce a national system of carbon trading before the world settles on a global system. A global system is not just preferable from consistency in a globalised business world point of view, it is necessary given emissions from anywhere on the planet contribute to the sum total of the planet’s problem, without discrimination. But in the meantime, it would be easy to consider that carbon cost in Australia will just mean higher prices for exported commodities such as coal or copper, or locally-consumed commodities such as petrol or airline tickets.
But Australia cannot simply export its costs to the world, nor even necessarily pass them on locally. Coal is Australia’s biggest export, and Australia is the world’s biggest exporter. But it is not the only exporter. In the blink of an eye the Japanese will be increasing imports from anywhere from Indonesia to Kazakhstan at Australia’s expense. Copper, for example, is an internationally exchange-traded commodity with a globally equivalent price (net of transportation etc). Australia simply cannot sell its copper for more than someone else can.
Locally, petrol companies could raise their prices even further, but watch sales of hybrid cars jump and public transport use continue its increase. And bicycles. And if Qantas whacks on more surcharges, see just how quickly it loses customers to other airlines. In these examples, increased prices would be offset by loss of market share.
The reality is that every industry that competes internationally will be forced to bear the brunt of carbon cost. Industries competing only locally, such as power and fresh food, will not be hit so hard. Only local consumers will be hit. However, analysis by Macquarie Bank suggests a carbon-traded Australia will only see marginally lower economic growth, and marginally higher price inflation. The economists are looking at inflation rate increases of only 0.1-0.2% – not enough to materially alter the outlook for interest rates.
They also point to analysis conducted suggesting a US$20/t global carbon tax would increase the cost of petrol in Australia, all things being equal, by about (A$) 6 cents. A local petrol distributor can already make that sort of a change between a Tuesday and Friday in any week.
That is not to discount the effect on those industries that will actually be hit more than once. The coal industry, for example, will suffer because it exports coal. But it also uses electricity and oil-based power to drive its mining equipment/processors/trucks/locomotives which will be more expensive.
Strict and Lenient Schemes
All of the above is a minefield. While a carbon trading scheme is a given in Australia it is unlikely that a particularly strict scheme, that would immediately and substantially hurt heavy industry and, most importantly, export industries, will be introduced at the outset. What is more likely is an ease-in sort of arrangement, which may entail starting with a strict scheme and then granting concessions.
By 2020, which seems to be a popular target globally (its Kyoto’s), there is little doubt that a global system will dictate a strict scheme. Unless we suddenly hit an ice age in the meantime. In 2008, there are many ways concessions could be granted.
A carbon credit scheme with an imposed value has to start somewhere. If it were up to the free market to determine a price, then what would transpire might look a bit like a futures exchange system. Contracts based on a pre-set amount of CO2 equivalent credit at a nominal face value could be bid for by the likes of BHP and co and offered by the likes of Origin Energy and co until a price is struck. More contracts would then be created as more buyers and sellers entered the market and then speculators could do the rest. The price would rise and fall on free market economics. Every time someone came up with a new design for a hydrogen-powered engine or the like, the price would collapse. Every time a scientist upgraded glacial ice melt acceleration, the price would soar. It might be a free market, but it would not necessarily be in the planet’s best interest.
For starters, the market needs a benchmark. A government (or eventually the UN one supposes) must impose the emission reduction target that gives value to the carbon credit in the first place. There also needs to be a consistent measure of carbon output by particular activities, and a measure of the opposite when considering such things as tree-planting. If it were left to the free market to reduce emissions on its own, it would never happen.
Given that the overnight introduction of a benchmark could scuttle industries which contribute significantly to GDP, there is no incentive to allow the free market to determine a price without providing initial concessions, and a free market cannot exist if concessions are granted to some but not others. Thus the carbon credit market must start in a government-controlled market place.
One starting point is to set the contract specifications and then hand out most of the contracts for nothing. The government can then favour which ever industry it determines is important to protect in the short term – for economic survival’s sake – and hand out the free credits accordingly. Another small amount of credits can be auctioned off to establish a value. This might seem unfair, but it serves the purpose of establishing a price without upsetting the economy.
Thereafter, the market can find its own way, driven by the government-imposed reduction targets.
Alternatively, the government could set emission reduction targets, start up a carbon trading scheme, and then give certain industries more time to reach targets than others.
Whatever is ultimately decided upon, the government will have a very torrid time dealing with industry lobbying as to who should get hand-outs/exemptions, what constitutes a nationally significant export market, what flow-through costs are going to insidiously undermine smaller industries and markets, and what profits might be eroded, jobs might be lost, livelihoods destroyed and so on, ad infinitum. One thing is for sure – there won’t be companies knocking on the prime minister’s door looking to hand some of their free carbon credits back.
Technology
Another important point to consider is that of technology. While climate change concerns have been around for a while now, developments in technology such as clean coal have not reached any sort of mature stage. Hence the government is now suddenly throwing money at the problem, just as the Bush Administration is offering hand-outs to projects that reduce US reliance on oil.
While the Toyota Prius has been a runaway success, it is still very much an early step in hybrid car technology. Other major car manufacturers are now fast-tracking their own plans for various hybrids. The Western world still has an SUV mentality.
Much has been talked about in the field of carbon sequestration (capture and storage), but to date the technology is largely on the drawing board. Other coal-based projects, such as coal-stream methane, or underground coal gasification, are in their early stages. Developments in alternative energy sources such as biomass and landfill are progressing, but still they are immature as well.
Australia was once the leader in solar power technology, until the government withdrew funding. Suddenly solar, along with wind and hydro, is back in contention.
If necessity is the mother of invention, and first strike profits are a fundamental driver of technological development, then it stands to reason that by 2020 various technologies that either reduce or alleviate carbon emissions will have reached a level of maturity in rapid time. When the government is considering just what concessions it might make to various industries, particularly on a time-to-respond basis, it can do so knowing that this allows time for technology to catch up. It can also throw more funding at project development.
By the same token, an onerous cost of carbon would force industry into speeding up the process.
Indeed, a government approach could also simply treat the cost of carbon as just another variable price input into the production process (this is something more akin to possible Labor philosophy). As Citigroup analysts put it:
“Industry faces many variables including commodity prices, and competitiveness is influenced by factors like exchange rates, tax regimes and wages levels. Carbon costs might simply be considered another variable for trade-exposed industry to live with, and concessions less readily granted.”
In other words, just let industry handle it. The stainless steel industry, for example, is still going strong despite huge increases in the price of iron ore, and a tenfold increase in the price of nickel since 2001. While these costs can be passed on to customers, carbon costs somewhat pale in significance by comparison.
Company Specifics
Citigroup has carried out extensive analysis of company specifics with regard to carbon cost. Following on from their ASX 100 scale of winners and losers in emission levels (last report), they have looked at the “long term carbon exposure” of the same Australian companies which responded to the global Carbon Disclosure project.
Based on exposure to Australia’s portion of emissions, coming in at 20-40% capitalisation-exposed are Bluescope (BSL), Iluka (ILU), AGL Energy (AGK) and OneSteel (OST).
Coming in at 5-20% are Alumina (AWC), Santos (STO), Boral (BLD), Origin Energy (ORG) and Caltex (CTX).
Based on exposure to all global emissions coming in at 20-45% are Bluescope, Iluka, AGL and OneSteel, and at 5-20% are Boral, Santos, BHP Billiton (BHP), Origin and Caltex.
Readers might be surprised to see Origin in the numbers, as Origin was previously noted by Citigroup as a big winner given its alternative energy projects. JP Morgan has also signalled out Origin for specific mention on the “good” side. However, Citi analysts have now applied the flow-through effect of higher electricity prices on Origin’s (and AGL’s) coal and gas as well as alternative energy projects.
In terms of companies that provided little or no data to the Carbon Disclosure Project, Citi analysts suspect that Qantas (QAN) and CSR (CSR) would fall into the high ranges and that Rinker (RIN), Amcor (AMC), James Hardie (JHX), Babcock & Brown Infrastructure (BBI) and Oil Search (OSH) would fall into the lower ranges.
Dyno Nobel (DXL), a recent entry to the top 100, would also fall into the lower ranges. Alumina did not actually provide any data, but the analysts extrapolated from data provided by Alcoa and AWAC.
The remaining top 100 companies fall outside these significant ranges. 15% are exposed to 1-2% of capitalisation, 35% to 0.5-1% and 25% to less than 0.5%.
Postscript: Blair Leaves A Legacy
This might be something for John Howard to consider, or perhaps Kevin Rudd.
Press Association recently reported that British prime minister Tony Blair has just announced draft legislation on greenhouse gas emissions which will target a 60% reduction by 2050. Blair’s intention is that Britain leads the world on combating climate change with this “revolutionary” step.
As well as the 60% target for 2050, the Bill sets an interim goal of a 26%-32% reduction in CO2 emissions by 2020. Legally-binding carbon "budgets" will be set every five years to ensure Britain remains on track to meet these figures, and progress will be reported to Parliament annually.
Blair’s tenure as prime minister is just about up, and heir apparent Gordon Brown stood alongside suggesting “future chancellors would have to count the carbon, just as they count the pennies, and they will have to account for the use of the resources of our country just as they account for the use of public money”.
The Bill was largely welcomed by environmentalists, businesses and opposition parties alike as a step in the right direction. However, Conservatives are pushing for five year, rather than one year benchmarks and Friends of the Earth said the Bill was too lenient.
Bring on the Australian federal election.