In the wake of the NSW Budget, which justified increased royalties due to the supposed hit to its bottom line from the federal carbon tax, it is useful to examine the actual impact of carbon pricing on coal-fired generators.
As a starting point, one needs to reflect that the methodology upon which compensation (in the form of free permit allocation) has completely changed since the original cap-and-trade schemes were designed. Both the US SOx and NOx schemes introduced in the 1990’s as well as the first and second phases of the EU ETS (from 2005 onwards) allowed for “grandfathering” of the emitters. Grandfathering means that permits are awarded based on historic emissions. If a generator emitted, say, 10 million tonnes (MT) previously, then it gets this stream of permits into the future. Part of the rationale put forward at the time for providing this compensation was that reducing the cash cost for the generators would lower the amount of pass-through into electricity prices. Another element of the logic was more on principle: this was generators wealth/equity, in allowance for removing a right (to emit) that had been previously allocated for free.
This was one of the largest “lessons learnt” from the EU ETS. As any economist would tell you, emitters passing through costs take into account the opportunity cost of the permits provided for free. They value them at their current value in the market, not at the cost (zero) that they had been charged for by the government. As a result, electricity prices went up by roughly the same amount they would have done if the permits had been auctioned and generators had acquired them at full value. This was seen as the generators making “windfall profits”, but in my view the windfall was from the original allocation of permits, not from the ability to pass-through costs to the market.
In learning this lesson, Australian ETS design has, since 2005, moved away from “grandfathering” and used another methodology. The principle under Rudd’s CPRS, and the existing legislation to be introduced by the Gillard government this week, was actually first proposed under Howard’s design (from the Shergold report), where the concept of compensation for “loss of asset value” was established. Some have argued against this logic (eg Garnaut, the Greens) and preferred zero compensation. This is based partly on the principle that the starting point of ownership of permits is the community/taxpayers, not the generators, and so the community (represented by the government) has the right to determine where best the asset value represented by a carbon permit should be distributed. However, the political reality has remained that it would be impossible to implement a carbon price without some kind of deal with the electricity sector.
So what is “loss of asset value”? If you consider an emission intensive generator, its costs go up at a greater rate as a function of carbon than its revenue. Its revenue goes up due to the ability of the entire market to pass through the carbon impost, and various studies have estimated this pass-through at roughly the grid intensity of 0.9 tonnes per megawatt hour, so for a carbon price of $23/t, electricity prices might be expected to increase by about $20/MWh (a roughly 50% increase on current wholesale costs of around $40/MWh). So a generator producing, say, 10million MWh at a greenhouse intensity of 1.3 t/MWh (average for Latrobe Valley generators), will see its costs increase by 1.3*23*10=$300m while its revenue will increase by $200m, so it will suffer an earnings reduction of $100m. The capitalisation of this loss of earnings is the “loss of asset value”.
If you’re a gas-fired generator, with an intensity of 0.4t/MWh, then your revenue increases faster than the cost, so you see an increase in asset value. This is the whole point of carbon price: to re-price the relative value of emission intensive activities relative to lower emission activities. It acts as carrot and stick all in one, by providing a profit incentive to move away from high emission activities and invest in lower emission activities.
This is why the carbon legislation to be introduced to federal parliament this week is structured so as to provide free permit allocation to emission intensive generators (>1t/MWh, but capped at 1.3t/MWh). It is based on the principle of compensating for loss of asset value, and clearly there is no need to compensate where this is no loss of asset value. Due to the Kennett privatisations in the 1990’s, the generation sector is predominantly, if not completely, in private hands, and now, many of those private players are offshore companies. However, NSW generators remain predominantly in state hands, especially those not contracted under the recent transactions with Origin Energy and TRU Energy. That is why Victorian brown coal generators get compensation while black coal generators in NSW & QLD don’t. This is a billion dollar question.
Which brings us back to the NSW budget. The fleet of generators in NSW is predominantly black coal-fired, and much of it relatively efficient but with some of the older and smaller units a little less so. As such, it has an emission intensity around 0.9t/MWh, roughly the same as the grid average. So for these generators, yes there is a carbon cost, but revenue will go up due to higher electricity prices by around the same amount as the carbon cost, meaning that there’s very minimal loss of asset value, and therefore no need for free permit allocation. While some of the older plants themselves may see a loss of asset value (to the extent their emission intensive is above the grid average, and they may qualify under Part 8 of the Act anyway), the portfolio as a whole may not be that much worse off.
On the whole, from a budget perspective, there’s no asset impairment and no need for retaliatory measures. It is disingenuous to discuss only the cost side of the equation (the expenditure on carbon permits) and leave out the revenue side (the ability to pass through costs). But again, perhaps this has more to do with politics than economics.