The NSW budget’s carbon lie

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.


  1. Interesting discussion, CeC, but can I point out that the NSW government is a substantial consumer of electricity as well as a generator? I assume that if the cost to households is going to rise, so is the cost to NSW government agencies, who will not be getting the compensation that households are promised. I don’t know if this is the premise on which the NSW claims of a hit to its bottom line are based, but that would be my first assumption.

  2. Yes you’re right about consumption of power, as is every state govt, but the $950m is essentially the generators: 40MT/yr * $23/t.

    • OK, thanks for the response. Government spin is still alive and well in NSW. Quelle surprise!

      OTOH, I’m not surprised that the NSW government is grabbing all the revenue it can, giving any excuse. I noticed to my surprise in yesterday’s Oz that Peter Onselen points out that Swan’s threat to cut NSW’s infrastructure funding is pretty much hollow, as they only get 2% of the Australian total. Not much for a state with 20% of the population.

  3. CC,
    Apologies in advance for going off topic.

    Only 3 responses when all previous posts were hammered with “whack a mole” ferocity. I realise that this topic was not controversial, but that never stopped any of your previous ones getting hijacked.

    It has me wondering whats changed?

    1. Carbonfatique.
    2. It had the word “lie” in the title.
    3. It’s basic premise “The GHG tax is being used as a smoke screen for price gouging” is already accepted by everyone.
    999 The implementation of the GHG tax is being seen as “no big deal”.

    Have we hit a turn around point here ?

  4. CeC,

    This is an interesting and generally correct re-cap of the economics of carbon pricing and its impact on generators both domestically and abroad.

    It has, however, one fatal flaw which renders its conclusion that “there’s no asset impairment and no need for retaliatory measures” utterly incorrect.

    You rightly point out that, in the case of NSW black coal generators, their emissions-intensity is close to the expected rate of pass-through (0.9-1 tC02-e/MWh) at the outset of the scheme. Critically, however, this is only the case at the outset of the scheme, before investment has a chance to respond to the new price signal being sent (i.e. before the stock of generation assets moves towards lower-emissions alternatives with a rising carbon price). As this happens, these new lower-emissions technologies will constrain the ability of relatively ‘dirty’ plant (such as NSW black coal) to pass-through their carbon costs – the result (indeed the whole point of the scheme) is a falling system-wide emissions-intensity over time – public estimates suggest towards 0.6-0.7t C02-e/MWh by FY2030.

    Quite clearly relative to a counterfactual without carbon pricing, NSW black coal generators will suffer reduced profitability over time, as their costs continue to rise in response to a rising carbon price while their revenues rise at a slower and slower rate due to falling pass-through over time. Notwithstanding the fact that this loss in earnings is “back loaded”, a simple DCF analysis of future cash-flows necessarily must yield a reduction in valuation and hence asset impairment.

    A number of public reports attempt to quantify this effect – this following report to NSW Treasury by Frontier Economics (see p13) suggests a loss across the three key generation assets still under public control (Vales Point, Bayswater and Liddell) of roughly $3.5bn, or 58%, as compared to a case not involving carbon pricing and assuming a discount rate of 7%.

    • Carbon E. Coyote

      Ths idea of compensation is to provide some “transitional assistance” to generators mostly affected by the implementation of the carbon price. It is not to compensate for the long term effect, or to keep them all “whole” in an absolute sense. The formula is only an approximation.

      In the longer term (2020/2030), yes all coal-fired assets may see impairment, including those that get compensation in the early years of the scheme.

  5. CeC
    John Doe is correct. Your argument that there is NO loss of asset value for black coal is simply wrong. You only consider year 1, though asset values are a function of revenue/costs over the asset life (or at least over 10 years, as the compensation period is intended to cover)
    The Commonwealth modelling verifies that (a) emissions intensity of the market falls over time (to ~0.7tCO2/MWh by 2020) – Chart 5.18; and
    (b) black coal assets suffer rising losses as a result of this – Chart 5.29 (this is only presented in % terms to 2022, but there is more black coal than brown coal so it would be closer in $ terms)
    So your argument is contradicted by the Commonwealth, not just NSW.

    The reason that compensation is directed at the Brown Coal generators is because they are privately owned while the Black Coal generators are state owned – you hint at this as the reason, but this has little to do with the extent of asset impairment. The formula is a convenient way of directing compensation to the private owners.

    It’s misleading to accuse NSW of a lie isn’t it?