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An Analysis of the Australian Carbon Tax

Adaptation Vs Mitigation: Coal Industry impacts

 

1.     Carbon Taxes, Electricity and Coal

 The notion that anthropogenic carbon dioxide is contributing to global warming has a degree of resonance in the Australian community, and policy instruments such as the portended carbon tax are at the forefront of discussions for dealing with some of the CO2 generated in this country. 

As generally articulated, the carbon tax in Australia could be applied in quite a broad based way across the economy, but it does seem to be the case that the energy sector and most likely the coal mining industry will be called on to bear a very significant impost. The expectation is that when calculated and implemented, the carbon tax will be applied explicitly to coal mining with the obvious consequence that the price of coal will increase substantially. This should mean that the quantity of coal used domestically – mostly to generate electricity – as well as exported, should fall and thus the carbon emissions attributable to this nation should decline.

However, there are a range of complications and industry realities which could confuse this picture. Ultimately, it is likely that while carbon emissions in Australia might be held in check, the global carbon impact of the new policy could be quite small. Ironically there is the possibility that some global adaptation to changes in Australian coal prices might lead to a deterioration in coal mining and use impacts in some other places. Overall however, whilst the global mitigation impacts of an Australian carbon tax might be quite small, the adaptation consequences could be quite substantial within Australia. Ultimately, any application of a carbon tax needs to be very clear in terms of the problem setting to which it is addressed and also needs to be conceived in a policy setting where other policy distortions are minimized and where complementary instruments are implemented to facilitate and enable the desired outcomes.

This paper initially reviews the foundations of the carbon tax in terms of perspectives of the CO2 problem and the structure of the Pigovian carbon tax. Subsequently, the impact of the tax on domestic and exported coal will be considered separately.

 2.     CO2 Emissions

 Global CO2 emissions have been increasing steadily for some considerable time. From a base of about 10 million kt per year in 1960 the annual growth has been in the order of about 450,000 kt per year so that the total output is now in the order of 30 million kt (2005). Thus, the global output of carbon dioxide has tripled in 45 years (Figure 1.). It is notable that the rate of output has increased from the early 2000s, particularly as a consequence of the additional output from China (A graphical presentation on the main elements of increasing CO2 concentration and climate change is available in “A Graphical Representation of Climate Change Information” .

Figure 1. Global CO2 Emissions, 1960 to 2005 (kt)

Australia ranks comparatively low in the aggregate CO2 emission stakes but very near the top of countries according to per capita emissions. It is notable that much of the western world has stabilized CO2 emissions since the early 1970s and much of the current surge in CO2 production is emanating from the developing world particularly China. Since 1975 an additional 15 m kt has been generated globally by the developing countries, doubling the previous output.

 

Figure 2. CO2 Emissions per capita by country

 3.     Electricity Supply

 A good deal of the CO2 emission has been attributed to electricity generation throughout the world, and particularly from coal. In Australia, per capita consumption of electricity has increased by about 450% since 1960 (Figure 3.). This is about 30% lower than in the US, but higher than the rest of the western world. Electric power consumption has shown a tendency to stabilize over the past 15 years in the west, but a surge in power consumption is emerging from the developing world, particularly China (Figure 4.).

 

 Figure 3. Electricity, per capita consumption, Australia

 

 Figure 4. Global electricity consumption, per capita.

 4.     Some facts on the Global Coal Industry

 Australian production Significance in the World Coal Industry

 Australia is amongst the significant producers and exporters of coal in the world. While Australia ranks fourth in terms of world producers, the actual share of global production is only 5.6%. China is the largest coal producer accounting for 49.6% of global production.

 Top Ten Hard Coal Producers (2009e)

PR China       2971Mt         South Africa       247Mt

USA                 919Mt             Russia             229Mt

India                526Mt             Kazakhstan      96Mt

Australia         335Mt             Poland              78Mt

Indonesia        263Mt             Colombia         73Mt

 Changes in coal consumption over the past 20 years

 Since 1990, world coal consumption has increased by 70%. While most regions have had stable consumption or have declined somewhat, the notable increase has been in China, up from 30% of world consumption to 46% of the total.

 Global Hard Coal Consumption

                                            1990                2008                2009e

World                               3471Mt           5661Mt           5924Mt

Selected Regional Aggregate Estimates

OECD Europe                   14%                 7%                   7%

OECD North America      22%                 19%                 18%

OECD Pacific                     6%                   7%                   6%

PR China                           30%                 45%                 46%

 Electricity dependence on coal

 Coal is a significant basis of electricity generation throughout the world, providing 41% of global needs. 79% of China’s electricity is generated from coal, whilst in Australia the dependence is 77%.

 Coal for Electricity Generation

South Africa    93%     Kazakhstan     70%     Morocco         55%

Poland             92%     India                 69%     Greece            52%

PR China         79%     Israel               63%     USA                 49%

Australia           77%     Czech Rep     60%     Germany         46%

 Coal Exports

Australia is the largest exporter of coal in the world accounting for 30.6% of global trade, closely followed by Indonesia with 27%.

 Top Coal Exporters (2009)

                        Total of which Steam              Coking

Australia         259Mt             134Mt             125Mt

Indonesia        230Mt             200Mt             30Mt

Russia             116Mt             105Mt             11Mt

Colombia        69Mt               69Mt

South Africa    67Mt               66Mt                1Mt

USA                  53Mt               20Mt               33Mt

Canada             28Mt               7Mt                 21Mt

 Coal Importers

 Japan (19.5%), China (16.4) and South Korea (12%) are amongst the leading coal importers, while other Asian nations India (7.9%) and Taiwan (7%) are also significant importers.

 Top Coal Importers (2009)

            Total of which             Steam              Coking

Japan              165Mt             113Mt             52Mt

PR China         137Mt             102Mt             35Mt

South Korea    103Mt             82Mt               21Mt

India                  67Mt               44Mt               23Mt

Taiwan              60Mt               57Mt               3Mt

Germany            38Mt              32Mt               6Mt

UK                      38Mt               33Mt               5Mt

 The Medium Term outlook for Coal, Electricity and Carbon

 The international energy sector is analogous to a very large super tanker at full speed at sea. When a decision is made to reverse direction, it will take a very long time to actually turn the ship around and a great deal of distance will be covered in that time.

It is the case that a very significant share of global energy is derived from coal fired power stations, and the greatest share of new initiatives in the developing world, particularly in China, are derived in this way. Nuclear energy, the other great hope for clean energy has now been found wanting, and in terms of the very large electricity requirements already established, there are few alternatives. The often touted renewable sources of hydro and solar are currently financially very expensive but also ironically environmentally costly as well.

Accordingly, the prospects for a quick technical fix for cheap energy and its carbon consequences do not look particularly bright. The “wicked policy problem” perspective of finding a technical fix to keep energy supply at current levels while mitigating the carbon impact, will come at a horrendous price. Ironically, when that technical fix is implemented and the price applied, demand forces will result in a collapse in the quantity of electricity consumed and society will be burdened with the horrendously costly white elephant.

In economic terms the carbon emissions problem is not a “wicked” problem. The issue was always about accounting the externalities from coal fired power stations. Electricity prices are cheap because of implicit government distortions as well as the unaccounted environmental consequences. And when a service such as electricity is too cheap, of course consumers will want to use much more of it.

The need is to remove industry distortions on electricity generation and account the environmental impacts of generation in the price of energy to users. Inevitably energy prices will rise and the quantity of electricity demanded will fall, along with the quantity of coal mined to generate it and the carbon dioxide externalities released to the atmosphere.

In economic terms, the prospect of the carbon tax is then portends a positive step in the right direction in terms of remediating the increasing trend in atmospheric CO2 concentrations.

 5.     The Fundamental Principles of Carbon Taxation

 The fundamental principles of carbon taxation are well known. The conventional analysis is developed according to the notion of the Pigovian tax.

 Referring to Figure 5.

  • The status quo pollution free optimum occurs where demand intersects the MSC, yielding coal price Po, Qo of coal
  • With the externality, we get marginal private cost = demand, yielding price Pp at Qp. Thus more coal is used at a lower price. Consumers of coal will benefit from the lower price, while new firms may join the industry and additional employment created. Interestingly, the firms producing the pollution will only accrue normal profits at equilibrium. At the same time it is true that the pollution may be visited on other enterprises. These firms will need to clean up and account the pollution, so that accordingly their costs of production rise while their final product price must rise. In such enterprises, unemployment will be created and the consumers of the “polluted” upon final product will be worse off.
  • After the evaluation of the externality and calculation of the external cost, the MPC is adjusted up to the dotted line and the output equilibrium of Qo and Price Po are re-established. Some coal firms will be driven out and unemployment created. Consumers of coal will be made worse off, but other firms initially suffering the pollution will benefit and will reduce costs and increase employment.
  • The Pigovian tax is the vertical difference Po – Pt
  • The Pigovian tax = environmental costs, is charged on each unit of production

 

Figure 5. The Pigovian Tax

 The key here is that every unit of coal output is charged the tax derived from the environmental cost of using specified units of the coal as a factor input in the generation of energy, say.

Since carbon pollution from coal represents a misallocation of resources it is observed that a Pigovian tax, set equal to the marginal social damage will restore the economy to resource efficiency. This has the result that the polluter pays for whatever pollution that is produced, while pollutees are compensated any damages that they incur.

The end result is that the scale of the polluting industry is reduced – some firms may go out of business – and other sectors of the economy, which previously carried the cost of pollution, are now enabled to expand to their original (larger) scale. Consumers of pollution producing goods, pay a higher price.

The polluter pays approach is much preferred by conventional economists since the Pigovian tax is “integrated” into the firm’s financial calculus in the same way any other price is dealt with. This provides incentives to firms to look for technical innovations and substitution of inputs.

 

 Figure 6. Equating Marginal Impacts

  • Tax is set at OT where marginal benefit to polluters of polluting is equated to the marginal cost on victims suffering the pollution
  • Output of pollution is reduced from Qp to Qo.
  •  At optimality, the net marginal cost of pollution is zero
  • At the optimum, it is the case that some level of pollution remains. Some polluters are still able to gain the benefits of polluting into the natural environment, but since the individuals suffering the consequences are fully compensated by the Pigovian tax from the polluters, it is appropriate for the pollution to continue.
  • It is not appropriate to reduce the pollution to zero by restricting or stopping the pollution altogether. This is a socially costly alternative.
  • Generally, it is appropriate to use the pollution tax collected to compensate to victims of the pollution – but not in all cases, where strategic behavior may eventuate.
  • The imposition of the tax on the polluting inputs will provide a foundation for substitution to less polluting products, as well as an incentive for technological innovation to less polluting method

Conclusion

 Generally, a tax approach should achieve the desired effect efficiently at minimum cost

  • Transaction costs can be a concern, evaluating the social damage of pollution is time consuming and costly
  • Adjustment of industry output is achieved by some firms leaving the industry, and unemployment will be invariably be created.
  • Incentive for technological innovation and substitution on the use of polluting products
  • Polluters pay and bear the costs whilst pollutees get the environmental rent

Carbon Tax Implementation in Australia: Mitigation & Compensation

 The process of implementing the carbon tax in Australia is not yet clear. It appears that the tax will be set to maintain the CO2 emissions at 2000 levels. Otherwise, the level of mitigation is considered to be in the order of 25% of current levels. Attention to an actual damage cost function whereby the real value of the tax is set to an objective measurement of damage is not addressed.

The prospect in the current proposal is that compensation will be a significant initiative. In formal Pigovian analysis, compensation of individuals, firms or industries suffering pollution is essential to achieve the optimal scale of resource use and environmental degradation/improvement. However, according to the Federal proposal the compensation is to be directed to citizen consumers directly. Such an approach does not appear to have any rationale or precedence in the theory. In this situation it is a difficult step to consider citizen consumers as suffering environmental damage as a consequence of the cheap energy they consume. Consumers of electricity in Australia are the primary beneficiaries of cheap energy/coal, which has been derived from unaccounted pollution, and the portended proposal appears designed to compensate them for any change in this abnormal situation.

6.     Employment and industry size, Domestic consumption

 Despite political wrangling on employment and industry size, it is the case that a carbon tax (as a Pigovian tax) will lead to industry contraction and the loss of employment. In fact this is the essential mechanism underlying the tax and the actual reduction of coal industry output and carbon emissions. In a general equilibrium setting it should be the case that the reduction of the carbon impost, domestically in particular, will reduce the pollution impact on carbon “suffering” industries which should now be able to reduce their costs, increase output and put on more employment.

  

Figure 7. Dynamics of the domestic coal market.

From Figure 7. we can see that because of the inelasticity of domestic coal demand, the original output response from Q1 to Q2 is comparatively small relative to the tax which is the price difference P2 – P1. Thus, the tax on coal will need to be reasonably substantial to bring about even a modicum of output decline and hence carbon reduction. With a dynamic growth in energy and demand for coal, the final output level of coal is likely to be higher than the original status quo level, and the price and tax will again be higher.

The spanner in the works domestically is that the demand for energy and coal in particular seems to be quite inelastic and dynamic. On one hand this would seem to be a saving grace for the coal industry which will probably not lose too much output if any, and thus the employment impacts could be small.

Ironically, in this setting the carbon tax measure becomes somewhat of a revenue raising measure, where the positive impact on carbon reduction might be difficult to perceive, although it might be claimed that carbon level is possibly lower than it would have been without the tax.

 Conclusion on the domestic coal industry

 Given inelastic demand for coal/energy and a dynamic increasing rate of growth for energy/coal;

  • The carbon tax will need to be substantial to induce a reasonable output adjustment. Given the targets of 25% for abatement, a 100% increase in the price of coal may be necessary
  • Given the dynamic growth of the energy – coal – industry, it is likely that the output will expand past the initial pre tax level quite rapidly
    • While the tax might initially put some pressure on industry size and employment, this could be swamped by the dynamic growth of the sector
  • Given the dynamic growth of the energy – coal – industry, CO2 mitigation might not be the strongest element of the carbon tax policy

Price incentives, substitution and technological adaptation

 The key feature of the carbon tax initiative is that to achieve a meaningful abatement target of 25% the level of the tax will need to be quite substantial. Some analysts have estimated the price inelasticity to be quite low, between -.5 and -.1. In tax terms the hike could then be expected to be as little as 50% or as much as 200%. A reasonable expectation might be 100%.

Such a hike in the price of coal would seem to have significant political ramifications and would possibly be the basis underlying the perceived need to compensate all domestic energy users.

Such a price hike however, should also provide a significant platform for energy production substitution and technological innovation in the energy sector. Unfortunately, without any deterministic pathway, anticipation of outcomes must be essentially speculative.

At one level there will be the possibility of energy product substitution, say from coal to natural gas, while the rates of technological improvement for alternative energy sources may paint a direction for new developments, which at the end of the day are still speculative.

The prospect of this class of policy is that the mitigation impacts are likely to be inconsequential, but the substantial price increases could provide a platform for significant consumer adaptation. Consumers confronted with spiraling electricity bills will consider and confront energy use alternatives relatively quickly and modify their consumption needs and patterns of use in appropriate ways at minimal cost. The accepted wisdom under such circumstances is that human initiative and technological innovation will bring forth an array of energy options not yet conceivable. The intent is that these options should not be fossil fuel intensive.

 7.     Dynamic International demand

 With dynamic and inelastic international demand the equilibrium impacts are much the same as described above in the Australian domestic situation. The actual impacts for carbon pollution are quite complicated and will be dealt with in more detail below. However, in the face of the dynamic and inelastic international demand the carbon tax in Australia will act as a significant environmental revenue raiser to the national consolidated account. In effect the major markets for Australian coal will subsidise carbon reduction IN Australia. And given the policy disposition to compensate the general Australian citizen, it will be the case that relatively poor Chinese consumers will be paying considerable carbon tax to compensate Australian citizens for their adaptations.

 8.     The impact of the carbon tax on global CO2 levels

 The general domestic abatement plan from current CO2 level is to reduce emissions by 25%. Given that Australia currently produces 5.6% of global hard coal, the 25% reduction in CO2 emissions in Australia would translate to a global impact of 1.398%. By any standard this would seem to be a rather small impact. At the price level the effect could be considerably higher, but given the scale of change the substitution ramifications should be quite small.

 9.     The supply impact of the carbon tax on global markets

 While Australia is a relatively small player on the coal production scene, the nation is the most significant player in the world trade for coal (both steaming and coking). Currently, Australian exports account for 27.5% of world trade in coal.

On a range of criteria, Australia has a very advantageous position in the global trade for coal.

  • Cost of production; is relatively low given the predominance of open cast mining for the largest component of export coal.
  • Location; is very favorable relative to the major markets of Japan and China, as well as the Asia region generally. This obviously helps with transportation costs.
  • Local environmental disruption; is relatively low compared to most of the export competitors
  • Coal output is of a very high quality, both in terms of energy output but also in relation to secondary pollutants.

 

 Figure 8. International Demand & Supply of Coal

 Inelastic Global demand & Supply

 At the international level, both demand and supply are relatively inelastic and the surging demand from China means that the actual demand is quite dynamic over time. The international supply functions for coal will tend to become increasingly inelastic as more marginal low quality and high cost coal is sought. The 25% reduction of Australian coal supply should translate to about a 7% reduction in the global market for coal. Given the inelasticity of demand this could generate a quite significant increase in market price in such places as China. The 7% supply reduction could translate into a 25 to 35% increase in price in the market.

Ironically, given the dynamic growth in electricity generation capacity in China and the necessary requirements for more coal, it is likely that world price of coal will surge from P2 to P3, while quantity consumed increases marginally from Q2 to Q3 (from Figure 9).

 Coal industry substitution

 The impact of the higher prices on Australian coal on international markets will be to bring on line coal which is more costly to mine and coal which is of a poorer quality. This effect is demonstrated by the increasing inelasticity of supply at higher prices. As the high quality – low polluting Australian coal becomes more expensive with the tax, it will be substituted by more costly and more polluting coal from Asia and Europe. Increased coal production from Indonesia could completely negate any global mitigating impact of the Australian carbon tax very quickly. 

Thus, the Australian carbon tax could then become an aid program for Indonesia.

On one hand it will be the case that the relatively poor citizens in a developing country will need to pay a significantly higher price for their coal/electricity, and this increased revenue will be collected by the Australian government by way of the Carbon Tax. Given the scale of the Australian export market this additional revenue could be quite substantive and would provide a platform for major compensation or income tax replacement to Australian citizens. In effect the tax will operate like a tariff on the export of Australian exports.

The other major impact of the Australian Carbon Tax will be that a good deal of poor quality coal could be brought on line to substitute for the now higher cost Australia coal. This will likely mean that more coal will be needed to generate the same amount of energy, leading to more emissions directly, but given the poorer quality in terms of sulphates particularly, there is likely to be substantially more pollution.

 10.  Mitigation Vs Adaptation

 The irony then is that the Australian carbon tax implemented to mitigate CO2 emissions to the atmosphere is in itself unlikely to have much discernable impact. Given that the advent of higher priced Australian coal is likely to lead to substitution from poorer quality coal, it is likely that CO2 emissions will in fact increase and there is also the high probability that other noxious pollutants such as sulphates will also be higher.

On the other side of the ledger it will be the case that the carbon tax should be a rather impressive revenue raiser both domestically and particularly internationally. This surge of government income should enable the development of a very large citizen compensation program which should facilitate high levels of electrical consumer adaptation to an economic environment in the future where electricity generated from fossil fuels is prohibitively expensive or possibly not possible at all.

In practice this accentuated possibly for adaptation should be facilitated with as little distortion via alternative government programs as possible. The positive prospects for such a program could largely depend on an ability to avoid technological determinism and the cluttering of the “policy space” with irrelevant and distorting secondary policy instruments.

 11.  Conclusions

 The portended Australian carbon tax will be poor carbon mitigation policy but potentially outstanding adaptation policy. The policy as generally understood will have the following features and impacts;

  • It will mitigate very little by the way of CO2 emission in Australia or overseas as a consequence of the highly dynamic and inelastic market for electricity and coal
  • While the carbon tax may initially mitigate to a small degree in Australia, the level of coal use and carbon emissions in the near future will be higher than today under the portended taxing regime
  • The Australian tax could lead to a deterioration of coal quality and an increase in CO2 and sulphate emissions overseas, and the overall impact of the tax designed to reduce global CO2 levels would be negative
  • The tax could act as somewhat of an aid program enabling Indonesia to significantly increase its exports
  • The tax will raise significant revenues both domestically, but interestingly from developing countries such as China
  • The significant government revenues should provide a platform for massive compensation to Australian domestic consumers. This compensation should enable very significant electricity adaptation which should prepare the nation very well for a future without carbon
  • The positive progress and impact of the adaptation program will depend on minimising policy distortions in the face of the pending huge new amount of public funds

 References

 Perkins, John L. Global warming: The case for a coal tax, A version of this paper presented to the Energy Working Party Conference National Institute of Economic and Industry Research, Melbourne, July 2007

Data source: World Bank, World Development Indicators – Last updated Apr 27, 2011

Garnaut, R. 2008. GARNAUT CLIMATE CHANGE REVIEW INTERIM REPORT TO THE COMMONWEALTH, STATE AND TERRITORY GOVERNMENTS OF AUSTRALIA, Feb. http://www.garnautreview.org.au/CA25734E0016A131/WebObj/GarnautClimateChangeReviewInterimReport-Feb08/$File/Garnaut%20Climate%20Change%20Review%20Interim%20Report%20-%20Feb%2008.pdf

Stern, N. 2006. “Stern Review on the Economics of Climate Change”, HM Treasury, Cabinet Office. http://webarchive.nationalarchives.gov.uk/+/http://www.hm-treasury.gov.uk/sternreview_index.htm. October.

An Analysis of the Australian Carbon Tax
Adaptation Vs Mitigation: Coal Industry impacts
By A. K. Dragun (Aug 2012)

 

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