Introduction

The Commonwealth Government has adopted an interim planning target of stabilising emissions of carbon dioxide, methane and nitrous oxide based at 1988 levels, by the year 2000, and reducing these emissions by 20% by the year 2005. The Government also decided that Australia will not adopt measures which would damage Australia's competitiveness, in the absence of similar action by major greenhouse gas producing countries.

Australia could reduce CO2 emissions by a variety of policies: by regulating to ensure higher standards of building insulation, or greater fuel efficiency; by "save energy" campaigns; or by raising the price of energy by an excise tax. This study examines the most widely discussed policy instrument for curbing CO2 emissions - a carbon tax, in the form of a specific excise tax on the carbon content of primary fuels (coal, oil and gas). No view is taken on whether emissions need to be reduced and on whether carbon taxes are the best option for achieving any given target level of emissions.

The study examines three questions:

1. How large a carbon tax would Australia require in order to achieve the interim planning target?
2. What effects would a tax of this magnitude have on Australian industry?
3. To what extent would these effects depend on whether or not other countries imposed a similar tax?

The significance of the study

The Australian economy is more dependent than most on natural resources and on the ability of its secondary processing sectors to add value to them. In 1990, Australia was the world's largest exporter of thermal coal, equal largest exporter of coking coal and the second largest exporter of aluminium and iron ore. It was also a significant producer of steel, oil and gas.

Together these six sectors account for about 6% of Australia's GDP, and for about one-third of Australia's total production of commodities and manufactures. They are all linked to energy, whether as producers (coal, oil and gas), or intensive consumers (metal refining), or suppliers to the latter (iron ore). The policy that Australia adopts will be critical to the future of these sectors. This study estimates that a unilateral tax which delivered the interim target could reduce these sectors' combined output by 1990 A$ 7 billion in 2005.

Modelling the impact of carbon taxes

A carbon tax on primary fuels would impinge on every part of the economy. The aim of such a tax would be to raise the price, and thereby discourage the purchase, of products and services in proportion to the CO2 released by their production.

Using advanced modelling techniques, the study tracks the tax through the Australian economy, in order to find out what effect it would have on the demand for different forms of energy, and how it would affect the unit production costs of the sectors above.

At the heart of this story lies the electricity industry: it accounts for about one-third of Australia's CO2 emissions, and the price of electricity has a bearing on energy consumption, and hence CO2 emissions, by the rest of the economy. For this reason, the study provides a detailed simulation of the industry's investment decisions, state by state, out to 2005, with and without a carbon tax.

The policy which other countries adopt will be of key importance to Australian industry. To span the range of possibilities, the study assesses the prospects of each of the sectors in three very different scenarios: Australia acts unilaterally to impose a carbon tax; all OECD countries act in concert; and all countries act in concert. An optimistic view of the likely participation of non-OECD countries is taken. For illustrative purposes we have assumed that in the global scenario, they would impose a carbon tax at half the OECD rate.

The comparisons between scenarios have been made on the basis of a tax of US$ 20() per tonne carbon. This figure is purely illustrative: the level at which a global carbon tax would have to be set in order to reduce global emissions by 20% below 1988 levels is highly uncertain. Some studies suggest a lower, others a higher tax than this.

An Australian carbon tax

The study concludes that in order to reduce CO2 emissions in 2005 to 20% below their 1988 levels, Australia would have to impose a tax of 1988 US$ 115 per tonne carbon (equivalent to 1991 A$ 153 per tonne carbon).

This would be a very significant tax, which would raise fuel prices sharply. The price of coal would increase by 213%, of oil by 74%, and of gas by 64%. In the analysis it is assumed that the tax would be phased in gradually, from 1992/93, rising by equal annual increments to 2004/05.

Impact on the Australian electricity industry and on energy demand

In electricity generation, a tax of US$ 115 per tonne carbon would force up the price of electricity by 108% (by about half as much as the price of coal, but by more than the prices of oil and gas). It would reduce the demand for electricity by 42%, compared to the base case.

The tax would also accelerate the displacement of brown coal by gas. Without the tax, in 2005 we expect that brown coal will account for 14% of the electricity generated. With the tax, there would be an economic case (not necessarily a decisive factor in this context) for phasing out brown coal by 2002. Gas's share of electricity generation would then rise from 7% in the 2005 base case to 18%.

We follow a convention, adopted in recent economic analysis of this subject, of denominating carbon taxes in terms of 1~X US$ per tonne of carbon, rather than on the basis of per tonne of C02; the former is numerically 3.67 times the latter (the atomic weights of carbon and oxygen being 12 and 1 respectively) .

Effects on unit production costs and profit margins

Once these fuel price increases had worked their way through the economy, unit production costs could rise, by differing degrees, depending on their direct and indirect consumption of energy. The study concluded that if a carbon tax of US$ 115 per tonne carbon were imposed, unit costs in industry would rise by 44% in aluminium; by 12% in steel; by 6% in coal, oil and gas; and by 5~7O in iron ore.

What matters to industry is how their profit margins would be affected, in each scenario. The study distinguishes between the short run (1998 or thereabouts), before much investment could respond to the tax, and the long run (2005) when such investment could be expected to have taken place. Australian producers could expect that:

1. in the unilateral scenario, their operating margins would be sharply reduced, in both the short and the long run;
2. in the OECD and global scenarios, in the short run, their margins would be less dramatically affected, particularly if their unit cost were low by OECD standards;

in both these scenarios in the long run, their margins would be squeezed severely, but more so in the OECD than in the global scenario.

Industrial sectors in the unilateral scenario

Table 1 indicates that if a carbon tax of US$ 115 per tonne carbon were imposed unilaterally, our analysis suggests that the combined production of the sectors would be 1990 US$ 5.4 billion (A$ 7 billion) lower than it would otherwise be in 20054.

The sectoral impacts would range from the catastrophic to the harmless. The steel and aluminium sectors would not survive. The production of thermal coal would be lower by 29%, gas by 13%, coking coal by 8%, and iron ore by 4~7O. Oil production would be unscathed. The message is a stark one: a unilateral carbon tax would spell the end of steel production and most of the aluminium smelting in Australia by 2005.

An OECD tax

When the OECD scenario is compared with a unilateral scenario on the basis of the same rate of tax (US$ 200 per tonne carbon), the sectors' combined production would be much the same in 2005 (one-third lower than the base case). However the effects on individual sectors are very different, as Figure 1 makes clear.

The OECD tax would be less damaging to the steel and aluminium sectors in the short run, but by 2005, both would be eliminated under this scenario, too. In contrast, thermal coal would be hit slightly harder (a fall in production of 47% in 2005, rather than 38°)

The two sectors whose disadvantage would be reduced most in 2005 from a widening of the tax to OECD countries would be coking coal and gas. Coking coal would be hit less because Australia's major competitor (the USA) would be caught by the tax. Gas would be no worse off because reductions in domestic demand would be compensated for because Japan would switch towards gas and import more LNG from Australia.

A global tax

The combined production of the sectors would fall slightly less in 2005 under a global tax than under an OECD tax. One smelter apart, the aluminium industry would not survive in 2005. The steel industry would now earn positive cash margins on its most profitable business (lowest-cost capacity in the domestic market). However, those margins would be half what would be needed to sustain competitiveness. The industry would eventually be forced to withdraw, perhaps beyond 2010. Only if non-OECD countries applied this carbon tax at the full OECD rate could this industry survive a carbon tax of this order. The difference between steel and aluminium in this context is that the low-cost, non-OECD producers in the steel industry use significant amounts of fossil fuel, whereas their counterparts in the aluminium industry use hydro-based electricity.

The Australian iron ore industry would fare less badly in this scenario, because its principal competitor (Brazil) would now pay the tax (we have assumed at half the OECD rate). Thermal coal would be even worse off, because there would be more widespread substitution away from coal, and a lower world coal price.

A production versus a consumption tax?

Would a unilateral tax on the production, rather than the consumption, of carbon be a less unattractive alternative? We think not. It would have very little impact on Australian emissions, because Australian energy-intensive industries would substitute imported fuels, albeit at some additional cost. A unilateral tax of any kind would make a minuscule contribution to reducing global emissions, but a production tax would achieve even less than a consumption tax, at the cost of considerable damage to the sales of the Australian energy industries, in both their domestic and export markets.

A case for caution

There is no easy option for Australia, no scenario which does not have profound consequences for a major sector. Australia needs to be concerned about precisely which other countries plan to tax carbon, at what rate relative to Australia's rate, and whether these taxes would actually be enforced. To ignore these factors would risk driving energy-intensive industries, and their CO2 emissions, to alternative locations.

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