Carbon tax compensation or rent seeking?


In today’s Australian, Brent Gunther from the Queensland electricity industry argues that not compensating electricity generators for a carbon tax would be disastrous. The article is here. Let’s look at his arguments.

Argument 1: The National Electricity Market (NEM) has been a great reform success and not compensating electricity companies will damage the NEM.

I agree that the NEM has been a fantastic reform that has allowed for competition and innovation in parts of the electricity production chain – particularly generation and retailing. And a carbon tax will hurt the coal-fired generators in the NEM. And most power in the NEM is currently produced using coal-fired base-load generators. So a carbon tax or emissions trading scheme (ETS) will hurt the coal-fired generators in the NEM. But that is not the same as damaging the NEM itself.

The NEM is a market. Markets are really good at dealing with structural changes in tastes, technology or taxes. Indeed, markets deal with these ruthlessly. Ask the blacksmiths that went out of business when internal combustion automobiles wiped out horse-drawn transport. Or more recently, ask the music companies and newspapers who are trying to survive the market storm surrounding the internet.

The NEM will not be damaged by a carbon tax. It will come under pressure. Because it is a market created with strict regulatory rules, the regulators who monitor this market will come under a lot of pressure. Electricity prices will rise. If the transition is not handled carefully, there could be large price spikes in peak periods.  The owners of coal-fired generators will lose a lot of the value of their investments. Significant investment in new efficient gas-fired generation will probably occur.

So gas-fired generators will win. Coal generators will lose. The price of electricity to consumer will rise. There will be increased research into alternative fuels as the monetary incentive for this research rises. But the NEM will survive. Indeed, the NEM is exactly the flexible market structure that we need for a radical change in relative prices created by a carbon tax.

Argument 2: The loss of value due to regulatory risk associated with a carbon tax will undermine new investment in generation.

Two responses to this. First, it appears that there is currently a lack of investment in electricity generation in the NEM because of regulatory uncertainty.  Who would want to invest in a new power station today when the future rules relating to pollution are so uncertain? Once the rules are set then investment can occur with less risk. So a clear carbon tax should offset current uncertainty, not increase it. Of course, the new investment is unlikely to be in coal-fired generators.

Second, while the current risk relates to unclear government policy, the underlying force here is improved knowledge. We need a carbon tax because our scientists have found out that carbon emissions are a lot more problematic than previously thought. In economic terms there is an externality that has been ‘underpriced’ and the government needs to deal with the problem. These changes have occurred throughout history. Sewerage used to be channeled down the middle of the street (and still is in some developing countries). As we understood the risks involved with this, governments acted. In the north sea, over-fishing and a lack of property rights meant that cod numbers rapidly declined. In that case, a failure of government to act means that a significant fishing industry has effectively been wiped out. Think of the debate on smoking and cancer in the 1960s and 1970s. Think of the current debate on gambling following improved understanding of the psychology of addiction.

As knowledge changes, so too must the rules of our markets. The debate on climate change and carbon taxes is simply one recent example. To call it regulatory risk is “an undergraduate rhetorical device”.

Argument 3: The owners of coal-fired generation should receive higher compensation to aid future investment.

It appears from the article that the compensation for coal-fired plants is to aid future investment in non-coal-fired power plants. It is far from obvious that this is a valid argument. The government, through a carbon tax, is simply correcting the price. Should cigarette companies be compensated when it is found out that cigarettes are linked to cancer and the government raises the tax on cigarettes?

A carbon tax (with certainty that relevant policies will not be subject to political whims), will aid investment in those technologies that produce less carbon-dioxide-equivalent emissions. It will aid research into technologies that will make coal-based fuels economically viable (after all, here in Australia, we have a lot of coal). But it will hurt the profits of coal-based generators. Why compensating the owners of coal-based generators will help this new investment in other technologies is far from clear.

Of course, the real risk is that the carbon tax will continue to be a political football. With uncertainty over the future of a carbon tax or an ETS or some other government climate policies, investment in electricity generation will be low. This is not an argument to compensate the owners of coal-fired generators. Rather it is an argument for the government (and the opposition) to get their act into gear and set a clear forward-looking policy framework for carbon emissions. This – not compensating the polluters – will aid investment.


8 Responses to "Carbon tax compensation or rent seeking?"
  1. Stephen, I agree. The main areas for compensation should be the traded goods sector – and of course consumers – and the electricity sector is not part of that.  I have heard that most generators have an average carbon tax of around $34/tonne in their heads as they plan new technologies. Its the uncertainty about policy that is hindering the move to gas.  Much of the sector needs an upgrade and expansion anyway as hybrid vehicles and other sources of electricity demand come on stream.

  2. Stephen,
    Thanks for posting on this issue.  The special pleading by the power generators – and the fact that they seem to get some traction with government – is a disgrace.
    I agree with all of your points.  But I think you have missed the salient argument that the generators make and that the linked article alludes to.  This is that, without compensation, the carbon tax will send them broke, meaning that their power stations will shut down and there will be power cuts.
    This argument is ridiculous, of course.  When a generator becomes insolvent it simply hands its assets to its lenders, the banks.  There is no way that the banks will shutdown a power station so long as it generates cashflow.   And, be assured, if there is a threat of power cuts, there will be plenty of cashflow.  As you note, the NEM works.
    So, it would be great if you could turn your mind to this argument in particular.
    Keep up the good work.

  3. Putting aside the important issue of rent-seeking, how are power companies going to invest long-term in alternative power generation if you (blithely?) send them broke in the shorter-term. That hardly seems an optimal solution.

  4. DP,
    You are not sending the companies broke, just some asset-based subisidiaries.  These subsidiaries are deliberately structured with very thin capitalisation and non-recourse loans so that their insolvency does not significantly damage the parent company.
    The parent companies are large multinationals who have plenty of capital to build new power stations in Australia, if opportunities are presented to them.

  5. Dave, you seem to have a limited understanding of the motivations behind banks. The key issue as you correctly point out is potential blackouts arising from insolvency of the coal fired generators as a result of carbon pricing. A few points:
    – gas fired power stations don’t magically appear out of thin air, they will take many years to replace the lost capacity. What to do in the meantime?
    – $6bn of Latrobe valley coal fired debt needs to be refinanced in 2012. Many foreign lenders in the syndicate will want out for a variety of reasons. So the Aussie majors will have to step up.
    – some of these generators are already in lock up, that is, equity is already getting no return. Without transitional assistance the policy will wipe out equity, and almost certainly force lenders to take a significant haircut.
    – no Aussie bank will want the repetitional risk of being blamed for turning off the lights. So they will run the stations in work out.
    – given all this, which credit risk manager is going to sign off on this 6 billion, given that you are losing from day one? It is not going to happen.
    – essentially you are asking the banks to take a sizable hit so that the lights stay on, because the govt hasn’t got a long term plan in place
    – which bank is ever going to lend in this sector ever again if all this comes to pass? Then you have a situation where the NEM is stuffed.

  6. Bob,
    Yes, the banks may take a haircut.  And why shouldn’t they?  They lent to thinly capitalised businesses with a huge exposure to carbon pricing that has been on the agenda for a decade.  They placed their bets and perhaps they are going to lose their money.
    Banks take credit risk and will lose money from time to time in many sectors: farming, property, ITT etc.  Are you suggesting that banks no longer lend to any of these sectors because of prior bad experience?  Come off it.
    Replacement, low-carbon, generation will take time to build as you say.  In the meantime, high-carbon generation will remain open, whoever owns it and whatever write-downs they have suffered.  This is not like an Ansett, say, whose jets were sold off overseas to pay off creditors.  The power stations are going nowhere.

  7. Dave, there is nothing wrong with banks taking a loss when they have made a bad loan, that is capitalism. This is not a credit risk issue, it is a sovereign risk one.
    – non recourse project finance is a critical element of the infrastructure capital markets, to imply that it is some kind of greedy leverage play on the part of the banks is ridiculous.
    – the point that carbon pricing has been seriously on the cards in Australia for over a decade, let alone when these deals were done is rubbish. Australia didn’t even sign the Kyoto protocol until 2007! I would argue one side of politics still isn’t seriously on board. And the one chance we had cost the leadership of two political parties.
    – given this, you undertake a long term billion dollar financing on the best available information. For what it is worth, banks obviously would have run downside cases however carbon price estimates a decade ago were far lower than what they are now.
    – you assume that given all this, the debt next year will be refi’d with no assistance
    – I would suggest this is fantasyland.

  8. Bob,
    The Kyoto Protocol was adopted in 1997.  Australia was a signatory, although it delayed ratification, as you note.  So, carbon mitigation has been “on the agenda” for at least 15 years.
    I am not saying banks were “greedy”.  I’m saying that they took a calculated risk.
    I never said that the debt will be able to be rolled over.  I said that if the generators become insolvent their power stations will nevertheless keep on operating.

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