Australia’s coal industry ‘making billions’ from carbon tax

Last updated on 25 February 2013, 9:38 am

Coal fired power stations are making huge profits from Australia’s new carbon tax while passing costs to consumers, an analysis published on Wednesday reveals.

It finds that since the introduction of a carbon tax in July 2012, electricity generators have passed on over 100% of the carbon price to retailers, while keeping $1 billion in cash compensation payments aimed to help heavy polluters make a transition to low emission generation.

Environment Victoria’s report cites figures from Australia’s Energy Market Operator, which suggest prices have increased by AUS$21 per MWh since the tax was implemented.

It warns that unless compensation payments from the Energy Security Fund are reviewed, generators could make windfall profits between $2.3 billion to $5.4 billion, depending on a future carbon price.

The Australian government rejects the report’s findings, saying it is driven by “ideological opposition to any form of brown coal fired generation”.

Brown coal accounts for 92% of electricity production in the state of Victoria (Pic: Environment Victoria)

Environment Victoria’s Mark Wakeham says consumers are “paying twice”, once for the tax transfers to major emitters, and also through their utility bills.

“Given this new evidence, it is critical the Gillard Government reviews the Energy Security Fund compensation to maintain the integrity of Australia’s carbon pricing package,” he said.

“The Gillard Government never intended for the compensation payments to be used as windfall profits but that appears to be what’s happening.

“Taxpayers should not be funding polluting activities and making our dirtiest power stations more profitable.”

Wakeham wants the government to review compensation payments to generators during forthcoming federal budget discussions. The next payment is scheduled on September 1.

Report author Bruce Mountain, from consultancy CME, based his findings on figures from the state of Victoria, the second most populated state in Australia.

“In the first six months since the introduction of the emission price, generators in Victoria seem to have been able to pass on all of the cost of the emission permits, through higher electricity prices in the spot market,” he said.

“Assuming the generators are able to pass on a similar proportion of the carbon price in future, the Victorian brown coal generators, which receive over 90% of Energy Security Fund payments, can expect to accrue additional operating profits somewhere in the range of $2.3bn to $5.4bn (Present Value) depending on emission prices in future.

“Others warned against compensation payments for generators stating they were unnecessary. The level of pass-through that has been observed so far has been unexpectedly high, and seems to vindicate their concerns.”

‘Illogical’ findings

Not all analysts agree with these findings. A response from Frontier Economics entitled Mountains from Molehills argues that ‘six months is an insufficient sample to draw any meaningful conclusions’.

In a statement sent to RTCC, a spokesperson for Greg Combet, Australian Climate Change Minister said the report was simplistic.

“The idea that the most emissions-intensive generators are passing through more than 100 per cent of the carbon price at the same time as market emissions were reduced by 8.6 per cent does not accord with logic, proper analysis of wholesale market data or the views of industry experts,” they said.

“In the first six months of the carbon price the Australian Energy Market Operator data demonstrates a 6% improvement in the emissions-intensity of generation in the National Electricity Market and a 2.7% drop in demand which have resulted in 7.6 million tonnes less emissions than the same period in 2011.”

Black and brown coal accounts for 75% of total electricity production in Australia (2010 figures), followed by gas and renewables.

Brown coal releases more carbon emissions than any other fuel, and is a major target of campaigners in Victoria as it fuels 92% of the electricity generated. More than 65 million tonnes are burnt every year.

Bruce Mountain

22 February 2013

CME response to Frontier Economics’ note “Mountains from Molehills”

Frontier Economics’ Matt Harris has written a critique (for want of a better term) to my recent report for Environment Victoria. Mr Harris considers the report to have “many flaws”. He says that he “strongly disagrees” with the analysis, that it lacks “common sense”, that it makes “ridiculous arguments” and so on.

In summary I reject Mr Harris’ critique, but for the sake of defending my reputation from a rather unseemly attack I have taken the time to write this letter to you. This is an open letter, and I have copied it to other journalists who have reported on my report for Environment Victoria, to which Mr Harris’ critique refers. Please feel free to distribute it as you see fit.

Before writing this letter, I telephoned Mr Harris to ask him if his critique was commissioned by a client, and he said it was not. He said he wrote it purely because you had referred to a study that Frontier Economics had done that concluded that Victoria’s brown coal generators would have net gains as a result of the Energy Security Fund payments.

It is worth noting that the Frontier Economics study mentioned concluded that Victorian generators stood to gain between $400m-$1b under carbon pricing arrangements for which they were strongly criticised by Minister Combet who said “I don’t have a lot of time for Danny Price’s work, and I don’t have for this”. It is unfortunate that a pattern seems to be emerging to attack the messenger rather than respectfully examine the issue of whether or not Energy Security Fund payments are over-generous and leading to windfall profits.

Mr Harris said that his response to my report had been sent to Minister Combet’s office and to all the journalists involved. I don’t know Mr Harris and have not had any previous interaction with him. It is not clear why he has produced such a vitriolic response to my analysis. Perhaps it might be because it reaches different conclusions to his – if not in direction then in magnitude.

As far as I can see, Mr Harris is not contending that I have made computational errors (again perhaps you can ask him directly) but he seems to take exception to what he seems to think are my assumptions and analysis. As I understand it, his main concerns are:

1. That I attribute all of the price increase in the NEM over the period of my study to carbon prices.

2. That I assume that generator output or carbon price pass-through rates will not change under any circumstances.

3. That I am wrong to assume away lower volumes in my calculation of pass-throughs.

His paper elaborates on several of these in various ways, but as far as I can see these are the essence of his criticisms. In the rest of this note I will respond to each in turn.

Response to point 1:

It is true to say that I attribute all of the price increase in the study period to the increase in the carbon prices. I am quite clear about this in my report. This is an entirely fallible assumption (as I say in the report), as indeed is any analysis that tries to unpick the various explanation for price changes in markets.

It is possible to draw attention to many reasons why prices may be higher or lower in one period compared to the next. Mr Harris draws attention to the flooding at Yallourn and notes that this raised prices in Victoria, particularly in June 2012. (As an aside the prices in the June 2012 are not used in my analysis.)

On the other hand, on 29 November 2012, prices in Victoria spiked and this increased average prices over the period from 1 July 2012 to 31 December 2012 by $4/MWh (according to Mr Harris). (Actually, to be precise the relevant issue is not the increase in the average price but the increase in the price received by the brown coal generators. The demand price spike and a spike in prices on 2 July apparently attributable to flooding at Yallourn raised prices received by the brown coal generators by $5.03/MWh.) If I had excluded these price spikes from the calculation of prices since the implementation of the carbon price, the pass-through rate would have been lower.

So, the relevant issue is how, if at all, one should adjust for factors, other than carbon prices, that may have affected prices. One approach is to attempt to list all the many different factors and then try to figure out what effect (up or down) each factor had. Mr Harris has had a go at identifying two factors (flooding and demand). In prior discussions of the report with advisors in Minister Combet’s office, other factors were suggested including Basslink outages, and mothballing and closure of plant outside Victoria. Specifically, Minister Combet’s advisors also stressed to me many times that there had been substantial mothballing or closure of coal generation plant and so you could not compare the prices before and after the carbon price. But we have an electricity market – generators are not forced to sell their produce. If generators mothball or withdraw capacity and as a result achieve higher prices, should we just imagine that this has nothing to do with the imposition of an emission price? This sort of argument is just subjective pleading (“things turned out differently but that has nothing to do with us” ) and should not be countenanced in an objective analysis.

Subjective unpicking is inevitably flawed, and prone to adverse claims. Firstly we can not know the full range of reasons why markets change from one moment to the next and secondly even if we did, we could not objectively attribute price changes to each of the factors. Those wishing to say that the impact of carbon prices was small will selectively point to other factors that they say caused price rises. Those wishing to say it was large will take the converse position. This is pointless in finding the truth, and to suggest that this sort of thing will produce a more valid analysis is mistaken.

However, before we leave this point, lets just check whether there are any big events that really distorted things, that I should have taken into account. Mr Harris mentioned the outage of Yallourn and higher peak demand in the period since the emission price was implemented, as major factors.

On the Yallourn flooding, this occurred on 6 June 2012. The capacity of the plant was reduced substantially in June and progressively restored after that. It is not clear how much of the Yallourn capacity withdrawal in 2012 was due to flooding, and how much was due to other factors such as maintenance or intentional withdrawal of capacity. As I noted EnergyAustralia seemed to make a point – in a press release – of saying that one unit would not be made available to the market. But, for the purpose of my analysis, the biggest price impact of flooding will show up in July 2012 (our study period started from 1 July 2011). If we exclude the prices in July 2012, the average price in the period 1 July to 31 December 2012 would have reduced by $2.65/MWh. This make around a 2% difference to the pass-through rate, and even then we are attributing all of the change in the Victorian spot price to Yallourn. This is not significant enough to merit exclusion or further examination.

On peak demand in November 2012, if we exclude the impact of all settlement periods where prices were greater than $350/MWh (which mainly occurred on 29 and 30 November) the average prices received by the generators in the period 1 July 2012 to 31 December 2012 would have been just over $5/MWh lower. Had I excluded these, the change in pass through (on sent-out generation) would have gone from 111% to 102%. I did think about excluding it, but decided this would be a subjective exclusion. To be consistent, I would also then have had to exclude very low price periods or made some adjustment to reflect lower demand in 2012/13 than 2011/12. Obviously once you start meddling with such adjustments, and you wish to be objective, you get into a great deal of trouble. Such subjective meddling simply undermines the credibility of an objective analysis.

(As an aside on this point, briefly, Mr Harris made a mistake in expressing all of the difference in the 29 November peak prices as a change in carbon pass-through. He took the $4/MWh change in average prices and expressed it as a percentage of the $34 increase in price between the two periods This is wrong, if the $4/MWh was attributable to peak prices, he should have compared the pass through based on the changes in total average prices – which as I said goes from 111% to 102%.)

A third approach is to simply ignore actual outcomes in trying to predict what the future holds, and instead rely on models of future outcomes in the electricity market. Consultancies such as SKM MMA, Frontier Economics, Acil Tasman and Roam Consulting have such models and they are hired to use them to predict the future. I cited these models in my study. The problem with these models is that they are sensitive to assumptions, they can not reliably predict behaviour and they imperfectly capture the physical system. Consequently they have poor predictive power. Specifically none of the modelling that was done for the Government on the impact of the emission price has correctly anticipated the (much lower) emission price expectations or (much higher) gas prices expectations that are now evident. The change in these two variables has a very significant impact on prices and pass-throughs. If these models could not even accurately predict prices so near into the future, what reliance should be placed on their predictive power far into the future? I suggest not very much. Eminent British economist, John Kay, best captures my views on the value of such models:

‘Models are a way of organising thought about the economy, not a crystal ball, and what you get out of one is a direct reflection of the analysis, the perception, and the judgments that you put in’

So, in summary on this point, Mr Harris’s criticism of the use of actual data, and that I have failed to subjectively adjust this data as he wishes, is a criticism that is unfounded. Perhaps you should ask Mr Harris to present his own analysis of cause and effect, and why it is necessarily wrong (not just because it is “simplistic”) to use actual data as I have.

However, notwithstanding all this, there is a fundamental issue here. The future is uncertain, and the issue is how we should attempt to determine what it may hold, in coming to a decision on whether the Energy Security Fund payments amount to a windfall? I faced this challenge by producing an estimated range that captures different carbon prices and different pass-through assumptions. I suggested that outcomes were likely to be towards the lower end of the range since emission prices were now widely expected to be lower than the Government expected (and this applies even if there is not a change in the Federal Government). I also noted that even if the pass-through was substantially lower than had been observed, the brown coal generators would still achieve a net profit from the scheme. This is shown in the charts of my report.

My client, Environment Victoria, has suggested the Productivity Commission should be asked to examine this issue in further detail. I agree with this. My report has established, prima facie, that Vicoria’s brown coal generators are likely to receive windfall profits from the compensation payments. Nothing Mr Harris has said dissuades me from that view.

Response to point 2.

It is not correct to allege that I assumed that generator output or carbon price pass-through rates will not change under any circumstances, as Mr Harris has alleged. To the contrary, the chart which shows the present value of the change in operating profit shows the change in this profit with a change in pass-through rates.

I did also consider whether pass-through rates would change in future from those that have been observed. I concluded that this seemed unlikely since expectations of much lower emission prices (than were envisaged when the compensation payments were decided) means that new investment in lower emission technology that would displace the emission intensive generation is now much less likely.

For the same reason (and that the sale electricity from brown coal generation is highly profitable) I concluded that a meaningful change in the volume of production from brown coal generators was unlikely. I also noted that this accorded with the Climate Change Authority’s recent modelling for the RET Review.

Response to point 3.

My response to this is captured in the text above, but for the sake of clarity I will expand on it. I suggested that the case for assuming lower production from brown coal generators after the emission price, was weak – because the brown coal generators, even after the emission price are still very profitable. Mr Harris said that “this is a ridiculous argument which demonstrates a lack of understanding of the role of generator bidding in setting electricity prices (the causal link between volume and prices)”. Mr Harris’ contention is that the fact that generator margins are positive is irrelevant, that if generators have achieved higher prices by withdrawing capacity, then we should also count the loss of profits attributable to the lower volumes. I don’t disagree with this, but I have no reason to assume – as Mr Harris necessarily does in order for his argument to hold – that the Victorian brown coal generators are able to exercise market power. It is the exercise of market power that would allow a generator to raise prices by withholding capacity (reducing production).

The Victorian electricity demand is less than the available supply from its brown coal generator for all but a few hours in the year. As the Electricity Supply Association corrected pointed out in their Press Release in response to my report, Victoria’s brown coal generators are price takers. In this context, the fact that generator margins are positive is relevant – in a competitive market the generators have an incentive to produce as long as their cost of production is lower than the prices they receive. As I noted in the report, even the much higher assumptions of emission prices (and much lower assumptions of gas prices) in the Climate Change Authority’s modeling showed essentially unchanged production by Victoria’s brown coal generators from their current levels. In view of expectations of lower emission prices and higher gas prices, the observation that Victoria’s brown coal generators can be expected to wish to maximize production is even less in dispute.

Yours sincerely

Bruce Mountain
Director