ssue 41, July 2008

Feeling the heat

Publication of the Garnaut Review draft final report has immediately lifted Australian governments -- all ALP -- and the front bench of the Federal Opposition out of their comfort zone. While publication of its green paper this month will give the Rudd Government a short breathing space, decisions now need to be made and the spillover in to State and Territory politics is immediate.

The concern of the power generation sector that brown coal plants will be forced out of operation by the proposed emissions trading regime makes Victoria Ground Zero for the political debate.  Richard McIndoe, managing director of China Light & Power's TRUenergy subsidiary in Australia, owner of Yallourn power station in the Latrobe Valley, says introduction of the proposed scheme, without allowance for coal power's circumstances, could cause the Victorian generators to write down their assets by 90 percent, or $12 billion -- "a dramatic financial impact."

The first indication of State and Territory government reaction to the draft report, with its major implications for local energy-intensive industry, will come via the Council of Australian Governments' Ministerial Committee on Energy, which has agreed to a special meeting in Melbourne in July to discuss the issue.

Garnaut observes: "Climate change is a diabolical policy problem, harder than any other issue that has come before our polity in living memory."

In contemplating Garnaut's report, political leaders are also confronted by ANU professor Warwick McKibbin, co-director of the US Brookings Institution project on climate and energy economics, who warns: "The Garnaut approach delivers a good outcome only if all major countries trade permits in a global emissions market." McKibbin comments that the Garnaut model seem to be more about income redistribution than reducing Australia's carbon footprint at the lowest cost.

Benign no more

While almost all media focus has been on the carbon charge issues of the Garnaut Review, the report contains some major reflections on national energy market issues.

Garnaut reports that there has been an increase of 60 percent in construction costs per installed kilowatt of power plants since 2004.  "The dynamics of what had been a relatively benign environment for the domestic energy sector has been challenged," he says.

Rising capital costs are starting to affect Australian electricity prices, Garnaut points out, adding that this has been exacerbated since last year by the impact of drought on hydro-electric systems and on cooling for coal-burning power stations.

While long-term contracts for black coal supply, the unsuitability of brown coal for export and the absence of LNG exports from the East Coast have sheltered the domestic power sector from global uplifts in coal prices (180 percent in three years and 118 percent in the past year) and gas prices, this is not sustainable, he argues. "Contracts will be renegotiated, new coal export infrastructure is being developed and several East Coast gas export projects have been announced."

While a $10 per tonne carbon charge will add $8 to $10 per MWh to the wholesale electricity price, Garnaut points out, an increase of $3 per gigajoule in the domestic gas price (bringing it close to export parity) would add more than $20 per MWh to the price of gas-fired electricity. An increase of $100 per tonne in black coal prices would add $53 per MWh to coal-fired wholesale power prices.

He forecasts that domestic gas prices will rise rapidly towards export parity and stay there over the long term.

Network stress

The Garnaut Review throws the issue of electricity transmission planning back on to the CoAG table.  The Council embraced the recommendations of the ERIG report last year -- chiefly the establishment, now underway, of a national transmission planner -- but Garnaut tells chief ministers they should rethink the planning role.

The problem, he points out, is that in a carbon-constrained environment many new sources of electricity -- for example, the large geothermal resource in the Cooper Basin in central Australia -- can come from areas not currently serviced by transmission or where the networks will not be able to cope with additional supply. "Current processes for extending the electricity network are likely to be sub-optimal from a societal perspective," Garnaut argues, "because they do not provide any mechanism for the exploitation of economies of scale. In some circumstances it may be desirable to provide additional transmission network capacity ahead of generation capacity."

Shorn of its "Yes Minister" tones, what this recommendation is telling CoAG is that there will need to be a multi-billion outlay on new transmission links in order to bring on the renewable energy required to replace the fossil fuel energy driven out of the market by carbon charges.

Part of the headache for CoAG in this respect is that the Garnaut recommendations resurrect a furious behind-the-scenes row from earlier in the decade -- with State government-owned transmission businesses successfully scuppering the ERIG push for the planner to have a building role.  Garnaut recommends that the planner needs to be given a financial role for priority projects -- including providing "incentives" for remote supply.

"The planner (should be) provided with a pool of funds to support suitable network projects," he says.

Can NEM survive?

One of the major competitive developments of the past decade has been the introduction of the National Electricity Market, which CoAG is in the process of turning in to an energy market, including gas in its operations, at present.  Now the Garnaut Review has raised the question: "Will the NEM survive the introduction of emissions trading?"

Garnaut says the trading scheme has major implications for NEM participants and their business models and strategies. This includes his proposal for a new approach to building transmission with its flow-on effects for existing generation.

Ensuring that the structure, policies, procedures and governance of the NEM accommodates the trading scheme will require "close involvement of key industry agencies with business to ensure any unforeseen consequences are identified and addressed early," he adds.

Energy intensive

The Garnaut Review finds that Australia's economy is the eighth most energy-intensive among OECD countries -- and about five percent less energy-intensive than the world average.  Garnaut adds that the carbon dioxide emissions intensity of Australian electricity supply is the highest of any OECD country -- and 74 percent higher than the world average.  He does not, however, provide residential and industrial retail power price comparisons -- Australia is among the five lowest-cost countries in the developed world for both.

The current reliability and low domestic price of energy have been largely taken for granted by the Australian community, Garnaut comments. "These realities are changing rapidly."

Who pays for piping?

Should governments play a major role in the development of a pipeline network to deliver captured carbon dioxide to its burial point? The Garnaut report says the preferred outcome would for the private sector to provide the infrastructure, critical for introduction of "clean coal" technology, but it warns that governments may need to step in to "support construction at a socially optimal scale" as well as to regulate pipeline construction and to provide "contingent subsidies."

No nukes -- probably

It would imprudent, "indeed romantic," to expect to see the community agree to deployment of nuclear power in Australia, according to the Garnaut Review. 

The report points to "community antipathy" during last year's federal election to support its contention and argues that the national interest will be best served by continuing to focus on exporting uranium while developing low-emissions coal power, gas plants and renewable energy for domestic electricity supply.

However, Garnaut adds, this attitude might need to be reconsidered if new nuclear technology can be developed at relatively low cost, there are improvements in storage arrangements for radio-active waste, "clean coal" development does not live up to expectations and community disquiet about nuclear power eases. 

Hydro uplift

The Garnaut Review foresees Snowy Hydro and Hydro Tasmania doing well out of a carbon constrained environment -- although how this squares with predictions that global warming will bring more droughts is not canvassed.

Garnaut says that, while there is little likelihood of more hydro power storage dams being built, "there is scope for much better utilisation of existing capacity in an environment where renewable power has greatly increased value."

He sees the growth in intermittent power sources -- wind and solar -- and above-average growth in peak demand enabling the 3,676 MW of the Snowy scheme and the 2,278 MW in Tasmania to develop "increased value, far beyond that suggested by their installed capacities alone" with power from intermittent sources at times of low demand being used to pump water in to storage for use at times of greater value.

Garnaut comes out on the side of privatising the hydro schemes. 

Public ownership, he says, has applied constraints on their supply of capital. "These constraints have high opportunity costs in the emerging environment (and) it is important they be removed."

Not happy

The National Generators Forum has snapped back at the Garnaut Review that the draft report is "simplistic" and "shows little understanding of how Australia's energy market works."

The NGF, which represents nine out of 10 generation businesses, most of them coal-fuelled, complains that Garnaut has chosen to ignore that failure to take account of the financing and risk implications of the trading scheme for sector "runs the very real risk of leaving Australia reliant on an insecure supply of electricity, especially in the short term.

It warns that what Garnaut proposes "can only lead to much higher costs" and a "major economic dislocation."

Seriously not happy

Although he has become the mock object of Sydney newspapers and other media over his ebullient public style, NSW Treasurer Michael Costa holds one of the top 20 government jobs in Australia -- given the size of the State economy for which he is accountable -- and he has Ross Garnaut square in his sights.

"For States such as NSW," writes Costa in a contribution to The Australian opinion page, "energy security is at the heart of emissions trading. This is a serious and real problem, which in typically neo-classical economic style is assumed away in Garnaut's report. Everything in Garnaut's world is frictionless, has no transaction costs and is equilibrating (over time of course).  Meanwhile, back in the real world, there is a clear need for fair compensation for the nation's power sector, not only to offset the significant asset value losses that will flow from the introduction of an ETS, but to ensure the ongoing investment required to maintain security of supply.

"Despite acknowledging the extent of economic restructuring, the report dismisses the potential disruption an ETS could cause to energy supply and the flow-on this would have to the broader economy.

"The extinguishing of property rights represented by the reduction in asset value in the generation sector because of the ETS would be unprecedented for an Australian government."

On the impact on energy-intensive manufacturing, Costa adds: "These industries face global competition from countries that have no commitment to implementing major emissions reduction policies. Significant technological breakthroughs (in Australia) will be required to achieve large-scale emissions abatement. The costs of these technologies are uncertain, providing another competitive disadvantage."

Costa sets three key hurdles for the emissions trading scheme design -- it needs, he says, to take in to account:

Victoria goes for gas -- and coal

The Victorian Government has welcomed the Origin Energy decision to spend $640 million on a natural gas power plant -- at 550 MW, the largest built in the State since the early 1990s -- and it has provided $50 million of taxpayers' money to support development of a new coal-fired project.

The coal plant is a $750 million development by HRL, another privatised descendent of the SECV, in partnership with China's Harbin Power Engineering Company.  Also supported by $100 million in Federal Government grants, the 400 MW project will dry and gasify brown coal, producing 30 percent less carbon dioxide than conventional power stations and using 50 percent less water.

State Energy Minister Peter Batchelor notes that, if the process to be used by HRL was substituted for the Latrobe Valley's other brown coal power stations, greenhouse gas emissions from the Gippsland operations would be cut in half -- and reduced to near zero if carbon capture and storage was also used.

On the capex values of the new plant, it would require an outlay of about $12 billion to replace the existing power stations -- plus the cost of capture and storage systems.

The Origin Energy development was take place near Mortlake in Western Victoria and is intended to have 1,000 MW capacity eventually


There are two good things about the draft final report of the Garnaut Review on emissions trading:  One is that it adds usefully, where it is being analytical rather than doctrinaire, to the body of information that has been accumulating in Australia over the past decade on energy supply and use.  The other is that it leaves the politicians nowhere to hide on the global warming issue -- years of fuzzy, warm rhetoric are now confronted with the stern (pun intended) reality of implementing carbon charges in an energy-intensive Australian economy.

The massive problems inherent in artificially driving up energy prices, and especially electricity costs, motivated John Howard for most of his prime ministership to maintain "implacable opposition" to emissions trading, a stance that went out the window in 2007 as the panic of imminent political destruction set in.

The core problem for the Rudd Government is that it is now trying to implement a political promise made some 18 months ago in a very different global environment -- the current credit crisis and consequent bonfire of stocks and shares around the world would be bad enough, but the rocketing oil price has created an environment that is not conducive to radical domestic economic shifts in the name of "leadership" on global warming.

Warwick McKibbin, ANU professor and luminary of the US Brookings Institution, an internationally-recognised economist, required just nine paragraphs in The Australian Financial Review on 7 July to demolish the Garnaut house of cards, all 540 pages of it.

McKibbin rejects Garnaut's approach because (a) it is not possible to know what it will cost, (b) it relies too much on the wisdom of governments here and abroad, (c) if it fails, the Australian economy will be "precariously placed" and (d) it delivers a good outcome only if all countries are allowed to trade emissions permits in a global market.

In a classic academic putdown, McKibbin observes: "Economists would not argue for a country to take on an arbitrary target with an arbitrary timetable for reductions and then try and reach the common price (for emissions permits) through global trading across markets."

Compare and contrast this with the facile political rhetoric of Treasurer Wayne Swan on the same page of the Financial Review: "Do we accept that we have obligations to our kids and grandkids that demand that we front up to this challenge and take decisive action now?"

By contrast, NSW Treasurer Michael Costa, whose government has much to lose if the trading scheme batters power generation and energy-intensive manufacture, vigorously rejects what he categorises as Garnaut's "hope and pray" approach to energy security.

One luxury that the Government does enjoy at the moment is the truly astounding lack of public understanding of the issue -- as witness a recent opinion poll showing simultaneously that 70 percent of those interviewed express ignorance of emissions trading and wholehearted support for its introduction.  However, the Rudd Government is already seeing in the more general opinion polls an emerging unease among voters. "Kevin 07 -- mistake 08" is a catchcry taking hold.  The unexpectedly large swing to the Coalition in the Gippsland by-election is another indicator to the Federal Government that the voters know what they don't like.

Weigh this against the fact that, in New South Wales alone, according to a recent Australian Industry Group presentation, the State's manufacturing industry employs 327,000 people -- accounting for 32 percent of the national sector. That extrapolates to a million Australians overall in the manufacturing industry, all of them at risk in the existing economic environment, let alone one where large arbitrary energy costs are proposed for addition to large increases already flowing through from the global marketplace.

Garnaut himself notes that the flow-through of global prices for coal and gas to the Australian market -- something he thinks will happen -- will add $20 per MWh to wholesale gas plant prices and $53 per MWh to coal-fire electricity wholesale prices.
To this under his scheme can be added an increase of between $24 and $30 per MWh to wholesale electricity prices as a result of a $30 a tonne carbon charge -- and it will take at least $30 to start driving coal power to the back of the NEM dispatch order, the prerequisite to achieving meaningful abatement of Australian carbon dioxide emissions.

(This is another area where the Rudd Government is being duplicitious, dog-whistling to the growing green, anti-capitalist segment of voters that it will deliver "lower emissions" -- lower than what? -- while promising (Swan) the more conservative majority that it will "strive to maximise economic prosperity." A $10 carbon charge barely impacts on the growth of greenhouse gas emissions from Australia; as Tim Flannery has pointed out, it will take a charge of about $70 to drive emissions down towards 1990 levels.)

The Federal Government will be hearing from the State and Territory governments on all this in the very near future -- see above -- and it cannot hold off making a decision indefinitely.  Uncertainty is a cancer for business investment and international investors have many places other than Australia to locate their energy development dollars -- as do energy-intensive manufacturers.

As NSW Treasurer Costa put it in his polemic against the Garnaut Report, "Value judgments -- that is political considerations -- will be the determining factor." Waiting for signs of judgment to emerge is proving a bit nerve-shredding for more than a few in the investment community.

Keith Orchison
9 July 2008

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