Volume 16 | NOV 2014

 

FEATURE ARTICLES

Pathways to growth: the reform imperative
Deborah Cobb-Clark, Barbara Broadway, Melisa Bubonya, Hielke Buddelmeyer, Abraham Chigavazira, Markus Hahn, Nicolas Herault, Paul Jensen, Jinhu Li, Gary Marks, Kyle Peyton, Tim Robinson, Chris Ryan and Sam Tsiaplias

Future of work: people, place, technology
Elisabeth Lopez and Peter Gahan

Why we need more powerful multinational corporations
William H. Starbuck

Lessons from a career in banking
Harrison Young

Starting points for a next-generation social contract
Thomas A. Kochan

Resolving energy policy dilemmas in an age of carbon constraints
Ross Garnaut

Celebrating luminaries in the field of accounting
Gunther Burghardt

What can economics tell us about guns and crime?
Andrew Leigh

Resolving energy policy dilemmas in an age of carbon constraints

Australia can return to its traditional position as a low-cost energy producer even in a world of renewable energy.

(Pages 47-55 of the printed journal)

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By Ross Garnaut

Illustration

Australia is the world's largest exporter of coal, uranium and (energy-intensive) aluminium; and will soon be the largest exporter of natural gas. Amongst developed countries, Australia has by far the greatest per-capita potential for low-cost production of energy from most of the promising renewable sources: solar, wind, biomass, deep geothermal, wave and tidal. It has two developed hydro-electric sources that are large enough to assist substantially in the balancing of intermittent renewable generation. East Gippsland and adjacent Bass Strait possess excellent proven geological structures for storing carbon dioxide adjacent to immense low-cost fossil fuel resources. If capture and storage of carbon dioxide from fossil fuel combustion works commercially anywhere, it will work in southeastern Victoria.

For many years, fossil energy endowments have contributed to Australians' high standard of living as sources of relatively low-cost electricity for households, as coal and gas exports and as inputs into exports of processed metals. However, China's resources boom interacting with policy innovations of the early twenty-first century turned Australia from a relatively low-cost to a relatively high-cost energy provider for domestic users. A timing coincidence caused the beginnings of climate mitigation policies to be blamed for the energy price increases.

Global energy developments

Post-2000, global energy markets have received four large shocks, namely:

  • Unprecedentedly strong growth in demand for energy driven by strong and energy-intensive economic growth in China, forcing big lifts in oil, coal and gas prices;
  • High energy prices and concern for the environmental impacts of energy use, leading to higher energy-efficiency and lower energy-intensity of economic growth, most powerfully after 2008;
  • High energy prices and incentives to reduce greenhouse gas emissions in developed countries, leading to sharply increased use of renewable energy, eventually leading to reduced costs as the scale of deployment increased; and
  • High energy prices driving deployment of unconventional gas technologies which increased supply from about 2008 and continues to do so.

Into the early 2000s, the standard forecasts anticipated that low global energy prices would endure. Although prices rose steadily as demand increased from China and a robust world economy, expectations of low prices persisted and discouraged investment in new mining capacity. In early 2003, Rupert Murdoch famously declared that the 'greatest thing' to come out of the invasion of Iraq would be 'cheap oil' the return of oil prices to $US20 per barrel.

It didn't turn out that way. The global economy expanded strongly, especially in Asia where it was exceptionally energy-intensive. China entered a decade of the fastest expansion in any economy ever. Global energy demand grew prodigiously. Global oil, coal and gas prices rose until the GFC of 2008.

Strong developed-country growth and its contribution to energy demand ended with the GFC. Developing-country growth in output rebounded strongly from 2009, but its relationship to energy use changed after 2011. Moderately slower growth in China and the developing world interacting with improved energy efficiency increased supplies; and lower costs of renewables and the advent of unconventional gas placed downward pressure on fossil fuel prices. Meanwhile, mining companies' expectations on price caused massive investments in expanding coal supplies just as the extraordinary growth in demand was concluding.

In China there was almost no reduction in energy intensity between 2001 and 2011, despite high global energy prices and increased integration of domestic into international energy markets. Investment shares of expenditure rose to the highest levels ever in any economy over a long period and contributed to high energy- and metals-intensity of economic growth. China's demand for coal made the first decade of the twenty-first century a time when the world quickly ran out of time for taking action to reduce the chances of dangerous climate change.

From late 2008, China gradually moved towards a new model of economic growth that would increase the consumption shares of expenditure, and reduce the intensity of energy use and carbon dioxide emissions. We are still in the early stages of the new model and investment shares of output have not yet fallen. Still, aggregate economic growth decelerated from an average of 10 per cent per annum in 20012011 to 78 per cent. By 2012, structural change and lower growth were substantially reducing the increase in Chinese and therefore global energy demand. Local environmental and global climate change concerns drove a sharp decline in the coal share of energy, and resulted in increases in renewable and nuclear energy. Although the huge upward pressure on global fossil fuel prices from Chinese economic growth ended in 2011 and will not return oil prices have stayed high as a result of resource constraints and limits to short-term substitution away from oil in energy use.

Figures 1, 2, 3, 4 and Table 1 tell the story of changing global energy demand and prices through the early twenty-first century.

Figure 1: Primary energy demand

 Figure 1: Primary energy demand

Figure 2: Coal consumption of China compared to other countries

 Figure 2: Coal consumption of China compared to other countries

Figure 3: Crude oil and coal annual prices

 Figure 3: Crude oil and coal annual prices

Figure 4: German hub, German oil-linked, and US Henry Hub gas prices, 2008-14 (/mmbtu)*

 Figure 4: German hub, German oil-linked, and US Henry Hub gas prices, 2008-14 (/mmbtu)

*Prices shown are historic until year-end 2013, thereafter forward curves. From Mark C Lewis 2014, Europe's Electric Shock: Lessons for Australia.

Table 1: Renewable-electricity production by source in Germany (GWh)

 Table 1: Renewable-electricity production by source in Germany (GWh)

*The 2012 and 2013 figures represent the German Government's estimate in 2010 of the indicative trajectory for Germany achieving its 2020 target for renewable energy under the legally binding EU-wide targets signed up to by all Member States under the Renewable-Energy Directive. **Preliminary estimates. From Mark C. Lewis 2014, Europe's Electric Shock: Lessons for Australia.

A closer look at electricity demand and supply

After many decades when electricity demand grew inexorably, post-GFC there was an absolute decline in electricity use in almost all developed countries. China began to enforce policies designed to reduce the energy intensity of growth by 16 per cent over the five year plan period 20112015.

China's focus on improved energy efficiency interacted with efforts to reduce the intensity of greenhouse gas emissions and reduce carbon-particulate emissions for health reasons. Growth in electricity demand fell to an average of 6.3 per cent in 20122013 and expansion of coal use in electricity generation fell to an average of 3.25 per cent per annum after a decade of double-digit growth. The majority of the increase in generation came from hydro-electricity, wind and nuclear. Solar increased by 270 per cent per annum and became a significant element in energy supply for the first time. During 20132017, China's generation of wind power is expected almost to double, and its solar power generation to rise more than threefold. These absolute increases far exceed Australia's total electricity generation capacity of all kinds.

China was first involved in this global shift to renewable sources of electricity as a source of capital goods for other countries solar panels, wind turbines and hydro-electric generators. The increased scale dramatically reduced prices, making renewable energy competitive with fossil energy in some circumstances, especially where the decentralised nature of renewables production allowed investment in transmission and distribution to be reduced or avoided.

Measures to reduce carbon emissions also favour nuclear power. After more than two decades of stagnation, major expansion programs began to be implemented in China and India. Lowered costs in China meant that in early 2011 the authorities anticipated that nuclear power costs would be competitive with coal in East China as early as 2016.

The Fukushima meltdown in March 2011 resulted in the closure of all Japanese nuclear plants (with some now reopened) and the closure of some in Germany, with total closure slated for 2020. Elsewhere, China continued with new plants under construction, but with strengthened safety requirements, and India's policy trajectory was broadly similar. China and India are both engaged in large-scale state-supported research on thorium-based nuclear energy.

The reduction in the costs of renewable energy capital goods has permanently changed the energy supply choices available to other developing countries. South Asian and African economic development is structurally different from China's; and these regions are unlikely to experience the extreme energy-intensity of recent Chinese economic growth.

The unconventional gas revolution

The third major global energy shock came from the application of unconventional gas technologies after 2008, driven by high fossil fuel prices. Production of gas from coal seams had its main early applications in eastern Australia, and from shale in the US. These technologies are gradually being deployed in other countries and will have a large impact where geological conditions are suitable.

Trade restriction in the US has created a fragmented global market. Intercontinental transport of gas is expensive, especially if it involves sea voyages and therefore liquefaction (Figure 6). East Asian prices reflect prices in exporting countries including Australia, plus transport costs; and are the highest in the world. The US once had relatively high prices, but the combination of increased domestic unconventional gas supplies and export restrictions has pushed prices to the lowest amongst developed countries. Eastern Australian prices, once the lowest in the developed world, are on a path soon to be the highest outside East Asia.

Figure 5: Regional gas prices in the Gas Price Convergence Case

 Figure 5:  Regional gas prices in the Gas Price Convergence Case

Figure 6: Spot the carbon price: electricity price and CPI

 Figure 6:  Spot the carbon price: electricity price and CPI

Environmental concerns favour gas over coal. The relative ease with which production can be varied in gas-powered generators also increases demand for gas for balancing natural variations in renewable energy output. But gas, like electricity, is experiencing the price effects of slowing demand. With the new technologies rapidly expanding gas supplies, these influences are likely to lower global gas prices.

The large price differentials across regions are likely to diminish through the erosion of US export restrictions and the eventual redirection of exports from the former Soviet Union away from European towards East Asian markets. The end point should see similar prices in the export countries Australia and the US, with each lower than European and East Asian markets to an extent that reflects international transport costs. Figure 5 plots one of the possible convergence scenarios.

Abundant cheap energy to abundant expensive energy in Australia

Energy costs everywhere have tradable and non-tradable components. The tradable component the cost of energy raw materials varies across countries with transport and transactions costs and restrictions on trade. The non-tradable component varies with the real exchange rate and the relative efficiency of Australian energy production. Relative efficiency is affected by the regulatory environment.

Tradable and non-tradable components of costs have both increased more rapidly in Australia than elsewhere post-2000. The tradable component has increased because export barriers have become less important in Australia and more important in some other countries, notably the US. The increase in the non-tradable component arises from the large appreciation of the real exchange rate through the resources boom and a dramatic fall in the productivity of distribution in Australia mainly due to flawed regulatory arrangements. The Australian Bureau of Statistics estimates the average decline in total factor productivity in Australian utilities at 4.5 per cent per annum between 20072008 and 20112012. Eventually, a substantial correction will come to the real exchange rate, which will reduce the excess of Australian over international energy costs.

A large part of the increased relative costs of electrical energy in Australia derives from the regulatory reform that was completed in 2006. The changes separated eastern Australian wholesale, transmission, distribution and retail markets and established a competitive wholesale market for power. This wholesale market is working well and should be left alone.

With the transmission and distribution functions, both natural monopolies, we have created difficulties by seeking to regulate price principally by reference to rate-of-return (ROR). Averch and Johnson (1962) demonstrated that setting the ROR too high spawns wasteful over-investment; setting it too low causes under-investment, risking service failure. We have set the ROR too high, and investment and therefore electricity prices have increased at rates beyond both past Australian experience (Figures 6 and 7), and the recent experience of other developed countries.

Figure 7: Electricity consumption and unit costs of network and wholesale power

 Figure 7:  Electricity consumption and unit costs of network and wholesale power

Reducing the regulated ROR would immediately reduce the dominant 'return on capital' component of network costs, and lessen incentives for wasteful future investments. The Australian Energy Regulator has taken a first step in this direction. The inherent problem of ROR regulation will remain, and there will still be a massive overhang of excessive investment earning a return, and unnecessarily raising prices. Higher prices reduce demand for all electricity and make self-provision through solar photovoltaics more attractive. Lower demand forces another increase in prices to secure guaranteed RORs for network owners, further reducing demand and increasing prices (see Figure 8).

Figure 8: Eastern Australian electricity demand 2005-13*

 Figure 8:  Eastern Australian electricity demand 2005-13*

With solar costs continuing to fall and Australians using less electricity, demand for power from the centralised system is likely to continue to shrink and complement an expanding decentralised system. Getting this relationship right will maximise the likelihood of restoring Australia's position as a low-cost energy economy.

The transmission system is straightforwardly a natural monopoly. An oversight planning agency should consider truncating the integrated grid through sales to interested parties of sectors not generating benefits that warrant the spreading of costs amongst all users. Established private owners in South Australia and Victoria could retain their current roles, but extension of private ownership would allow for separation of management from ownership, with rights to ownership being sold by tender to parties seeking low-risk investments without necessarily having management responsibilities. Charges for use of transmission would be related mainly to access to capacity at specified times in the day and year, reflecting the relevant marginal cost of transmission.

Reform to the distribution function should involve users being charged for capacity rather than volume of use, with the right to buy and sell access to capacity in specified locations. New users would buy new capacity from others, or pay the marginal cost of capacity to service their requirements. This would bring to account the greater capital costs of energy infrastructure for 'greenfields' expansion of cities compared with denser settlement of established areas and create incentives to reduce peak-power requirements and facilitate greater use of storage at the place of use for example by integrating the energy requirements for households and electric cars.

Cost hikes in the retail sector mainly reflect heavy expenditure on marketing. Greater competition in retail services would encourage development of services which focus on overall cost reductions, unaffected by retailers' interests in established generation capacity. Integration of distribution and retail functions would expand opportunities for cooperation between energy service suppliers and users to reduce electricity costs.

The need for large-scale reform argues for caution in privatising network assets that remain in state ownership. New privatisations should await fundamental reform of network pricing systems. Conversely, the competitive wholesale power market provides favourable economic conditions for the sale of generation assets which should be structured to expand competition wherever possible.

Illustration:Resolving energy policy dilemmas in an age of carbon constraints

Increases in Australian energy prices in the immediate future are probably unavoidable. The electricity story is complex. Established policy would see some reduction of wholesale prices, possibly exceeding any upward pressure from increased prices for renewable energy certificates required for compliance with the Renewable Energy Target. Downward adjustments in regulated RORs should reduce network costs, but this will be outweighed initially by momentum for expanded network investments due to the current ROR distortions.

There are longer-term prospects for restoring Australia's relatively low energy costs. Expanding domestic gas supplies will reduce prices to export parity, which should fall with international convergence. Reform of network regulation and ownership has the potential to gradually remove the huge excess burden imposed by regulatory distortions since 2006. The eventual reversal of much of the real exchange rate appreciation of the resources boom will see a substantial fall in Australian relative energy costs.

Reconciling environmental, commercial and economic objectives

Resources development has negative environmental and positive commercial effects. Good economic analysis takes environmental damage into account in assessing the value of projects. Sound institutional and policy arrangement, based on objective scientific assessments, can reduce the supply price of investment and greatly improve the trade-off between environmental and commercial values, while maximising economic value.

It has become difficult to place scientific assessments at the centre of policy in Australia. Big business has never been so directly influential with Government, compounded by an extraordinary fact the four business leaders who have been given the most senior advisory roles to the current Commonwealth Government share a strong view that the science is wrong on the crucial environmental issue of climate change.

Objective reading of the science leaves no reasonable doubt that the release of greenhouse gases into the atmosphere imposes costs on humanity. The rigorously calculated assessments range from around $US10 per tonne of carbon dioxide equivalent to well over $US40 per tonne, and rising over time. No legitimate assessment based on the science says that the external cost of carbon emissions is near zero.

Illustration:Resolving energy policy dilemmas in an age of carbon constraints

The relationship between economic activity and carbon emissions is changing but not fast enough to avoid substantial costs from human-induced climate change, or to be confident that we will hold temperature increase to two degrees Celsius. Virtually all developed countries are now experiencing large reductions in energy-intensity of economic output and absolute reductions in carbon emissions. Particularly for Australia and the US, this represents a radical change in trajectory. The move in Australia to repeal the carbon laws enacted in 2011, and replace them with an ineffective Emissions Reduction Fund does not make sense to anyone who understands the implications of the science on climate change. Policies that take full account of external costs are most likely to be achieved with broadly-based carbon pricing. Australia now has the laws and institutions and administrative systems that can do the job effectively and at low cost. Better to keep the laws and gradually to make them more effective.

Australians doing well through the global energy transition

While many factors post-2000 changed Australia from a country with relatively low to relatively high domestic energy prices, this shift was not caused by the introduction of carbon pricing. For Australia to realise its potential to become a relative low energy-cost economy in a low-carbon world will require a depreciation of the real exchange rate, fundamental reforms to the institutional arrangements for transmission and distribution of electricity, and an appreciation of the role of honest science in official policy.

The reality that others are moving to reduce the energy- and emissions-intensity of economic activity has large implications for Australia. These actions have changed radically the demand for coal, and left 'stranded' many billions of dollars of investment in coal mining. The costs of renewable energy have fallen to the extent that the economic foundations of the old centralised power systems have been shaken and cracked.

Australia has immense advantages as a producer of energy. We now must use these advantages in the low-carbon world to which the rest of the world has been travelling gradually and along which it will continue to travel. This is the world for which Australians must construct energy policy for the future.

References

Averch, H, and Johnson, LL 1962, 'Behavior of the firm under regulatory constraint', The American Economic Review, vol. 52, no. 5, 1052-1069.

Garnaut, R (forthcoming) 2014, 'China's role in global climate change mitigation', Journal of China and World Economy.

Lewis, MC 2014, Europe's Electric Shock: Lessons for Australia. Report prepared for Energy Supply Association of Australia drawing from Deutche Bank Global Energy Research.

Wood, T, Carter, L, and Harrison, C 2013, Shock to the System: Dealing with Falling Electricity Demand, Grattan Institute, Melbourne.

Acknowledgements

I am grateful for assistance from Veronica Webster, Derek Cheng and Xin Lih Loh.

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A condensed version of the 2014 John Freebairn Lecture given at the University of Melbourne on 20 May 2014. A fuller version of the lecture will appear in the December 2014 Australian Economic Review.

Ross Garnaut AO is Professorial Research Fellow in Economics, the University of Melbourne, and a former Australian Ambassador to China.


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