Air-Source heat pump water heaters in Australia and New Zealand

National Economic Review
National Institute of Economic and Industry Research
No. 68   October 2013

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board. The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

©  National Institute of Economic and Industry Research

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ISSN 0813-9474

Air-source heat pump water heaters in Australia and New Zealand
Graham Armstrong, Consultant, NIEIR

Abstract
This paper is based on a study prepared and presented by Graham Armstrong to the Air Source Heat Pump Water Heater Asia (ASHPasia) Forum in Shanghai, China on 17 November 2012. This study draws on two main information and data sources: the National Institute of Economic and Industry Research and Saturn Corporate Resources database for projects undertaken for a range of Australian electricity and gas distributors (low voltage wires and metering responsibilities) and retailers (customer billing, energy end-use advice and liabilities under government end-use programs); and a study for the Australian and New Zealand Governments’ E3 Equipment Energy Efficiency joint initiative entitled ‘Product Profile: Heat Pump Water Heaters, Air-source Heat Pump Water Heaters in Australia and New Zealand’ (June 2012; E3 report, available at www.energyrating.gov.au). An outline of E3 programs is provided in the Appendix.

Introduction
Although similar in many ways (e.g. having mild climates very suitable for air-source heat pumps), Australia and New Zealand have quite different energy supply and demand characteristics. Australian electricity generation is greenhouse gas intensive (GHGI), averaging approximately 1 t CO2e/MWh, and is predominantly based on coal.1 Australia has substantial gas production (approximately 50 per cent exported as LNG) and reserves (i.e. conventional, mainly offshore and onshore; coal seam methane; and shale (no production as yet)). Renewables account for approximately 10 per cent of electricity generation. Water heating is increasingly based on gas (48 per cent), with 45 per cent electricity (declining), and growing contributions from a low base (5 per cent) of solar hot water (SHW) and air-source heat pump hot water (HPHW) systems. Regional variations are significant. There is a national policy to phase out electric resistance water heating because, on average, it is GHGI. A carbon tax was implemented in July 2012 at A$23/t CO2e, which will be replaced by an emissions trading system (ETS) in 2015–2016.

New Zealand electricity generation has low greenhouse gas intensity, averaging approximately 0.15 t CO2e/MWh, and is predominantly based on renewables (hydro-electricity, geothermal and wind). New Zealand has limited gas production and reserves. Water heating is dominated by electricity (80 per cent). Natural gas contributes 16 per cent and SHW 1.4 per cent. An ETS is in place.

The above summary of the two national energy systems indicates that the drive for low end-use GHGI water heating is far greater in Australia. However, the wide availability of reasonably priced gas has meant that, without incentives, low GHGI SHW and HPHW systems are not competitive with gas in reticulated gas areas. Liquefied petroleum gas/propane is also widely available but is relatively expensive.

In Figure 1, data on average annual mean temperatures in Australia (annual) indicate favourable conditions for air-source HPHW systems. The efficiency of heat pumps, measured as the coefficient of performance (COP), depends on the temperature differences between the medium to be heated (i.e. water or air) and the desired service (i.e. hot water or warm or cool air) delivery temperature. The smaller the seasonal difference, the higher the COP.

In New Zealand, the low GHGI of electricity does not raise climate change concerns for electric resistance water heating. In both Australia and New Zealand, residential water heating economics can be attractive for SHW and HPHW systems replacing ERHW units when incentives to install SHW and HPHW units are available.

In Australia, replacement of a typical ERHW unit using 4 MWh annually with a heat pump with an average COP of 2.2 provides a saving of 2.4 MWh per year. Under the average current tariff for water heating using the two systems, the annual savings would be approximately A$350 when a HPHW heater replaces an ERHW unit. In New Zealand, the savings would be approximately NZ$600 per year (E3 report (Australian and New Zealand Governments, 2012)). Note, however, that the savings depend on the tariffs ($/MWh) applied to the ERHW units and the heat pump. In Australia, domestic electric water heaters are typically storage heaters using off-peak (22:00 to 07:00 hours) electricity, at approximately A$150/MWh.

In Australia, a heat pump system producing hot water on demand would use electricity at an average price of approximately A$230/MWh, thus reducing the efficiency advantages of a HPHW system. Most HPHW systems installed in Australia are off-peak storage units and seldom require non-off-peak boosting. Smart (interval) meters are being installed in Australia but, as yet, time-of-use tariffs are not mandated.

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The residential water heating market: Current and potential
In 2011, there were approximately 8,602,000 residences in Australia (see Table 1). By comparison, there were approximately 1,730,000 residences in New Zealand.

Water heating proportions by state/territory are presented in Table 2. Gas dominates in Victoria and is also the major energy source for water heating in South Australia and Western Australia. In all states, solar penetration increased markedly over the 2009–2011 period, albeit from a small base. SHW systems (and HPHW) are subsidised under the Federal Renewable Electricity Target (RET) and state initiatives, and were, until 1 July 2012, under the Federal Renewable Energy Bonus Scheme. SHW and HPHW are also encouraged in new homes in Victoria (SHW or plumbed water tank must be installed), New South Wales (under the Building Sustainability Index (BASIX)) and South Australia. SHW and heat pump hot water installation rates peaked in 2009 but then dropped as households preferred to invest in photovoltaic (PV) rather than SHW/HPHW installations. HPHW heating is not reported separately by the Australian Bureau of Statistics (2011).

In terms of the residential water heater market in Australia, there are approximately 800,000 units installed annually: 650,000 are replacement systems and 150,000 are for new residences. In 2011, there were approximately 70,000 residential SHW installations and approximately 15,000 residential HPHW installations.

Average annual energy use for water heating and potential heat pump hot water savings

There are variations in annual energy use for water heating in Australia by region and household structure and characteristics. Electric resistance heating produces the highest level of GHG emissions and running costs are high. At approximately $150/MWh ($42/GJ) off-peak and using 4 MW per year, the annual cost is $600. For gas, consumers pay approximately $20/GJ. Using 25 GJ per year, an average household pays $500. Hence, for electricity and gas, a 60-per cent reduction in use when a HPHW unit replaces an electric resistance (ERHW) or a gas water heater saves the household $360 and $300 per year, respectively.

If a 10-year payback were acceptable to consumers, the maximum capital cost for HPHW units would be approximately $3,600 for electricity (ERHW unit) and $3,000 for gas (GHW) replacement (undiscounted, with no energy price increases).

In November 2012, Chromagen was offering (in Victoria) a Midean HPHW unit of 280-L capacity for $2,300 (total subsidies approximately $2,000; i.e. without the subsidies the cost would be approximately $4,300). At this price, capital payback from savings is approximately 6.4 years in non-gas areas for this replacement, which assumes the ERHW system replacement is relatively new. However, at ERHW or GHW unit end-of-life, the economics for an HPHW unit are much better. In this case, when the ERHW or GHW unit fails (end-of-life), the choice is between an HPHW unit and a new unit of the same type that has failed (i.e. like-for-like replacement). In this situation, the real cost of an HPHW unit for the householder (consumer) is the difference in cost between the HPHW and conventional units. These costs vary but are approximately $1,000 for an HPHW unit versus a new ERHW unit, and $800 for an HPHW unit versus a new GHW unit. At a cost for the HPHW unit of $2,300 (as in the case above), the paybacks would be: 2.8 years for an HPHW unit replacing an ERHW unit and, when the new HPHW unit is displaced (early in life or later (or end) in life (average non-HPHW unit is approximately 12 years)), 2.7 years for an HPHW unit replacing a GHW unit. These paybacks should be attractive for most householders. As indicated above, paybacks will vary. Paybacks will depend on:

  • if end-of-life, price differential between non-HPHW units and HPHW units;
  • gross costs of HPHW units (e.g. $4,000) net of subsidy cost (e.g. $2,000);
  • efficiency of hot water units (HPHW, ERHW and GHW) (for HPHW units COPs will be higher in warmer regions);
  • electricity and gas prices (vary by region);
  • hot water usage per year (lower hot water usage reduces HPHW attractiveness; reverse for higher hot water usage); and
  • life and maintenance costs of units.

Given, as indicated above, the attractive paybacks of HPHW units in Australia, why do HPHW units not have a higher market share (now approximately 2 per cent)? One of the main reasons is that although the cost of an HPHW unit is not much greater than the cost of a conventional unit and paybacks are good, many householders will purchase equipment on a first (capital) cost basis and ignore operating CO2 advantages of HPHW units. Second, there are concerns about the reliability and life of HPHW units. Third, there is very limited promotion of the benefits of HPHW unit technology and, finally, the tendency for like-for-like replacement, particularly at end-of-life situations when replacement with an HPHW unit, might take 1 to 2 weeks (hot water is seen as an essential service and delay in restoration of the hot water service is very inconvenient). These issues need to be addressed by the air-source HPHW industry (manufacturers and retailers) in Australia. For example, at end-of-life, a temporary hot water unit could be immediately supplied and used until a new HPHW unit is installed.

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Residential sector gas and electricity prices
Electricity and gas prices have a significant influence on water heating economics and, thus, the consumer choice of water heating systems. Australian retail electricity prices have risen significantly in real terms over the past 5 years due mainly to increases in distribution (‘poles and wires’) costs. Costs of ‘green’ policies passed on to consumers, and since 1 July 2012 carbon pricing, have also contributed to residential electricity price increases. The estimated breakdown of retail electricity and gas prices (variable energy, not including fixed supply charges) in 2011 in Victoria (typical of other States/Territories) is presented in Table 3.

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Carbon (CO2 equivalent) pricing impacts
Carbon pricing increases the prices of electricity and gas according to the carbon dioxide equivalent (CO2e) price, the CO2e content of fuels used to produce electricity and the CO2e content of end-use combusted gas. In end-use markets energy users will respond to increased energy prices by reducing energy demand, particularly in the longer term when energy using equipment can be changed. Carbon pricing also changes the generation mix required to balance demand and supply towards gas and renewables.

The Australian CO2e price is $23/t from 2012–2013 to 2014–2015 (see Figure 2). Then, as the ETS phase is linked to the European Union (EU) scheme, the estimated price falls to $15/t by 2015–2016, rising linearly to $18/t in 2020 and $22/t in 2025.

For electricity, at $23 to $27/t CO2e, the pass-through (CO2e price impact on wholesale electricity price) is approximately 85 per cent, resulting in an electricity price rise of $21 to $24/MWh plus goods and service tax (GST), or, at current price levels, approximately a 9-per cent increase in retail price. At higher CO2e prices the pass-through percentage decreases, and increases at lower CO2e prices.

CO2e content of end-use gas varies by state. For example, the CO2e content is 0.057t CO2e/GJ in Victoria and 0.71t CO2e/GJ in South Australia. At $23/t CO2e, the price rise in Victoria is $1.3/GJ plus GST, or a 9-per cent rise in retail prices.

The demand response, that is, the price elasticity of demand for electricity, is estimated to be approximately −0.3 in the long run. High real price increases such as the ones that have occurred in Australia over recent years could engender a short-run response close to the long-run elasticity, or even greater.

From an electricity demand viewpoint, the focus of electricity retailers on CO2e pricing impacts will be on CO2e pricing increasing electricity prices and reducing demand compared with no carbon pricing, and on gas prices rising. Accordingly, gas versus electricity competition may not be significantly affected.

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If the current Federal Coalition removes the carbon tax, electricity and gas prices could still rise as a result of Coalition climate change policies. The impact, however, is indeterminate at this time.

National Institute of Economic and Industry Research projections of residential electricity prices are presented in Table 4, together with a breakdown of price components in Victoria. These prices include fixed supply charges. Off-peak (22:00–07:00 hours) rates, mainly applying to water heating, are $100 to $120/MWh below peak rates (tariffs). Each retailer offers a range of tariffs (available on their websites). The above tariffs are the average of the most common peak tariffs. Tariffs may fall due to carbon price changes and as ‘green’ policies, and responses to them, change.

Gas prices have, where gas is available, made the fuel very competitive for water heating. In Victoria, where over 90 per cent of residences have access to natural gas, 66 per cent of residences used natural gas for water heating in 2011.

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As indicated in Tables 4 and 5, gas prices are low compared with electricity prices. However, higher efficiency electrical equipment, such as heat pumps (with efficiencies of 200 to 300 per cent), can offset the lower cost of gas (gas efficiencies are 65 to 95 per cent).

Note that electricity and gas prices post-2013 are difficult to predict mainly because of carbon pricing uncertainty.

Performance of heat pump hot water units
Heat pump water heater performance depends on several factors, including: the location and climate where it is installed; the heating efficiency or COP of the system under standard conditions; the heat loss of the storage tank; the quantity of hot water drawn off each day; the quantity, the duration and the time of day of each draw; the time interval between draws; the thermostat and control strategy settings; and whether the heat pump can run at any time or whether it is constrained from running at certain times due to electricity tariff structures, for example, lower off-peak rates. These factors contribute significantly to the competitiveness of HPHW systems with alternative water heating systems.

Most relevant standards for performance are AS/NZS 5125: 2010 Heat Pump Water Heaters (product performance assessment) and AS/NZS 4692.1: 2005 Electric Water Heaters (energy consumption, performance and general requirements).

Independent laboratory testing in 2010 and 2011 of heat pump water heaters of the most common models sold in Australia and New Zealand using AS/NZS 5125 generally gave similar results to the tests undertaken by manufacturers. Testing raised some concerns about heat pump water heaters that had very slow heat up times, particularly in colder temperatures. Key concerns raised as a result of testing include low energy efficiency in cold ambient temperatures in some models and slow reheat times, especially in cold ambient temperatures in certain models. In addition, many models had higher noise levels than expected.

While physical test results were largely consistent, the modelled performance estimates using AS/NZS 4234 were often inconsistent with manufacturer-modelled results. This divergence appears to be a result of: a lack of clarity in some definitions in the standards; inconsistencies between instructions and how the model actually operated; and the small, medium and large load categories in AS/NZS4234, which can result in step changes in calculated displaced energy if a product is only marginally below the requirements of a particular load category.

Testing of heat pump hot water units
The Australian and New Zealand standards that relate to the design, construction and performance of HPHW units are listed in Appendix 1 of the E3 report (Australian and New Zealand Governments, 2012).  The greenhouse gas performance of HPHW units in Australia depends on energy used and energy GHGI. These factors vary by region and over time. For example, in Victoria, with a cooler climate compared to other regions of Australia, there is high electricity GHGI and gas is widely availability and low in cost. For a HPHW system, average electricity use is 1.6 MWh/year, with GHGI of 1.3 t CO2e/MWh, resulting in 2.08 t CO2e/year. In contrast, a new high efficiency GHW system uses 20 GJ/year, with GHGI of 0.06 t CO2e/GJ, resulting in 1.20t CO2e/year. There is a clear advantage to gas unless GHGI reduces significantly and/or HPHW COP increases significantly.

In Queensland, the climate is warmer and there is lower electricity GHGI, and limited availability and higher costs of gas. For a HPHW unit, the average electricity use is 1.2 MWh/year, with GHGI of electricity of 0.90t CO2e/MWh, resulting in 1.08t CO2e/year. A new high efficiency GHW unit uses 18 GJ/year, with GHGI of 0.06t CO2e/GJ, resulting in 1.08t CO2e/year. For an ERHW unit, the average electricity use is 3.5 MWh/year, with a GHGI of electricity of 0.9 t CO2e/MWh, resulting in 3.15t CO2e/year. There is a clear advantage to HPHW compared to ERHW, the dominant hot water source in Queensland. In gas (limited) areas, there is similar greenhouse performance for HPHW and GHW units.

Suppliers of heat pump water heaters in Australia and New Zealand
There are 18 brands and approximately 80 separate models of HPHW systems registered with the Australian Clean Energy Regulator (CER) (see Table 6). (There may be other models that are not CER registered.) The GWA Group and Rheem Australia share approximately 60 per cent of total sales. As is evident from Table 6, China has a significant role in the manufacture and assembly of HPHW units. As noted above, Chromagen is offering Midean HPHW units at prices that are attracting sales, particularly in non-gas areas.

Regulations and policy initiatives applying to heat pumps
Mandatory energy efficiency regulations
Mandatory energy efficiency regulations do not apply to HPHW units in either Australia or New Zealand. In both countries, storage heat tanks, if a component of heat pumps, are exempt from standing tank heat loss provisions if resistance heating provides less than 50 per cent of annual energy supplied.

Building codes
Australian states and territories (except Tasmania and the Northern Territory) have rules that restrict the use of GHGI water heaters in detached houses, semi-detached houses and townhouses. This has virtually eliminated ERHW systems in new homes. In New South Wales, the BASIX energy rating system contributed to an increase in the HPHW share of the New South Wales water heater market. The New Zealand Building Code specifies maximum heat losses for all types of water heaters up to 700-L capacity.

In existing buildings, South Australia and Queensland have regulations restricting the replacement of ERHW systems. In 2010, the national Ministerial Council on Energy agreed to phase out GHGI water heaters for existing homes except Tasmania (mainly a hydro system). When the policy is implemented, water heater replacement in detached houses, semi-detached house and townhouses will be by heat pumps, SHW, gas or wood-fired water heaters.

The Australian Federal Renewable Electricity Target
Under the Australian Federal RET policy, the use of renewable energy for electricity generation and hot water production is provided with incentives delivered through electricity retailers (sellers of electricity to end-users). A target for renewable energy as a percentage of total electricity consumption (with some exemptions) has been set for 2020: now approximately 25 per cent. The retailers are liable for acquisition of renewable energy in proportion to their share of total electricity sales. The RET is divided into two parts:

  1. small renewable energy systems (SRES), which cover small-scale renewables, including PVs, and other small (up to 100 kW) generators and displacement technologies (SHW and heat pump units); and
  2. the large renewable energy target (LRET), which covers large-scale renewables.

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There is no maximum target (cap) for SRES. In contrast, 41,000 GWh by 2020 has been set as an LRET, with the target increasing gradually from 12,500 GWh in 2011. In recent years (2009 to 2012), SRES has been dominated by PV. In 2011, approximately 15,000 heat pumps and 70,000 SHW units were installed under SRES out of a total residential water heater market of approximately 800,000 for new and existing residences. The heat pump installations have declined from approximately 65,000 units in 2009 when state rebates (see Table 7) were very generous for heat pumps, resulting in a virtually zero price for heat pumps.

The SRES is delivered through Small Scale Technology Certificates (STCs) created following SRES regulations. In the regulations the number of STCs is specified for each type of equipment installed. When eligible equipment, such as a heat pump, is installed, STCs can be created and sold to retailers. At a price of $30 to $40 per STC, the price of HPHW systems can be reduced by approximately $900 to $1,200 per unit. Each electricity retailer must purchase and deliver to the SRES regulator (Clean Energy Regulator) STCs in proportion to their share of the end-use electricity market.

Since 2008, households  have preferred to put their ‘solar dollars’ into PV systems, mainly because of greater PV incentives under RET and state/territory feed-in-tariffs, and reductions in state/territorial incentives for heat pumps and SHW.

Rebates and subsidies
Federal rebates
Up to 1 July 2012, the Federal Government provided rebates to replace ERHW systems with SHW or HPHW units. The progress of the rebate over 2009–2012 is shown in Table 7: 250,000 water heater installations were covered by the program.

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New South Wales

From 2007 to 2011, 48,000 rebates were paid for HPHW units under a state program that terminated in June 2011. Rebate levels varied from $300 to $1,200 per unit.

Victoria

Under Victoria’s Energy Efficiency Target, a ‘white certificate’ program, HPHW units are eligible for subsidies to replace ERHW units. In addition, until March 2013, direct subsidies for HPHW and SHW units were available from Sustainability Victoria.

South Australia

Since 2002, low income households have been eligible for incentives to install SHW, HPHW and GHW units in new and existing residences. Incentives will end in June 2013. Approximately 1,200 HPHW units will be installed under the program.

Queensland

Since 2010, rebates up to $1,000 have been offered for SHW or HPHW units (heat pump take-up unknown).

Australian Capital Territory

The Australian Capital Territory (ACT) offers $500 for replacement of heat pump units to replace ERHW units. Heat pump take-up is not known.

New Zealand

Over 2009–2012, rebates of $575 to $1,000 were offered for installation of heat pump water heating units. Take-up data is not available.

Heat pump installations
Apart from the SRES element of the federal RET, incentives to install HPHW units have been significantly reduced since 2009 in Australia. As a result, HPHW installations appear to have dropped from approximately 80,000 in 2009 to fewer than 20,000 in 2011, partly due to reduced incentives and partly due to consumer preference for PV installations.

In New Zealand, installations are very low, perhaps 500 per year because of relatively low electricity prices and low climate change concerns associated with low GHGI electricity.

In the future, heat pump installations will depend on several factors, including HPHW performance (coefficient of performance); electricity and gas prices; subsidy/rebates for heat pump installations; promotion of HPHW units by suppliers to enhance consumer acceptance of the units; and regulation of water heating technologies.

There was a close correlation between the total level of federal and New South Wales rebates and installations up to 2011 (see Figure 3). New South Wales and Queensland installations accounted for the majority of HPHW installations to 2011 due to incentive levels, favourable climatic conditions and the limited availability of natural gas (see Figure 4).

New South Wales and Queensland have 76 per cent of the Australian stock of heat pump water heaters, even though they have 52 per cent of the total number of Australian dwellings. The higher rate of HPHW unit installations in these states is due to a number of factors. First, a lower share of households in these states have access to reticulated natural gas than in Victoria, South Australia and Western Australia, and, as a result, there is less competition from gas in the low greenhouse emissions water heater market. Second, there were favourable financial incentives (especially in New South Wales) over 2008–2010. Third, New South Wales benefitted from the effects of the BASIX requirements for new dwellings. Finally, large populations live in climate zones where HPHW units perform well. Final data for 2011 and 2012 are not yet available, but installations have declined in these years as the availability of rebates has declined, even though SRES has continued.

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In Australia, HPHW sales are forecast to increase, with current policies, from approximately 20,000 per year in 2011 to approximately 40,000 by 2030 (E3 report (Australian and New Zealand Governments, 2012). However, if the phase-out of ERHW system policy is fully implemented, sales of HPHW units could reach approximately 100,000 per year by 2020 for new heat pumps and heat pump replacement use. Sales increase factors besides the planned electric resistance phase-out are consumer acceptance of HPHW units (which could be enhanced by supplier promotion), increases in heat pump efficiency, a decrease in the price of units, an increase in electricity price and the introduction of favourable tariffs for HPHW units.

In New Zealand, approximately 350 HPHW units were sold in 2009 and 400 in 2010, with an expected 500 in 2012 (E3 report). The much lower New Zealand numbers are due to fewer residences (1.7 million versus 8 million in Australia), fewer climate change concerns, less favourable electricity prices, and overall less favourable air-source heat pump operating conditions.

Policy options to improve heat pump water heater performance
A range of studies, performance testing and comparison with global experience indicate that the market penetration of heat pump water heaters in Australia and New Zealand could be significantly improved.

Potential policy initiatives include improved information on heat pump benefits and costs, enhanced unit testing, improved publicity, better appliance performance labelling, Minimum Energy Performance Standards (MEPS), and research and development for units to ensure unit specific suitability for Australian and New Zealand conditions.

The E3 study (Australian and New Zealand Governments, 2012, pp. 36–37) proposes the following strategies for consideration by stakeholders:

  1. Establish a system of mandatory product testing and registration, based on AS/NZS 5125, as well as noise testing to ISO 3741. As heat pump water heater suppliers already conduct physical tests to AS/NZS 5125 and governments already maintain registers of other appliances, the additional costs should be relatively minor in comparison with the potential public benefits.
  2. Introduce MEPS and functional performance requirements, including addressing cold temperature performance and noise issues, with proposed notification of the requirements no later than mid-2013 and requirements to take effect by mid-2014. There are likely to be significant benefits from ensuring that all models are fit-for-purpose and achieve MEPS.
  3. Enable public access to the registered data, with models identified. This will provide potential purchasers, competing suppliers and regulators with an overview of the range of products and performance levels on the market.
  4. Develop energy labelling standards, either as a mandatory requirement or initially for voluntary use by suppliers.
  5. Develop a roadmap of potential future increases in minimum performance criteria and associated measures such as labelling.

From the author’s perspective, what is also needed is promotion of the costs and benefits of HPHW units. In Australia this is almost totally lacking.

Heat pumps in the residential sector for space heating and cooling
Based on heat pump technology, reverse cycle air conditioners (RACs) are increasingly used for space cooling and heating in the Australian residential sector. Space cooling penetration is now applied in the majority of Australian residences (see Table 8) mainly through the use of RACs. In the states/territories (New South Wales, Victoria, Tasmania and South Australia) where there is a significant heating load, RACs are increasingly being used for space heating, particularly in non-gas areas.

Except in Western Australia and the Northern Territory, new air conditioner sales are virtually all reverse air cycle (RAC) units, which can be used for heating and cooling. In hot, dry regions, evaporative air conditioners are very effective and space heating requirements are low.

In gas areas, the high efficiency of RACs (COPs of 3.5 to 4.5) virtually offsets the lower price of natural gas. With gas at A$16/GJ and electricity at $250/MWh, gas space heating costs per year are A$750/year and RAC space heating costs are A$794/year.

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Conclusions of heat pump hot water review in Australia and New Zealand
The following can be concluded after reviewing the use of HPHW in Australia and New Zealand. First, there is significantly more potential for HPHW in Australia compared with New Zealand. Second, in Australia, climate conditions and the policy environment are favourable to HPHW. Third, HPHW incentives, although reducing in Australia, continue to provide attractive payback returns to HPHW units. Fourth, payback returns and greenhouse performance vary regionally: potential for HPHW units is greater in New South Wales, Queensland, South Australia and Western Australia. Finally, greater HPHW market penetration requires monitoring and reporting of HPHW performance combined with enhanced promotion of the reliability and benefits of the technology and addressing the end-of-life, like-for-like issue.

The Australian and New Zealand MEPS initiative is an early (1999) and major element of national energy efficiency improvement (EEI) and climate change policies. MEPS was originally developed under the National Appliance and Equipment Energy Efficiency Program (NAEEP).

Minimum Energy Performance Standards now form part of and are developed under the Equipment Energy Efficiency (E3) Program, a joint Australian and New Zealand initiative. Energy labelling (part of E3) was introduced into both Victoria and New South Wales in the late 1980s, and the first MEPS were introduced in Australia in 1999. They now cover a range of residential, commercial and industrial appliances and equipment. Once introduced, MEPS levels are regularly updated and new energy using appliances and equipment continues to be added. In addition to this, the energy rating algorithms used for appliances are updated from time to time and made more stringent, so the labelling scheme continues to encourage the marketing of high-efficiency appliances.

The MEPS set a regulated minimum energy performance standard for appliances and equipment covered by the program. That is, MEPS prevent (subject to compliance) low energy performance units from entering the Australian market and, therefore, contribute to savings in consumer operating costs and reducing generation requirements. It is illegal to sell products which do not meet the required MEPS levels. Mandatory energy rating labels give an indication of energy performance (higher stars = higher efficiency). Some appliances (refrigerators/freezers, air conditioners and televisions) are subjected to both MEPS and mandatory energy labelling. In general, where both MEPS and energy labelling apply to an appliance, the sales weighted star rating of products sold exceeds the MEPS levels by a significant margin.

In 2007, a total of 5 appliance categories were subjected to mandatory labelling, and 9 appliance categories were subjected to MEPS. By the end of 2010, 7 appliance categories were subjected to mandatory labelling (plus 2 voluntary levels) and 16 appliance categories were subjected to MEPS. In 2009, MEPS were introduced for chiller towers, close controlled (computer room) air conditioners, external power supplies, set top boxes, self-ballasted compact fluorescent lamps and incandescent lamps. Both MEPS and energy labelling have been introduced for televisions.

The implementation of MEPS and energy labelling is coordinated through a joint Commonwealth, state and territory government E3 committee.

Given the long MEPS history and the regular updates and additions, the determination of the additional impact of the MEPS on energy use and greenhouse gas emissions is complex. It is very difficult to estimate how energy performance for each group of appliances would have changed in the absence of MEPS, and this becomes more difficult as the time elapsed since the introduction of a MEPS increases. Due to MEPS in countries to which export appliances to Australia, there may be improvements in performance not related Australian regulatory change.

George Wilkenfeld and Associates (GWA), the MEPS impact consultant to the E3 program, provided the GHGA MEPS national and state impacts to 2025 in a 2009 report. In the report’s analysis, GWA attempted to estimate the beyond business-as-usual (BAU, no MEPS) impact of MEPS. That is, the estimated impacts did consider EEIs, which would have arisen if the MEPS had not been implemented. The estimates also considered the impact beyond BAU of new MEPS initiatives scheduled to be implemented over the 2009, 2010 and 2011 period (the next MEPS triennium).

The resulting GWA estimates do not include adjustments related to estimates of rebound, non-compliance with MEPS and deterioration of appliance and equipment over time. These factors could reduce these estimates. However, the GWA estimates also assume that carbon pricing would be introduced but in 2011.

Estimates by GWA of E3 program savings in the National Electricity Market (annual) over 2000–2022, from a 1999 efficiency base for new appliances and equipment, are presented in Table 9. The estimates are additional in that they assume that without MEPS and labelling new appliances and equipment efficiencies would have been ‘frozen’ (i.e. fixed) at 1999 levels. On this basis and given the extensive range of appliances and equipment the MEPS apply to, the estimated savings are substantial.

Electricity savings in Australia from E3 programs from 2000 to 2009 were estimated by GWA for E3 to be approximately 6,750 GWh and from 2009 to 2022 increasing by approximately 26,500 GWh.

References

Australian Bureau of Statistics (2011), ‘Environmental Issues: Energy Use and Conservation’, Cat. No. 4602, March, Australian Bureau of Statistics, Canberra.

Australian and New Zealand Governments (2012), ‘A study for the Australian and New Zealand Governments’ E3 Equipment Energy Efficiency Joint Initiative: The study entitled Product Profile: Heat Pump Water Heaters, Air-source Heat Pump Water Heaters in Australia and New Zealand, June 2012 (E3 report – available at www.energyrating.gov.au).

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National Economic Review

National Institute of Economic and Industry Research

No. 68 October 2013

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474

Mercantilist and equilibrium fallacies in regional economics

Dr Ian Manning, Deputy Executive Director, NIEIR

 

Abstract

The present paper discusses the divergent conclusions of two studies: that of Abelson, ‘Evaluating Major Events and Avoiding the Mercantilist Fallacy’, published in Economic Papers, and an economic impact evaluation completed in 2005 by the National Institute of Economic and Industry Research. In this case, the conflicting results are not due to major disagreements on theory: NIEIR agrees with most of the theoretical statements in Abelson’s article. Here, disagreement arises from the application of theory, or the relevance of assumptions

 

Introduction

In the March 2011 edition of Economic Papers Peter Abelson accuses unspecified economists of committing the ‘mercantilist fallacy’ in their evaluation of major events. He shadow-boxes the culprits without naming them or examining any of their reports in detail, but the shadow which haunts his discussion of the 2005 Formula 1 Grand Prix in Victoria is easily identified as the economic impact evaluation completed in 2005 by the National Institute of Economic and Industry Research (NIEIR). Abelson is not to be blamed for shadow-boxing since the Australian Grand Prix Corporation, which holds copyright to the NIEIR report, has chosen not to publish anything but the bottom-line result, a gross benefit to the Victorian economy of approximately $175 million. This benefit contrasts strongly with the result of a study by Applied Economics (2007) (i.e. Abelson under his consulting hat) that estimates that the same event imposed net costs on Victoria of $6.7 million. En route to their final conclusions, NIEIR and Abelson agree that visitor-generated expenditure in Victoria was of the order of $60 million. Abelson whittles this down to a benefit of $9.4 million in ‘local production surpluses’, whereas NIEIR expands it to an increase of over $100 million in gross state product. (The total published by the Grand Prix Corporation includes a number of additional costs and benefits which are not relevant to Abelson’s accusation. For completeness, they are discussed towards the end of this article.)

How can economists come to such divergent conclusions? In this case, it is not due to major disagreements on theory: NIEIR agrees with most of the theoretical statements in Abelson’s article. The disagreement concerns the application of theory, or, to put it another way, the relevance of assumptions. The assumptions NIEIR applies to event assessment are described by Manning (2012). The present article reports a detailed comparison with the neoclassical approach to the same topic.

The importance of assumptions

Abelson (2011, p. 48) does not define the mercantilist fallacy precisely: only as analysis, which, in his view, ‘typically exaggerate(s) the benefits of export income’. Benefit exaggeration arises when the analyst fails to realise that ‘export income is valuable only in so far as it has more value than the consumption foregone’ (Abelson, 2011, p. 52). Along these lines, Abelson (2011, p. 48) summarises his argument against subsidies to events that generate export income as follows:

Any visiting consumer wants a service in return for their expenditure and the provision of this service almost always requires the use of resources that could be employed in other activities. Consequently, an external injection of funds guarantees neither net employment generation nor a welfare-enhancing economic project.”

The mechanism proposed for this crowding out is price equilibration of demand and supply assuming upward-sloping supply curves based on rising marginal costs in all relevant markets. An extreme case of this mechanism is provided by general equilibrium models, in which rising marginal costs are necessary to generate results, but the assumption of rising marginal costs has also frequently, and unthinkingly, been transferred to economic impact analysis. Such transfer is only appropriate where there is empirical evidence that the postulated price movements actually take place; it generates false results where the relevant supply curves are horizontal or declining. The mercantilist fallacy, accordingly, has a counterpart, the equilibrium fallacy, which occurs when the market conditions that generate the mercantilist fallacy are wrongly assumed to apply.

Our purpose is not to fault Abelson’s claim that event assessments may suffer from mercantilist fallacies nor is it to deny that the eighteenth-century Corn Laws that so displeased Adam Smith were an example of the mercantilist fallacy in action. Again, we do not enter into the welter of arguments, such as those surrounding the concept of export-led growth and the circumstances in which additional exports may or may not add to the consumption possibilities of the exporting region. The case under discussion is whether subventions to the organisers of public events can have welfare-increasing results via the generation of additional export income, while admitting that whether they will or not depends on the circumstances of the place and time. In the example considered by Abelson the fallacy lies in assuming that Victoria, at the time of the analysed event, was experiencing full employment in the sense that additions to the demand for factors of production due to increased exports raised their prices and so ensured that increases in export production crowded out other production. This is an empirical, not a theoretical matter, concerning market conditions in and around Albert Park, Melbourne, Victoria in March 2005.

A digression: Labour mobility

As Abelson himself reports, in the extreme context of general equilibrium theory rising labour supply curves do not necessarily condemn public support of events as expressions of the mercantilist fallacy. In an imaginative assessment of the 2005 Grand Prix, the same event as assessed by Abelson and NIEIR, the Allen Consulting Group (ACG) (2007) drew on the Monash Multi-Regional Forecasting model (MMRF), the doyen of Australian computable general equilibrium (CGE) models. The MMRF assumes that economies operate at equilibrium full employment with rising marginal costs.

The ACG observed that the event transferred visitor expenditure from the visitors’ states and countries of origin to Victoria. The increase in expenditure in Victoria would be matched by decreases in the states of visitor origin, creating demand for labour in Victoria and excess supply elsewhere. Given the assumed hypersensitivity of labour markets to changes in demand, equilibrium would be maintained by transfer of labour from the states of visitor origin to Victoria, increasing Victorian gross state product by around $60 million at the expense of the other states. If this reasoning is correct, an injection of funds by Victoria does precisely what eighteenth-century mercantilists wanted to do: it strengthens Victoria at the expense of other states and expresses mercantilist truth rather than fallacy. However, the exercise is pointless because most of the ‘benefit’ goes to people who have lost their jobs in other states and very few individuals actually benefit. Abelson is critical of this analysis on the grounds that it omits relocation costs and depends on an incredible degree of sensitivity of interstate migration to tiny variations in the demand for labour. He argues that it is ‘far more likely’ that a one-off event ‘would simply increase part-time labour for a few days or weeks’, a suggestion that is difficult to reconcile with the dependence of his own results on rising marginal labour costs (Abelson, 2011, p. 57).

Data on interstate migration support Abelson’s criticisms of ACG. Because employed persons come with partners and dependents, we assume that every additional employment position created in 2005 required the interstate migration of two people. The following equation was estimated:

Mercantilist 1

 The equation is nonlinear. The higher the employment to population ratio, the greater the proportionality and the greater the net immigration rate, a form which allows the ACG labour mobility assumption to be tested. When the data for the March quarter 2005 is plugged into the equation and the employment level is increased by 1,000, the resulting increase in net interstate migration into Victoria is 43 persons, which is considerably lower than what is implied by ACG. We accordingly condemn ACG’s application of MMRF to event assessment as an example of the equilibrium fallacy.

Short-run crowding out via the labour market

Abelson (2011, p. 58) gives various reasons why the ACG assessment of the 2005 Grand Prix using CGE modelling went wrong: mainly that CGE models are ‘not primarily designed for the task of event assessment’ and are ‘not well-suited to estimate the micro intra-industry impacts of small and temporary events’. He proposes cost–benefit analysis as the appropriate methodology, whereas NIEIR was briefed to undertake an economic impact analysis concentrating on effects on gross state product and employment. This difference in aim accounts for part of the difference in the results, mainly because Abelson deducts an estimate of the value of leisure foregone as employment increases and NIEIR does not. A serious problem with the value of leisure foregone is that it cannot be directly observed and is likely to be low, or even negative, when previously unemployed persons gain work. However, the difference between cost–benefit and economic impact analysis does not explain the wide divergence of numerical results, which arise because Abelson did not follow up his own suggestion that labour supply for small and temporary events is likely to come from part-time workers and, instead, based his cost–benefit analysis on the assumption that relevant markets are subject to rising marginal costs. This is an empirical question, and failure to check the empirical position exposes him, like ACG, to the equilibrium fallacy.

The relevant markets can be identified from the expenditure surveys carried out as part of the assessment of events. The industries that gain noticeable additional demand during an event comprise accommodation, restaurants, bars and air transport. Other visitor expenditures on motor transport, entertainment and shopping, although substantial, are but small percentage additions to resident demand and, hence, are unlikely to strain regular provision. Instead, production is likely to increase through the utilisation of normal excess capacity: shops and petrol stations are a little busier and entertainment venues sell additional seats. Similarly, even though it is likely to experience a noticeable increase in demand, air transport has sophisticated means of matching demand to capacity, including complex pricing, and is likely to have the capacity to meet the surge in traffic caused by an event. Notice, however, that these observations imply a range of capacity over which sales can vary without causing any changes in wage rates or other factor prices.

The case is different in the hospitality industries (accommodation, restaurants and bars) because the additional demand is likely to be large enough to require additional labour input, at least within a small area, such as the environs of Albert Park. When the hospitality industry requires additional labour, the full employment assumption that underlies rising marginal costs gives it only one source, people already working elsewhere: ACG assumes interstate and Abelson assumes in other industries located near the event. It is also assumed that labour will be attracted to hospitality by the offer of slightly higher wages. Relaxing the full employment assumption allows us to list a number of additional sources of labour, beginning with the offer of additional time to existing employees (the hospitality industry in Melbourne in 2005 had numerous part-time workers who might be persuaded to work additional hours and also had the option of offering overtime). The industry could also offer work to people otherwise unemployed or underemployed.

The conventional measure of spare capacity in labour markets is the unemployment rate estimated quarterly by the ABS Labour Force Survey. This rate was defined in the era of male full employment in full-time jobs and is now highly unsatisfactory as an indicator of excess capacity, both because of the increase in part-time employment and (more importantly) the increasing capacity of the Commonwealth Government to move social security recipients between payments that require job search and those that do not (NIEIR, 2011, pp. 7– 10 and 59).

In the March quarter of 2005 Victoria experienced official (ABS) unemployment rates of 5.2 per cent for males and 5.7 per cent for females. In addition, ABS surveys confirmed the presence of part-time workers who wanted to work longer hours, the presence of discouraged workers and an overall ratio of hours worked to the working-age population well short of ratios common elsewhere in the OECD. From these sources it can be estimated that in March 2005 approximately 700,000 people were available in Victoria to undertake and, in most cases, could adequately provide, the generally low and semi-skilled services required to support an event. Even the most optimistic estimates of the employment opportunities created by the Grand Prix represent less than 1 per cent of this available labour.

Despite the slack in the labour market in Melbourne in March 2005, it could be argued that the hospitality industries were competing with other industries for skills in demand. For non-hospitality industries to be adversely affected, the competition must be inter-industry. Competition for skills within the hospitality industry does not reduce factor supply to other industries, although it might lead to an increase in hospitality prices and, hence, possibly choke off some of the increase in demand. In 2005 the scarce skills that the hospitality industry needed to recruit were, by and large, industry-specific (e.g. skilled chefs and suave waiters) so that an increase in demand for skilled labour was not likely to spill over into withdrawal of staff from other industries.

The question of capital capacity and accommodation prices

If it is conceded that suitable underemployed and unemployed labour was available at the time and in the place where an event occurred, the labour requirements of the event would have been met without withdrawal of labour from other industries and, therefore, without any mercantilist effects via labour supply. However, labour is not the only input to the holding of an event and it might be asked whether mercantilist effects can arise from limited capital capacity, which for events effectively narrows down to the stock of hotel rooms, bars and restaurants. The short-run answer to this question is no. Accommodation capacity is of crucial relevance to the ex-ante assessment of events because it can limit the number of visitors and, hence, the export earnings from the event, but is not relevant to short-run ex-post assessments such as the three under discussion because these are based on actual visitor numbers and expenditures. In these cases the main possible capacity effect is distributional: price increases in local hospitality venues, which transfer income from local consumers to hospitality providers. However, there is little evidence of price inflation due to a spike in demand for accommodation and eating out in Victoria in March 2005.

For evidence on this point, we can turn to the implicit deflator of the Victorian consumption of accommodation, cafes and restaurants, divided by the overall Victorian implicit consumption deflator. An upward trend would be expected, due to the effect on the overall Victorian implicit consumption deflator of rapid growth in labour productivity in goods industries compared to service industries, the China effect on goods prices and the hedonic price adjustment for electronic equipment. Accommodation prices did, indeed, drift upwards in the March quarter 2005, but only modestly at 0.7 per cent per annum, much less than the increase in health and education prices. These data give no evidence of capacity constraints in the Victorian tourism industry around March 2005.

These data series also show that real hospitality price growth tends to fall below trend when output growth is high and vice versa. In the late 1990s, when output growth exceeded 10 per cent per annum, real tourism sector prices fell, indicating that productivity growth in the Victorian tourism sector is positively related to output growth and, therefore, that the sector is subject to increasing returns to scale. For every 1-per cent increase in output growth, productivity growth (output per employee) has increased by approximately 0.6 per cent. Therefore, the industry supply curve may be downward sloping, rather than horizontal as argued so far.

Multipliers in the short run

With capital capacity not a concern and underemployed labour available, the short-run impact of an event turns into a simple exercise in macroeconomics. Due to the increase in demand, average fixed cost will be less than in a no-event base case, although average variable cost may be greater due to overtime working and/or the costs of induction of recently-unemployed people. With these effects offsetting each other, production will rise to meet demand at reasonably similar average cost. Indeed, the econometric result is that demand will be met at falling average cost due to increases in productivity.

Additional export sales add to regional demand and employ otherwise underemployed capital and labour. Not only does the additional demand fail to crowd out alternative production, it generates a Keynesian multiplier, which, in traditional fashion, peters out as savings and imports increase. NIEIR’s final estimate of the benefits of visitor expenditure at the Grand Prix thus increases from under $60 million to over $100 million. The underlying assumption is that capacity limitations are not triggered in any relevant market, including those benefiting from multiplier effects. (We note that, true to its brief, NIEIR is here conducting an economic impact analysis rather than a cost–benefit analysis in which alternative means of generating multiplier effects might be relevant.)

This is not a final estimate of the impact of the event. Various other positive items include expenditures by overseas-based media and competitors, expenditures by Victorians who run down their savings rates and import substitution effects (local motor racing enthusiasts receive local satisfaction rather than heading off interstate or overseas to attend substitute events). Negative items include the import content of the event itself and the ‘tourism repulsion effect’, which, in addition to potential visitors repulsed by the lack of discounts for accommodation during the event, includes local residents who temporarily abandon Melbourne rather than put up with the crowds and noise. These effects and their multipliers account for the final NIEIR estimate of a gross benefit of $175 million. There is room to argue over the details, but the main short-run conclusion is clear. Doing away with the equilibrium fallacy not only yields a much more positive assessment of the benefits of injecting funds into events that generate export income in a less than fully employed economy, it means that the mercantilist fallacy did not apply to events held in Melbourne in March 2005.

No claim is made that this is a universal result. To take an extreme example, the labour shortages in the Pilbara make the argument inapplicable to an event held in Karratha in 2011. In these circumstances, diversion of labour to event-staging would almost certainly curtail work in the construction sector.

The long run

The estimate for Victoria in 2005 is a short-run result and does not preclude the possibility that the mercantilist fallacy might apply in the long run, either through long-run labour market effects or through long-run capital effects. However, long-run effects are unlikely to apply to events that are strictly one-off as distinct from one of a series. Since the Grand Prix was one of a series, we will take this as background to the long-run discussion.

A long-run labour-market effect would arise if, for example, a series of events encourages workers to acquire hospitality-industry skills rather than train to alleviate skills shortages in non-subsidised industries. This argument requires a limited supply of potential trainees and limited but flexible capacity in training institutions. The argument remains possible, but it is hard to argue that it applies currently. Hospitality training institutions are specialised (rather than flexible) and have lately been very busy training aspiring immigrants.

It could also be argued that subsidised serial events adversely affect production in other industries because enhanced visitor demand induces capital investment in the hospitality industry, which reduces investment and output in other industries. There is no need to quarrel with the first step in this argument. Serial events are, indeed, likely to induce investment in capacity. Because hotel occupancy in Melbourne peaks in March, the month in which the Grand Prix is held, the event adds to peak hotel occupancy. A simple investment model for accommodation is that long-run room supply adjusts to expected growth in demand, as indicated by the trend rate of growth adjusted to the extent that current occupancy rates are more or less optimal in the peak month. The March room occupancy rate in Melbourne has oscillated around 75 per cent. When the actual room occupancy rate moves above this, investment in hotel rooms drives the rate back below the 75-per cent mark. Given that around 45 per cent of net additional and enhanced-duration visitors to major events stay in hotels, it is estimated that the 2005 Grand Prix increased demand by approximately 70,000 visitor nights, or (at an average room occupancy of 1.5) approximately 47,000 room nights. To maintain the 75-per cent peak-month average room occupancy rate, this translates into 2,000 rooms, which in March 2005 represented 8.8 per cent of available rooms. This simple model explains the increase in room supply in Melbourne Statistical Division from 29,900 in March 1996 to 37,100 in March 2006, with the Grand Prix accounting for a little over a quarter of the increase. The question is whether this had ill effects on other industries.

Investment crowd out

If a series of subsidised events induces investment in additional accommodation, does this crowd out other investment? In general equilibrium models, equilibrium of aggregate investment and aggregate savings is ensured by movements in the appropriate price: interest rates. Investible funds are pooled by the finance sector, which distributes them disinterestedly across projects to the point where prospective marginal rates of return are equalised to the interest rate. Under this account of investment, a change in expectations which increase investment in any one industry will reduce investment in others, so redistributing capacity and generating a mercantilist long-run result.

However, this theory is far from universally accepted. A major challenge has been mounted to the information requirements of the model, the argument being that a disinterested, rational distribution of investment funds is impossible in a world of uncertainty and risk (Kornai, 1971). In this world, investment tends to be determined more by immediate past industry profitability and the current climate of business opinion than it is by dispassionate contemplation of comparative opportunity, and a positive outlook in hospitality is as likely by contagion to generate investment in other industries as it is to crowd such investment out. A second challenge has concentrated on the assumption that savings are pooled and allocated by a disinterested financial system. The flow of funds accounts show that the financial system is currently marginal to the finance of Australian industrial investment, as distinct from household investment in housing. Instead, businesses reinvest their own savings: particularly depreciation allowances, but also retained profits. If this is the case, increased profitability in the hospitality sector leading to increased investment does not affect investment prospects in other industries unless there is limited physical capacity in the construction industry, which did not appear to be the case in Victoria in the mid-2000s.

Multipliers in the long run

The question as to whether an expanded hospitality sector reduces long-run production in other industries is partly a question about full employment. Returning to Albert Park, the simplest argument is that the lack of full employment in March 2005 was temporary and cyclical, in which case the 2005 event might be diagnosed as an appropriate Keynesian stimulus with long-run mercantilist fallacy effects to the extent that it encouraged investment, which increased production in the hospitality sector at the expense of production in other industries once full employment returned. This is a practical question, and the practical answer is that Victoria has underemployed labour, as it has had since the end of full employment in the 1970s. In the presence of this chronic underemployment it is reasonable to assume that subventions to events that generate export incomes will continue to provide jobs for otherwise underemployed workers, including via multiplier effects (Brain, 1986). It is true that in some parts of Australia severe shortages have developed for construction and related skills, but this is not the case for hospitality-related skills in Melbourne.

Economies of scale

Even if subventions to a series of events causes a transfer of resources into investment in the hospitality industries, this is not necessarily to be regretted, because as we noted in connection with capacity limits and price effects, the hospitality industries are subject to increasing returns to scale. More formally, productivity growth for the Victorian tourist industry has been positively related to output growth. This has been tested using quarterly data for the 1-digit accommodation and restaurant ANZSIC industry in Victoria between June 1994 and June 2006. The estimated equation is:

Mercantilist 2

The coefficient for (VAT/VATt–4) is strongly positive, which suggests that the hospitality industry exhibits strong economies of scale. The short-run explanation is that once the hotel rooms are in place, the restaurant tables laid out and the core staff employed, any additional demand can be met with low marginal costs. The long-run explanation may be due to economies of scale at the level of the individual hotel or to Marshallian external economies at the local industry level (Marshall, 1920, ch IX). Either way, increased productivity is likely to compensate for any mercantilist effects of a transfer of investment resources into the hospitality industry, always assuming that industries that suffer from the transfer of investment are not equally subject to economies of scale.

The additional rooms are available for the remainder of the year. Because of economies of scale, accommodation prices can be cut, helping to fill the additional rooms and so maintain the stable relationship between the peak room occupancy rate and the average annual room occupancy rate. This is an average 8 percentage point difference. Assuming that average occupancy is maintained, for the other 11 months of the year there are an additional 470,000 occupied room nights or 700,000 visitor nights. If the visitors come from outside Victoria and, on average, spend $100 a night in Victoria, total additional exports amount to $70 million. As explained above, these will generate multiplier effects. However, it should be acknowledged that other subsidised events also contribute to the attraction of visitors. Because of the uncertainties, NIEIR did not include this effect in its estimate of the benefits of the Formula One Grand Prix.

Conclusion

The point at issue is whether ‘external injections of funds’ to support events that generate export income add to the welfare of consumers in the jurisdiction injecting the funds. The claim that there is little if any addition to welfare is based on short-run equilibrium assumptions: essentially that any addition to demand in the hospitality industries must withdraw labour from production elsewhere, either interstate (ACG, 2007) or in other industries locally (Abelson, 2011). In a rhetorical flourish, Abelson accuses any analyst who argues to the contrary of committing the mercantilist fallacy. While admitting that this assumption may be approximately true in some places and at some times, we have asserted that it is not generally true and, in particular, was not true in Melbourne in March 2005. Economic assessment of an event in Melbourne at that time based on the assumption of rising marginal costs is, therefore, an example of the equilibrium fallacy.

Although the mercantilist fallacy did not apply to hospitality events in Melbourne in March 2005, an argument can be formulated that a series of such events would lead to expansion of the hospitality industry at the expense of other industries. The expansion of hospitality is, indeed, likely but additions to investment in one industry do not necessarily crowd out investments in other industries and long-run additions to capacity do not crowd out long-run production in other industries if there is chronic underemployment. Finally, given that the hospitality industry is subject to economies of scale, the effect on other industries may be less important than the cost-reducing effects in hospitality itself.

Theories that depend on equilibrium under rising marginal costs can be very attractive intellectually but it is a mistake to draw conclusions from them in circumstances where their underlying assumptions are not met. The equilibrium fallacy can be very seductive.

References

Abelson, P. (2011), ‘Evaluating Major Events and Avoiding the Mercantilist Fallacy’, Economic Papers, vol. 30, pp. 48–59.

ACG (Allen Consulting Group) (2007), ‘Commissioned Study B. Computable General Equilibrium Analysis’ (of Formula 1 Grand Prix). In: Victorian Auditor-General (2007), State Investment in Major Events, Victorian Printer, Melbourne.

Applied Economics (2007), ‘Commissioned Study A. Cost–Benefit Analysis’ (of Formula 1 Grand Prix). In: Victorian Auditor-General (2007), State Investment in Major Events, Victorian Printer, Melbourne.

Brain, P. J. (1986), The Microeconomic Structure of the    Australian    Economy,    Longman    Cheshire, Melbourne.

Kornai, J. (1971), Anti-equilibrium: On Economic Systems Theory and the Tasks of Research, North Holland, Amsterdam.

Manning, I. (2012), ‘The Economic Impact of Public Events’, National Economic Review, no. 67, pp. 19–28.

Marshall, A (1920), Principles of Economics (8th edition), Oxford, Oxford University Press.

NIEIR (2011), State of the Regions Report 2011–12, Australian Local Government Association, Canberra.

 

Economic Overview (NER 60)

National Economic Review

National Institute of Economic and Industry Research

No. 60               December 2006

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson

© National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

ISSN 0813-9474

Economic overview

Peter Brain, Executive Director, NIEIR

Abstract

In this article Peter Brain assesses the medium term outlook for both the world and Australian economies, including the importance for the latter of public sector demand and immigration as important drivers of growth.

An overview of the medium term outlook for the world and Australian economies

The medium-term outlook for the Australian economy remains shaped by a number of conflicting influences.

On the positive side these include:

  • the strong terms of trade gains which will exert upward pressure on growth, particularly in States such as Western Australia and Queensland.
  • a steady outlook for immigration; and
  • the fact that public sector balance sheets in Australia are very strong.

On the negative side are:

  • the strong downward pressure on discretionary consumption expenditure from the weight of household debt;
  • increased import penetration of final and intermediate manufactured goods, particularly from China, leading to manufacturing closures, namely in New South Wales, Victoria and South Australia; and
  • the current downturn in new dwelling construction, concentrated in 2005-06.

The strong terms of trade gains made over recent years – shown in Figure 5 – are expected to exert strong upward pressure on Australian GDP growth over the next two years. The resource boom will bring higher levels of private business investment, infrastructure development and a higher exchange rate that would have otherwise have been case. This will support higher income growth. Actual expenditures will be concentrated in the resource rich states of Queensland and Western Australia. The developing imbalance in the world economy (US trade and budget deficits, China’s increasing share of world production) will produce a correction by 2009. The question is, how severe this correction will be. A sharp correction has not been factored into this forecast, however, world growth is forecast to weaken in 2009 and 2010, and the terms of trade to fall back significantly.

Whilst the contribution of the household sector to growth will be limited by debt constraint, the state of public sector balance sheets in Australia can increasingly drive growth. The public sector can drive growth by income tax changes, infrastructure spending (which is already occurring in some states) and also debt leverage through public sector partnerships and co-opting the superannuation sector, through their infrastructure funds, to play a direct role in driving growth.

Whilst the increase in the terms of trade will benefit the resource based sectors of the Australian economy, the higher exchange rate and increasing competition from imports have, and will continue to, lead to a downsizing of Australia’s established manufacturing sectors.

The import penetration has been steadily rising in Australia, both in terms of final manufacturing products and intermediate inputs. More and more Australian manufacturers are either shifting their operations overseas or stopping operations and importing products from overseas. Australian established manufacturers in older urban area have also seen a dramatic increase in their land values as a result of the housing boom. The profitability of these operations, under increased import competition, has narrowed against the actual income potential of the land they occupy. The high exchange rate has also blunted Australia’s manufacturing export potential.

Capture1As we have seen over the recent years in Australia, the gains by the commodity based sectors of the economy and the resource based sectors will be partly offset by the downsizing and closure of established manufacturing operations. The established manufacturing sectors are concentrated in New South Wales, Victoria and South Australia.

International outlook

The world economy continued to expand at a rapid pace in 2004 with continued strong growth in the United States, China and East Asia. Economic growth in the Western Europe and Japan also picked up significantly in 2004. World economic growth was around 5 percent in 2004. This follows growth of 4 per cent in 2003 and 3 per cent in 2002. China’s GDP growth rate was around 10 per cent in 2003 and 2004.

In the projections, growth in the Chinese economy is expected to continue at around 8 to 10 per cent level through to 2009. Growth is expected to fall following the Beijing Olympics. Australian commodity exports and prices are expected to weaken at this point, with Australian terms of trade and the exchange rate both falling.

The world economy appears to have passed its cyclical peak growth rate. World economic growth is forecast to weaken slightly over 2005 -06 and 2006-07, partly in response to high oil prices. Growth is still however between 3.5 and 4.0 per cent.

The United States economy, which grew by 4.4 per cent in 2004, is projected to grow by 3.5 per cent in 2005 and 3 per cent in 2006. With continued pressures on US public sector balance sheets, high household and corporate debt levels, growth in the US economy us expected to slow post 2006. The US current account deficit reached around 6.5 per cent of GDP in early 2005. The Federal Reserve has been successively increasing rates since mid-2004, and further rates rises seem likely.

Growth in Japan was 2.7 per cent in 2004 following growth of 1.4 per cent in 2003. Growth in 2005 is projected to be 1.4 per cent and 1.8 per cent in 2006. The fundamental of the Japanese economy definitely improved over the last 18 months, and even the banking sector balance sheets have improved.

World economic growth slows to 3.5 per cent in 2008-09 and then 2.7 per cent in 2009-10, mainly reflecting weaker US economic growth and growth in China contracting to around half current growth rates.

The recent drivers of Australian economic growth

The drivers of Australia’s economic growth over the last decade are now going into reverse. From Figure 2, the household debt service ratio reaches 28 per cent of net disposable income in 2004-05. The debt service ratio is the ratio of interest and repayment of loans to net household income. This is now considerably higher than the peak level that prevailed before the 1991 recession.

In the March quarter 2005, the Australian household debt to disposable income ratio reached 174 per cent as shown in Figure 4. By comparison, the ratio four years earlier in March 2001 stood at 123 per cent. This rate of increase cannot be sustained. Indeed, this rate of increase in the household debt to income ratio is declining, as indicated by Figure 3.

It is not only debt saturation that is leading to a decline in households’ ability to absorb debt. As Figure 3 indicates, there has been a decline in the household net worth to income ratio over the last four quarters, compared to the peak level in March 2004. Household net worth is household financial assets plus market value of housing stock less financial liabilities. The major reason for the decline/stabilisation has been the stabilisation of house prices in the context of further growth in household debt.

The deteriorating household balance sheets are being reflected in the current sluggish growth in retail sales and the current slower growth in household consumption expenditure. As a result, household consumption expenditure is forecast to slow to 2.9 per cent in 2005-06 and remain at between 2.5 and 3.0 per cent per annum till the end of the decade.

Capture2In the May 2005 Budget the Federal Government gave personal income tax cuts equal to 1.0 percentage point of household income. The commencement of severe downward pressure on household expenditures from debt saturation and falling net worth to income ratios (from expected falls in house prices over 2005-06) will either offset the impact of the expenditure enhancing effects of the tax cuts, or will force the additional income from the tax cuts to be saved.Capture4
Capture3The Australian medium-term outlook

Australian GDP growth over 2004-05 was 2.3 per cent, the lowest since 2000- 01. The slowdown in Australian growth over 2004-05 reflects a gradual slowing in private consumption expenditure growth and a small fall in new dwelling investment. Household consumption expenditure and new dwelling investment were drivers of Australia GDP growth over the 2001-02 to 2003-04 peri

High levels of consumption expenditure and rising levels of business investment have lead to sharp increases in imports over the last 3 years. Import growth over the 2002 -03 to 2004-05 period has been averaging around 12 per cent per annum. Imports significantly subtracted from growth in 2004-05.

Australian GDP growth is forecast to accelerate to 2.9 per cent in 2005-06 and 3.5 per cent in 2006-07. Private consumption expenditure and dwelling construction, however, will not be the key drivers of growth. Dwelling approvals have already fallen and private dwelling construction expenditure is expected to fall by 10 per cent in 2005-06. The decline could be more significant depending upon the rate of adjustment by builders in this sector.

The decline in private consumption expenditure growth over the course of 2004-05 confirms the household debt constraint is increasing taking hold. The Federal Government tax cuts announced in 2005 will mostly be absorbed by increases in the household savings ratio. Consumption expenditure growth will fall below that ratio of growth in real household disposable income.

For the next two years Australia’s export performance will be relatively strong.

Australia’s export performance will improve over the next two years. Average export volume growth is expected to be in the vicinity of 5.0 to 6.0 per cent per annum. Export volumes are also expected to be reasonably strong as resource projects commencing over the next year are completed.

The restructuring of the manufacturing sector is adversely affecting exports. As import penetration steadily increases and plants close, exports fall because many of these bigger plants also export. Between 2008 and 2011, given the world outlook, Australia’s export performance looks bleak, unless a significant devaluation occurs.

The Australian dollar is likely to devalue strongly after 2007 or 2008.

Given Australia’s current high terms of trade from the high commodity prices and the likely downward pressure on the US$ over the next one to two years, Australia’s currency, in US$ terms, could well appreciate to the 80 cents range. This will not last. The slowdown in world GDP growth post 2008 will return the Australian current account deficit, as a per cent of GDP, to the 7.0 per cent benchmark. The return of commodity growth to more normal levels will combine with these factors to drive the Australian currency to the 60 to 70 cents range, against the US$. Given the expected devaluation of the US$, this implies a significant weighted average devaluation of the Australian currency. This is 25 per cent by 2010. The weighted average exchange rate returns to close to the low levels of 2001.

Capture6Public sector demand will become a more important driver of Australian growth.

The 2005 round of Government budgets is the forerunner of what is to come. That is, Governments in Australia sustaining growth by using their strong balance sheets to offset the decline in the capacity of the household sector to sustain growth. The State Government’s 2005-06 infrastructure expansion will add 0.5 per cent per annum to Australia’s growth rate over the next two years.

More importantly, Governments are beginning to think long term. The Queensland Government has announced a $55 billion expenditure program, while the New South Wales program is around $20 billion. Over the next 20 years, depending on the PPP (private-public sector partnership) component, Australian Governments could spend between $700 billion and $1 trillion dollars and still maintain acceptable debt to GDP ratios.

The Government sector will take over the role from the household sector in driving total investment.

 Immigration will also become an important driver of growth.

The Federal Government has announced that permanent and long term immigration will be increased by 20,000 to offset Australia’s skill shortages. Over the projection period, immigration will become an important source of growth from a variety of linkages. These include:

  • workplace growth to offset the ageing of the population;
  • direct capital inflows associated with wealthy immigration; and
  • network integration with Asia to sustain Australia’s export performance.

The next movement in interest rates will be downwards.

The downturn in the dwelling cycle has commenced. In the Eastern States the level of approvals are 10 to 20 per cent below the levels that prevailed a year ago. Domestic demand growth is slowing. Interest rates are likely to be lowered at some point in 2006. However, the extent of the downward adjustment is likely to be limited. Inflationary pressures (currently from skill shortages and commodity prices) will be joined by currency devaluation post 2008.

This will keep nominal wages and inflation at near the upper bound of the Reserve Bank of Australia’s (RBA) acceptable range for much of the projection period, despite periods of weak labour market conditions. This will also occur despite downward pressure on low skilled wage rates that will flow from the Federal Government’s industrial relations reforms.

Overall, the outlook over the projection period is one described by the RBA Governor last year. It is a growth outlook for annual Australian GDP growth that “will sometimes have a 2 in front of it and sometimes a 3”.

Capture6 Energy trade

Despite rapidly rising oil prices, rising crude oil and product imports and static domestic crude oil and condensate production, net exports of energy continue to rise. Energy exports are expected to be strong post-2006, mainly due to large expected increases in LNG exports.

Capture7

Economic Overview (NER 58)

National Economic Review  National Institute of Economic and Industry Research   No. 58        September 2005

The National Economic Review is published four times each year under the auspices of the Institute’s  Academic Board.  The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson National Institute of Economic and Industry  Research 

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

 

Economic overview  Peter Brain, Executive Director, NIEIR 

Abstract : Peter Brain assesses the Australian economy and describes alternative scenarios.

Although the GDP growth for 2003-04 was 3.6 per cent, this represented a relatively poor performance.  The GDP growth rate of 3.6 per cent for 2003-04 was the same as earlier projections. However, it represented a relatively poor performance. The reason for this assessment is due to the fact that over 2003-04 the Australian farm sector recovered from the drought. Farm product in 2003-04 grew by 27 per cent, adding 0.7 per cent to GDP growth. However, non-farm GDP grew by 3 per cent for 2003-04 despite a 5.6 per cent private consumption growth which represents the highest rate of growth for a number of years. Moreover, the growth rate of all the private investment components was 6 per cent or greater.  The reason for the relatively poor GDP growth outcome is, firstly, the poor performance of exports and, secondly, the growth in imports. There is a lag between farm production recovery and exports so the growth in exports resulting from the farm recovery will occur in 2004-05.  In 2003-04 imports grew by 13.1 per cent, only slightly below the growth in 2002-03. This represents a growth in import penetration across a wide range of sectors, including clothing, textiles, motor vehicles, chemicals and machinery. Imports represent one quarter of GDP. Hence, a 13.1 per cent import growth rate means that the growth in imports over 2003-04 reduce GDP by 2.5 per cent from what would otherwise have been the case if imports had growth in line with GDP.  Over the last two years in particular, the growth in imports has been a major negative factor in determining  Australia’s growth performance.

Australia’s exports performance has also been poor but will recover over the next three years.

In the few years since 1999-00, the value of Australia’s non-resource based exports has been flat. That is, no change has occurred. This is despite the value of trade in the Asia-Pacific region for non-resource based products growing between 30 and 40 per cent over the past four years.  In 2004-05 exports of goods and services are expected to grow by 5.1 per cent, in part due to the recovery of the farm sector. Exports will also recover over the next two to three years because of the coming on-line of major resource projects that were commenced in 2002 or 2003. The most important of these will be the fourth liquefied natural gas (LNG) train on the North West Shelf. In 2006 the Darwin LNG train will come on-line.

Both the United States and Australian dollars will devalue over the next five years relative to our trading partners. 

Exports may well recover, but without a substantial devaluation of the Australian dollar, import growth will continue to outstrip the growth of exports. With the upswing in the world interest rate cycle now occurring, the continuation of the current growth in imports would lead to an Australian current account deficit of around 7 per cent of GDP. To hold the current account deficit at the 5 per cent level, which is the projection to 2008-09, it is necessary for the Australian dollar to devalue,  in weighted average terms of around 15 per cent over the 2006 to 2009 period. This is built into the projection.  It can be seen from Table 1 that the United States/Australian exchange rate stays relatively unchanged over the projection period. The projection also allows for the outcome that the United States dollar devalues 20 per cent against the Euro, yen and yuan over the projection period. Because Australia maintains parity with the United States dollar, it follows that there is an equivalent devaluation of the Australian dollar against these currencies. The appreciation of the yuan against the United States dollar is also assumed to trigger the appreciation of other Asian currencies against the United States dollar.  It is the devaluation of the Australian dollar that leads to a more subdued growth rate for imports over 2008 and 2009.

The recent evidence is that the downside phase of the dwelling cycle has commenced.

It has long been NIEIR’s contention that the down-phase of the current dwelling cycle would only commence when significant growth in established house prices ceased. By the June quarter 2004, established house prices had stabilised with a fall in established house prices in Sydney offset by more moderate price growth elsewhere. Moreover, the trend in approvals and the financing of dwellings for new construction all point to falls in dwelling construction over the next two years. Over the next two years the cumulative decline in housing construction is projected to be 18 per cent.

The borrow and spend behaviour of households is now reaching its peak. Household balance sheet constraints will be a negative factor for growth for the foreseeable future. 

The ending of the established house price boom will also lead to a curtailment of a key driver of recent Australian economic growth, namely household borrowing to support consumption expenditure.

The growth in established house prices since 1996 resulted in the ratio of household net worth (the value of the housing stock plus financial assets less financial liabilities) increasing from 6 to 7.8 by June 2005 (Figure 2). From Figure 4, this allowed households to borrow to fund a borrowing gap which has reached 15 per cent of disposable income by June quarter 2004. The borrowing gap represents the difference between consumption expenditure and discretionary income. Discretionary income is significantly smaller than household income in the national accounts because it includes superannuation contributions and superannuation interest, which represents income that is not available for current consumption.  From Figure 3, by the June quarter 2004 the build up in debt to fund the borrowing gap (as well as the high level of housing investment) drove the household debt to net disposable income ratio to 163 per cent. In the June quarter 2002 the rate stood at 137 per cent.  From Figure 1, the household debt service ratio now stands at 25 per cent of disposable income, the highest on the historical record.  The combined impact of stable (or falling) house prices, high debt service and debt-income ratios will, at the most optimistic, force households to hold the borrowing gap at around 15 per cent of income. This will force consumption expenditure to grow in line with household disposable income, which in turn will reduce the rate of growth of private consumption expenditure to between 2 and 3 per cent over the medium term.

Even with modest consumption growth, the debt-income/debt-service ratio will continue to rise. A recession is likely at some point before 2010.

If the borrowing gap is held at 15 per cent, the debt-income ratio will still increase by around 7 percentage points per year. By 2009, given the projection in Table 1, the debt to income ratio will reach 200 per cent. If households decide to stabilise their debt-income ratio then the household savings ratio will have to rise to 6 to 8 per cent. Household consumption would most likely fall and the economy would experience a recession, probably a severe recession. However, given the forecast methodology outlined above, this aspect has been translated into a lower trend rate of growth rather than a recession and this aspect makes the low case projection of more interest than the high case projection.

Fiscal stimulus will support the household sector in the short term.  

The position in the short term is not as bleak as the borrowing gap would suggest because of the strong fiscal stimulus being given to the economy. The May 2004 Federal Budget and the election promises of October 2004 will give a stimulus of around 1 per cent per annum to household income over the next two to three years. This will probably be enough to partially offset the constraints of the household debt-service ratio. Beyond 2007, if a severe recession is to be avoided, further significant fiscal stimulus will be required. That is, as the growth in household debt slows, public sector new borrowings will have to increase significantly.

The alternative scenarios

The problem for Australia is that Australia is not the only economy with households with large amounts of illusionary wealth created by housing price bubbles. The same is true in North America, the United Kingdom and some Western European economies. An economy that is an indicator, in terms of a low scenario over the medium term, is the Netherlands. The Netherlands was a fast growing economy over the second half of the 1990s, in part driven by rapid increases in borrowings funding a house prices-wealth creation consumption boom. In 2001, house prices stabilised due to tightening monetary policy. In 2003 the economy was in recession with private consumption falling by 1.5 per cent, the largest fall since World War II.  For the Netherlands the catalyst was tightening European monetary policy over 2000. For Australia the likely trigger for a low scenario is also most likely to be an external shock such as illustrated in Table 2. There are a number of potential shocks with good probabilities of occurring over the next two to five years. They are listed in the Table.

The reason why a transition path from the base to low scenario is likely to be associated with an external catalyst is that there are two factors that would allow policy authorities to keep the economy on the base scenario trajectory despite increasing constraints in growth. These are:

  1. strong public sector balance sheets which would allow fiscal policy to be expansionary for a decade or more;
  2. the potential for Australian nominal interest rates to be lowered by between 1 and 2 percentage points.

This cushion would allow the base scenario to be achieved if the world economy remained supportive.  Unfortunately, because of vulnerable households in a number of major economies, any negative shock to the world economy is likely to trigger the ushering in of a long period of low growth for Australia, in particular, and many parts of the developed world in general. In short, the low scenario, at least to 2012 or thereabouts, does not have a low probability of outcome.  The high scenario assumes the most optimistic outcomes for the world political economy.

Australian energy trade, 2004-10 

ABARE and NIEIR analysis and estimates of Australian energy trade trends are presented below. Over the period there continues to be an energy trade surplus with projected increases in net oil imports being more than offset by coal, natural gas and uranium export increases.  In 2004-05 the trade surplus, at a projected $7.4 billion (NIEIR/ABARE), will be about $2 billion higher than in 2003-04 due to higher thermal coal exports (tonnes, prices) and higher LNG exports.

Capture1

Capture2

Capture3 Capture4

 

Energy and Environment (NER 67)

National Economic Review

National Institute of Economic and Industry Research

No. 67               November 2012

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

© National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474

Energy and environment

Graham Armstrong, Consultant, NIEIR

Abstract

This paper first reviews the United Nations Framework Convention on Climate Change Conference of the Parties in Durban (COP-17) and discusses the global and Australian developments during the months leading up to COP-18 in Doha, Qatar in November–December 2012. The legislation progress and climate action developments of Brazil, South Africa, India, China, the USA, the European Union and Australia are reviewed. Although the Durban climate talks were able to maintain momentum in the global climate effort, it remains to be seen whether the Durban Agreement will in fact be a ‘historic breakthrough’ or a deferment of ambitious climate action into the future. Second, the paper reviews Australian climate change policy developments up to 12 September 2012.

Introduction

Since the Durban Conference of the Parties of the United Nations Framework Convention on Climate Change Conference (COP-17) in December 2011, there has been little comment on global climate change policy. In Australia, comments and debate have focused almost exclusively on the Clean Energy Futures Act (CEFA), particularly the perceived negative effects of carbon pricing. Globally, more countries and regions have developed (e.g. British Columbia in Canada, some US states and China), or are developing, carbon pricing (e.g. through taxes or emission trading schemes (ETS)) (e.g. South Korea) and complementary initiatives (e.g. renewable energy, energy efficiency improvement (EEI), forestation and agriculture and transport fuel). A review of COP-17 Durban and events leading up to COP-18, Doha, Qatar are outlined in what follows.

Durban

Outcomes of Durban

Despite the disappointment that annual negotiations on a post-2012 regime have not resulted in an overall global climate agreement with quantified objectives for, at least, major greenhouse gas (GHG) emitters, there have been several positive developments. For instance, there are agreements on adaptation, the Green Climate Fund and the Technology Mechanism. With the Durban Platform, the division between developed and developing countries in terms of differentiated responsibilities has become less strict. Moreover, the focus seems to have shifted from quantified commitments (what) towards how pathways for low emission development can be realised.

Negotiating a climate policy package with quantified targets for countries (such as tried in Kyoto) is very complex. Countries negotiate within an intergovernmental setting without an overarching authority so that no country can be committed to sign a deal that it does not want. Consequently, negotiations become a game to form a coalition, the size of which is determined by the countries for which the benefits of joining the coalition are higher than the costs. As climate change is a global issue, the coalition needs to be global, so that for all countries the benefits are higher than the costs.

Negotiations have become so complex that an ambitious package with strict emission reduction commitments is likely to drive up costs. This is especially the case with many low emission technologies still being early on their learning curves with much R&D to be done, followed by deployment in the market and diffusion to commercial application. In this respect, the current financial market turbulence, with reduced availability of private and public financing, does not work in favour of new efficient technologies.

Moreover, as the Kyoto Protocol has shown, costs of quantified national commitments are difficult to predict and become an endogenous economic parameter.

Practice has shown that once a country realises that it cannot comply with the target, it can withdraw from the agreement (e.g. Canada stepped out of the Kyoto Protocol). This is especially the case if other countries are in a similar position and are willing to join the move.

On the benefit side, there is a challenge to make countries aware that ambitious climate actions could also support sustainable development objectives. There is always a risk that climate policy-making resembles the prisoner’s dilemma: if a country does not undertake actions but the others do, then it benefits from the others; if the country fears that it is the only one taking strong actions, then it will be reluctant to do so. In both cases, an individual country, in an uncoordinated setting, has an incentive not to act. The challenge, therefore, is to find ways to support countries in maximising climate and development benefits against given resources, irrespective of what other countries do.

How have the recent climate negotiations managed to address this challenge? After Durban, media headlines were not spectacular. There was a general feeling that there had been an agreement not to agree now. Durban did not provide hard figures. Canada avoided penalty by stepping out of the Kyoto Protocol. The week after Durban, this action was emphasised.

However, Copenhagen, Cancun and Durban have delivered important results, with the establishment of a framework for adaptation, through the Green Climate Fund and the Technology Mechanism, as well as provisions such as low carbon development strategies and the Technology Needs Assessments. Although not enough yet for the ‘Green Industrial Revolution’ that United Nations Framework Convention on Climate Change (UNFCCC) Executive Secretary Figueres desires, these mechanisms and provisions could considerably contribute to required system changes in countries for climate and development, backed by international capacity support, with financial, technology and knowledge transfer. All these steps are modest, but they do reflect progress.

The Durban Agreement: A deal to negotiate a deal

‘We have made history’, said UN climate negotiation chair Maite Nkoana-Mashabane when gavelling the longest negotiation session in the history of the two decades of climate negotiations to a close. However, considerable uncertainty remains as to the effectiveness of the Durban Agreement to realise sufficient climate change mitigation. This review investigates the main elements of the Durban Agreement (these are briefly summarised in Box 1) and the perspectives of several negotiating Parties, analyses the Durban outcome, and looks forward to Qatar (COP-18).

After the failure of Copenhagen (2009) and the only modest success of Cancun (2010), expectations for Durban to realise a comprehensive, legally binding agreement were not high. As such, the negotiations were essentially preoccupied with two main objectives:

  • to maintain momentum in the process to realise an agreement that incorporates all main emitting Parties (especially the USA and the BASIC countries, Brazil, South Africa, India and China); and
  • to revitalise the Kyoto Protocol through the establishment of a second commitment period and, as such, prevent the creation of a commitment gap.

Box 1 E and E NER 67

The Durban Agreement

The outcome of the Durban negotiation round, which ran from 28 November until 11 December (2 days longer than scheduled) is the Durban Agreement. One of the main components of the Durban Agreement is the establishment of a second commitment period of the Kyoto Protocol (UNFCCC, 2011a). Within this second commitment period (which is scheduled to start in 2013 and end in either 2017 or 2020 (to be decided upon at COP-18)), the aim is to ensure aggregated emissions by Parties included in Annex I are reduced by at least 25– 40 per cent below 1990 levels by 2020 (IISD, 2011). To realise this aim, it is the intention to convert the Cancun Agreement pledges for emission reductions into quantified emission limitation or reduction objectives (QELRO), information on which was to be submitted by the Parties to the Ad-hoc Working Group–Kyoto Protocol (AWG-KP) by 1 May 2012. An important unresolved issue in this regard is the implication of carry-over of assigned amount units (AAUs (abatement credits)) from the first to the second commitment period on the scale of emission reductions to be achieved (IISD, 2011). In addition, to eliminate the ‘ambition gap’ between the pledged reductions and the above emission reductions goals, the AWG-KP decision emphasizes the relevance of the 2013–2015 review of pledges.

Furthermore, the Durban Agreement outlines a negotiation process that is to result in a ‘protocol, or legal instrument, or agreed outcome with legal force’ that covers all negotiating Parties (UNFCCC, 2011b) and is to come into effect and be implemented from 2020. As such, the Ad Hoc Working Group on a Durban Platform for Enhanced Action (AWG-DP) is to complete its work no later than 2015. An important consideration in the process will be to raise the level of ambition in terms of emission reductions. This consideration will be informed by the Intergovernmental Panel on Climate Change (IPCC) Fifth Assessment Report, the 2013–2015 review and the work of the subsidiary bodies.

The Durban Agreement also allows for the completion of the design of the Green Climate Fund and designates the World Bank as the interim trustee. With these developments, the Fund should be operational in 2012 (UNFCCC, 2011c). The aim of the Fund will be ‘to promote the paradigm shift towards low-emission and climate-resilient development pathways’ by providing balanced support for developing countries between mitigation and adaptation efforts in the context of  sustainable development. With the aim of making the Technology Mechanism fully operational in 2012, the negotiations also focused on the two components of the Mechanism: the Technology Executive Committee (TEC) and the Climate Technology Centre and Network. The Durban Agreement contains a decision on the modalities and procedures of the TEC policy-making body (UNFCCC, 2011d). The TEC has had its first meeting and has developed a rolling work-plan for 2012–2013. This is an important step towards the operationalisation of the Technology Mechanism with the objective of enhancing action on technology development and transfer to support action on mitigation and adaptation. Besides financial support, support for technological development is seen as a major component of an effective climate action strategy.

Perspectives and opinions

The Durban Agreement was heralded by most negotiating Parties as a positive development towards a global climate policy regime.

The process established under the AWG-DP mirrors the call for a ‘roadmap for climate action’ made by the European Union (EU) prior to Durban. The EU posited that, for it to be persuaded into a second commitment period of the Kyoto Protocol, a pathway to universal action was a prerequisite. Therefore, it is not surprising that the EU sees the Durban Agreement as a ‘historic breakthrough’ document capable of finally realizing a global and ambitious climate policy regime (Ebels, 2011).

An important development in the international negotiations was the alignment of the small island states and least developed countries with the position of the EU (Vidal and Harvey, 2011a). This coalition allowed for a stronger negotiation position to confront the other Parties. In addition, the African countries were determined to prevent the burial of the Kyoto Protocol on African soil (IISD, 2011).

Because the USA has consistently called for symmetry between developing countries (especially China and India) and the developed countries in terms of climate policy actions, it eventually supported the proposed roadmap of the EU (Vidal and Harvey, 2011b). As such, the USA is satisfied with the Durban Agreement as it ascribes to a legal document in 2020. The US climate envoy Todd Stern stated that the Agreement:

‘had  all  the  elements  that  we  were  looking  for’

(EurActiv, 2011a; U.S. Department of State, 2011).

With a large number of Parties backing the EU proposal, attention turned to India and China. Early on in the negotiation process, China signalled some flexibility to participate in a climate regime with legal force (Conway-Smith, 2011). In return for support for the roadmap process, the EU offered to commit to a second period of the Kyoto Protocol. The formulation of what form of legal status the 2020 agreement would entail, without any current clarity of what the specifics of the deal are going to be, encountered fierce resistance, especially by India (Vidal and Harvey, 2011c). As such, the realization that the BASIC countries have agreed to a commitment with legal force ‘applicable to all Parties’ is a substantial deviation from their original negotiation position and, therefore, a major concession.

Effectiveness of Durban

With the establishment of the AWG-DP and the agreement on a second commitment period for the Kyoto Protocol, the multilateral process seems to have been revitalised. However, several aspects of the Durban Agreement allow for critical analysis. Importantly, Canada, Russia and Japan will not participate in the second commitment period of the Kyoto Protocol (Euractiv, 2011b). This signals the dwindling political importance of the Kyoto Protocol. Furthermore, the second commitment period of the Kyoto Protocol is still to be inscribed with new QELRO and amendments, and the length of commitment is still to be decided. Therefore, ‘commitment’ is limited. As such, all the second commitment period appears to achieve for now is to realise continuity for climate action.

In addition, due to persistent pressure provided by the USA, India and China, the Durban Agreement specifically incorporates the year 2020 for implementation of a new climate regime (Lynas, 2011). As such, this formulation appears to exclude the option for earlier implementation even if political agreement has been achieved. The wording of the AWG-DP aim to realise a ‘protocol, or legal instrument, or agreed outcome with legal force’ is sufficiently ambiguous to allow for multiple interpretations. In fact, when one considers the considerable negotiation effort invested in this formulation, it is not at all clear whether the different Parties have a similar understanding of what is to come into effect in 2020.

These two aspects are significant because they separate mitigation ambition and the legal nature of targets until 2020 (Lynas 2011). The voluntary Copenhagen process, dubbed pledge-and-review, will be the only system in which all Parties participate until 2020. Critics point to the fact that the pledged emission reductions made so far are insufficient to limit temperature increase to 2°C (CAT 2011). Moreover, while the Durban Agreement notes that ‘the process shall raise the level of ambition’, it does not provide methods to actually do so. This limits the potential of the Agreement.

The participation by all Parties in a legal climate regime signals the end of the Kyoto Protocol dichotomy of Annex I Parties and non-Annex I Parties. As such, it appears Durban will allow for the reformulation of the meaning of the Convention principle of ‘common but differentiated responsibilities’ into a spectrum of climate action in light of country-specific development. This could turn out to be one of the main achievements of Durban as this dichotomy was one of the principal obstacles for global agreement on climate action throughout the history of the negotiations on climate change.

Durban Agreement: A historic breakthrough or a deferment of ambitious climate action?

The long timeline involved with the established process raises doubt as to the commitment of negotiating Parties to undertake climate action. This doubt is further substantiated by the history and dynamics of the climate negotiations, which clearly outline the trade-offs made between participation, compliance and stringency. The negotiation process as it is currently formulated postpones multilateral action outside of the Kyoto Protocol to 2020.

In the meantime, climate action will need to be initiated unilaterally through the voluntary pledge-and-review approach, which, in its current form, offers no effective approach to climate change. This realisation not only stems from the notion that current pledges and actions are insufficient to realise the emission trajectory required to limit climate change to 2°C, but also finds a basis in the notion that voluntary commitments have a historically inadequate performance record both inside and outside the climate change negotiations. Moreover, because the pledge-and-review approach does not provide incentives for ambitious action, the level of commitment is unlikely to become sufficient after Durban.

The 2013–2015 review, the Fifth Assessment Report by the IPCC, and the work of the subsidiary bodies are to provide means to reduce this gap in ambition over the next couple of years. As such, while the Durban climate talks were able to maintain momentum in the global climate effort, it remains to be seen whether the Durban Agreement will, in fact, be a ‘historic breakthrough’ or a deferment of ambitious climate action into the future.

The USA

The US administration has proposed CO2e emission limits for new electricity generators at 454 kg CO2e/MWh. Unless carbon capture and storage (CCS) can be applied commercially, this effectively restricts new generators to combined cycle gas turbines (CCGT) or renewables. The rules do, however, allow new coal-fired plants to exceed the cap for 10 years provided they subsequently make up the difference by installing effective pollution controls: essentially declaring that CCS may be viable 10 years after a new coal generator is built.

Low gas prices and lower demands for electricity have favoured gas generation, kept electricity prices low and made coal generation less competitive. Continuation of these trends means that the proposed GHG inventory (GHGI) (tCO2e/MWh) rules would not have a significant impact.

Under the US Clean Air Act, with Supreme Court affirmation, the GHG emissions are a threat to ‘public health and welfare’ and GHGI rules will have to be developed for existing generators.

The European Union

European Union Allowance Unit (EUA) CO2 prices continued at low levels through the first half of 2012, at €6–9/t (A$7.5–11.25), well below the Australian CEFA prediction of A$29/t in 2015–2016 and the Australian floor price of A$15/t (see discussion below).

The  UK  Government  has  proposed  a  floor  price  of €30/t (A$38) in 2009 prices, well above the current EUA price. UK programs and regulations mean that, effectively, in the UK CO2e prices are in the A$25–30/t range. The EU is examining the possibility of reducing permit caps to provide a stimulus to attain higher EUA prices.

Current EU emissions are well below the current cap for the 11,000 liable companies, due mainly to economic conditions: hence, the EUA price drop from approximately €30 in 2008 to today’s levels of <€10/t.

Sales of permits to raise revenue for green energy projects and new EEI initiatives will add to EUA oversupply, which could reach 8.45 × 106 available permits in 2020 against a planned 2020 cap of 1.8 × 106 permits.

In December 2011, an EU committee proposed three possible strategies:

  • withhold (set aside) a tranche of permits from the market;
  • withhold 1.4 billion permits; or
  • tighten the cap.

Tightening the cap, the most effective solution (although by how much is hard to determine), would be strongly resisted by heavy emitters, such as Poland, and would reduce EU investor confidence. Cap reduction would have to be spread among EU states, which might not be easy depending on the size and timing of the cap reduction. Improving economic conditions could ease the cap reduction problems. A gradual reduction could be monitored to gauge the economic impact, which could be quite modest as the market adjusted to emission reductions by developing lower than expected cost abatement actions.

Australian developments

On 1 July 2012, the start of the fixed carbon price period commenced. As it approached, support for the carbon package dropped to below 40 per cent. Negative comments from some industry groups and the Federal Opposition continue to dominate media coverage of the legislation. Positive aspects of the package, such as compensation, early mover advantages, transition to an ETS, grants for EEI in the industrial sector and movement by other countries and jurisdictions, do not receive nearly as much publicity. Surveillance of the international press on climate change policies reveals, overall, a quite different story: one that is much more positive.

A particular aspect of the debate is the A$23/t CO2 starting price on 1 July 2012: it is above other specific CO2e prices (except in British Columbia in Canada), while the EUA price continues to be <€10/t. However, in other jurisdictions, regulatory policies have a price impact, and while probably <A$20/t, are pushing the global economy towards a lower GHGI level compared with business as usual (BAU). In the UK, the EUA prices and regulatory policies and initiatives have pushed the effective CO2 price above A$25/t.

Clean Technology Investment Program

Further details of the Clean Technology Investment Program (CTIP) were released in April 2012. Under the program, A$800 million is allocated for general manufacturers and another A$200 million for food and beverage processors and metal foundry and forging firms. For firms with turnovers of <A$100 million, 1:1 grants will be available for funding of <A$500,000. For grants from A$500,000 to A$10 million, applicants will be required to contribute A$2 for every A$1 from government. For grants of +A$10 million, a contribution of A$3 for every A$1 from government will be required (co-investment).

The total expenditure (private plus government) for EEI is likely to be well below the potential for economic EEI investment over the next 20 years. However, the CTIP is an appropriate initiative that could stimulate further EEI investment.

The CTIP application process, based on previous requirements, may be overly administratively burdensome for small and medium sized enterprises (SMEs) where no employee is dedicated to the grant application process. This does, however, create an opportunity for firms, such as Energetics, that specialise in EEI to work with SMEs on CTIP applications (also VEET in Victoria).

The CEFA programs (CTIP and the Clean Energy Finance Corporation (CEFC)) require statements on Australian participation in applications in an effort to ‘maximise’ Australian content of programs (not a mandatory percentage as in Ontario, Canada).

International permits and the floor price for permits

A floor permit price of A$15/t was proposed in the ETS phase of the CEFA. Up to 50 per cent of a firm’s liability under the CEFA was to be accessible from eligible international permits under the Clean Development Mechanism certified emission reductions (CERs) and joint implementation (JI) emission reduction units. Several politicians, industry groups and analysts proposed removing the floor price and letting the market (domestic and international) determine the price. Note that at a CO2e price below A$20/t CO2e, the impact on BAU emissions is likely to be negligible.

A ‘surrender tax’ on international permits was proposed if international permit prices continued to be below A$15/t. For example, if a permit were purchased at A$12/t, a A$3/t levy would be imposed to arrive at the A$15/t floor price.

In the ETS phase it seemed there would be two permit markets:

  • The international permit market with prices set in those markets: up to 50 per cent of the ETS cap permits could come from this source.
  • The domestic permit market for the balance of the ETS cap permits liability (which could be 100 per cent of the ETS cap if the international price were above the domestic price). Several politicians, industry groups and analysts called for a lower or no floor price, but this approach was rejected by the government. At CO2e prices below A$20/t, our analysis indicates that there will be price impacts but little impact on GHG abatement (GHGA).

Caps for the post-fixed carbon price will not be set until 2014. The caps set will depend on:

  • the 2020 target (now 5 per cent below 2000 levels by 2020);
  • progress towards the target by 2014; and
  • the schedule decided on for annual progress towards the target.

To meet the current 2020 target, modelling in 2011 estimated that approximately 160 Mt CO2e/a would need to be removed from trend GHG emissions. By 2014, the carbon tax and associated programs might have reduced this GHGA to 140 Mt CO2e/a, but the 2012–2014 GHGA impact is quite uncertain and could be very low. Assuming 50 per cent of the 140 Mt came from international permits at A$15/t (price could be much higher by 2020), 20 Mt would need to come from domestic GHGA over 2014–2020. The first cap period would presumably be for 2015–2016, the first ETS year after the fixed price years of 2012–2013, 2013–2014 and 2014–2015. Over the 2015–2016 to 2019–2020 period, domestic GHGA could come from the following.

  1. Closure of 2,000 MW of GHGI coal capacity and replacement with CCGT capacity (but not likely to be viable at under A$40/t CO2e).

With a 90-per cent capacity factor (CF) brown coal closure (2,000 MW) and a GHGI of 1.5 t CO2e/MWh, annual saving would be:

2,000 × 8.76 × 0.9 × 1.5 × 103

t = 23,652,000 t.

Replaced by 2,000 MW of CCGT at 90 per cent CF and a GHGI of 0.4 t CO2e/MWh:

2,000 × 8.76 × 0.4 × 103 = 6,307,200 t.

There is a net saving of 17,344,000 t per annum.

To save 70 Mt/a would require approximately 10,000 MW of coal of higher (>1.2 t CO2e/MWh) coal capacity to be displaced by CCGT requiring a CO2e price of A$40–50/t depending on relative coal and gas prices. A total of 45 Mt CO2 from displacing approximately 6,000 MW of higher GHGI coal might be feasible at approximately A$50/t CO2e.

  1. The Carbon Farming Initiative (CFI) might deliver 10 Mt CO2e at <A$25/t CO2e but levels and prices are quite uncertain.
  2.  Enhanced EEI might deliver 10 Mt CO2e at <A$0/t CO2e (value of discounted energy savings less investment cost).
  3. Renewables (above the renewable energy target (RET), which is included in BAU) at A$50– 150/t CO2e, approximately 5 Mt CO2e might be possible but unlikely given current trends and policies.

The above very preliminary estimates indicate that the target could be reached with international permits at an average cost of approximately (price × per cent contribution of GHGA required by 2021):

15 × 0.5 (international) + 50 × 0.32 (fossil generation) + 20 × 0.07 (CFI) + 0 × 0.07 (EEI) +   100 × 0.04 (renewables) = A$(7.5 + 16 + 1.4 +  0 + 4) = A$28.5/t CO2e (This is not the market permit price. It is the average GHGA price paid by liable parties.)

The above example indicates a potential path for achieving a 2020 target. Emissions would be reduced (50 per cent overseas and 50 per cent in Australia). However, how would the permit market evolve?

September 2012 update

As outlined above, the permit floor price of A$15/t CO2e in the ETS period was criticised as:

  • being too high and unnecessary in some industry analysts; and
  • being too low to bring about structural change toward low emission technologies by others.

In early August, it was reported in the media that changes were in the offing to limit further (from 50 per cent of liabilities) the proportion of international permits that could be acquired by liable parties. In the early years of the ETS (2015–2016) it has become more likely that international permits could be available at prices >A$5–10/t CO2, necessitating an administratively cumbersome surrender ‘tax’ top-up to A$15 from the price actually paid by liable parties.

On 28 August, the Federal Government announced major climate change policy changes. These changes are:

  • removal of the floor price of A$15/t CO2e, which was to operate over 2015–2016 to 2018– 2019, the first 3 years of the ETS phase;
  • linking of the ETS phase directly to the EU market (initially one-way, Australia buying 1 g EEAAs, but two-way by 2018), resulting in EU permit prices being the same as Australian prices; and
  • limiting access to CDM CERs and JI emission reduction units (ERUs) to 12.5 per cent of a liable entity’s liabilities (previously 50 per cent).

The Treasury modelling estimate of a A$29/t price in 2015–2016 was retained.

Issues

  1. Price of EU permits post 2014–2015. Current estimates are approximately A$12 in 2015 and A$20 in 2020. However, these estimates depend on:
  • EU growth with the current EU scheme; and
  • any changes to the EU scheme (e.g. cap tightening and deferring permit auctions) that (several proposed) that would have the effect of increasing the EU permit price.
  1. Approach taken for the proposed auctioning of domestic permits to ensure that the 2020 target of a 5-per cent reduction on 2000 emissions by 2020 is achieved. This would not become evident until liable parties began buying ERUs and EU AAUs to cover their liabilities.
  2. At permit/CO2e prices below approximately A$20/t, there would be negligible domestic GHGA from price responses by consumers and generators, although GHGA from complementary policies would continue. Limited domestic GHGA over 2015–2020 is likely to result in higher GHGA action costs, if desired, post-2020.

September 2012 status of Australian climate change policies

The 2020 target remains at 5 per cent below 2000 levels, requiring 159 Mt CO2e of abatement by 2020 according to the Treasure 2011 modelling in the Strong Growth, Low Pollution (SGLP) report (Australian Government, Treasury). In 2009–2010, emissions were 578 Mt CO2e and in the Treasury modelling, the 2020 BAU (i.e. no CEF Act policies) was 679 Mt CO2e.

At a carbon price of A$29/t CO2e by 2020, domestic emissions were estimated in the SGLP report to be 621 Mt CO2e (i.e. 58 Mt CO2e below BAU without carbon pricing), but approximately 12 per cent above 2000 levels of 550 Mt CO2e. This gives a 2020 target of approximately 520 Mt CO2e, 159 Mt CO2e below 2020 BAU emissions of 679 Mt CO2e. With domestic emission reductions of 58 Mt CO2e, 101 Mt CO2e would come from international permits.

Now with CEF Act policies in place with lower projected electricity growth rates, 2020 emissions are likely to be much less, perhaps by around 60 Mt CO2e. This would reduce the abatement task to meet the 2020 target to approximately 100 Mt CO2e.

Given the policy change to restrict JI and CDM Kyoto credits to 12.5 per cent of liabilities, the linking with the EU and the availability of EU permits (EU assigned abatement units (EUAAs)) for acquitting liabilities, and the reduction in the abatement task, where will permits for the attainment of the 2020 target now come from?

2020 emissions, targets and greenhouse gas abatement sources

  1. 2020  emissions  under  BAU  (i.e.  without  the CEFA) will now be approximately 620 Mt CO2e, as against 679 Mt CO2e in the Treasury 2011 SGLP, due to slower growth in emissions and responses to the carbon tax and CEF Act complementary measures.
  2. Attainment of the 2020 target (5 per cent below 2000 emissions by 2020) would then require abatement of approximately 100 Mt CO2e (620 – 520), compared with 159 Mt CO2e in 2011 SGLP. (Note: levels in the SGLP are not entirely consistent with respect to 2000 levels, projected 2020 levels and the abatement task required.)
  3. At 100 Mt CO2e  abatement required 12.5 per cent (12.5 Mt CO2e ) could come from Kyoto (CDM and JI) credits at <$10/t Mt CO2e , perhaps <$5/t CO2e .
  4. Some of the other 87.5 Mt CO2e (100 – 12.5) could possibly come from purchase of EU permits (EUAAUs) and from Australian CFI permits if the prices were below domestic auctioned permit prices. EUAAUs are permits to emit CO2. Currently, a surplus of EUAAUs are available due to issuance being greater than requirements, mainly due to low economic growth causing emissions to be lower than anticipated. Available permits do not result in emissions abatement unless their price is high enough to induce a switch from a higher GHGI source to a lower GHGI source. Thus, purchase of EUAs may or may not result in GHGA. Given the foreseeable surplus amount of EU permits, GHGA from purchase of these permits is likely to be negligible. Abatement to attain a given target must be sought elsewhere.
  5. Other abatement could come from additional carbon price response and complementary measures (e.g. CTIP, CEFC and CFI).

However, note that under the CEF Act, closure of 2,000 MW of high GHG intensive generators was proposed, entailing negotiation of closure with the generator owners. Prime targets for closure were Hazelwood, Yallourn and Morwell brown coal operators in Victoria, Playford B (low grade black coal) in South Australia and Collinsville (black coal) in Queensland. However, on 3 September the government announced the failure of negotiations due to unacceptably high closure dollar demands (>A$2 billion expected cost) by the generation companies. With lower than previously expected permit prices in the ETS phase, the economics of operating high GHGI plants have improved, hence their asset values.

The closure would have saved up to 23 Mt CO2e per year out of the required reduction to meet the 2020 target of a now estimated 100 to 120 Mt CO2e (lower than the previously estimated 160 Mt CO2e due to lower electricity and gas demands and impacts of complementary policies). The government claims that the closure abandonment will not affect target attainment. Why? Because of lower target attainment requirements or lower costs of other GHGA opportunities?

This failure to close the 2,000 MW of highest GHFI generators, together with compensation for carbon pricing to high GHGI generators and lower CO2e prices, makes it much less likely that significant gas generation will replace coal generation.

  1. On 1 September, the government announced that 40 million permits would be auctioned in 2013– 2014 at a projected price of $15/t CO2e. If the EU AAU price is <$15/t CO2e, why would liable parties bid $15/t CO2e at the auction for up to 40 million permits unless EU AAU access was restricted (not apparent)?
  2. How then will the target be attained? Presumably, by monitoring and frequently announcing progress towards the 2020 target and, if necessary, taking further GHGA action (e.g. by subsidising the new gas base load) to attain the target.
  3. Liable parties will continue to buy permits from CDM, JI and the EU to meet their liabilities unless domestic permit auctioning results in prices for domestic permits <EU AAU prices. If prices are less than the EU AAU prices, domestic permits can be sold into the EU market when two-way linking is established.
  4. In conclusion, to attain the 2020 target under the new permit availability arrangements, target GHGA must be continuously estimated and announced, and progress toward the target continuously monitored and announced. This is necessary to limit 2020 emissions to approximately 520 Mt CO2e. With the current (September 2012) polices, it seems very unlikely that the 2020 target will be attained.

Liable parties

Generators

Fossil generators would have to purchase permits to cover their liable emissions from accredited suppliers (see below).

Other liable parties

Other liable parties would attempt to reduce their emissions at a cost below the expected permit price by changing production characteristics and improving energy efficiency (assisted by CEFA programs). The resulting (balance of) liable emissions would be purchased in the permit market(s).

Permit suppliers

Carbon Farming Initiative

Accredited CFI units (Australian carbon units (ACUs)) can be sold directly to liable parties. If non-liable party EEI ‘suppliers’ could reduce their emissions impact through EEI and the use of renewables, they could become, for example, accredited suppliers of permits.

Government

Permits will be auctioned on the basis of the cap for each year. Liable parties will bid for these auctioned permits on the basis of requirements and marginal costs of internally reducing their emissions and purchasing international permits (depending on price and CFI AEUs).

Potential evolution of greenhouse gas emissions, greenhouse gas abatement and carbon prices over 2012–2013 to 2020–2021

In regards to estimated target emissions, does the target refer to total emissions or to liable emissions (liable emissions are approximately 65 per cent of total emissions)? Some emission reductions will come from non-liable sectors, such as agriculture.

In 2012–2013 to 2015–2016 there will be some impact of the fixed CO2e price, with the impact depending on the elasticity of demand for covered fuels, particularly electricity. Complementary measures and economic conditions (e.g. closures and household formation) will also have an impact. Note that the now expected carbon price impact will be less than the total of other price increasing impacts (e.g. fuel prices, network costs and green program costs) and not enough to significantly shift generation merit order. CEFA complementary measures are unlikely to have a significant impact until around 2015. These impacts will depend on the 2013 election results.

Overall, it is now expected that there will only be a small departure from BAU trends over this period.

The impacts of the CEFA over 2015–2016 to 2020– 2021 will depend on:

  • the CO2e permit prices over this period and the expected prices beyond this period;
  • economic conditions; and
  • the impacts of complementary measures.

Changes to the CEFA (likely under the Opposition and global pressure) would change the emission path and policy impacts.

Preliminary analysis suggests that under the CEFA, as it stands, the target (2020) could be reached if actual and expected average permit prices exceed approximately A$30/t; that is, until a combination of complementary measures and CO2e prices induce a significant (6,000–8,000 MW) shift from coal to CCGT generation. No other domestic actions appear likely to fill the target gap if this change does not eventuate.

Liable parties

In April 2012, the Clean Energy Regulator released a list of 280 liable parties: more will be added later. This is preliminary and well below the estimated 500 liable parties estimated in the CEFA analysis. A particular liable party issue is the liability of landfill sites operated mainly by municipalities. Although the minimum liable party emissions limit is 25,000 tCO2e, because landfills emit methane (×21 global warming potential) many sites, seemingly small, could become liable parties. Reduction of emissions is possible through collection of methane (from anaerobic digestion of organic wastes) and combustion to produce electricity (eligible under RET) and heat. This is practiced widely overseas (some with Australian technology) and at some landfill sites in Australia.

Accordingly, the ‘problem’ could be resolved with best practice waste management, such as at Nanaimo in British Columbia, Canada.

In June 2012, BHPB said it would not be in favour of rescinding carbon pricing but would attempt to make it ‘more optimal’ (not explained). Over 2006–2017, BHPB has a target of holding emissions constant despite a large increase in production from the company’s range of operations.

Lowy Institute Poll, 2012

The Lowy Institute’s 2012 Poll, an opinion survey of 1,005 Australian adults in March–April 2012 on a range of issues reported the following on climate change:

  • 63 per cent are against the Clean Energy Futures Act (carbon pricing elements);
  • 45 per cent are strongly against the Act (53 per cent of men and 36 per cent women);
  • 35 per cent are in favour of carbon pricing;
  • 52 per cent oppose the legislation as it will result in job losses;
  • 38 per cent say it is not necessary to act on climate change before other countries (were they told some countries were acting?);
  • 57 per cent are in favour of the Coalition removing the ETS (39 per cent with a degree) but 39 per cent against this action;
  • 36 per cent support more aggressive action on climate change (in 2006, 68 per cent were in favour);
  • 45 per cent support global warming being addressed but in a gradual and low cost way (increase of 5 per cent from 2011); support for this option is 56 per cent for the 18–29 year age group;
  • 7 per cent say they are less concerned since the climate change debate began in Australia; and
  • 18 per cent are not sure global warming is a problem and reject any steps that would have an economic cost.

The poll is not good news for the government and its partners (e.g. the Greens) but will opinions change once carbon pricing is introduced on 1 July? We await the next 6–12 months with great interest.

Polls: 1 July 2012 on

A Fairfax poll on 1 and 2 July indicated that 62 per cent of those surveyed opposed the carbon tax (up from 57 per cent in April/May) and 33 per cent were in favour. Fifty-three per cent said they would be worse off under carbon pricing despite substantial compensation. The message on the advantages of carbon pricing and the compensation was, at that time, not getting through.

In the same week, a poll by ANU’s Crawford School of Public Policy found that 40 per cent of liable companies, carbon financiers and carbon analysts (53 per cent of emitters) believed the carbon pricing would be repealed by 2016. However, only 21 per cent of those surveyed thought there would not be a scheme in 2020. Seventy per cent believed that the 5 per cent below 2000 emissions by 2020 would still be in place in 2015. Twenty-five per cent thought that the target would become more ambitious. Seventy per cent of emitters surveyed had already cut emissions; 84 per cent said they expected to make cuts over the next 3 years.

A report by The Economist found that 75 per cent of senior executives polled expected the scheme to survive, but only 33 per cent believed carbon pricing advantages would outweigh the longer-term risks of the scheme. Hence, a significant proportion of business does not believe Abbott!

A Fairfax/Nielsen poll in late July 2012 indicated that the percentage of those who thought they would be worse off under a carbon taxed dropped to 38 per cent from 51 per cent in late June 2012, with 52 per cent believing they were no worse off (37 per cent in late June and 54 per cent in late August). However, in August–September 2012 electricity and gas bills will be arriving to ‘remind’ people of the carbon tax impact, even though this will be responsible for only part of the price increase incorporated into the bills

References

Australian Government, Treasury (2011), ‘Strong Growth Low Pollution: Modelling a Carbon Price’. Available from: http://carbonpricemodelling.treasury.gov.au/carbonpric emodelling/content/report.asp.

CAT (Climate Action Tracker) (2011), ‘Climate Action Tracker: Durban Agreements a Step towards a Global Agreement but Risk of Exceeding 3°C Remains’. Available from: http://climateactiontracker.org/news/116/Durban-Agreements-a-step-towards-a-global-agreement-but-risk-of-exceeding-3C-warmingremainsscientists.html.

Conway-Smith, E. (2011), ‘China is Surprise Good Guy at Durban Climate Conference’, Globalpost, 6 December 2011. Available from: http://www.globalpost.com/dispatch/news/regions/afric a/south-africa/111205/china-surprise-good-guy-at-durban-climate-conferenc.

Ebels, P. (2011), ‘EU Claims Climate Victory but Global Warming Goes On’, EUobserver, 12 December 2011. Available from: http://euobserver.com/885/114590.

EU (2011), European Commission Press Release: Durban Must Deliver a Roadmap for Climate Action by All Major Economies. Available from: http://europa.eu/rapid/pressReleasesAction.do?referenc e=IP/11/1436&format=HTML&aged=0&language=EN &guiLanguage=en.

EurActiv (2011a), ‘UN Climate Talks Wrap 2020 Global Pact’, EurActiv, 12 December 2011. Available from: http://www.euractiv.com/climate-environment/un-climate-talks-wrap-2020-globa-news-509607.

EurActiv (2011b), ‘Canada Becomes First Country to Quit Kyoto Protocol’, EurActiv, 13 December 2011. Available from: http://www.euractiv.com/climate-environment/canada-country-quit-kyoto-protoc-news-509686.

U.S. Department of State (2011), United Nations Climate Change Conference in Durban, South Africa. Available from: http://www.state.gov/r/pa/prs/ps/2011/12/178699.htm.

IISD (International Institute for Sustainable Development) (2011), ‘Summary of the Durban Climate Change Conference’, 28 November–11 December 2011, Earth Negotiations Bulletin, vol. 12. IIISD, New York, NY. Available from: http://www.iisd.ca/download/pdf/enb12534e.pdf.

Lynas (2011), ‘The Verdict on Durban – A Major Step Forward but Not for Ten Years’. Available from: http://www.marklynas.org/2011/12/the-verdict-on-durban-a-major-step-forward-but-not-for-ten-years.

UNFCCC (United Nations Framework Convention on Climate Change) (2011a), Decision CMP.7: Outcome of the Work of the Ad Hoc Working Group on Further Commitments for Annex I Parties under the Kyoto Protocol at its Sixteenth Session. Available from: http://unfccc.int/2860.php.

UNFCCC (United Nations Framework Convention on Climate Change) (2011b), Decision CP. 17 Establishment of an Ad Hoc Working Group on the Durban Platform for Enhanced Action. Available from: http://unfccc.int/2860.php.

UNFCCC (United Nations Framework Convention on Climate Change) (2011c), Decision CP. 17: Launching of the Green Climate Fund. Available from: http://unfccc.int/2860.php.

UNFCCC (United Nations Framework Convention on Climate Change) (2011d), Decision CP. 17: Technology Executive Committee – Modalities and Procedures. Available from: http://unfccc.int/2860.php.

Vidal, J. and F. Harvey (2011a), African Nations Move Closer to EU Position at Durban, EurActiv, 9 December 2011. Available from: http://www.euractiv.com/climate-environment/african-nations-move-closer-eu-p-news-509568.

Vidal, J. and F. Harvey (2011b), ‘Durban Climate Talks See US Back EU Proposal’, Guardian, 8 December 2011. Available from: http://www.guardian.co.uk/environment/2011/dec/08/d urban-climate-talks-us-backs-europe.

Vidal, J. and F. Harvey (2011c), ‘Durban Climate Deal Struck after Tense All Night Session’. Guardian, 11 December 2011. Available from: http://www.guardian.co.uk/environment/2011/dec/11/d urban-climate-deal-struck.

Governing the Market: Threats to Australia’s Stability and Security

National Economic Review

National Institute of Economic and Industry Research

No. 64   July 2010

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

 

ISSN 0813-9474

Governing the market: Threats to Australia’s stability and security

Peter Brain, Executive Director, NIEIR

 

Abstract

This paper was presented as a lecture in the Senate Occasional Series at Parliament House, Canberra on 8 August and represents an update of ‘The Australian Federation 2001: Political structures and economic policy’, a 2001 Alfred Deakin Lecture. The basic message here is that unless Australia adopts a middle course between the highly successful corporatist state model of development and the extreme neoliberal model that Australia has selected as its development framework, Australia’s internal stability and national security could well be severely degraded over the next two decades. In short, Australia will have to relearn and reapply some strategies and instruments to govern the market.

 

This will involve some restoration of the practices and institutions that were swept away in the name of microeconomic reform over the past two decades. Australia will never be able to match the efficiency of the informal governance structures of corporatist states. For Australia, leadership will have to be provided by its governance institutions in general and parliament in particular.

Introduction

In my 2001 ‘Alfred Deakin Lecture’ I set out to:

(i)            explain why Australia in the 1980s had adopted the extreme neoliberal (or the economic rationalists) model as its development framework; and

(ii)           discuss some likely consequences of that choice.

Put simply, under the neoliberal model the state plays a largely passive role, with many of the key decisions determining the direction and quality of Australia’s economic development and its social consequences being left to the market. The explanation for why Australia adopted the model was, in part, attributed to the relatively weak state of Australia’s parliamentary institutions as a representative democracy and strong executive. This is not to say that the Australian system does not produce good outcomes for many decisions. The problem is that for some key strategic decisions the tendency is to select simple, easy to market solutions for economic and social problems that reflect the capacity, interests and vision of the political leadership group. More complex solutions that require the input of the broader political community and the design of new governance structures that may lie beyond the control of strongly established, including bureaucratic interests, tend to be eliminated at an early stage.

The likely consequences for the future noted in the 2001 lecture include:

(i)            increasing wealth/income inequalities;

(ii)           increasing foreign ownership and a narrow based economy;

(iii)          no solution to Australia’s high current account deficit and foreign debt;

(iv)         financial instability as a result of the capacity of the financial sector to expand debt to whatever level was in its interest; and

(v)          a vulnerability to negative economic shocks and a poor capacity to respond, which is now an important issue in the context of a likely carbon price shock.

The focus of this paper is to elaborate on the likely consequences of the adoption of the neoliberal model for Australia.

The Corporatist state model

The neoliberal approach focuses on market conduct and structures on the assumption that if market conduct and structure are appropriate then optimal outcomes will be achieved. Whatever outcomes are achieved through market forces will in the main, by definition, be optimal.

Corporatist states tend to approach development from the reverse direction. Objectives are specified in terms of social, political, security, export and industry output/cost targets. The means are then designed to mobilise whatever is necessary to achieve the defined objectives in the minimum time subject to global resource constraints and global as well as local market forces. The strategies of corporatist states to achieve objectives involve reducing the risks to the institutions (governance and commercial) charged with the responsibility of ensuring the objectives are achieved by:

(i)            building large scale enterprises to dominate markets and supply chains, reaping maximum economies of scale and scope, and reducing market risk to a minimum;

(iii)          ensuring that all necessary resources in terms of finance, skills and technology are available for the task;

(iv)         ensuring that any other domestic or foreign organisation cannot impede the performance of the chosen organisation(s) for the task; and

(v)          relying on regulation rather than the price mechanism.

An early Corporatist state, Germany grew by 12 per cent per annum between 1933 and 1937, with the unemployment rate cut from a third back to full employment, while most developed economies had an inferior performance though not necessarily by much. What is important is not whether a more neoliberal approach would have been more effective, but the approach was different and it seemed to work. It changed history.

The North Asian countries took note of the German strategies and applied them post war with astonishing results. One nation’s experience, South Korea’s, is miraculous. In 1961, South Korea had an annual income of US$82 per person or less than half that of

 

Ghana at the time. Today, it is one of the wealthiest countries in the world. It took the UK two centuries and the United States one and a half centuries to achieve a similar result (Chang, 2008). More importantly Korea, Taiwan, and Singapore continue to maintain per capita GDP growth rates well beyond the level achieved by other countries with a similar high level of per capita income.

In this context there are three categories of corporatist states:

(i)            The social market model of Western Europe with democratic institutions where policy institutions rely on codified statute and regulations with some reliance on non-parliamentary governance bodies representing stakeholder interests.

(ii)           The corporatist state model of Singapore, Korea, Japan and Taiwan which may or may not have effective democratic institutions but where the governance is non-transparent relying on networks between governments, bureaucracy and businesses with decisions made in the interests of the collective irrespective of codified statutes and regulations. The penalties for non-compliance are exclusion from social networks and business supply chains with severe consequences for social standing and material advancement.

(iii)        The extreme authoritarian models of Germany/Italy in the 1930s and Russia and China today, where along with social and commercial exclusion, violence (i.e. loss of property, liberty and in the extreme cases life) is a penalty for non-compliance. The extreme authoritarian model has an impenetrable informal governance structure.

 

The Germans showed in the 1930s that the arrest of an individual for economic treason when it was clearly understood that the real crime was the import of product instead of using the favoured domestic supplier was a very effective form of industry policy, which did away with the need for costly tariffs, subsidies or other financial inducements. In this context, it is interesting to note that the criteria applied in determining what foreign enterprises can and cannot currently do in China is expressed in terms of largely undefined parameters based on the concept of national economic security. Many countries aspire to the status of corporatist states. Few, however, have the capacity to reach the desired status. On this criteria the classification of Russia as a corporatist state is problematic.

China: Where to?

Of high importance to Australia’s national interest is how China will evolve. Neoliberals tend to assume that it will evolve into a market-based economy.

China is not going to be transformed into a neoliberal market economy. Instead, it may well transform itself into perhaps the most efficient corporatist state model of all time with, over the next two to three decades:

(i)            A large number of its state-owned (or indirectly controlled) enterprises (70 per cent of business assets are still under direct government control) becoming the largest companies in the world, dominating the control of capacity in many industries.

(ii)           A Communist Party that will grow rapidly and in influence on the basis of generating individual material advancement that will also provide an informal governance framework that will be simply impenetrable. No matter what the codified statutes, China will have a machinery of governance capable of doing the opposite on non-transparent command. In this context, who owns the enterprises will be irrelevant.

The Chinese see large-scale foreign investment in China mainly as a short-term strategy to:

(i)            introduce new technologies, management expertise and new skills generation; and

(ii)           construct distribution systems to the world economy,  in the shortest possible time.

It is likely as their own enterprises are built up to reach world competitiveness, the assets of foreign enterprises that directly compete with and are of no strategic value if left independent to a mandated Chinese enterprise will be taken over by a combination of intimidation (as per the Russian approach to BP and Shell assets in oil and gas sites), financial incentives and frustration, of which the recent creation of Communist Party control of Trade Union cells in foreign enterprises will be a useful tool. At worst foreign enterprises exiting China may find that they will lose a significant proportion of non-Chinese assets and intellectual property and, in the extreme, the entire enterprise.

The only major uncertainty about China is the extent to which extreme nationalism will become a hallmark of its external relations similar to what occurred in Germany in late 1930s. The recent signs in this regard are not encouraging. There are signs that strong nationalism is taking root among the young with the state having the capacity, like Germany, to manufacture outpourings of mass nationalism triggered by suitable incidents. The optimists assume that massive environmental problems and widening inequalities will trigger a move, at worst, towards the social market model. The pessimists contend that threats to the legitimacy of the elite in the context of severe resource and environmental constraints will result in the sustained administration of the drug of extreme nationalism and the rectification of past injustices at the hands of the West. To quote Robert Kagan (2008) in his recent assessment of China:

If East Asia today resembles late-nineteenth-and early-twentieth-century Europe, … a comparatively minor incident could infuriate the Chinese and lead them to choose war, despite their reluctance. It would be comforting to imagine that this will all dissipate as China grows richer and more confident, but history suggests that as China grows more confident it will grow less, not more, tolerant of the obstacles in its path. The Chinese themselves have few illusions on this score. They believe this great strategic rivalry will only ‘increase with the ascension of Chinese power.

All that has to be done is to assume, as is the case here, that China behaves no worse that the United States as a global power or no worse than the Western European powers behaved towards China in the 19th century to arrive at the conclusion that a difficult period for Australia lies ahead. This is returned too below.

The governance riddle

The riddle is that the leadership of corporatist states is even more politically exclusive and dominated by existing bureaucratic and commercial interests than is the case in Australia. Yet these states, because of a combination of history, culture, ethnic homogeneity, strength of nationalism, genes, a common view of economic competition as warfare by other means, requiring the nation to be on a permanent war footing, or whatever, are capable of delivering high performance sustainable outcomes on a long-term basis. My only answer to this riddle for Australia, based on observed Western European outcomes, is that the appropriate response to the corporatist states is not to emulate them in political structures and conduct, but to achieve similar outcomes by strengthening the institutions of representative democracy. That is, governance and the institutions of governance are important. This is in contrast to the neoliberal view that governance is relatively unimportant.

What  is  the  focus  here  is  in  regard  to  some  of Australia’s current and future economic problems, how would a corporatist state solution differ from the actual or likely neoliberal solution.

Monetary policy

The 2001 lecture I pointed to the Australian neoliberal ‘privatised’ monetary policy regime where no intermediate target for credit growth was set as is the case for the monetary policy of the European Union. Provided CPI inflation is within the desired bounds then debt accumulation could be at whatever level the market was willing to absorb. For the European Central Bank (ECB) inflation in the long run is a monetary phenomena and any credit growth on a sustained basis in excess of desired nominal GDP growth will result in undesirable inflation. In Australia credit growth in excess of desired nominal GDP growth is taken as a sign of a healthy economy. For the ECB monetary growth should be little more than desired nominal GDP growth.

 

As Table 1 indicates, the ECB has achieved its objective since 1996, while in Australia the growth in M3 relative to nominal GDP has been 28 per cent. This does not seem much but, as will be outlined below, the consequences for long-run economic and social stability will be very large.

Over the years I have criticised the Australian approach to money policy as irresponsible. That is, I have agreed with the ECB view provided inflation is defined as including established asset prices (shares, dwellings) as well as newly produced goods and services.

Therefore, sustained credit growth in excess of desired nominal GDP growth will:

 

(i)            increases the vulnerability of the economy to negative shocks by encouraging borrowing for

(ii)           create an increasing proportion of households in ‘serf’ status by forcing households to pay high debt service/rent payments as a proportion of income over an extensive period of their life cycle;

(iii)          lead to house prices (and rents) putting home ownership beyond the reach of an increasing proportion of the population and

(iv)         easy short-term growth diverting energy and attention from the constant resource mobilisation effort required for long-run sustainable growth.

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The excess monetary growth for Australia drove the build-up in asset values (Figure 1) which encouraged households to borrow and spend (Figure 2). Figure 2 shows the precipice the Australian economy is now sitting on. Non-dwelling investment borrowings by households over the last half decade have increased from 5 per cent of income to currently around 15 per cent. If only a third of this is used to support consumption, then a repeat of the 1991 experience of household borrowings for non-dwelling investment turning negative would cause the household savings ratio increasing by 5–7 percentage points, plunging the economy into the severest recession since the depression. In the context of Figure 2, the current (August 2008) dilemma facing the Reserve Bank of Australia (RBA) is self evident. Although inflation is 1.5 per cent per annum above the 3 per cent upper bound of acceptable outcomes, the RBA can either maintain tight monetary control and risk a severe recession, or abandon tight monetary policy and risk the return of longer-term unsatisfactory inflation, thereby simply postponing the day of reckoning to greater pain down the track.

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The RBA has only itself to blame for this as it is simply the result of a decade of irresponsible monetary policy. It knew of the ECB approach, but showed no intellectual leadership and simply went along with the short-term political objective of maintaining the financing of the new aspirational society. Indeed, a good case can be made that Australia’s low inflation rate over the decade to 2006 was in spite of, not because of, the RBA. Its only effective task over this period was to ensure that financial structural disequilibrium did not occur. It failed. Ultimately, Parliament will be held responsible for delegating without appropriate guidelines a core governance responsibility to unelected officials.

 

 

Towards debt serfdom

What if Australia escapes the current policy difficulty and interest rates start to come down within a year or so? The current undersupply of housing (a shortage of around 150,000 units by 2010) is increasing rents and when interest rates come down will trigger a rapid rise in dwelling prices as many try to escape rental status. In other words, the 2003–2007 cycle will be repeated with a further increase in the proportion of households that could be classified as ‘serfs’ risking longer-run social stability.

The origins of serfdom in Russia were based on the need to keep labour fixed in place because of the excess supply of land relative to labour, with high marginal physical product of labour resulting from the large territorial gains from conquest with small populations. Market forces would have driven wages to very high levels. Various tactics were tried to constrain labour mobility, such as finding replacement labour before a peasant could move. One tactic was for the landlord (the farmer of the day) to willingly lend to peasants all that was needed and more (e.g. implements, livestock and fencing): another unfortunate linking of readily available finance with an emerging aspirational society. Droughts, wars and plagues would force more lending until peasants were hopelessly in debt. This debt serfdom facilitated legislated serfdom, with the peasant tied to the land with the requirement of up to 3 days a week work for the landlord. As other family members could work on the serf’s allocated land or in the cash economy, modern serfdom ‘status’ will be taken here to arise when households pay over 35 per cent of income in debt service and rent.

The recent Australian history of the more than doubling of the household debt to income ratio since the mid-1990s is well known. However, there is little recognition of what this might mean at the micro level. Both Tables 2 and 3 clearly spell this out. It means less homes in fully-owned status and more households paying more than 35 per cent of income in rent and debt service costs. In terms of mortgage households, the 2008 estimate of the share of households paying more than 35 per cent of income in debt service costs is 23 per cent due to interest rate rises since June 2006. It should be kept in mind that from the 2006 Census, those households paying more than 35 per cent of income in debt service costs were paying an average debt service cost of just under 50 per cent of income. That is, the living standard of a household with no debt would, on average, be twice that of the average household of serf status, despite both households having the same income.

By 2018, on current conservative trends (an increase in the household debt to income of 30 per cent from current levels and interest rates declining from current levels), it is estimated that at least 22 per cent of households will be paying more than 35 per cent of income in debt service and rent costs, or a doubling since 1996 levels. This excludes the high debt of fully-owned households. It might be claimed that the use of the concept of ‘serf’ status in the modern context is over the top as households can eventually escape debt status and Russian serfdom was intergenerational. I would counter argue that, in fact, the intergenerational aspect of serfdom is de facto also emerging in modern times.

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The movement towards neoliberal solutions in education and health means that access to quality services is determined by household circumstances. The greater the number of households in serf status, the more likely the serf status will be passed on to their children as a result of underinvestment in social capital complemented by increasing resort to reverse mortgages, allowing a lifetime of high debt service costs with little or no inheritance for children. This is consistent with findings from the United States vis-à-vis Sweden. For the United States, the correlation coefficient between status of parents and children is approximately 0.5, while for high taxing equal opportunity education/health service across Sweden, it is 0.2 (Bjorklund and M. Jantti, 1997). The irony is that the United States is a society that is approaching as rigid an intergenerational class structure as what prevailed in Europe in the 18th and 19th centuries which, in part, forced the migration to the United States.

The likelihood is that if something radical is not done, there will be a high degree of intergenerational correlation in serf status. This will leave Australia with an unenviable choice around 2030 of either a severe one-off tax on wealth to ‘emancipate’ the serfs, or suppression of the serf class to maintain social stability. In any case, a society in 2018, characterised by the results given in Table 3, will be a very grumpy place. Economists have discovered that after national per capita income is greater than US$20,000, happiness is a function of relative incomes not absolute incomes. The greater the serf class, the greater the inequality of discretionary income and the greater the unhappiness.

Housing affordability

One of the core solutions to arrest the march towards a serf society is to significantly increase housing affordability for first home buyers. In this regard, the case of Germany is important because German house prices in nominal terms are only a little more than what was the case a decade earlier and have fallen in real terms. In other parts of Europe, such as Italy, house prices have doubled, so that although ECB tight monetary policy has helped, it is a necessary not a sufficient condition for maintaining high levels of housing affordability. For Australia, over the same period the increase in house prices has been a little under 180 per cent. You would think that current German housing market policies would be at the top of the agenda for all Australian governments.

Corporatist state-type housing solutions have been followed in Austria and Germany for decades. These are called social partnerships. These policies are aimed at coordinating and accommodating conflicting interests between landlords, tenants, financial institutions and government. One core feature is risk shifting from the private sector to the state.

In terms of the rental market, the features of the German housing market are:

(i)            long-term contracts of 3–10 years for tenants;

(ii)           defined rules for rent increases (e.g. consumer price indexing);

(iii)          housing benefit support based on monthly income for both renters and owner-occupiers;

(iv)         strong public sector housing construction with municipal housing construction providing approximately 10–15 per cent of housing stock.

In terms of dwelling construction and the supply of housing, direct subsidisation of housing construction at the state level takes into account the regional housing market situation. Construction support is allocated to housing companies, housing associations and individual builders on application, via, for example, preferential interest loans, grants, guarantees/securities and provision of land.

Direct financial support comes from Federal Government/state financial institutions. The focus of loans is on:

(i)            housing stock renovation;

(ii)           CO2 reduction retrofitting;

(iii)          rental new housing construction; and

(iv)         low interest loans for the construction or purchase of owner-occupier housing.

The CO2 Building Renovation Program of 25 billion Euro was introduced in 2008 for the modernising of heating systems and the energy efficiency optimisation of building shells for both renters and owner-occupiers. In addition, regulation makes it difficult to borrow more than 60 per cent of house value, with German lenders reluctant to allow mortgage top ups if a home increases in value. The overarching German objective is to ensure that the supply of houses runs well ahead of demand.

In an unequal society, increasing housing affordability and equal opportunity for housing affordability can only come from one strategy; namely, through rationing of opportunities by rationing of finance and a very targeted list of incentives. This is how the market was governed to allow Australia to solve its last major housing crisis after World War II. Each state had different strategies. Victoria rationed credit via the State Savings Bank, while New South Wales (which lost its Saving Bank in the Depression) focussed on public sector housing construction. There were many other niche instruments that have been swept away over the past 20 years under the mantra that the market will solve everything. However, the Federal Government has introduced new supply-side measures. What is clear about housing policies is that they have to be comprehensive to stop ‘leakage’ into house prices if they are to achieve the delivery of affordable housing to those who need it.

Telecommunications

If the corporatist states are as good as I am inferring in economic development, then it would be expected that they would be well ahead in the provision of quality telecommunications infrastructure. This is the case. By mid-2008, the average download speed was 61 Mbps in Japan, 45 Mbps in South Korea, 18 Mbps in Sweden, 17 Mbps in France and 1.9 Mbps in the United States.

Eighty per cent of households in Japan can connect to a fibre network at a speed of 100 mlps, 30 times the average speed in the United States. Australia is 30–50 per cent below United States levels. Australia has announced a supply-side initiative to improve the situation, but the past delay in trying to incorporate market forces into the process will mean that like electricity to Timbucktoo, Australia will get there but only when quality telecommunications is a competitive necessity and no longer a competitive advantage. The image of Australia being a technological laggard is not a good one in terms of attracting investment. The same approach in many other economic aspects has and will cost Australia dearly.

Greenhouse gas abatement policies

There is no better example of this than the approach to greenhouse gas abatement policies (GGAP). The design of GGAP regimes currently being undertaken in Australia is proceeding along strict neoliberal lines. The central touchstone is that the market is the most efficient platform for engineering the appropriate changes. All the government has to do is to set an emissions cap and the resulting price changes will miraculously allow the emissions objective to be achieved. Quoting from the ‘Carbon Pollution Reduction Scheme Green Paper’ (2008, p. 12):

There are two distinct elements of a cap and trade scheme – the cap itself and the ability to trade. The cap achieves the environmental outcome of reducing greenhouse gas pollution. The act of capping emissions creates a carbon price. The ability to trade ensures that emissions are reduced at the lowest possible cost.

Let’s consider by illustration a segment of the adjustment effort, mainly the electricity sector. Assume that a target is set to reduce total emissions by 20 per cent below 2005 levels, which would represent a (EU 2020 target) 223 million tonne reduction from a 2020 business-as-usual level in 2020. Of the 223 million tonnes, a large part of the reduction would need to come from the electricity sector. Around 91 million tonnes would need to come from replacing approximately 11,000 MW from coal fired plants. To do this, the price of carbon would need to (on NIEIR and ACIL-Tasman estimates) quickly ramp up to around $55/tonne by 2020, based on the long-run marginal cost of alternative supply in order to achieve the long-run marginal costs of a combined cycle gas turbine plant in combination with the mandated Federal renewables target.

A corporatist state would immediately conclude that the Australian market of independent generators independently bidding for supply would not be successful, even if the $55 CO2 price were achieved. The market will not react because to achieve the target, approximately $50 billion would have to be spent on generators, gas development, pipeline and transmission investment. In an unfettered market environment, the risks would simply be too great.

The risks would include:

(i)            Existing supplier risk. Yes, the asset value of existing brown and black coal plant would be reduced by over 90 per cent. However, bankruptcy would merely mean that the new owners would be willing to supply some of the market at short-run marginal cost, which might require an additional $20–25 a tonne in CO2 price (i.e. $80/tonne) to reduce the risk. If they continued their pre-emissions trading scheme output, the cap would not be attained.

(ii)           Technology risk. Electricity generation technologies are rapidly changing. At any point in time, technological change may well reduce the real long-run marginal cost by 20–50 per cent in 10 year’s time. Few are going to build a $2 billion plant today that could become obsolete shortly after it becomes operational.

(iii)          Regulatory risk. If a $60–80/tonne CO2 price results in excessive economic damage, the CO2 price will be lowered and cap attainment strictly regulated, for example, by applying a mandatory gas target, as is now applied in Queensland. Without a compensation guarantee of future prices, few will risk large investment funds.

(iv)         Gas supply risk. Yes, long-term contracts for gas supply will be negotiated with existing suppliers. However, at any time, gas discoveries could result in suppliers willing to supply long-term gas at a fraction of current prices, especially if the location were remote from existing gas distribution infrastructure or the global LNG market were oversupplied.

One option a corporatist state would readily implement would be to combine all the generators into a single body. The arithmetic is simple. Under the present structure of independent suppliers, a $55/tonne carbon price would result in costs per megawatt hour increasing from $45–$50 to approximately $90, or around 80 per cent of the wholesale price. If these costs could be spread over the entire capacity, as would be the case under a single entity, then the wholesale price increase could be limited to 20 per cent, or approximately 7 per cent for the price increase at the retail level, which would represent a minor irritant.

However, there would be further short-term savings. The price increases would be phased in as plants were completed. In terms of cost savings, the strict neoliberal approach to the current Australian situation would result in cumulative CO2 price costs of anywhere between a minimum of $110 billion and $150 billion being imposed on the economy between now and 2020 to allow for market instability and required risk margins, without any guarantee that much of the required capacity would be completed by 2020.

The corporatist state would allow a guaranteed outcome for total cumulative electricity costs increases of between $15 billion and $20 billion. All other risks are reduced to zero by allowing a monopoly. It is this logic that explains why the electricity sector was nationalised in Australia in the first half of the 20th century as state after state gave up trying to induce the required supply response at the right price from an albeit regulated private electricity sector.

A good corporatist state that did not want to renationalise the generating industry in Australia would sit down with the generators and hammer out an agreement for ownership change, exit arrangements on reasonable terms, and a regulatory environment that delivered an outcome in line with the old nationalised model where the private sector could still play a part. The current Queensland model for encouraging the use of gas in electricity generation would be a good place to start. The ultimate model would probably resemble this model and the model used by Victoria to run its train system.

The Garnaut recommendation to ignore private sector losses is not the right way to go. Governments are going to have to rely on the private sector (albeit with substantial risk shifting to the public sector) to undertake a substantial portion of the hundreds of billions of expenditures needed for greenhouse gas reduction.

Any rational corporatist state approach to CO2 reduction would place the emissions trading system at the end point, not at the beginning, in policy design. It would work out all the possible regulatory, technology and mandatory market incentives (by directly paying tradesmen to retrofit dwellings with insulation, solar panels, gas etc.), with the carbon price then set in terms of financing requirements and long-term strategic direction. A corporatist state would laugh off the suggestions of the neoliberals that Australia needs a high CO2 price for energy efficiency. Yes, there is some low lying fruit, but this isn’t the main game. Australia makes little equipment, so energy efficiency gains will depend on how overseas suppliers respond to the world carbon price. Accelerated depreciation allowances, tied investment allowances and energy efficiency performance regulation would be far more efficient in encouraging speedy adjustment. High carbon prices by themselves would simply result, in many cases, in plant shutdowns when they reached the end of their commercial life.

If the Treasury modelling into carbon prices simply assumes that the market operates optimally with ‘near perfect’ substitution between factors of production, then it should be immediately thrown into the bin. In this context, one of the best things the Federal Parliament could do for climate change is to give back to the states their income tax base set in line with their responsibilities so they can build the necessary transport infrastructure and urban design to minimise the CO2 content of connectiveness. The situation is now reaching an extreme position, where an increasing number of households in major metropolitan areas will not have the time and/or financial incomes to reach their place of work on a regular basis. The Federal Parliament must stop the practice of spending what should be State resources on income tax cuts to enhance its short-term election prospects.

Finally, in relation to climate change, if the implication of Figure 3 is correct, then by 2012 the Intergovernmental Panel on Climate Change may well revise the sea level rise up by 2100 to 10–20 metres in the same way that predictions of an ice free summer Arctic have been quickly brought forward from 100 years time to the near term. The 2–4°C predicted rise in global temperatures, even with substantial emission reduction success, would still result in rises in the sea level of tens of metres. This would require a response to reduce CO2 in the atmosphere back to the 1990 level of 350 parts per million, which would, in turn, require a near zero emissions target by 2050. This would necessitate drastic action, but the tools of the corporatist state could enable it to be done, albeit with no increase in living standards (consumption per capita) for decades.

 

National security

In the 2001 lecture I gently suggested that to protect the national interest and economic sovereignty it was desirable to bring foreign investment decisions under more parliamentary control and not leave them to an effectively unaccountable body. This course of action has become more urgent. There is no national interest in allowing major customers (i.e. Chinese enterprises) to control Australian resources. The objective here is simply to transfer value from Australia to China to enhance international competitiveness and real incomes. The concept of sending tax inspectors to Beijing to politely ask to see the books of what will be the biggest companies in the world owned by a potentially hostile country to try and recoup billions of lost tax revenue is laughable.

A good case can be made that Australia is heading towards a classic ‘banana republic’ status. The phrase ‘banana republic’ was invented to describe a country like Honduras, where foreign interests (United States) controlled the region producing the principle Honduras exports (bananas) and all supporting infrastructure. The region was run like a private chiefdom in which companies kept order, and crushed labour dissent using their own security forces or, when necessary, by calling in United States troops, who then established military bases in the country. The irony is that the aim of preventing Australia from becoming a banana republic (Paul Keating, 1986) was one reason for adopting the extreme neoliberal model. It wouldn’t be the first time that a policy shift achieved the reverse of what was intended. In this context, for Parliament not to take back control of foreign investment decisions could well be seen from the hindsight of 2030 as pure treason. The immediate task is to reduce Chinese foreign investment in Australian mineral resources to zero.

When doing this, Parliament could usefully abolish the Productivity Commission and replace it with a body directly under Parliamentary control, focussed on protecting Australia’s economic and political sovereignty. The Productivity Commission can do good work but, unfortunately, its ideological blinkers can result in it unintentionally operating as a fifth column within government, reinforcing those private and foreign messages and demands that have and will undermine the national interest. This is an intolerable situation.

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United States and Australian security

Whether the above can occur depends in part on the speed of the relative decline of the United States relative to China. Over the next decades, Australian security very much depends on the relative decline in political economy strength of the United States being as slow as possible so as to allow the region to develop balanced multipolar counterweight power centres in which Australia can enhance its security. Unfortunately, trends in this regard are not optimistic. The United States seems to have gotten itself into an unstable political cycle, where the Republicans have been hell bent on exhausting the Federal treasury (largely for the benefit of their own constituency) so there are few resources available to correct some of the United States fundamental problems (not all that dissimilar to Australia). This, when coupled with established interests being able to influence both parties for changed regulation, removal of regulation and less regulatory oversight for the enormous benefit of a few and the eventual misery of many does not bode well for a political response that will arrest the United States’ relative decline.

In this context, not surprising, is the outcome that during the Bush administration three-quarters of the economic gains went to the top 1 per cent of taxpayers (The Economist, 2008). To sustain its economic strength and to combat climate change, the United States, like Australia, requires a redistribution of resources from consumption to investment. The magnitude of such a change can probably only be done with very strong political leadership that, in relatively normal times, would only effectively come from a leader from the right; that is, a Republican such as Teddy Roosevelt. This avoids the charge of class warfare. For a Democrat leader to engineer this outcome would require a massive economic or security crisis, as per Franklin Roosevelt. This might, of course, occur, but the probability is that the United States will continue to experience destabilising political cycles that will sap its economic and political strength.

The point may well be reached sooner than any of us think when the United States will have to decide, as Britain had to in 1902 with the Anglo–Japanese treaty, what its strategic interests were and what had to be let go. That is, the United States will have to decide what will remain in its sphere of interest and what will have to be conceded to, for example, China and India. As Australia becomes more vital to the Chinese economy, and the greater the Chinese investment in Australia, the more likely, irrespective of history, culture and tradition, that the United States will have to decide that Australia can no longer be justified as being a member of its sphere of influence.

From this perspective, the faster Australia can diversify its trade and the stake of countries in Australia, the greater the ability Australia will have to protect its effective sovereignty. This gives industry policy a strategic security status, which is common to most corporatist states.

Industry policy

The record of Australian industry policy has been appalling. As Table 4 indicates, the relative fall in Australia’s non-mining merchandise exports has accelerated over the past decade, which would be expected given the Coalition Government’s downgrading of industry policy. Australian service exports in real terms have been virtually stagnant since 2000. The resort to trade agreements will not be successful. NIEIR investigated the impact of the trade agreements to the end of 2007, including the United States Free Trade Agreement, and found the effect to be small, in terms of manufacturing (NIEIR, 2008). They might have been successful 20 years ago, but now

Australia’s trading relationships are being massively overshadowed by the growth of Asia and Latin America. The neoliberal policy focus is largely irrelevant. The concept of an Australia–China free trade agreement is an oxymoron.

To succeed in the future, Australia will have to integrate itself into the informal networks of Asia, using whatever levers it has to lift the glass ceiling applying to Australia as set by informal governance structures. These levers would include defence relationships, foreign investment in Australia, ethnic networks operating from Australia, cultural affinity and the strategic foreign investment in selected countries. For success, this requires a coordinated effort from many.

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Conclusion

The outlook over the next 20 years has to be approached with a sense of pessimism. Left unabated, current trends suggest that Australia will be facing increasing external pressure, coupled with internal economic malaise and a growing feeling that political institutions are not working. The most recent period that is likely to be similar to the future is the mid-1970s. The mid-1970s was characterised by a combination of intense Cold War pressure and economic meltdown from an energy crisis. The mid-1970s was a strange time, with coups, quasi coups and attempted coups in a number of places, including the UK, where the early stages of an attempted coup centred on Lord Mountbatten. The attempted coup was terminated by the resignation of the British Prime Minister of the day, Harold Wilson (Freedland, 2006).

To avoid similar circumstances prevailing, Parliament’s role is clear. It must put in place institutions and policies that will govern the market in such a way that the current and future challenges are controlled, stemmed and defeated. A large percentage of the population could have a very poor long-term expectation of the future, and this time around Australia could be without powerful friends. To effectively combat the three challenges of climate change, external security and internal stability, the requirement is for the adoption and maintenance of a semi-wartime footing in policy focus and implementation.

 

 

References

Australian Government  (2008),  Carbon  Pollution Reduction      Scheme   Green   Paper,   July,   p.   12, Department of Climate Change.

Bjorklund A., and M. Jantti (1997), Intergenerational mobility in Sweden compared to the United States,

American Economic Review, Volume 87 See Also The Economist, Even higher society even harder to ascend, 29 December 2004.

Chang, H-J. (2008), Bad Samaritans: The Myth of Free Trade and   the   Recent   History   of   Capitalism, Bloomsberg Press, NY.

Freedland, J.  (2006),  The  Wilson  Plot  was  our Watergate, The Guardian, 15 March 2006.

Kagan, R. (2008), The Return of History and the End of Dreams, Alfred A. Knopp, New York.

NIEIR (2008), An Evaluation of the Impact of Australian Free Trade Agreements to the End of 2007, for the AMWU, 9 April.

The Economist (2008), 1 August, p. 43.

Income Tax Zone Rebates

National Economic Review

National Institute of Economic and Industry Research

No. 68               October 2013

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474

Income tax zone rebates

 Dr Ian Manning, Deputy Executive Director, NIEIR

Abstract

 

Remote area zone rebates or allowances have been a feature of Australian income tax since 1945 and the social security system since 1984. In 2009, the Henry report on the tax system recommended that they should be reviewed, but no action has been taken. Zone rebates accord with each of the major purposes of the tax system. The first of these is the promotion of economic efficiency and economic development, chiefly by supporting the costs of infrastructure provision in remote areas and so assisting the pastoral and mining industries, where there is a case for compensation for the incidental effects of macroeconomic policy on these industries, and also assisting tourism, defence and indigenous development. The second major purpose of the tax system is the ability to pay principle; in this case, compensation for lower real incomes due to higher outback prices. Third is the benefit principle; that is, recognition of the higher cost of access to essential services from outback areas. As the Henry review expected, there is also a case for a review of zone boundaries, of the residence requirements and, in particular, of the rates, which have not been indexed since 1993. This paper presents the case for a review.

This paper was prepared for the Shires of Bulloo, Murweh, Paroo and Quilpie, the Maranoa Regional Council and Regional Development Australia, Darling Downs South West region. It is printed with permission.

Introduction

 For 68 years the income tax has included provisions to reduce the tax that would otherwise be payable by residents of remote areas. The major report into the tax system prepared by the Australian Treasury in 2009 (Australia’s Future Tax System: Report to the Treasurer or, informally, ‘the Henry review’) refers to these provisions as the ‘zone tax offset’. The report admits that it does not examine the zone offset in any detail but its basic attitude is clear from the wording of its Recommendation 6:

To remove complexity and ensure government assistance is properly targeted, concessional offsets should be removed, rationalised or replaced by outlays. … The zone tax offset should be reviewed. If it is to be retained, it should be based on contemporary measures of remoteness.”

Such a review has yet to materialise. The remote area tax rebate continues to be offered at rates that were last adjusted in 1993 and, therefore, have been significantly eroded by inflation. As of September 2011, all classes of zone rebate were worth around 62 per cent of their value in 1993 (adjusted by the consumer price index for Darwin). Longer term comparisons are more difficult because of changing consumption patterns, rising incomes and the switch from tax deductions to rebates. Updating using the consumer price index, the current zone A rebate is worth approximately 70 per cent of the value of the zone A rebate to a single worker on average earnings in 1948, but in relation to average weekly earnings the current zone A rebate is worth only a quarter of its value in 1948.

Given the recent lack of indexation, it appears that the remote area rebate is fated to fade away. This paper outlines the case for retaining and updating it.

History of income tax concessions for remote areas

In its present form, the Australian income tax dates from the Second World War. To pay for the war, the Commonwealth increased its rates of income tax considerably and incorporated the various state income taxes into its own tax. When the fighting ended the enhanced income tax continued to be collected, largely to pay for post-war investments in national development and also to enhance the social security system. In line with contemporary practice, the tax featured a schedule of rising marginal rates.

At the time, Australia was experiencing full employment and both businesses and governments resorted to paying ‘district and regional allowances’ to attract workers to remote and tropical jobs, many of which were considered of high priority for national development reasons. Much of the benefit of these supplements was clawed back by the Commonwealth through its marginal tax rates: at the time, the top marginal rate was over 75 per cent, although the marginal rate for a typical worker was around 18 per cent. In 1945 zone allowances were introduced in the form of deductions from taxable income for taxpayers resident in regions where workers commonly received district or regional allowances to compensate them for ‘disabilities of uncongenial climatic conditions, isolation or relatively high cost of living’.

Zone allowances were made available to all taxpayers who spent at least 6 months of the tax year living in a zone, not merely those who received district or regional allowances.

Two zones were defined. Zone A comprised the Australian tropics apart from the Queensland east coast south of Cape Tribulation, and zone B included the Queensland coast from Cape Tribulation south to Sarina plus the following: a belt of inland Queensland adjacent to zone A; the far west of New South Wales; the far north of South Australia; the Western Australian goldfields and the west of Tasmania. From the beginning, and to this day, zone A attracted a greater allowance than zone B.

In 1955 the zone A boundary was extended south to the 26th parallel. From 1958 zone allowances were complemented by loadings on the deductions for dependants, which had long been a feature of the tax system. In 1975 the zone allowance was converted to a rebate. The additional allowances for dependants were also converted to rebates and zone residents became entitled to percentage additions to their basic dependent rebates. When rebates for children were merged into Family Allowance payments they remained as an element in the zone rebate system.

The Public Inquiry into Income Tax Zone Allowances was conducted in 1981. Zone dependant rebates were increased as a result of this inquiry. A second important change was the creation of special areas, defined as places within zone A or B located more than 250 km by the shortest practicable surface route from the nearest town with more than 2,500 people as of 1981. The rebate in the special zone has been set at 3.47 times the zone A rebate.

Finally, in 1984 remote area allowances were introduced as supplements to all the major income-support social security payments. Remote area allowances are available to pensioners and some beneficiaries who are permanent residents of tax zone A and special tax zones located within zone B. They are not available in the non-special parts of zone B. The allowances are paid at the same rate without distinction between the special zones and the rest of zone A. Although not part of the income tax system, these allowances are an obvious complement to the income tax zone rebate. Taken together, they mean that the Commonwealth provides income allowances for nearly all permanent remote area residents.

The Cox Inquiry

The 1981 Cox Inquiry is the only review of the system to date and, therefore, is worth considering in detail. The four members of the Public Inquiry into Income Tax Zone Allowances called for submissions and arranged public consultations. After going through this process they found that their views diverged. As a result, the team of four members produced three reports with different recommendations. The main report was signed by the chairman (P. E. Cox) and S. G. W. Burston and, with reservations, by the other two members. G. Slater prepared a minority report with alternative recommendations and A. M. Kerr added a statement in which he endorsed some recommendations and varied others. However, the Cox Inquiry was unanimous in recommending that zone allowances should continue; the differences between its members concerned the geography of eligibility and the rates of allowance.

It is likely that in any future review much the same arguments will be considered and similar divergences will emerge. We will accordingly base our discussion of the purpose of the rebates on the points raised in 1981. We will also ask whether conditions have changed so as to affect the relevance of the arguments, keeping in mind two obvious differences since 1981:

  • that the real value of the rebates has declined through failure to index them; and
  • that the income tax rebates are now complemented by social security entitlements.

There have also been various other more subtle changes since 1981 and, indeed, since 1945.

Incidence of zone rebates

Serious discussion of remote area rebates is only possible if we know who they benefit. As compared with a situation where rebates are not available, do they benefit employees, granting them higher disposable incomes, or do they benefit employers, allowing them to reduce cash pay rates?

When remote area allowances were introduced in 1945 it was assumed that they were essentially a benefit to employers who would be able to attract labour with lower remote area loadings than would have been required in the absence of the tax allowance. However, much recent discussion of the equity of zone rebates assumes that they have no effect on pay rates and, therefore, the rebate benefits the employee. It is hard to make a definitive judgement since the answer depends on an unobservable variable: What would remote area wage rates be in the absence of the zone rebate?

Tentative answers are as follows:

  1. Where the rebate is large (as it was, in relation to wage rates, when the provision was first introduced), it is hard to argue that it will not affect at least some wage rates. When this happens at least some of the benefit will accrue to employers, who may increase the level of remote area employment in response. Per contra, when the rebate is small (as it is now, in relation to wage rates) it is less likely to be taken into account in wage negotiations.
  2. Where wage rates are fixed by centralised wage-setting authorities without regard for geographic area, it is more likely that the benefit will accrue to employees. When wage rates are set by ‘the market’, it is more likely that the rebate will be taken into account in setting wage rates and, therefore, will accrue to employers.

Given the erosion of the value of the rebate in relation to wage rates, one would expect a trend towards its benefiting employees rather than employers. However, the trend away from centralised wage determination to bargained rates has increased the chances that the rebate will benefit employers. These two trends cancel out, and the best that can be said is that the incidence of the rebate is likely to vary with circumstances. By contrast, the remote area allowance in social security unambiguously increases the income of its recipients.

Decentralisation and industry development

The Second World War was a shock to Australia’s sense of security. One reaction to this shock was to seek to raise the national population and in particular to populate the north: those vast regions with population densities way below those not so far away in Asia. It was also believed that there were significant unutilised resources in the north and that exploitation of these resources would be of national benefit. Tax incentives were an obvious element in policies to populate and develop the north.

‘Develop the north’

In 1945 it was commonly believed that one of the hindrances to populating and developing the north was the ‘uncongenial climate’. For decades up until the Second World War most tropical countries were under the control of the European powers as colonies. In these countries the colonialists managed and the natives worked. The racial division of labour in the tropical colonies meant that the idea that people eligible to be citizens of White Australia could do all the work necessary to develop tropical Australia was still somewhat novel. Populating the north would be a great national experiment and there was a sense that the nation as a whole should participate in the experiment by providing cash rewards to people who went north.

The Australian population doubled during the 37 years separating the original provision of zone allowances and the Cox Committee’s hearings in 1981, but not in the pattern envisaged by those who sought to populate the north: the growth was based on manufacturing and much of it occurred in the cities, reflecting deliberate policies of industry development. The committee held its hearings at a time when Australia was debating government involvement in industry development, particularly tariffs. Tariff cuts were a cause célèbre in remote areas where it was argued that abandoning protection would provide a major stimulus to local export industries, including pastoral production and mining. It was even argued that, in the absence of tariff cuts, zone rebates were justified as compensation for the costs of protection. Three decades on, tariffs have been cut, the mining and pastoral industries continue their cycle of boom and bust (currently boom) and the argument for zone rebates as compensation for tariffs has disappeared. The Australian population has grown by a further 50 per cent, still mainly in the major cities and their immediate surrounds but with one significant change: Darwin has moved from backwater status to become a vibrant if small city.

During the post-war period the cry to develop the north became muted. The memory of recent conflict faded and various high-profile investments to develop the north struck economic trouble (e.g. Humpty Doo rice and the Ord River Dam). At the same time, Australians became less anxious about their capacity to survive and work in the tropics, although to this day Australian tourists avoid the north and centre during the hot and wet seasons. Despite these subsiding anxieties, the Cox Inquiry took the idea of compensation for an uncongenial climate seriously. The committee observed that no place in Australia has a completely congenial climate: everywhere there are episodes when it is too hot or too cold or too wet or too dry. However, some places are less comfortable than others. According to a meteorological discomfort index, which emphasises heat and humidity, the most uncongenial region extends eastwards from Kununurra. Even in this area it is now possible (at an expense) to create congenial indoor, car-driving and plant-operating conditions through air conditioning. If air conditioning is the answer, there is no need for compensation for uncongenial climate but there may be a case for compensation for the cost of air conditioning and, for that matter, for the cost of heating in cold places.

Interest in population geography did not disappear when the metropolitan electorates forgot about populating the north, but was replaced by the promotion of decentralisation, which meant moving jobs out of the capital cities to reduce congestion costs. This argument for decentralisation was, however, irrelevant to zone rebates since it was not necessary to move more than a moderate distance from the capital cities to avoid congestion; indeed, longer moves into the remote regions tended to increase transport costs.

Although decentralisation provided no more than weak support for zone rebates, there was still the argument that it was in the national interest to encourage the development of remote area resources. Whereas this argument was important in 1945, the Cox Inquiry gave it relatively little attention. All members of the inquiry, despite their divergences in other respects, seem to have been persuaded that resource development would be better pursued by other means. They provided very little discussion of what these other means might be, although in the 1980s there was a rising body of opinion that held that development should be left to the private sector. The Cox Inquiry concluded that zone rebates were justified on ‘horizontal equity’ but not industry development grounds. The equity arguments will be considered below, after the economic development arguments are reconsidered.

Structure of the outback economy

Discussion of the economic development argument for zone rebates not only requires assumptions about incidence (employee or employer?) but a definition of the remote areas. It would be possible to adopt current tax definitions (i.e. zone A, zone B and the special zone), but, as the Henry report points out, these zones are in need of review. Remote areas can be conceptualised in two main ways:

  • as regions of low population density that either lack urban centres or have few and isolated towns; or
  • as regions with limited agricultural resources apart (perhaps) from small irrigated oases.

The two concepts are related, with the low population density the result of the limited resource base. For the purpose of this discussion the remote area, or outback, will be defined as country where there is no, or very little, arable or forest land. By this definition Victoria, Tasmania and the Australian Capital Territory do not contain any remote areas. In Western Australia, South Australia and New South Wales the remote areas comprise all country outback of the wheat-sheep belt and in Queensland all country west of the Maranoa, the Peak Downs and the Tablelands back of Cairns. All of the Northern Territory is remote except Darwin and its immediate surrounds. To avoid confusion with ‘remote Australia’ as defined by the Australian Bureau of Statistics (ABS), we will refer to this area as the outback.

Although the outback lacks arable land and, hence, has few farmers, it is by no means lacking in pastoral and mineral resources. This is reflected in the industry distribution of the approximately 150,000 jobs (1.6 per cent of the national total) that were located in the outback in 2001 (Table 1).

 Table 1   Outback employment by industry, 2006

 Capture

 Three industries were overrepresented in outback employment: mining (including associated manufacturing such as smelting and equipment repair), the pastoral industry (plus fishing, hunting and a few meatworks) and tourism (in so far as this can be separated from the more general accommodation and transport industries). Defence and general government service employment was present at slightly above national average rates, while all other employment was underrepresented in relation to the national average. In particular, the outback generates few jobs in finance, information, professional and scientific services.

Arguments for assistance to outback economic development

Several strands of argument for assistance to outback economic development can be distinguished. Two of the arguments are familiar from the history of zone rebates:

  • the strategic and moral argument that Australia wishes to occupy, and be seen to occupy, its whole national territory, and to take such measures as are necessary to defend it; and
  • the argument that resources should be developed.


The question is whether, given the range of policies available, zone rebates are an efficient means towards achieving these ends. In addition, a new argument has arisen. In 1945 and even in 1981 the proponents of developing the north tended to overlook the fact that much of remote Australia was already occupied by indigenous people, admittedly at low density but including regions where a century of efforts to develop profitable settler enterprises had failed. Over the past 30 years indigenous occupation has been recognised by the award of native title over significant parts of remote Australia to traditional owners. Social and environmental changes mean that these owners and their families can no longer live on their traditional lands as hunter-gatherers. Although some remote indigenous communities have an assured economic base, many of them depend on a mixture of Centrelink payments and government employment. It is beyond the scope of this paper to enter into the current vigorous debate about the economic future of these communities but it is fair to ask whether zone rebates have a role in generating ‘real jobs’ for them.

The economic development argument for zone rebates resolves into the judgement that it is desirable to develop remote areas more rapidly than would take place under ‘hands off’ policies and that zone rebates make sense as a component of the resulting economic development policies.

If the benefit of zone rebates goes to the employee, they may be interpreted as an incentive to employees to undertake remote area work. If the benefit of zone rebates goes to the employer, they may be interpreted as an incentive to employers to create remote area jobs. Although the discussion could be cast in terms of either interpretation, the present discussion will assume that the benefit of the rebates goes to employers and reduces the cost of remote area labour. It is, in effect, a wage subsidy.

At this point it must be conceded that the effectiveness of wage subsidies in generating remote area employment and economic development is likely to vary across the outback and also between remote area industries. However, outback areas have several features in common:

  1. Their industry structure is thin. Typically, they have only one or two economic base industries plus support services.
  2. Their  economic  base  industries  are  typically trade-exposed;   indeed,   most   are   export industries directly dependent on overseas markets.

 These characteristics leave the remote areas subject to several market failures:

  1. Along with other tradable industries, they are exposed to overvaluation of the exchange rate. Australia’s chronic balance of payments deficit provides evidence that the exchange rate is, on average, overvalued and that, to correct this, trade-exposed (particularly export) industries should be encouraged vis-à-vis trade-sheltered industries. This applies to trade-exposed industries generally but is crucial in the remote areas due to their dependence on such industries.
  2. Not only is the exchange rate overvalued but it fluctuates unpredictably. In addition to the price fluctuations generated by international markets, the trade-exposed industries are further exposed to price fluctuations generated by movements in the exchange rate. Current policy is to welcome these movements for their contribution to short-term macroeconomic management but they have the serious side-effect of increasing the level of risk borne by long-lived investment in the trade-exposed industries. Much of the investment required by outback industries is long-lived, consisting as it does of property improvements and transport infrastructure. Once again, there is a case for policies to ameliorate this side-effect.
  3. This industry structure and low population density mean that the remote areas depend more heavily than others on government provision of infrastructure. For example, telecommunications are commercially highly profitable in high-density areas but not so in low-density areas.

These arguments will surface in various forms as we discuss the major outback industries. As shown in the discussion above, mining now dominates the outback export industries. However, it remains that pastoral production is the classic, and most widespread, outback export industry. We will consider it first.

 

Pastoral production

From first settlement the pastoral industries (wool and beef) were seen as the economic mainstay of the outback, as they still are in western New South Wales,Western Queensland, northern South Australia and much of the Northern Territory. Judged by employment, they dominate the economic base of shires such as Central Darling (New South Wales), Barcoo and Boulia (Queensland). In such shires pastoral production may be augmented by hunting (e.g. feral goats and kangaroos). Some of the coastal outback supports a fishing industry, which, like hunting, is run by small businesses.

When considering the importance of sheep and cattle in the outback it is important to remember that pastoral production also occurs elsewhere, including in the wheat/sheep belt and hilly pastoral areas such as New England and the Monaro. Is it reasonable to argue for zone rebates for the remote part of the pastoral industry while denying them to the same industry operating in closer-settled regions?

Managing a high-risk industry

Government policy towards the remote area pastoral industry is discussed in a companion article that deals with the position in South West Queensland. The experience in South West Queensland and, indeed, in the pastoral industry as a whole is that the industry is high risk as the succession of good and bad seasons interacts with fluctuating commodity prices and the risk-increasing effects of fluctuating exchange rates. For the best part of two centuries the pastoral industry has proved its resilience, not only to price fluctuations but to the sequence of good and bad seasons. Resilience involves prudent accumulation of reserves during the good times and maintenance of capacity during the bad: it is hard to take advantage of the next in the capricious series of booms without productive capacity in place.

Reserves can be accumulated in different ways. One way is through cash and off-property investments but another is by making improvements to property. The pastoral industry has traditionally used a combination of off-property and on-property investment to employ funds generated in the upswings of the seasonal and commodity cycles. Similarly, the maintenance phase can be financed by running down investments (and in dire necessity incurring debt) and by postponing on-property investment, but preferably in a way that does not threaten capacity.

At the regional level, these business strategies can be complemented by government action. When the pastoral industry is in a boom phase, the government can help to release local resources to participate in the boom by restricting itself to maintenance. When the pastoral industry is in a maintenance phase, it is appropriate for governments to attempt to take up the slack, investing in infrastructure as a contribution to readiness for the next boom. It is, of course, as difficult for governments as for businesses to make the necessary financial arrangements, exercising discipline during booms and countering despondency during periods of slack activity, but this is no excuse for not trying.

In this discussion it has been assumed that fluctuating commodity prices are inevitable. It has often been pointed out that steady capacity utilisation would be less wasteful than the current alternation between the costs of overcapacity production and the costs of underutilised capacity. While steady prices sufficient to generate a moderate rate of profit minimise costs, there is no known way to achieve this steadiness in commodity markets. The chief lesson from Australia’s long and sorry history of government schemes to stabilise 0agricultural markets is that intervention at the industry level is hazardous, to say the least, and that governments are best restricted to general countercyclical policy, including the maintenance of infrastructure and its extension during times when activity levels require support.

Case for remote area wage subsidies in the pastoral industry

Against this background, can a case be made for zone rebates to assist the remote area pastoral industry? Because the rebates have to be financed, it may be assumed that they (slightly) increase tax rates in non-remote areas and, therefore (slightly), reduce employment in these areas. Can a case be made for this?

We have already noted an argument on these lines: the claim, in 1981, that zone rebates compensated for the effect of tariffs on remote area industry costs. This argument has lapsed with the cuts in tariffs, and in any case it drew a long bow. However, it can still be argued that pastoral employment in remote areas should be encouraged through zone rebates, as follows:

  1. Remote areas depend on trade-exposed industries subject to volatile international prices. These industries are important for balance of payments reasons. Price volatility coupled with a finance sector that is unable to provide insurance against medium-term price fluctuations creates risks which, if not managed, will result in these industries having less capacity (and the non-tradable industries having more capacity) than desirable in the overall long-run allocation of resources. It is neither possible nor desirable that the price volatility should be removed. In lieu of removal of price volatility, other ways should be sought to ensure that capacity is maintained, particularly in downturns.
  2. The prohibition of direct industry-specific subsidies by World Trade Organisation rules means that indirect industry support measures are relevant. Possible indirect support includes skills training, subsidies to research and market development, government provision of infrastructure and wage subsidies available on a regional rather than an industry basis.
  3. The advantages of wage subsidies on a regional basis are stronger than they appear prima facie, in that such subsidies assist the maintenance and development of regional infrastructure (defined broadly to include support services) on which the pastoral industry depends.
  4. The case for regional wage subsidies is strongest in the remote areas, due to their high level of risk. Not only are the seasons more variable than in the closer-settled regions but the thin industry structure means that there is little flexibility to turn to alternative sources of income when the pastoral industry is suffering from a downturn.
  5. The case for wage subsidies is strongest when the industry is in maintenance phase but can be made generally, in that wage subsidies compensate across the trade cycle for the higher than average (and partly artificial) risks, which otherwise result in the pastoral industries attracting less investment than is economically efficient.

 

The market failure case for wage subsidies in remote areas where the pastoral industry provides the economic base therefore rests on these areas being much more dependent on a trade-exposed industry subject to volatile prices than the rest of the country. In addition, the residents as a whole contribute, through their social networks and support services, to the productive capacity of the pastoral export industry.

Providing wage subsidies to all outback employers, rather than just to the trade-exposed pastoral industry, strengthens the capacity of the region as a whole to support export production while avoiding interference with the market allocation of resources within the remote areas and interfering no more than marginally with the allocation of resources between the remote and non-remote areas. The capacity of local and state governments to maintain infrastructure and the capacity of local service suppliers (e.g. retail, equipment maintenance and social facilities) are enhanced along with the capacity of pastoralists to maintain their properties

 Mineral resource exploitation

Although the pastoral industry is the classic outback activity, the mining industry is currently very active in several outback regions.

Mineral resource exploitation and the pastoral industry: Similarities and differences

The mineral resource industry covers mining broadly defined to include production of metal ores, energy minerals and non-metallic minerals plus mineral exploration, services to mining and related manufacturing activities, such as ore beneficiation and heavy equipment repair carried out close to mine sites. This industry has several characteristics in common with the pastoral industry:

  • many of its operations, to the extent of a quarter of total industry employment, are in the outback as defined for this paper;
  • the industry is trade-exposed and has to cope with the vagaries of international commodity markets and the Australian dollar exchange rate; and
  • like the outback pastoral industry, the mining industry has the choice of making do with the levels of infrastructure provided by the Commonwealth, state and local governments, or providing its own.

Despite the likenesses there are major differences. First, most parts of the mineral resource industry are capital intensive and wages are a minor proportion of costs. Therefore, wage subsidies are unlikely to affect the location or level of industry activity. However, they may affect resource allocation decisions within the industry, particularly resource allocation to labour-intensive industry activities, such as site remediation.

Second, the exploitation of mineral resources is extractive whereas pastoral production is sustainable provided overstocking is avoided. The extractive nature of the mining industry is reflected in different financial arrangements: miners have to pay royalties to the state governments. The high profitability of the mining industry during the current boom has generated debate as to whether the states and territories are levying sufficient royalties to compensate future generations for the sale of the resource (see discussion in the companion article). Those who argue that the industry is being subsidised through low royalty payments are likely to argue that it should not receive any further benefits from wage subsidies.

Third, the exposure of the mining industry to fluctuating exchange rates is limited by the fact that the industry is largely overseas-owned, which means that its capital transactions are carried out in overseas currency rather than Australian dollars. This reduces risk and reduces the cogency of the argument for compensation for uninsurable risk.

Fourth, the financial strength of the large overseas-owned corporations which dominate mining lessens the case for wage subsidies.

Fifth, mining industry employment is concentrated in a small number of major outback centres. The four Pilbara shires plus Kalgoorlie and Mount Isa together account for nearly half of total outback mineral resource employment. These workers have access to reasonable urban facilities, which lessens the case for wage subsidies to ease recruitment.

Finally, as noted in the companion article, the mining industry has adopted a completely different employment strategy to the other remote area industries, one which may further reduce the case for wage subsidies. Many of the firms in the industry have adopted a policy of high wages, low expenditure on workforce development and low job security. A major element in this strategy is fly-in fly-out and the question raised is whether wage subsidies should apply to fly-in fly-out workers.

We will first consider fly-in fly-out and then return to the more general case.

Fly-in fly-out

Currently, whether a fly-in fly-out worker can claim a zone rebate depends on the 6-month rule. A claim can be made if the worker spends more than 6 months worth of nights in the zone during 2 successive financial years. It is not unknown for employment contracts to be drawn up with an eye to satisfying this requirement. It would be a simple matter to withdraw eligibility from fly-in fly-out workers by extending the residence requirement to (say) 10 months in each year or, alternatively, to reduce the residence period so as to include visiting professional personnel who stay for shorter periods.

The decision here depends on conceptualisation. If the wage subsidy is simply a wage subsidy to industries that are under-investing due to uninsurable risks arising from price and exchange rate volatility, it would be appropriate to extend it to all persons employed in such industries, whether in remote areas or no. If, however, the wage subsidy is a form of compensation to those who employ the residents of communities that are heavily dependent on the risk-exposed export industries and that contribute to the prosperity of those regions, it is not appropriate to extend the subsidy to fly-in fly-out workers. Looked at this way, fly-in fly-out workers should be seen as belonging to the labour markets of their region of primary residence. It is argued in the companion article that the mineral exploitation industry, with exceptions, has not been highly committed to regional development, and when it is committed to such development, it is likely to develop a resident workforce that would be eligible for remote area rebates under a 10-month rule.

A second argument for excluding fly-in fly-out workers from wage subsidies was also reviewed in the companion article: fly-in fly-out is perceived as imposing unnecessary costs on workers’ families. If this is the case, the least the Commonwealth can do is to refrain from subsidising it. Exclusion of fly-in fly-out workers while continuing to support resident employment provides employers with an incentive to the latter.

It should also be noted that, in so far as fly-in fly-out workers spend their incomes in their places of permanent residence and not in the remote regions, arguments for compensation for high living costs or for high costs of access to public services do not apply to them.

Finally, the extent to which remote area employers resort to fly-in fly-out is also influenced by fringe benefits tax. A review of this tax is beyond the scope of this article but would have to be incorporated into any considered review of the zone rebates.

Exploration and infrastructure

Mineral production sites (i.e. mines, quarries, oil and gas wells and processing facilities) generally have specialised infrastructure requirements that are, rightly, provided by the industry. However, one crucial part of the mineral industries depends more heavily on general infrastructure: mineral exploration. This is also a high-risk part of the industry because many mineral explorers find nothing. This risk is magnified financially since it arises well in advance of any resulting revenue.

Approximately 8,000 people are employed in mineral exploration nationally, which is a little over 10 per cent of the workforce employed in mining broadly defined. Of these, around 1,500 work in the outback and a further 900 or so work at no fixed address. Even if we add these numbers together, mineral exploration is responsible for less than 2 per cent of outback employment and many of these workers are likely to be flying-in and flying-out. Employment in mineral exploration is spread across the continent, with concentrations in the capital cities (particularly Perth) and the mining provinces.

Where mineral explorers are engaged in proving up and extending deposits that are already in production they may rely on purpose-built industry infrastructure, but where they are seeking new deposits far and wide they rely on the transport, supply and support facilities that happen to be in place. Support to the providers of these facilities, whether by wage subsidies or otherwise, assists mineral exploration, leading to a case for wage subsidies to infrastructure provision useful to mineral exploration.

The case for wage subsidies to the outback mining industry in general is less strong than for the pastoral industry, particularly in boom times such as the present, but is likely to become stronger when it becomes a question of maintaining capacity during a slump and when the industry is providing infrastructure of general benefit. Wage subsidies also reduce the cost of remediation, thus encouraging the industry to take this responsibility seriously. There is also a case for wages subsidies to outback resident workers as a way of lessening the advantages of fly-in fly-out to employers.

 Defence

Four significant defence complexes are located within the current tax zones A and B, at Cairns (Queensland), Townsville (Queensland), Darwin/Berrimah (Northern Territory) and Katherine (Northern Territory). In total, these installations account for 13 per cent of persons employed in the defence of Australia (compared with 16 per cent Canberra). However, only about 1,250 defence personnel are employed in the outback as defined in this paper and they constitute less than 1 per cent of total outback employment.

It may be argued that the Commonwealth does not need to provide itself with wage subsidies in order to employ its own employees: it could equally well charge full taxes and use the proceeds to raise employee wages. On this argument there is no need for zone rebates for Commonwealth employees, including defence personnel. However, zone rebates are only a wage subsidy if their eventual incidence benefits the employer; technically, they are a tax rebate claimed by employees. Therefore, It would be administratively inconvenient to deny them to Commonwealth employees while allowing them for other income recipients.

It is more important to note that the effectiveness of defence personnel depends not so much on the location of their bases as on the ease with which they can access the areas that they are to defend. Access is mainly by road, although also by air and sea. Local and state governments have substantial responsibility for roads and airstrips in remote areas. There are no explicit Commonwealth payments that recognise the defence importance of these assets, although this is partly taken into account in Commonwealth grants for roads and other local government expenditures. Wage subsidies assist in equalising costs so that similar amounts of grants yield similar amounts of road maintenance. The main defence argument for outback wage subsidies is thus an argument for infrastructure subsidies.

Tourism

A number of Australia’s major tourist attractions lie in remote regions, along with a considerable further number of potential attractions. Remote locations that have developed significant trade over the past three decades include Kakadu, Uluru, Broome and Shark Bay. Many less well-known remote locations have also developed tourism as part of their economic base.

Governments have acknowledged the importance of tourism as an economic activity through regulation to maintain standards and assistance with publicity. They also provide the transport infrastructure that underpins tourism. Remote area transport infrastructure is undergoing steady improvement, which has generated additional tourism activity. However, there are plenty of opportunities to develop the industry further.

The current high Australian dollar is proving that tourism is a trade-exposed industry with a claim on outback wage subsidies not dissimilar to that of the pastoral industry. Like defence, it depends on transport infrastructure, not to speak of basic social infrastructure. In this way, it generates an argument for wage subsidies to the provision of outback infrastructure broadly defined.

Lands in traditional ownership

Much effort has been expended over many decades to find an economic base for communities living on traditional lands, including experiments with agriculture, silviculture, pastoral production, tourism and mining. In some places these experiments have succeeded but, scattered across remote Australia, there remain many indigenous communities that depend on welfare payments and, hence, on remote area social security allowances.

Wage subsidies assist the states, local governments and non-profit agencies in provision of welfare-oriented employment (including health services and education). They also assist with the provision of physical infrastructure, including the transport and communication facilities without which there is little hope that ‘real jobs’ will become available. For example, it is sometimes argued that real jobs could arise in land conservation, including from such measures as the recent Carbon Farming Initiative. These developments will require local transport between communities and the places to be conserved, not to speak of transport facilities for tourists to come and admire conservation areas.

Service employment

The industries discussed so far (i.e. the outback export or economic base industries) account for roughly one-third of outback employment (Table 1). The remaining two-thirds comprises employment in various service industries, including transport, trade, education, health services and government services. In discussing the outback export industries, the importance of these service industries has been emphasised: the economic viability of outback export industries (including defence) depends on infrastructure; that is, on the adequacy of the services provided by the service industries. As a general rule these industries are labour intensive (particularly health and education) and stand to benefit from wage subsidies. Indeed, much of the economic case for outback wage subsidies rests on their contribution to infrastructure provision and the indirect contribution this makes to the export industries.

Contribution of zone rebates to outback development

It is argued above that zone rebates have a place in encouraging outback economic development and by this means underwriting the effective occupancy of the Australian continent, both by indigenous communities and by the general population. In particular, wage subsidies are helpful in two ways:

  • by assisting with the provision of infrastructure in the broad sense, so benefiting the economic base industries of the outback and enabling them to fulfil their role in utilising the resources of the outback to the national benefit; and
  • by countering high levels of uninsurable risk in the major outback export industries.

Additional benefits arise because the assistance to infrastructure helps with defence and will potentially contribute to the self-improvement of the remote indigenous communities.

Higher Education Contribution Scheme

We have so far considered zone allowances as primarily an income tax provision. However, the provision could be extended to the Higher EducationContribution Scheme (HECS). HECS has many virtues as a means of financing higher education. It is essentially a tax measure since it relies on income tax assessments to recoup loans, thus avoiding many of the problems of private-sector student loan schemes, although with the corresponding disadvantage that repayment can be avoided by emigration.

An incentive to young professionals to work in remote areas could be provided by the Commonwealth forgoing HECS repayments which would otherwise have been exacted from residents of remote areas.

Costs of living

We now turn to the equity arguments for zone rebates considered by the Cox Inquiry.

Remote area rebates have frequently been defended as compensation for higher costs of living in remote areas. This is most easily argued if one takes the view that the benefit goes to employees: the concession then goes to increase the taxpayer’s disposable income to compensate for higher prices. However, in a free labour market it is likely that price compensation has already been included in the wage package and that the benefit of the rebate goes to employers. In this case, the rebate (partly) compensates employers for the higher costs of labour hire in the remote regions, where these costs relate to the higher cost of living.

The Cox Inquiry took the simple approach. If the taxpayer rather than the employer benefits from the rebate, it is arguably fair that income received should be adjusted for geographic price differentials. Comparing two people on the same cash wage, the one who has to pay higher prices has the lower ability to pay taxes. However, as always, there is a contrary argument. If geographic differentials reflect different costs in service provision or different land costs, they have a function in providing incentives to the efficient location of economic activity. Compensation will blunt the incentives. A taxpayer who objects to the higher prices charged in the remote areas has the option of shifting elsewhere and the incentive argument says that this is exactly what he or she should do; the taxpayer should not be granted a concession. In this conflict of values the Cox Inquiry inclined towards the ‘real income’ or ‘horizontal equalisation’ view. Essentially they argued that the incentive effects were less important than the inequity of depressing the standard of living of outback employees.

It is one thing to claim that the cost of living is higher in remote areas than in some reference area, say the metropolitan areas. It is quite another to give this monetary expression. The following observations are more or less agreed:

  1. Transport costs add to the price of widely-distributed consumer goods in remote regions.
  2. In small remote towns there are further additions due to diseconomies of small scale, including less than truckload shipments and/or high warehousing costs for larger shipments. Consumers can avoid these costs only at the considerable expense of driving to a larger town.
  3. Remote area consumers are further disadvantaged by the limited range of goods and services on offer.
  4. Housing cost differentials are more complicated; in general, the unimproved value of the underlying land is less than in metropolitan areas but the costs of construction are greater.
  5. Construction costs are particularly high in small towns that lack resident tradespeople, since transport and accommodation costs have to be met.

The Cox Inquiry noted that the ABS had, in the late 1970s, prepared an experimental index of relative retail prices for food across Australia’s major metropolitan areas and a large selection of country towns. Where a weighted average of prices in the eight capital cities was set at 100 this index yielded values of 110 in Cunnamulla and Charleville, the only two centres assessed in South West Queensland. It was only in the Pilbara that larger and smaller centres could be compared, with an index value of 115 in Port Hedland and 136 in Marble Bar. Judging by this differential, Thargomindah would probably turn in a value around 125. The index was experimental and was not continued, but the differentials thus documented accord with current anecdotal experience in South West Queensland: not only for food but for consumer prices generally. The main exception is housing costs, which depend on the balance of supply and demand in each town.

A fundamental feature of price indices is that they cover the same ‘basket of goods and services’ for each comparison. This is a bold assumption over time (new commodities are constantly entering consumers’ shopping trolleys and old items exiting) and it is an even bolder assumption when comparing places. Consumers in remote areas have different opportunities to those in the metropolitan areas: less choice, perhaps, but also some choices that are not available in metropolitan areas (a rodeo perhaps). Again, restricted choice itself has benefits: there is no need to agonise over choice and perhaps there is more time for simple entertainment, like yarning over a beer or playing participant sport. Some remote area residents have rejected the rat race; they don’t have to keep up with the Joneses and consider that they pay less for a better life than they would have had in the cities. More generally, people confronted with different price patterns adjust to those patterns; they buy more of what is relatively cheap and don’t agonise over what is relatively expensive or not available. The resulting difficulties of measurement are known in economics as the ‘index number problem’, which means that comparisons apply to ‘typical’ people and not to those who have taken particular advantage of the opportunities available in different places or at different times. When metropolitan and remote areas are compared, the result regarding a ‘typical person’ is robust: the cost of living is, indeed, higher in remote areas.

Even so, the difficulties of measuring cost of living differentials and the lack of up-to-date evidence have caused people to appeal to an alternative differential (i.e. differences in access to government services) as a way of quantifying outback disadvantage. This does not mean that the cost of living argument has lost its force; rather, it has been supplemented with a related argument pointing in the same direction.

Isolation and services

In 1945 zone allowances were, in part, justified as compensation for isolation. This is a somewhat slippery concept. In so far as it was desirable to compensate for isolation so that it would be easier to recruit labour to the developmental task in the remote regions, the argument collapses back to populating the north, decentralisation and the exploitation of remote resources already discussed. However, the argument can take another tack: zone rebates can be seen as (possibly token) compensation for the reduced range of government services available to the residents of remote regions and/or as partial compensation for the transport and telecommunications costs occasioned in accessing essential services. Here the appeal is to another of the classic principles of taxation, the benefit principle, which argues that taxes should be related to the value of benefits received. Remote area residents receive less benefit and, therefore, should pay less. Alternatively, the private (mainly transport) costs of accessing government services are greater and there should be compensation for this. Those who make this argument tend to assume that taxpayers receive the benefit of the rebate, but like cost compensation the argument can also be applied when the benefit is assumed to go to employers. The rebate then compensates employers for the extra wages they have to pay so that their employees can access services.

In 1981 it was argued that zone rebates were an unfair way of compensating for service access costs because they were available only to taxpayers and not to people who fell below the tax threshold. This argument is no longer valid. The provision of remote area allowances to social security recipients in 1984 means that most remote area residents now gain compensation.

Remote area residents have two main ways of dealing with the problems of service access. These are:

  1. Bundling trips: Visits to service outlets, other than emergency visits, can be bundled together and satisfied in a single ‘trip to town’.
  2. Accepting a more limited range of choice and a concentration on the quality of local facilities. Thus, metropolitan residents who disapprove of the education provided in their local high school send their children somewhere else. Residents of towns that are not large enough to support multiple schools are much more likely to campaign for an improvement in standards in their local school.

By contrast with the lack of recent work on cost of living differences, two studies on geographic differences in service provision have been published since the Cox Inquiry.

In 1997 the Commonwealth Department of Health and Aged Care commissioned the National Key Centre for Social Applications of GIS to develop an accessibility/remoteness index for Australia. There are two main inputs to this calculation:

  • a list of urban centres classified into five population groups, 1,000–5,000, 5,000–18,000, 18,000–48,000, 48,000–250,000 and >250,000; and
  • a matrix of road distances.

For each ‘populated locality’ in Australia, road distances are calculated to the nearest urban centre in each of the five groups. This distance is divided by the average all-Australia distance for the category. The five scores thus obtained are added and used to define five ‘remoteness area classes’. (That there are five scores and five classes is coincidental: the researchers could have varied either number.) The remoteness area classes vary from ‘major city’ through ‘inner regional’, ‘outer regional’ and ‘remote’ to ‘very remote’. (Note the peculiar use of ‘regional’ in this nomenclature to mean neither metropolitan nor remote.) The ABS has adopted this index as a means of classifying the remoteness of localities throughout Australia.

The fundamental assumption underlying the remoteness index is that service availability depends on town size and that increments in service availability occur at the five population thresholds used in the classification. Using the same general methodology, a different size classification would yield different patterns. Similarly, different weights could be awarded to the size categories. Work by NIEIR for the Farm Institute provides a check on these assumptions, since this work did not take urban centre size as a proxy for service availability but instead plotted actual locations of service delivery and estimated the distances residents would have to travel to visit the nearest outlet for a standard list of services, mainly in the education, health and welfare fields. For some services, the second-nearest and third-nearest (and so on) facilities were included at reduced weight, to allow a modicum of choice. Not surprisingly, in view of the major differences between services provided in the heavily and sparsely populated regions, both the ABS and NIEIR studies supported two conclusions:

  1. The accessibility of services differs systematically between rural locations (defined as all settlements of less than a thousand population) and urban locations. (The ABS has been understandably reluctant to publish remoteness indicators for other than very small geographic areas because the typical larger area, say a local government area, contains a range of locations that often have significant differences in accessibility to services).
  2. The accessibility of services also differs systematically with distance from the major metropolitan areas. This differential is particularly marked if emphasis is placed on choice of service outlets; for example, only the metropolitan areas have multiple universities.

 The NIEIR study distinguished between widespread and centralised services. The former are available locally in most country towns complete with a choice of service providers where this is appropriate (it is not appropriate, for example, for police services), while centralised services are provided mainly in the metropolitan areas and not in the country. Centralised services include tertiary education and specialised health services, and also, surprisingly, secondary education, which is available in the typical country town but with very limited choice.

Judged by employment, centralised services account for roughly one-third of the public services provided in Australia. Because of their metropolitan concentration, they account for the way in which service accessibility declines with distance from the main cities. However, even if attention is confined to the widespread services and the micro-variation between towns and the countryside is averaged out, the NIEIR service accessibility index generates patterns that largely accord with the ABS remoteness index. According to the ABS the ‘very remote’ area comprises: the Australian north coast from Shark Bay nearly to Cooktown, except around Darwin; the coast of the Great Australian Bight; and all the country between these two coasts except for the immediate surrounds of Alice Springs and Mount Isa, which are merely ‘remote’. In South West Queensland all places west of Mitchell are considered ‘very remote’, while the ‘remote’ area is a strip between the ‘very remote’ area and a line running from roughly Dirrinbandi to Miles.

The NIEIR study helps to place these patterns in context. According to this study a typical journey from a residence to the nearest outlet of a widespread service (or nearest several outlets in the case of services like GPs where choice is important) will take more or less the following times:

  • 12 minutes in Brisbane;
  • approximately 12 minutes in Dalby but more like 40 minutes in the rural parts of Western Downs;
  • just under 2 hours in Roma (due to restricted choice in some services) and over 2 hours in the rest of Maranoa;
  • just under 3 hours in Charleville (again, mainly due to restricted local choice) and over 3 hours in the rest of Murweh and in Paroo; and
  • nearly 5 hours for residents of Quilpie and Bulloo Shires.

These estimates can be roughly translated into dollar costs. Without imputing any cost to residents’ time, the typical metropolitan service access trip costs around $3. It costs less in towns like Bundaberg due to less congestion and lower car parking costs. At the other end of the distribution, the typical remote area trip costs around $50. As already pointed out, remote area residents manage these accessibility costs by restricting choice, by bundling trips and simply by doing without (e.g. by forgoing education).

To a large extent the superior accessibility of essential services in the metropolitan areas and provincial cities is due to the inexorable logic of economies of scale. An approach that emphasises economic efficiency narrowly defined would leave it at that: services are cheaper to provide in large centres and if citizens want good services they should shift to these centres. (Never mind if the shift causes congestion and increases land costs.) However, the Queensland Government endeavours to guarantee equality of service access to all its citizens, if necessary by bearing transport costs and also by upholding service standards in remote areas to overcome the need for choice and duplication.

Given this policy, is there any need for zone rebates and the complementary social security allowances as contributions towards service access costs? Whatever the good intentions of the state governments, remote area residents bear significant service access costs that have to be met from their own pockets. The zone rebates can be interpreted as a contribution towards basic mobility (e.g. car ownership, assumed by service providers). In addition, accessibility costs for essential services can be taken as proxy for accessibility disadvantages more generally – those which we have already considered as cost of living disadvantages or, more broadly, the costs of a minimum level of engagement with society as a whole – those costs which, in the broad social welfare literature, are called the costs of belonging.

The Cox Inquiry argued that poor service accessibility and high costs of living together provided an equity argument for zone allowances. At the very least, accessibility calculations help to identify the affected areas and the size of the disability. Given that the prime purpose of social security is to provide minimum

incomes to people who have no other income source, equity arguments apply particularly strongly to the recipients of remote area allowances, but also apply to income earners in general.

Zone boundaries

When the system was inaugurated in 1945, the then Treasurer, Mr Chifley, said that the zone boundaries took into account latitude, rainfall, distance from centres of population, density of population, predominant industries, rail and road services and the cost of food and groceries. Unfortunately, the exact criteria used in the demarcation (if there were any) have been lost.

The only general change to date in the zone boundaries occurred in 1955 when the boundary of zone A was extended south to the 26th parallel, so conveniently including the whole of the Northern Territory within zone A. As noted above, special zones were introduced in 1981.

A comparison of the current zone map with the ABS remoteness/accessibility index broadly mapped, and similarly with the NIEIR/Farm Institute service accessibility index, shows several major divergences. We consider first the zone A/zone B differential:

  1. Although Darwin is somewhat disadvantaged (according to the ABS it ranks as ‘outer regional’) its level of remoteness is well short of that in the typical zone A location. It might be added that Darwin has now developed a broad industry structure and is no longer dependent on the prosperity of a limited number of export industries exposed to fluctuating world prices.
  2. Similar considerations apply to the Queensland coast between Mackay and Cairns, which is included in zone B despite ‘outer regional’ status.
  3. There is essentially no difference in remoteness between zone A and B locations either side of the 26th parallel. No remoteness gradient runs along this line, nor is there any noticeable difference in industry composition either side (although it is roughly the northern limit for sheep).
  4. Apart from Darwin and the Queensland coast, zones A and B taken together are remarkably similar to ‘very remote Australia’ as defined by the ABS and confirmed by NIEIR. This applies whether remoteness is defined in terms of distance from services, distances from towns or thin industry structure arising from a lack of arable land.

By contrast, apart from Mount Isa, Alice Springs, Kalgoorlie and Esperance, the special zones are not recognisable in the ABS remoteness map, nor are they to be found in the NIEIR calculations. For example, in Queensland, Charleville and Longreach are each responsible for large circles in which residents are not entitled to special zone allowances, but in both instances the typical trip to access a widespread service from within the town is rated at around 2 hours and from within the excluded circle is closer to 3 hours. Among the isolated centres in Queensland, only Mount Isa is large enough, and has a sufficient range of services, to produce a significant improvement in accessibility. This suggests two conclusions:

  1. A town population of 2,500 is too low to produce significant improvements in accessibility in an otherwise remote area. Judging by the populations of Alice Springs, Mount Isa and Kalgoorlie, the cut-off appears to be more like 15,000.
  2. The radius of 250 road km is too long. Accessibility drops rapidly with distance from urban centres.

 

There is a strong case for redefining the zones to take these findings into account. The exclusion of Darwin, Mackay, Townsville and Cairns and the adjacent coast, plus an extension of the eligibility period from 6 to 10 months, would go a long way towards financing the redrawing of zone boundaries. An outback zone could be based on ‘very remote’ Australia as defined by the ABS. A new fringe outback zone could serve as a transition area and also accommodate towns of 15,000 plus population which would otherwise be located within the outback zone. The special zones would be abolished. It is suggested that the rebate for the outback zone would be the current special zone rebate, updated, while the rebate for the marginally outback zone would be the current zone A rebate, updated. The social security remote area allowance would be available to permanent residents of the outback zone and possibly, at reduced rates, to permanent residents of the marginal outback.

Value of the allowance/rebate

When introduced the zone A allowance was set at £40 but in 1947 it was increased to £120, a considerable concession at a time when workers were typically paid around £500 a year (average earnings per railway employee were £477 in 1948–1949). In conjunction with the schedule of marginal rates, this increased disposable incomes by 3 to 4 per cent compared with charging the full income tax to workers in zone A. The zone A deduction was indexed sporadically and in 1958–1959, after an increase, produced increases in disposable income of the order of 6 per cent for workers on average weekly earnings. The additional deductions for dependants meant that the proportion was broadly similar for taxpayers with and without dependants. From 1959, however, there was a pronounced reluctance to index the allowances, later rebates, for inflation.

The Cox Inquiry failed to produce any indexation of the rebates but its recommendations to raise the loading for dependants and introduce special zones were implemented. As a result, in the 1981–1982 tax year zone rebates produced the following increases in real incomes (calculated, for convenience, on the assumption that the allowance benefits the taxpayer rather than the employer).

  1. For a taxpayer on average weekly earnings living in zone A, an increase in disposable income of approximately 1.8 per cent. Due to the dependant allowances, this increase was roughly the same for all levels of dependants.
  2. For a taxpayer on the minimum wage living in zone A, an increase in disposable income of approximately 2.7 per cent. Increases for taxpayers with dependants were somewhat less because they ran out of tax to offset the rebate against.
  3. For a taxpayer on average weekly earnings living in a special zone: an increase in disposable income of 6.3 per cent (9.4 per cent for a taxpayer on the minimum wage).

The two dissenting members of the Cox Committee would both have made more generous allowances available:

  1. Mr Kerr, a rebate sufficient to raise the disposable incomes of taxpayers earning average weekly earnings in the special zone by 12.6 per cent (18.8 per cent if on the minimum wage); and
  2. Mr Slater, a rebate sufficient to raise the disposable incomes of taxpayers earning average weekly earnings in a revised zone A by 16.8 per cent (22.2 per cent if on the minimum wage).

The rebates were increased in 1984, 1985, 1992 and 1993, but since then the zone A rebate has remained at $338 plus a 50-per cent loading on dependant rebates. Due to growth in earnings and lack of indexation of the rebate, its value has now been eroded to an increase of 0.8 per cent in the disposable income of a zone A resident without dependants receiving average weekly earnings. The value of the rebate for a taxpayer without dependants working in the special zone now stands at an increase in disposable income of 2.7 per cent.

The value of the remote area allowance for social security recipients stood in 2011 at an increase of 2.6 per cent in the disposable income of a single pensioner and 3 per cent in the disposable income of a couple.

The real value of zone rebates has been falling since

1993, which accords with Treasury’s preference for removing concessional tax offsets. Indeed, the failure to review the zone rebate might indicate satisfaction with the current non-indexed benefit: from Treasury’s point of view there is a risk that a review will defend the rebate and recommend that it be raised. The present paper has shown that there are, indeed, strong arguments for retaining and increasing the rebate.

Conclusion

It is 4 years since the release of the Henry Report into Australian taxation and its recommendation that remote area tax offsets be reviewed. The review has not taken place and, in the meantime, zone rebates continue to decline in real value.

There remain three arguments for the continuation and updating of zone rebates, including the related social security remote area allowances.

First, support is necessary for remote area economic development. Zone rebates provide partial compensation for the reduction in the competitiveness of remote area export industries, which has occurred as an unintended side-effect of the market-determination of the exchange rate coupled with heavy reliance on monetary policy to counter inflation. Zone rebates also assist in the provision of local infrastructure and support services in the remote areas. This infrastructure is important for the export industries, for defence and for the future of remote indigenous communities. (In discussions of public finance, this is essentially an economic efficiency argument.)

Second, compensation may be justified by the higher prices of necessities in remote areas, particularly food. This is especially important for social security recipients. (In discussions of public finance, this is essentially an ability-to-pay argument.)

Finally, partial compensation may be granted for the costs of accessing government services from remote areas. Although the primary responsibility here lies with service providers, the zone rebates recognise that remote area residents bear a share of these costs. (In discussions of public finance, this is essentially a benefit principle argument.)

This article provides a preliminary discussion of each of these topics and shows that zone rebates can be justified by arguments invoking each of the major principles of taxation. Following through from these arguments, the present paper also suggests that the zones should be updated and the levels of rebate revised. Zone rebates have not been reviewed for three decades. This article has shown that there is a strong case for updating the rebates, subject to a review of eligibility. It is time that the review recommended in the Henry report took place.

 

 

 

 

 

 

 

References

Australian Bureau of Statistics (2001), ‘ABS Views on Remoteness’, cat 1244.0, Australian Bureau of Statistics, Canberra.

Australian Bureau of Statistics (2001), ‘Outcomes of ABS Views on Remoteness Consultation, Australia’, Australian Bureau of Statistics, Canberra.

Australian   Bureau   of   Statistics   (2003),   ‘ASGC Remoteness Classification: Purpose and Use’, Census Paper  No.  03/01,  Australian  Bureau  of  Statistics, Canberra.

Henry et al. (2009), ‘Australia’s Future Tax System: Report to the Treasurer’, December, CanPrint Communications, Canberra.

Hicks, P. (2001), ‘History of the Zone Rebate’, research note no 28, Department of the Parliamentary Library Commonwealth Parliamentary Library.

National Institute of Economic and Industry Research (2009), ‘A Comparison of the Accessibility of Essential Services in Urban and Regional Australia’, report for the Australian Farm Institute.

Public Inquiry into Income Tax Zone Allowances (P. E. Cox, Chairman) (1981), Report, Commonwealth Parliamentary Paper No. 149, Australian Government Publishing Service, Canberra.

 

The Macro Melbourne Initiative Discussion Paper

National Economic Review

National Institute of Economic and Industry Research

No. 61 March 2008

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson

© National Institute of Economic and Industry

Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

ISSN 0813-9474

The Macro Melbourne Initiative Discussion Paper – a response

Ian Manning, Deputy Executive Director, NIEIR

Abstract

In responding to the Macro Melbourne Initiative Discussion Paper, Ian Manning does not take dispute with it, but rather considers some of the same issues from a slightly different direction.

The professed purpose of the Paper, as indicated in its sub -title, is to develop strategic responses to disadvantage. Despite this, the Paper itself is less ambitious, aiming to describe disadvantage in a way which will “stimulate new thinking on strategic giving and point to possible strategic investments by philanthropic trusts and corporate organizations that would address disadvantage and help prevent social problems arising”. Local Government may be added to the list of interested parties, but neither State nor Commonwealth Governments, whose policies are taken as background.

This Initiative comes 23 years after the Commonwealth adopted broadly economic rationalist policies. Despite two bursts of economic growth in that time, punctuated by severe recession, Ian Manning concludes that such growth has redistributed, rather than alleviated, poverty while generating two new discontents – those arising from over commitment and the more subtle dangers of workaholism. Alarmingly, although there has been a decade of continuous economic growth, Ian manning concludes that the balance sheet has indications that this cannot continue forever.

Professor Henderson’s legacy

The study is firmly in the intellectual tradition of established in Australia by Professor Henderson in his studies of poverty three to four decades ago. It equates disadvantage with poverty broadly defined, and notes the association between disadvantage and membership of disability groups – using the word disability in a broader sense than is common today. The importance of disability groups is twofold. First, the opportunities for poverty reduction vary between disability groups. Different policies will be appropriate for each group, particularly as regards services. Second, disability group membership provides a proximate reason for people being poor, and hence a reason why they should be assisted through public policy and not left to their own devices.

The disability groups mentioned in the Macro Melbourne study follow much the same list as that established by Professor Henderson, though there has been some updating of euphemisms and considerable change in the relative size of the groups. Going back to Henderson’s disability groups, we find the following.

• Indigenous poverty remains as intractable as ever.

• The aged are growing in numbers and still have relatively low incomes, but in relation to the poverty line pension rates are a little more generous than they were in Henderson’s day.

• There are fewer large intact families than there were thirty years ago, and the financial position of large families has improved due to increased social security assistance.

• Recent migrants are much more strongly divided into a skilled group, who are prospering, and an unskilled, mainly refugee group, who face considerable difficulties in establishing themselves in Australia.

• The transition from childhood to adulthood has not become any easier, and significant numbers of young people are poor.

• The number of single parent families has increased, and there is still a high incidence of poverty among them.

• Deinstitutionalisation has increased the number of people with disabilities living in the community. To this group may be added the many who have acquired physical and mental disabilities due to prolonged unemployment.

• The number of unemployed workers has burgeoned. This group tends to have low cognitive and/or social skills, and overlaps with a new group of working poor, whose earnings are low and precarious.

In summary, compared to the era of full employment, much more trouble is being caused by unemployment and underemployment, most of which is associated with low skill and/or physical or mental incapacity. On the other hand, large families are no longer a major disability group.

Disadvantaged aspirationals?

Though the Macro Melbourne Initiative for the most part equates disadvantage with poverty, there has been a tendency to add two further disability groups to the list. Both of these are groups whose incomes place them well above the poverty line however updated, but who are in trouble despite this.

• People whose financial affairs are in disarray due to over indebtedness (usually on mortgage) and/or addictive spending (such as heavy gambling or expensive recreational drugs). Let us call these the financially over committed. The perceived needs of this group have received considerable political attention.

• A group which is less obviously in trouble – indeed, which is often held up for public admiration – comprises the workaholics. These are people who devote such long hours to paid work that other aspects of their lives suffer. Sometimes the consequences are born solely by the workaholic – he reaches retirement age and realises that he’s never lived. They become more serious when they are borne by others, particularly the workaholic’s small children. In Henderson’s time it was believed a neglected childhood was usually the result of poverty, but it is now argued that in addition to children neglected due to the stresses of poverty there are a troubling number of rich families in which workaholic parents fail to provide a stable and loving home. This group is likely to have considerable overlap with the financially over committed.

There is considerable prima facie evidence for growth in the numbers of both these groups. Household indebtedness in relation to incomes has risen to unprecedented levels, as has the proportion of the workforce working longer than standard hours and the proportion of married women in paid work. Much less is known about the significance of these phenomena, including

• What has been the relative importance of home purchase, purchase of other consumer durables, education expenses and purchase of current consumables in the generation of over indebtedness?

• What are the associations between over indebtedness and marital instability?

• What scope is there for households to manage over indebtedness?

And, on the much more sensitive issue of workaholics:

• In how many households is the priority given to paid work having negative effects on children? (We must acknowledge that there is lively debate on employer responsibility for the wellbeing of employees’ children, and on the effectiveness and adequacy of child care services.)

Answers to these questions would assist in determining the significance of the two proposed new disability groups. They would also assist in addressing their problems. Since they are not poor, raising incomes further is unlikely to provide much of a solution. It is more likely that their problems can be addressed though better management of resources, particularly time: efficiency in consumption, if you like, as distinct from the present emphasis on efficiency in production. In this context at least some poor people have much to contribute, since they are shining if enforced examples of efficiency in consumption.

 

Economic rationalism and the political incorrectness of poverty

Mention of efficiency in production introduces a further major change since Henderson’s time: the rise of economic rationalism, which has mounted a head-on challenge to Henderson’s strategy of using redistribution to direct portion of the benefits of economic growth to the abolition of poverty. Put baldly, the claim is that economic growth cannot occur without free play for market incentives, including the incentive to work provided by the reality of poverty.

Though it can be traced back to nineteenth century British utilitarianism and developments in economic theory in Britain and continental Europe a hundred years ago, the current main source of economic rationalism is the USA. Its current prominence in Australia has been assisted by American ownership of the media, and much of its attractiveness arises from the perception of the USA as the world’s most successful and powerful country. The Macro Melbourne study does not, however, deal with this big picture; it instead considers economic rationalism through an extended discussion of the definition and measurement of disadvantage, reflecting the debates over poverty measurement of the past three decades. These debates arose because economic rationalists, who extol free markets and deprecate government intervention, wished to counter the argument that poor people should be assisted by social security payments and government financed services. What better way to counter than with the argument that poverty is voluntary, the result of individual choice? They also argue that much poverty is bearable because it is temporary, and that poverty can even be attractive because poor people now are better off materially than the average citizen was a couple of generations ago.

It is a very small step from these arguments to the age old discussion of whether poverty is deserved or not; which also entails whether riches are deserved or not. Questions of the deservedness of riches and poverty have been the stuff of religious debate for millennia, with each religious system developing its own sophisticated account. However, these accounts have limited influence in Australian public debate, since Australia prides itself on being a secular country. Instead, with the adoption by the Commonwealth and, by and large, the state governments of economic rationalism as their guiding ideology, the view that whatever the market delivers is optimal has gained great currency. Both religious people and philosophers point out that economic rationalism has very shallow foundations as a moral theory, but that does not prevent its being used to justify two propositions: all riches gained by competition in the market place are deserved, and equally all poverty generated by unsuccessful competition in the market place is likewise deserved.

The economic rationalists’ stress on individual responsibility for poverty has an undeniable plausibility, at least in some cases. Charity workers have long known that people who aren’t good money managers can easily get themselves into financial difficulties, and that addiction, whether to alcohol, drugs or gambling, makes money management impossible. Direct financial assistance to such people can be problematic. The economic rationalists, living as they do in a world of incentives, go further and argue that people should never receive something for nothing, for to give is to encourage laziness and dependence on handouts. The traditional reply to this is that people can find themselves members of disability groups through no fault of their own, or through understandable fault (there, but for the grace of God, go I). This reply, and the benefits of adjusting assistance to the needs and opportunities of people in their disability groups, accounts for the prominence of such groups in social policy.

Moving outside the traditional disability groups, what is to be said about people who are in financial hardship due to over commitment? The economic rationalist answer is that their over commitment is the result of their free choice to borrow and buy, and that they should work harder and meet their commitments, or, if this is impossible, take advantage of the law of bankruptcy. However, what if over commitment results from people succumbing to the blandishments of sophisticated advertising to spend and to borrow, much of it cleverly designed to exploit common psychological weaknesses, and none of it countered by equally persuasive advertising in favour of saving? This claim strikes at a founding assumption of economic rationalism, which is that consumer desires are autonomous, and consumers accordingly know when to stop. Economic growth, which economic rationalism claims to maximise, is a poor bargain if in the process of pursuing it we develop insatiable desires, and so make ourselves miserable.

Another test case for economic rationalism is the neglected child of workaholic parents. Economic rationalism places high value on paid work, almost to the point where it claims that nothing bad can result from hours spent earning. Further, in the name of freedom it places great emphasis on the importance of personal choice in the labour market: if a parent chooses to work long hours, this is his or her valid choice. Unfortunately, this choice has the potential to result in failure to provide children, particularly small children, with the security and love that they need, with the consequence that the children become socially, and economically, incompetent adults. When people turn out to be unemployable, perhaps this is due to their being the victims of parental, or community, neglect when they were children. Once again the autonomous individual of economic rationalism turns out to be a chimera.

None of these critical observations on economic rationalism denies that people respond to incentives – both gross material incentives and incentives of a more subtle social kind. Kept within its limits by people whose values and priorities do not derive from it, economic rationalism can work wonders in fulfilling needs; but adopted as a primary value system by people who allow it to generate their wants, economic rationalism can result in a downward spiral into misery.

This raises the interesting question of the role of philanthropy in a country committed to economic rationalism. It is worth noting the mainstream economic rationalist view that individual decisions to be generous are legitimate exercises of choice. This is modified by advice that individuals should be careful in their giving, lest they undermine the self reliance of the recipients of their charity. This is good advice, and the disagreements do not begin to arise until the economic rationalists claim that any interference with the pattern of market rewards constitutes an unacceptable incentive.

The Macro Melbourne initiative can be interpreted as aligning philanthropy with the priorities of the prevailing ideology: there is a strong flavour of the economic rationalist pursuit of efficiency in the survey of disadvantage followed by the allocation of assistance to the groups where it can most speedily reduce disadvantage, or even followed by its allocation to the neediest groups. The initiative seeks to increase the efficiency of giving both in targeting and in the selection of strategic projects which will yield high returns in disadvantage allayed. However, there is an aspect to giving which is not economically rational. That occurs where the giver heeds traditional morality and does not count the cost, and certainly does not count the benefits. There is a contradiction between the gift which expects no reward – let not your right hand know what your left hand is doing – and the economically rational mind, with its self centredness and its obsession with a quid pro quo for every transaction. It could well be that the chief value of philanthropy lies in its witness to values other than the self seeking exchange values of economic rationalism.

We have so far covered some fairly fundamental criticisms of the prevailing ideology. There is also a rich vein of criticism based on market failure, and we will now take two examples from the Macro Melbourne Initiative, poor accessibility and the (in)affordability of housing. The Initiative treats these as two dimensions of disadvantage, but does not make a strong connection between the two.

Accessibility and housing affordability

From a geographic point of view, accessibility is best defined as the ease with which one can reach a specific kind of destination from a specific place of origin. The usual place of origin is home, and the usual destinations are workplaces, shops, schools, health services and the like. Sometimes the nearest destination is the most important – say the nearest hospital emergency department – but more often it is important to have access to a variety of similar destinations: a variety of shops, different schools and health services. Variety of possible destinations is most important when one is looking for work: the greater the number of accessible jobs the better. Following these two approaches, accessibility is sometimes measured by distance to the nearest opportunity (this house is 200 metres from a playground; it is 500 metres from a convenience store, and so on), but it can also be measured by the number of possible destinations within a convenient travel time or distance (a house in a trendy suburb may have ten latte bars within walking distance, and, more important, is likely to have several hundred thousand potential workplaces within half an hour’s drive).

In this context, it does not make much sense to speak, as the study does, of the accessibility of public transport. Public transport is not a destination in itself. Rather, in combination with walking, it is a means of transport. Because public transport involves walking and waiting, it is necessarily slower than motoring for all trips bar those where motoring is slowed by severe congestion and parking difficulties. When one measures accessibility by counting potential destinations which can be reached within a given time, the walking and public transport version is inevitably less. It reduces even further if the streets are not perceived as safe for pedestrians. At the limit, nothing is accessible by walking or public transport when one is unwilling to venture beyond the front gate without the protection of a car. This is, perhaps, the position of quite a few children and some old people.

Setting aside such cases of fear, the continuing importance of walking and public transport derives from the following.

• There are people who cannot, or should not, drive. Such people are disadvantaged if they are unable to access important destinations by walking and public transport.

• Motoring is costly, though for decades its cost has fallen relative to average earnings and relative to the social security pension, and it has for many years been included on the list of Australian necessities. However, with indications that fuel costs are beginning to rise, households which can access employment and services by walking and public transport are likely to be increasingly advantaged.

• Walking is healthy. Households are advantaged when they can access destinations on foot, with or without a little help from public transport. By contrast, motoring is dangerous and has a poor crash record.

• En masse, motor vehicles cause congestion. The public costs of providing road space to ease congestion are considerable, as are the public costs of providing car parks. In addition, it has become very difficult to build major activity centres served solely by motor vehicles. An important argument for public transport is that it can support activity centres which are larger and more diversified, yet more compact, than the typical suburban shopping mall, technology park or campus university.

Accessibility from residential areas to various kinds of destination can be enhanced by the following means.

• Shifting to faster transport. The obvious way is by buying a car, but even if one sticks with public transport improvements are possible through more frequent, more direct and more connective services.

• Making sure destinations are near residential areas. The retail sector has been adept at this, though it tends to assume that the only worthwhile customers are those who travel by car. Service administrations have also been conscious of the need to provide outlets that cover Melbourne.

• Conversely, making sure homes are near destinations.

A particular problem area has been the relationship between residential areas and employment opportunities. In the 1950s and 1960s Melbourne added both housing and jobs to its outer suburbs. Many of the jobs were in manufacturing and warehousing, attracted to the outer suburbs by low cost land and good truck roads. The resulting jobs were accessible only by car, but provided valued work opportunities within acceptable time distance for many outer suburban residents. From about 1975 the trend reversed. The emphasis on the knowledge economy resulted in job growth in the CBD and the inner suburbs. Despite the effort to decentralise universities, no significant knowledge hubs have been created in the middle or outer suburbs – a failure which is perhaps related to the policy, noticeable particularly at Commonwealth level, that public investment in transport should concentrate on roads with public transport reduced to a ‘social service minimum’ level. This prevented its being used in the promotion of employment centres. The result was that the difference in job accessibility between the outer and inner suburbs became more acute.

This failure of urban strategy was exacerbated by the deregulated financial sector, which in the 1990s found itself with unlimited funds for lending on residential mortgages. The banks borrowed overseas in Australian dollars at rates which compensated the lenders for the risk of devaluation and were accordingly high by world standards. They were on-lent to Australian households plus a profit margin. Households borrowed willingly, partly because the rates seemed low to people who had been paying two digit interest rates less than a decade before. One result of debt financed demand was a house construction boom, which as usual extended the perimeters of Melbourne. However, poor accessibility to jobs, particularly from the outer suburbs, directed much of this boom into redeveloping the inner and middle suburbs. The result was a classic land boom. One need only add that the land boom was an essential element in the Commonwealth’s economic strategy in the late 1990s. It was the only way in which deregulated markets could deliver economic growth.

The Macro Melbourne Initiative has much to say on housing affordability, but does not trace it to the land boom. Indeed, productivity improvements in house construction have reduced the cost of the built component of housing. The increases in house size which was a public response to this reduction in cost contributed a little to the rise in house prices, but the main component was the cost of land. As always when there is a rise in the price of an asset in widespread ownership, there was a complex pattern of capital gains, all at the expense of new entrants to the market. There is a long tradition in economics that landowners do not deserve the capital gains they make from changes in accessibility patterns.

The result of this double failure – a failure of accessibility planning compounded by macroeconomic policies focused on the short run – is now ensconced in household balance sheets across Melbourne. Some households have achieved capital gains, which they can potentially cash in by retirement migration to some place where housing is cheaper – though demand from people Sydney and Melbourne has raised house values in many of the favoured destinations. Other households have achieved high debt to income ratios, making them vulnerable to even the slightest increase in interest rates or decline in earnings. Again, were there to be a downwards correction in the urban land market, some of these households will find themselves with negative net worth. Their best hope is for a burst of inflation, such as benefited the post war generation of home buyers. Needless to say, inflation is not in fashion at the moment, though it is quite probable that Australia will suffer from it as its dollar slides in value in order to correct the balance of payments deficit.

Given present imbalances, a relatively benign macroeconomic scenario would be one in which nominal Melbourne urban land values are maintained while inflation reduces real household indebtedness. Household consumption is likely to be restrained while people save to repay their debts, but overseas demand, from people seeking property ownership in what remains a liveable city, could be important. A much less pleasant scenario would have interest rates rising, which could lead to a classic recession complete with non-performing loans and the resulting financial institution instability.

From the point of view of young people seeking affordable housing, the second of these scenarios would have the benefit of undoing some of the 1990s increase in land prices. For a while this would be offset by higher interest rates – there could even be a return to the 1980s housing affordability problem, which arose out of deposit gaps and high repayments in the early years of borrowing. Higher unemployment would also make life unpleasant, but the eventual result would be land prices no longer out of kilter with household incomes. The alternative is more of a ‘soft landing’ scenario, where the necessary realignment of prices takes longer. Over this longer period, there would be more scope for government policy on urban development to start affecting relative accessibility, with possible reductions in the location rents so prominent in the recent land boom.

The examples of accessibility and house affordability both contain elements of market failure. The inability of the land market to carry out strategic town planning complements the tendency of financial markets to create financial assets and liabilities which are out of kilter with the underlying ‘real’ position. Both land and financial markets perform well in the allocation of resources at the microeconomic level, but can generate great trouble at the macroeconomic level.

Conclusion 

The Macro Melbourne Initiative comes 25 years after Mr Keating’s conversion to economic rationalism. During that period Australia has experienced two bursts of economic growth, punctuated by a severe recession. This growth has redistributed rather than alleviated poverty, and has generated at least two new discontents: the discontent arising from over commitment, and the more subtle danger of workaholism. Despite these discontents, economic rationalist polices are being pursued with vigour, in the belief that they guarantee steady economic growth. A more sober judgement is that the trade cycle is too fundamental a feature of capitalist economies to claim that it has been eliminated on the basis of a ten year absence.

Even if the trade cycle stays its hand, in the 22 years to 2030, the Melbourne Community Foundation is likely to have no shortage of disadvantages to address. These include both the traditional disadvantages of poverty and the newer discontents which have arisen where economic rationalism has exceeded its boundaries. The Macro Melbourne Initiative is to be commended for charting the territory.

Energy and Environment (NER 66)

National Economic Review

National Institute of Economic and Industry Research

No. 66               September 2011

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.
Editor: Kylie Moreland

National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474

Energy and environment

Graham Armstrong, NIEIR

Abstract

This paper reviews the global and Australian developments during the months leading to the Conference of the Parties of the United Nations Framework Convention on Climate Change Conference in Cancun, Mexico (COP-16) in December 2010. The legislation progress and climate action developments of Brazil, Indonesia, Africa, New Zealand, the United States and Australia are reviewed.

Introduction

In the year following the Conference of the Parties of the United Nations Framework Convention on Climate Change (UNFCC) Conference in Copenhagen (COP-15) and the associated disappointments, a range of UNFCC subsidiary bodies and non-UNFCC organisations met to advance global negotiations leading up to COP-16, Mexico.

Some progress has been made in relation to the major issues, including: the future of the Kyoto Protocol, the positions of China and India, the status policy after the mid-term elections, the financing of reduction of emissions from deforestation and forest degradation (REDD), the prospective roles of regulations, carbon taxes and emissions trading systems, the 2020 and beyond targets, the adaptation strategies and the outlook for abatement technologies.

Prospects for Cancun

As this paper was being finalised (1 December 2010) there had been very little discussion on COP-16, Cancun, Mexico, particularly compared to the lead up to Copenhagen the previous year.

On a recent (August–September 2010) trip, Graham Armstrong held discussions with two respected climate change observers on the prospects for Cancun.

Erik Haites, Margaree Consultants, Toronto, Ontario, Canada

Erik is an economist with a long-established (30 years) consultancy based in Toronto. Over the past 15 years, Erik has been involved in climate change policy at both national and international levels. Erik is a principal advisor to the UNFCC and the Intergovernmental Panel on Climate Change and, as such, is in an excellent position to comment on global climate change policy trends.

Approaching COP-16 in Cancun, Mexico in December 2010, Erik sees the global institutional structure for addressing climate change developing along some promising lines. Erik recognises the divergent views of the groups involved: the Organization of the Petroleum Exporting Countries, the Small Island States, Africa, China, Brazil, Russia, India, China, the United States and the European Union (EU).

Erik believes that despite much pessimism over Copenhagen and the potential outcomes from Cancun, there are drivers for some progress at Cancun:

  • There will be a desire, overall, not to have two successive COP failures.
  • Actions, agreements and negotiations outside the UNFCC, for example in China, sub-national progress in North America and Australia, and developments on energy efficiency improvement (EEI) and renewables, are progressing greenhouse gas abatement (GHGA) and there is a trend towards concensus on the need for and forms of a global agreement.
  • There is growing acceptance, albeit grudging by the EU, and others, that there will need to be a differentiated approach to obtain ‘approval’ from the United States.

Perhaps Erik is too optimistic, as indeed he must be as an advisor to the UNFCC/IPCC, but he is deeply involved with the global process and, accordingly, his views are very important.

Erik emphatically believes that China has the most progressive and aggressive climate change policies, despite the general view that China’s growth in emissions is out of control. He views Chinese policies, for trade and overall environmental disruption concern reasons, as having a significant impact on reducing emissions growth in China and globally.

On overall energy policy and trends Erik believes that, in line with the 2010 International Energy Agency (IEA) World Energy Outlook:

  • energy use is stable or declining in the OECD;
  • energy security is of major concern in most parts of the world;
  • China/India energy use will continue to grow, although not as rapidly as GDP;
  • excess supply capacity is exerting downward pressure on energy prices; and
  • energy infrastructure requirements are increasing in the United States (declining market) due to ageing assets compared, on an energy use basis (i.e. investment compared with energy use), with China (an expanding market), where infrastructure is overall of a newer vintage.

On technologies, Erik sees carbon capture and storage (CCS) and nuclear costs as increasing in real terms compared with solar, for which costs are declining in real terms.

Rod Janssen, Energy/Climate Change Consultant to the European Union, Brussels and to the European Council for an Energy Efficient Economy

Rod is a Canadian who worked for the Federal Energy Department in Ottawa and for the IEA. Since 1982 he has been an independent consultant. He is now based in Paris.

Rod recently acted as rapporteur for the European Capacity Building Initiative (ECBI) funded by Sweden to encourage dialogue and action on climate change action in developed and developing (e.g. African) countries. At an ECBI meeting in Oxford, UK in early September, Rod’s general impression was that no agreement was likely in Cancun in December 2010 or even in South Africa in 2011. Rod believes that an agreement might not be reached until 2020! He sees the United States as the major problem due to the lack of concensus in relation to political action. However, the United States Environmental Protection Agency (EPA) CO2 regulations starting with power stations might provide some progress. In contrast to the United States, China has taken considerable climate change GHGA action even though China is wary of political action at a global level.

The EU is becoming more aggressive in relation to coal phase-out, renewables and aviation, but has been slower to act on EEI. There has been increased emphasis on energy security (gas from Russia), and on CCS and renewables.

Reduction of emissions from deforestation and forest degradation

One positive outcome of the COP-15, Copenhagen in December 2009 was the pledge by some wealthier countries to provide US$4–5 billion by 2012 for REDD in developing countries. Much more support will be needed for a significant REDD result, but beyond 2012 the funding mechanism is uncertain. Currently, forest carbon credits are not accepted in the EU emissions trading scheme (ETS), but this is likely to change as REDD develops stringent, credible and audited credits.

The Informal Working Group on Interim Financing for REDD estimates that a REDD investment of US$100 billion by 2025 could cut deforestation by 25 per cent: this is the equivalent of 3 million ha of forest saved and 7 Gt of carbon emission reductions a year, approximately 17 per cent of total global emissions. The estimated cost was US$2.4/tonne of CO2e.

However,  Indonesia’s  National  Council  on  Climate Change puts the opportunity cost of foregoing oil palm plantations at US$30/tonne of CO2e, still a relatively low cost. For example, CCS is probably not viable at under US$75–115/tonne of CO2e.

Concerns

Avoided deforestation might not be permanent, particularly where there is a risk of climate-induced forest dieback.

In addition, REDD funds will inevitably go to the most ‘avid’ deforesters, such as Indonesia, which might create an incentive for other countries to engage in deforestation. Hence, REDD will have to be applied on a large comprehensive scale, even if the payments vary.

Brazil

Brazil has been developing REDD for 2 years and has received US$1 billion in funding from Norway. The payment formula favours Brazil’s Amazon states with higher deforestation rates. However, a state’s record on meeting REDD commitments is also taken into account when determining payments.

In Brazil, REDD faces substantial challenges, including, for example, forest title issues. Unowned forests are unprotected, leading to Brazilian grileiros (land grabbers) turning rainforest into pasture.

In the Brazil State of Para in 2009, 20 ranches were identified as operating on illegally cleared land, and selling meat to well-known retailers, such as Wal-Mart and Carrefour. The ranchers were fined US$1.2 billion in total and the retailers were threatened with fines, unless they were able to verify legal supply chains.

As a result, abattoirs in the region only deal with legal suppliers. Greenpeace has also acted on a report on Amazon beef and deforestation, linking beef and leather from the region with companies such as Adidas, Nike, Toyota, Gucci and Kraft. Many of these companies have agreed to work with Greenpeace, thus putting pressure on developing countries’ to adopt developed world standards in the supply chain, and thereby raising the prospects for an effective REDD program to reduce global emissions.

Indonesia

Even where governments own a forest, the degradation results can be similar. An estimated 63 per cent of Indonesia’s West Kalimantan national parks were illegally cleared by loggers between 1985 and 1990.
Unclear ownership is a barrier to the effective land use planning necessary for REDD. For example, in Indonesia, palm oil can be produced on degraded land (40 million ha available) rather than on forested land. Between 1990 and 2005, Indonesia planted over 3 million ha of oil palms, with over half of it on freshly cleared land.

When forests are on peat deposits, the problems are substantial as peat land can store over 5,000t CO2e/ha and, when drained for cultivation, greenhouse gases are emitted for over 20 years.

Indonesia’s peat area plantations contribute less than 1 per cent of GDP but nearly 20 per cent of emissions. With Indonesia planning to double the area for oil palms, emissions could increase greatly, but this provides a REDD opportunity through palm oil expansion on degraded land. A 2-year moratorium on commercial deforestation resulted in US$1 billion in funding from Norway for REDD in Indonesia.

Corruption also poses a threat to REDD success. Indonesia’s forest ministry, claiming control of over 75 per cent of the country’s area, is suspect. In the 1990s, over US$5 billion disappeared from the national reforestation fund: saving trees is not a priority at the national or state level.

Africa

In Africa, the problems are even greater. National forest is virtually non-existent, land titles are vague and corruption rife. However, aerial surveillance can help and REDD payments tied to improvement in practices can provide an incentive to improve performance. REDD dollars can be partly provided for improved land use control and inventory programs, and to encouraging local forest management. Overall, the prospects for REDD are not encouraging, but there are some grounds for optimism for REDD to contribute to reducing global CO2e emissions.

New Zealand climate change policy

On 1 July 2010, the New Zealand Government introduced an ETS. The ETS is expected to cost New Zealand households an average A$2.45/week. This cost will be derived from of an increase in petrol prices of A$0.025/litre and an increase in average electricity prices of 5 per cent.

A major reason for introducing an ETS was concern that without it New Zealand could have been subject to trade sanctions, a concern that appears to be absent from the Australian climate change debate. Revenue from the ETS will be used for reforestation.

The ETS covers emissions from six greenhouse gases: CO2, CH4, N2O, HFCs, PFC and SF6. The ETS will eventually incorporate all sectors of the economy, and, by 2015, all greenhouse gases will be included. The ETS is internationally linked and conforms to current climate change rules. Self-assessments will be undertaken for monitoring, reporting and verifying emissions produced by liable parties.

During a transition phase between 1 July 2010 and 31 December 2012, liable parties will be able to buy emission permits from the government for a fixed price of NZ$25/t CO2e. Also in this period, parties in the energy, industrial and liquid fossil fuel sectors will only have to surrender one emission unit for every 2 tonnes of emissions they produce, effectively halving the costs. Parties can surrender international permits, such as Clean Development Mechanism (CDM) carbon emission reductions (CERs) and EU assigned amount units. The ETS will eventually cover the following sectors: forestry, transport fuels, electricity generation, industrial processes, synthetic gases, agriculture and waste. Forests planted after 1989 can produce emission units for CO2 stored or removed from the atmosphere.

Most participants are required to meet their obligations under the scheme by surrendering emission units. Surrendering a unit means it cannot be used again: for example, it cannot be also given to another participant.

Some participants, such as those with forests planted after 1989, are able to earn emission units for carbon dioxide stored or removed from the atmosphere by their activities.

The liable party is not necessarily the business at the actual point where emissions are produced. For example, a coal producer would be required to surrender units for the coal it sells, even though the actual emissions will occur when the coal is burned.

Alongside those who are required to participate in the scheme and those who can opt in, other people may also hold and trade emission units. These parties are commonly referred to as ‘secondary market traders’.

Businesses participate in the ETS in different ways.

  • Some have a legal obligation to acquire and surrender emission units to cover their direct greenhouse gas emissions or the emissions associated with their products. These participants are generally ‘upstream’ operators: for example, transport fuel producers or importers of products.
  • Some have the choice to apply to opt into the scheme if they carry out a relevant GHGA activity.
  • Some receive free emission units that can be used to meet their own obligations or to sell to other firms: for example, landowners with forests planted before 1990.
  • Some do not have to take part in the ETS, but can trade emission units in the same way that stockbrokers or real estate agents trade in their respective markets. These are secondary market traders. They may have specialist expertise in linking those who can reduce their emissions and have spare emission units with those wishing to buy these units.

Liable parties are required to:

  • monitor, record and report activities that produce or remove greenhouse gas emissions; and
  • surrender to the government emission units to cover emissions associated with their activities each year.

Secondary market traders, such as brokers, can also hold and trade emission units, but do not have to monitor and report emissions and are not required to surrender emission units. They can hold and trade emission units to take advantage of opportunities in the financial market.

Examples of emissions trading scheme participation

  • Firm A is an oil company. It needs to buy emission units to cover the greenhouse gas emissions it is responsible for.
  • Firm B is a large forestry company that receives emission units for land it is planting in forests. It is also cutting down some trees, leading to emissions for which it has to surrender emission units. Initially, Firm B has a shortfall of units,
  •  Firm C is a major industrial user of electricity for which it has to surrender emission units. To help Firm C adapt to these higher costs, the government gives Firm C a free allocation of emission units, which Firm C can sell to offset its increased electricity costs.

Under the ETS, Firm A and Firm B can both buy Firm C’s units in the short term to cover their emissions.

Because it now has to pay higher energy prices, Firm C finds it has lower costs if it invests in energy efficiency.

Over time, as its forest matures, Firm B has spare units available and can sell them to Firm A.

Some participants will be eligible to receive a free allocation of emission units from the government to cover some of their emissions.

The New Zealand Emission Unit Register (NZEUR) will record:

  • who holds emission units and the number of units that they hold;
  • transfers of emission units between holders both within the NZEUR and between international unit registers; and
  • emission units surrendered by participants to meet their obligations under the ETS.

As with a share registry, the NZEUR does not record information about the price or financial value of emission unit trades, nor does it provide a mechanism for exchanging cash for units traded.

Sectors will be introduced to the ETS gradually over a period of 7 years, starting in 2008.

The transport fuels, electricity production, industrial processes and waste sectors are able to start voluntarily reporting their greenhouse gas emissions 2 years before their obligations to surrender emission units begin, and are required to report their emissions 1 year before. Those in the agriculture sector can voluntarily report emissions 4 years before their obligations to surrender emission units begin and are required to do so 3 years before.

Table 1 E and E NER 66

 The Ministry of Economic Development manages the day-to-day running of the ETS. It is the main compliance and enforcement agency. It also runs the NZEUR.

The  Ministry  for  the  Environment  administers  the Climate Change Response Act, which established the ETS. It is also responsible for developing emission unit allocation plans and regulations under the Act, except for those relating to the forestry sector, which are managed by the Ministry of Agriculture and Forestry.

The ETS will be reviewed once during each international commitment period: the review must be completed 12 months before the end of each period. The review will consider impacts of the ETS on the economy, how it links with other trading schemes, and any social, economic and environmental impacts, such as the effects on biodiversity. The review will be conducted by an independent panel of experts.

Penalties will be imposed on liable parties for incomplete and incorrect emissions data or if all required permits are not surrendered, at a rate of NZ$30/t CO2e plus a requirement to acquire and surrender liability permits.

Progress of the New Zealand ETS should be closely followed in Australia.

United States climate change policy

The United States Administration has abandoned efforts to limit United States greenhouse gas emissions through a cap and trade ETS. Instead, at this stage, the 27 July Energy Bill only includes measures such as subsidies for home insulation and natural gas vehicles due to the seeming impossible task of gaining Senate approval for the comprehensive Bill passed in the House last year.

Like Abbott in Australia, Republicans and some Democrats view carbon pricing as detrimental to the economy, especially when economic recovery is weak. In addition, representatives from coal states are concerned about the impact of carbon pricing on their constituents. Polling indicates low levels of belief in the seriousness of the impacts of global warming.

However, despite the demise at this time of a United States ETS, there has not been complete United States inaction on climate change. Under the Clean Air Act, the United States Supreme Court has ruled that regulations could be applied to greenhouse gas emissions and, therefore, that the United States EPA could decide on their public health impacts.

The EPA has determined that there are considerable negative public health impacts of greenhouse gas emissions and is now working on regulations to apply to large stationary emissions sources, such as generation plants. Such regulations will include the introduction of minimum efficiency standards, and the use of renewable/green technologies will be promoted.

In addition, agencies, at the government’s discretion, can set fuel efficiency and appliance standards. Again, states are developing measures to restrain greenhouse gas emissions: for example, north-eastern states have a cap and trade ETS in place for power stations. The World Resources Institute has studied the potential for emission reductions using the existing federal and state regulations and has concluded that emission reductions of 13 per cent below 2000 levels could be achieved by 2020 (below the 17 per cent reduction pledged at Copenhagen).

However, indications are that United States action over the next 5–10 years will fall far short of 2009 expectations, unless international pressure is applied through sanctions and/or competitiveness in domestic and global markets. Inaction is likely over the next 2 years as a result of Republican Party (members of which are mainly opposed to climate change policies) success in the November 2010 mid-term elections. One surprising climate change outcome of the elections was the rejection of the referendum proposal in California to defer the state climate change action plan until the state economy recorded 3 per cent annual growth.

Carbon markets

Under the CDM, destruction of HFC-23 can be eligible for CERs, which are tradeable in the EU ETS. HFC-23 has a global warming potential 14,800 times that of CO2. HFC-23 is produced as a by-product of HFC-22 manufacture, an ozone depleting refrigerant. HFC-22 is banned in developed countries but will not be banned in developing countries until 2030.

Wind and solar energy and other low greenhouse gas intensive projects are eligible to create CERs under the CDM, but destroying HFC-23 is much lower cost for the creation of CERs and has, therefore, become the main source of CDM credits. In the EU ETS in 2009, 55 per cent of CERs came from HFC-23 destruction, representing approximately US$700 million in credits. HFC-23 production/destruction is limited to HFC-22 plants operating in 2000–2004 so as to avoid setting up HFC-22 plants to produce HFC-23 credits.

Clean Development Mechanism Watch, monitoring the offsets market, has found that some plants reduced their HFC-22 production during periods in which they were ineligible for CERs and increased production when they became eligible. Since the CDM Watch report by the CDM Executive Board, eight HFC projects have been placed under review and the HFC-23 methodology is being reassessed. As a result, the supply of CERs from this source is likely to decline, putting upward pressure on CER prices, possibly from €15 in August 2010 to €25 by January 2011.

Increased price pressure could result from any CDM Board decision to retroactively invalidate some HFC-23 credits, causing entities responsible for invalid CER issuance liable for replacing those CERs.

Australian developments

Overview

Before the 21 August 2010 federal election, neither the Australian Labor Party (ALP) nor the Coalition planned to introduce carbon pricing, the Coalition with no carbon pricing plan (but with policies that would have a price impact: see Energy Working Paper, August 2010) and the ALP with no price before 2013 and some incentives (particularly for renewables). However, both parties aimed to reduce 2000 emissions by 5 per cent by 2020.

The Greens, with a 25–40 per cent below 2000 emissions by 2020 target, wanted immediate introduction of carbon pricing at around A$20–25/t CO2e.

In the aftermath of the election, the support of two Independents and a Green enabled the ALP to form government, but in the Senate, the Greens will hold the balance of power after 1 July 2011. The Greens’ electoral success put early carbon pricing back on the agenda and the two Independents supporting the ALP, together with the Greens, want increased support for renewables and EEI. A further climate change policy ‘twist’ was the release of the Victorian Climate Change White Paper in late July 2010 (see below).

Two ‘round table’ consultative/advisory bodies were set up, one comprising business and one non-government organisation, reporting to nominated Ministers to consider options: a limited ETS, a carbon tax and incentives/regulations.

Post-election, several senior business leaders came out in support of carbon pricing, while other business identities (e.g. mining industry) continued to oppose carbon pricing.

In  another  development,  the  Prime  Minister’s  (then Rudd) Task Force (TF) on Energy Efficiency released the TF’s report, which strongly supported a major energy efficiency effort. The TF also released a study (commissioned by the TF) on design, costs and benefits of a National Energy Efficiency Obligation Scheme. Thus, since the election, the Australian Climate Change debate has been reinvigorated and carbon pricing is firmly back on the policy agenda.

Whether it will be introduced, and its timing, depends on support in the House of Representatives (and the Senate before 1 July 2011) from the ALP, Independents and possibly some dissident Coalition members. Support from some powerful business interests (e.g. BHPB, AGL and Origin Energy) and a majority of community support suggests to us that carbon pricing will be introduced in 2012 (the consultative committees are not due to report until the end of 2011). Accordingly, NIEIR is building carbon pricing into modelling, commencing with $10/t CO2e in 2012 (revenue raising, minimal GHGA impact) rising to approximately $45/t CO2e in 2015–2020.

A CO2e tax/price of <$20/t CO2e would have a low price response impact, but would raise revenue that could be applied to GHGA incentives.

National Institute of Economic and Industry Research analysis indicates that a price of at least $30/t CO2e is needed before there will be significant incentives to shift towards gas for base load generation. The prospect of such a price would remove much of the uncertainty surrounding electricity generation investment, a major reason for business support for early introduction of carbon pricing.

Removal of this uncertainty is urgently required as although electricity demands are, overall, increasing slowly (<2 per cent per year) and spare capacity remains, by 2015 there could be significant electricity supply security concerns.

Grattan Institute study on emissions trading scheme/Carbon Pollution Reduction Scheme free permit compensation

In a study released in April 2010, the Grattan Institute argued that Australia would gain from letting its aluminium smelters and oil refineries close rather than providing them with free carbon permits under an ETS. The study argues that free permits undermine emission reduction, which is the purpose of an ETS. Issuance of free permits to these industries would remove the incentive for them to shift to lower emission operations.

Regarding job losses through industry relocation, the study states that a carbon price would leave most emissions intensive sectors relatively healthy. Where there were noticeable negative effects, permits should only be issued if a closure would not noticeably reduce greenhouse gas emissions. The money saved by not issuing free permits could be spent on support for communities affected by plant closures.

The study, ‘Restructuring the Australian Economy to Emit Less Carbon’, is based on A$35/t CO2e. Some assistance would be justified to prevent steel and cement production shifting to countries that did not penalise carbon, but this would be best done by rebating the carbon cost on exports and imposing tariffs on competing imports. This would be allowable under World Trade Organization rules, provided imports were treated the same as local production.

In the study, it was estimated that free permits would have an average cost of A$59,000/employee, highest for aluminium at A$161,000/employee and A$103,344/employee for LNG (see Table 2). At a price of A$35/t CO2e, the study found that there would be little impact on the profitability of the Australian LNG industry, as Australia has fewer establishment and operating risks for developers and customers. With respect to aluminium, the study argues that higher Australian electricity costs without carbon pricing is still directing investment towards lower electricity price locations (such as Qatar) with or without carbon pricing.

table 2 E and E NER 66

The ETS (Carbon Pollution Reduction Scheme) legislation did not eventuate and the policy debate appears to have moved away from carbon pricing compensation (although it is likely to reappear with any carbon pricing) and towards, at least initially, a carbon tax, regulation and incentives.

Business supporters of carbon pricing

Given the advantages of carbon pricing to gas industry players such as Origin Energy, AGL and Santos, their support is not surprising. However, the support by BHPB’s Marius Kloppers changed the balance of industry support for carbon pricing because of the potential impact on BHPB’s investment in a range of commodity sectors. On 20 September 2010, the Australian Financial Review put the impact on BHPB’s net present value at 21 per cent, assuming a carbon price of A$25/t CO2e in 2012 rising to A$50/t CO2e in 2019. Note also that the Business Council of Australia acknowledges that it is inevitable that implementing some form of ETS is the lowest cost way to cut carbon emissions.

In September, AGL analysts indicated that the cost of a delay until 2013 in regulatory uncertainty is A$2.1 billion a year to 2020. The rationale is that wholesale electricity prices would be 13 per cent higher ($8.6/MWh) in 2020 than if certainty on carbon pricing were delivered in 2010.

Energy Supply Association of Australia data indicates that the generation sector’s forecast of capital expenditure over 2010–15 has fallen by more than 50 per cent, from A$18 billion in 2007 to A$8.2 billion, due mainly to uncertainty on climate change policy. For example, TRU Energy has A$3 billion in gas fired power in Victoria and New South Wales on hold and Origin cannot, in this situation, commit to upgrading Mortlake from essentially a gas peaking plant to a combined cycle gas turbine base load plant.

Any plant, coal or gas, requires more than 5 years from decision to commissioning, and risk of power shortages is increasing as investment decisions are not taken. AGL suggests consideration of an ETS for generation, whereas BHPB suggests a combination of carbon tax, land-use measures and a limited ETS.

A recent (August 2010) survey of 1,000 members by the Australian Chamber of Commerce indicated 75 per cent believed policy should focus on renewable energy and EEI rather than placing a direct price on carbon.

Garnaut Climate Change Review update

In October 2010, Greg Combet, the Minister for Climate Change and Energy Efficiency, commissioned Garnaut to update significant elements of his 2008 Garnaut Climate Change Review (the 2008 Review), and to report on the update by 31 May 2011.

The review update will update elements of the Climate Change Review:

  • where significant changes have occurred, or the sum of expert knowledge has increased, since the original analysis of the 2008 Review was undertaken; and
  • where these changes or improvements in expert knowledge could have significant implications for the key findings and recommendations of the 2008 Review, such that they should be updated.

The Review update should consider:

  • international developments in climate change mitigation efforts;
  • developments in climate change science and understanding of climate change impacts;
  • previous proposals to develop a carbon price in Australia and the ensuing public debate;
  • domestic and international emissions trends;
  • changes in low emissions technology costs and availability;
  • the potential for abatement within the land sector; and
  • developments in the Australian electricity market.

Throughout the Review update, consultation with key stakeholders will be required to understand views and inform analysis. A series of publicly released papers is to be prepared between November 2010 and March 2011. A final report is to be presented to the Government by 31 May 2011. The Report will embody the independent judgments of its author.

 

Victorian Climate Change White Paper,

July 2010

The Victorian Climate Change White Paper, ‘Taking Action for Victoria’s Future’, while not detailing how plan proposals are to be implemented, goes further than any other Australian Government in drawing up a climate change strategy. A White Paper Implementation Plan is due to be released before 2011. The Paper outlines 10 Action areas (see Table 3).

Note that following the Victorian 27 November election the future of the Climate Change Policy is very uncertain.

Targets

From 2008, emissions of 122 Mt CO2e to a 2020 BAU of approximately 130 Mt CO2e, the White Paper proposes a target of 20 per cent below 2020 BAU emissions by 2020: a reduction from BAU of 34 Mt CO2e, or 24 Mt CO2e below 2000 emissions.

This is a significant challenge. In August 2010, NIEIR projected an average 1.25 per cent increase per year for electricity (GWh) over 2010–2020 (without considering the potential White Paper impacts).

Clean energy

There is a commitment to reduce greenhouse gas emissions from brown coal generation by up to 4 Mt CO2e/year, a cumulative saving of 28 Mt CO2e by 2020. This is generally seen as closing 25 per cent of Hazelwood capacity. Financing and compensation are significant implementation issues. There is an emissions target level of 0.8t CO2e/MWh for any new brown coal plant. This compares with 0.8t CO2e/MWh for new black coal stations and 0.4t CO2e/MWh for gas CCGTs.

Solar

The target for large-scale solar (+100 MW) is approximately 5 per cent of electricity supply by 2020 (approximately 2,500 GWh), derived from 5–10 large-scale plants. This target will be supported by a Large-scale Solar Feed-in-tariff (FIT). The tariff might also be available for other low emission technologies, such as geothermal energy. A Medium-scale Solar Working Group has been established, and FIT could also be available for medium-scale plants. There will be funding of A$5 million provide for up to 10 solar energy hubs, generating approximately 8.6 MW of community-based solar power.

Homes

From May 2011, a 6-star standard will be required for new homes (as per a Council of Australian Government’s decision).

The goal is to improve the energy efficiency of existing housing stock to an average 5-star equivalent energy rating by 2020.

Also included are:

  • a doubling of the Victorian Energy Efficiency Target (VEET) and expansion of VEET activities;
  • a comprehensive household retrofit program;
  • extended solar hot water rebate scheme;
  • mandatory disclosure of residence energy performance on sale and lease, in 2011; and
  • promotion of Green Power (GP), aiming to increase GP homes from 300,000 to 500,000.

Business

Goals for Victorian business include VEET expansion to small and medium enterprises. The government will encourage energy efficiency in businesses though the Climate Tech Strategy and the Clean Business Fund. The Environment and Resource Efficiency Plan is to be expanded.

Transport

Transport initiatives include an electric vehicle program. The government has committed to improving fuel efficiency in the Government fleet to reduce emissions by 20 per cent emissions by 2015. They will purchase 2,000 Camry hybrids.

Government

Additional 20 per cent in EEI in all government buildings and facilities by 2018:

  • further $100 million in Greener Government Building Program;
  • study installation of 50 MW of cogeneration in Victoria’s existing hospitals (36 MW at present);
  • increase Green Power commitment to 35 per cent by 2015 and 50 per cent by 2020 (said to be equivalent to output of 100 MW of wind); and
  • support for local government initiatives.

Overall, the Victorian Climate Change Strategy is impressive (although relatively weak on initiatives in the business sectors, both commercial and industrial), but success will depend on effective implementation plans and the monitoring, review and evaluation of initiatives as they proceed.

Coalition plans for energy and climate change include:

  • review of Smart Metering: (impacts, costs, in-house display);
  • review of wind farm guidelines;
  • $1 billion Regional Growth Fund, including a $100 million natural gas distribution expansion;
  • review of brown coal phase-out and transition strategy (road map) for the Latrobe Valley;
  • ‘apparent’ support for carbon pricing and natural gas replacement of brown coal generation;
  • support for cogeneration, tri-generation and standby generation;
  • support for consideration by VCEC of gross FIT design, including tariff PV policies and low emission sources and expansion of size limit;
  • support for CCS, algae research and doubling of ETIS for low emission R, D, D and C;
  • support for 5 per cent solar generation by 2020, doubling of VEET (to SMEs) but review of VEET compliance; and
  • review of VCEC of barriers to distributed energy (renewables, cogeneration/tri-generation).

The Economic Impact of Public Events

National Economic Review

National Institute of Economic and Industry Research 

No. 67 November 2012

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

© National Institute of Economic and Industry

Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474
The economic impact of public events

Ian Manning, Deputy Executive Director, NIEIR

Abstract

The present paper examines a small and ill-defined area of government–private sector interaction: the organisation of public events. In particular, events that receive subventions from the public purse and that draw patrons from outside as well as within the subsidising jurisdiction are considered. Neoclassical economics asserts that economic policy should concentrate on leaving decisions to markets. As applied to the analysis of events, the neoclassical policy recommendation is for reliance on user charges except where there are non-economic reasons for free or subsidised provision. However, NIEIR’s analysis of event provision shows that this recommendation relies on assumptions that have not applied in most parts of Australia over the past 30 years. Instead, subventions to events that increase tourist visitation can increase incomes and employment. Thus, the case for subventions becomes one of priority against other expenditures, preferably exercised in the context of a coherent strategy for the future.

 Mixed economies and government– private sector interaction

When the United States went into ideological overdrive following the end of the Cold War, it let loose a wave of propaganda for market economics. Soviet central planning and government ownership of business enterprise were discredited. Economies should, therefore, be reformed to the opposite extreme, with government curtailed to providing law and order and all else left to the private sector. Some of the most effective propaganda involved the promotion of sophisticated neoclassical economic modelling, which purported to show that a completely privatised economy delivered the best of all worlds. In countries dominated by the American way of thinking, this modelling became the standard by which economic policies were assessed. Its intended target was not the Soviet-style centrally-planned state but the mixed economies inherited largely from the wave of socialist reforms that followed the Second World War.

In Australia’s case, it was conveniently forgotten that the economy had been mixed ever since the 19th-century colonies found that private enterprise was unable to provide them with the infrastructure they required. For the most part, academics and treasuries influenced by the neoclassical wave of thought deliberately assumed away the insights of Keynes’s generation, which supported mixed economies. One of these was the finding that markets are generally ‘imperfect’, which is a polite way of saying that they cannot be relied upon to generate an optimum allocation of resources as described by neoclassical theory. This is not to claim that government action can be relied on to improve matters: far from it. However, there are occasions when governments have opportunities to increase employment and incomes. It is arguable that they should be on the lookout for such opportunities and take advantage of them when they arise.

Since its foundation in 1984, NIEIR has remembered the findings of the economists of Keynes’s generation and, accordingly, has stood apart from the neoclassical economic models favoured by the American economic evangelists. The intellectual problem with the neoclassical models is their high level of abstraction and the plethora of assumptions, many of which contribute directly to their pro-market findings. It should not be surprising that when attempts are made to apply them to policy problems, highly abstract models can generate misleading results. It is inevitable that economic models should simplify the intricacies of the mixed economy in which governments, privately-owned business and non-profit organisations have basically complementary tasks but can sometimes be in (necessarily imperfect) competition, but important that the simplifications capture the major causes and effects rather than being assumed from ideological principle.

The commitment to the vision of a purely private market economy has diverted attention from the realities of government–private sector interaction. These differ industry by industry. Although all industries rely on government for the enforcement of contracts and property rights, the dependence of the mining sector on the administration of exploration and mining licences differs from the dependence of the finance sector on the administration of debtors’ and creditors’ rights and its ultimate dependence on government as lender of last resort. Again, there is general reliance on governments for the provision of an educated workforce but skill requirements are frequently industry-specific. Despite the targeting of government-provided physical infrastructure in privatisation campaigns, one major industry, road transport, is, to this day, completely dependent on infrastructure owned and managed by the three levels of government. Others depend on infrastructure that is to various degrees government provided, guaranteed or assisted. The mixed economy refuses to go away.

 

Event organisation as an activity

This article looks at a small and ill-defined area of government–private sector interaction: the organisation of public events. In particular, the paper considers events that receive subventions from the public purse and that draw patrons from outside as well as within the subsidising jurisdiction. Public events in this sense include sporting, cultural and business-oriented events, such as trade fairs. The event may be as brief as a few hours or last for a season and may take place on a single site or a range of sites. Events can be organised by government agencies, non-profit organisations or commercial businesses. Event organisation includes the production and marketing of the event itself and the coordination of a range of suppliers, including (in various proportions) venues, entertainment, security, accommodation and transport.

The production of events is not recognised as an industry in standard industrial classifications. If anything, it would be a subsector of tourism, which again is not recognised as an industry in the standard classifications, although the Australian Bureau of Statistics (ABS) has a definition of the sector and from time to time releases statistics about it. Persons employed putting on events may be classified as working in sport, the arts, business services, religion or,if all else fails, in entertainment not elsewhere classified.

An important distinction is that between events themselves and associated economic activity. Although accommodation, meals and transport may be arranged as part of an event, they are provided by recognisable related industries. There is also a distinction between events and event venues, sometimes expressed as arm’s length transactions (the event organiser hires the venue). However, events are frequently organised by venue operators while, in the opposite direction, organisations that are primarily event promoters may branch out into venue ownership. In the closely-related field of tourist attractions, venue and events may coalesce.

 

The predilection for user charges

Economic theory distinguishes between excludable and non-excludable events. The latter, exemplified by street parades and fireworks displays, are conducted in public spaces where it is impractical to charge for entry and where, indeed, some of the attendees may be unwilling witnesses rather than beneficiaries. Because it is not possible to charge attendees directly, the source of finance preferred in neoclassical economics, user charges, is not available and non-excludable events must, therefore, be financed from sources such as public culture and recreation budgets, business advertising budgets or the demonstration budgets of groups wishing to apply political pressure. Neoclassical economics allows that where governments finance a non-excludable event, they cannot be faulted for failure to impose user charges, although (as with all government expenditure) their priorities may be criticised.

Excludable events are those where it is practical to charge entry fees. The neoclassical principle is that both the event and the venue should be financed from user charges or, if available, by the use of voluntary labour. However, it is common practice for governments to contribute to the staging of excludable public events, sometimes by way of direct subventions, sometimes through more limited assistance (e.g. for marketing) and quite frequently by contributing to the infrastructure cost of venues. These contributions are contrary to neoclassical principle, but have been defended in two major ways.

A government may decide that an excludable event has such merit as a community occasionthat entry should be free, an approach often taken for events with educational, cultural or commemorative content. Short of this, it may decide that the event should be available at subsidised prices, either through a subsidy paid to the event provider or indirectly through venue subsidisation. A great many arts events fall in this category.

It may be argued that the event generates spin-offs for businesses that justify the subvention. In the extreme case, it may even be argued that the addition to business activity generates increased tax revenue such that the subsidising government actually gets its money back.

The first of these arguments is not particularly amenable to economic analysis because the benefits can only be measured indirectly. This is the domain of cost–benefit analysis, which specialises in the imputation of market-derived values to costs and benefits that are not directly valued by market transactions. Sometimes reasonably satisfactory surrogates are available, but sometimes they are not: for example, it has proved very difficult to put a market value on biodiversity. Where such values are important, difficult decisions have to be made as to how to evaluate mixed bags of market, near-market and distant-from-market values. In some studies, particularly those with environmental costs and benefits, NIEIR has included non-market costs and benefits, but other studies have concentrated on the second, purely economic effects of events. This may be termed economic impact analysis, as distinct from cost– benefit analysis, and concentrates on effects on employment and incomes.

Approaches to economic impact assessment

The economic impact of subventions to events can be estimated by economic modelling. Assessment using neoclassical models produces predictable results: events are assumed to absorb resources that would otherwise be employed in other types of production and, therefore, have negligible overall effects. Given the underlying assumption that the economy is subdivided, without remainder, into a series of perfectly-competitive price-equilibriated markets and is therefore fully employed, this result is inevitable. There is no need to have recourse to models if these assumptions are made, except to identify which areas of production contract in order to expand the production of events.

The position is rather different if the industries impacted by the event have spare capacity. This requires that markets be imperfectly competitive, including that production can be marginally increased without affecting price. A typical case would be a chef who does not increase prices just because his or her restaurant achieves 95 per cent occupancy for a night or two. Whether or not production can be increased without affecting prices is a practical matter, and cannot be solved by assumption. NIEIR has frequently been contracted to estimate the economic impact of events where it can be argued that the concerned industries have spare capacity and production is, for a range of capacity utilisation, demand-determined. The institute has evaluated both events where the existence of spin-off benefits is the primary defence of a subsidy and events whose primary justification is cultural or educational but where spin-off benefits are welcome and help to justify the subvention. Impacts may be calculated in advance (as part of advice as to whether the event should be supported) or in arrears (as part of an audit process and also for reference in deciding future applications). Either way, the calculation requires a comparison of two scenarios: a scenario in which the event is held (in the ex-post case what actually happened) and a scenario in which the event is not held. The impact of the event is estimated by differencing the scenarios.

The construction of formal scenarios requires both geographic and time definitions. These are adopted primarily according to client requirements but might also reflect data availability. The geographic area impacted may be limited to the immediate surrounds of the venue(s) but may be expanded to include their Local Government Area (LGA), the state or the whole country, while time definitions may include the run-up to the event, the event itself and its lasting effects. NIEIR can match these definitions to its datasets and models and, hence, provide assessments at the LGA, state and national levels (the sub-LGA level generally requires additional data collection) and for time periods defined by quarters (with the peak day or week a possibility subject to additional data collection).

Because the argument for subsidisation from spin-offs is expressed in economic terms, it is appropriate to measure the impact of the event by the addition to gross income obtained by differencing a scenario that includes the event and one which does not. (Gross income, in this context, means cash income before deduction of depreciation.) Some clients are also very interested in benefits in terms of employment generation and governments are sometimes interested in estimates of the amount of additional tax revenue generated by the event. The benefits thus calculated can be related to the size of the subvention and different subventions can then be compared for effectiveness and (with a little further modelling) can also be compared with the benefits of equivalent tax cuts.

Measuring benefits in terms of changes to income and employment does not provide a full cost–benefit analysis. Two elements are missing:

  • assessment of additional external benefits, such as the educational value of the event or environmental benefits; and
  • assessment of additional external costs, such as environmental costs and alternative leisure foregone to participate in, or work for, the event.

The simplest approach to these costs and benefits is to limit assessment to market values. This approach is regularly accused of ignoring much that is relevant. However, attempts to be all-inclusive can end up giving excessive weight to shadowy and elusive effects. NIEIR prefers to err on the market-value side but includes major external costs and benefits where it assesses them as relevant and assessable.

In evaluating events, it is not common to spend much effort on environmental effects. This is because few events have the primary purpose of generating environmental benefits and for most of them environmental costs are incidental. There is a substantial literature on environmental costs and benefits and defensible conventional values are available for many environmental costs, such as noise and carbon emissions. If these are considered significant they can be included in the assessment.

When events have educational value, it is theoretically desirable to include a value for this benefit. Various methodologies have been suggested, such as estimates of the cost of providing the same education by alternate means or estimates of the capital value of the addition to earning power resulting from the education. Educational and entertainment values are sometimes hard to distinguish, and attempts have been made to tie them down by surveys of willingness to pay over and above the actual admission charge and documentation of how much people have spent travelling to the event. These types of evaluation can quickly become subjective. Similar arguments apply to health effects.

A category of cost sometimes put forward is the cost of leisure foregone by people who work as a result of the event, to which one might add alternative leisure foregone by those who attend the event. As with all allocations of time, the basic point is simple: if people didn’t do one thing, they would do something else. The problem is that evaluation is necessarily subjective. Take the case of those who forgo leisure to work. At one extreme, the foregone leisure may have been, for example, a family occasion that the worker would much rather have attended but forgoes in order to retain a reputation for reliability with his or her employer. At the other extreme, the foregone ‘leisure’ may have been moping around for want of anything better to do or money to do it with. In this latter case, hours worked are not a cost but rather bring the benefit of approved social participation. The cost of ‘reservation wages’ is further discussed below.

Event assessment methodology

A decision to concentrate on income generation as the measurable benefit of subventions to events has the great advantage of bringing assessment into the realm covered by the National Accounts and, hence, of economic models based on the National Accounts. Thus, additional income resolves into additions to wage and salary income and gross profits within the selected geographic area. Remembering that the income and expenditure sides of the National Accounts are, by definition, equal in aggregate, the increases in gross income are conveniently measured as net additions to expenditure. There are two dimensions to this: direct expenditures that would not have taken place in the absence of the event (with an offset for direct expenditures curtailed by the event) and indirect expenditures that arise as a multiplier result of the direct expenditures.

Direct expenditures for the geographic area that includes the event venue comprise, primarily, expenditures to the area by visitors who came to attend the event and also, pro rata, expenditures by people who visited partly because of the event and partly for other reasons. There may be other additions: for example, a trade fair will generally receive additional income from the local expenditures of out-of-region exhibitors and may generate income from additional sales of local products, while the accommodation and other expenditures of a visiting sporting team, its officials and visiting media may be offset against the share of the gate revenue that the team takes home.

Sources of information on the direct impact vary from event to event. Subject to judgements as to relevance, NIEIR has used the following sources.

Surveys of attendees are conducted face-to-face at the event. All attendees are asked their age and gender and, depending on the study, they may be asked about their marital status, number of dependent children, occupation, household income and ticket type. Where events run for multiple days or cover multiple venues, the questionnaires cover days and places of attendance. After asking normal place of residence, local attendees (those who live in the geographic area or region defined for impact assessment) are asked their expenditure at and associated with the event, whether they would have travelled elsewhere to attend a similar event had the event not been held locally and whether they ran down savings to attend. Visitors from outside the region are asked whether the event is a major or merely contributing reason for their visit, their expenditure associated with the event (including its broad composition) and the means of transport and type of accommodation employed. Data are also collected on satisfaction with the event and the likelihood of attendance at subsequent similar events, but these data are for market research purposes and do not affect the assessment of benefits.

Similar data may be collected from event participants themselves. At trade fairs these include exhibitors and buyers, at sporting events the competitors and visiting officials and at cultural events the performers. However, for sporting and cultural events, information from the organisers may be substituted for direct interviews with participants.

At trade fairs, locally-based exhibitors may be asked to estimate the value of additional sales generated at the event. It is admitted that such estimates are necessarily approximate, if only because sales concluded after the event can only be anticipated.

Information provided by the venue owner and the event organiser and their subcontractors generally includes the event budget (particularly cash flows into and out of the region) and total patronage (so that survey data may be expanded to total coverage).
Interviewers are supervised and endeavour to question a random selection of attendees. Participant data may, however, be collected by distribution and later collection of forms. Data are compared to the results for other events as a check on validity and also to dimension particular events in relation to others in the same region.

Although local visitors are asked various questions for market research purposes, their only contribution to the economic analysis is the amount they spend financed by reductions in savings or by forgoing travel outside the region. All other spending is, by their own admission, financed at the expense of other local expenditures and, hence, does not alter demand within the region.

Greater attention is paid to visitors from outside the region. The number of net additional visitors from outside the region (typically interstate and overseas) who would not have come apart from the event is estimated, as is the number of visitors who extended their visit because of the event. The resulting addition to visitor days is estimated along with the number of bed-days of additional accommodation, by accommodation type. (Overseas visitors tend to stay in hotels or backpacker hostels, but interstate visitors frequently stay with relatives or in a caravan.) Crucially, an estimate is made of additional expenditure in the region, divided into: event entry fees and other revenue to the event organiser or venue; meals, food and drinks; entertainment; accommodation; transport; additional sales by local businesses resulting from trade fair or similar exposure (if any); and other.
The estimate thus prepared may be termed the addition to the exports of the region promoting the event. The estimates will vary according to geographic definition: as the geographic boundary is broadened from local through state to national, a higher proportion of expenditure becomes local and exports diminish.

None of this has proved particularly controversial. It is the next step that brings out the difference between neoclassical and post-Keynesian approaches.
Neoclassical assumptions to minimise assessed impact
We must first dispose of the neoclassical trump card, known technically as the reservation wage. The underlying assumption is full employment, meaning that all people who want paid employment are at work for precisely their desired number of hours. In these circumstances, increases in employment are not possible without increases in wage rates. People who take on work as a result of the increase in wage rates are accordingly giving up leisure to the value of the previous wage rate (because by the full employment assumption they would have worked at the previous wage had they not valued their leisure more highly). Therefore, the benefits of any additional employment are negligible. However, it has been noted that the value of leisure foregone is highly subjective and can even be negative, and will argue below that the full employment assumption is questionable. Reservation wages are irrelevant when the focus is on income and employment, and even in a strict cost–benefit context their value is highly debatable.

We now turn to the main point at issue, which is the valuation of expenditures curtailed by the event: expenditures which would have been made in the absence of the event but are not made due to the event. As already noted, the neoclassical analysis depends on the assumption of full employment and means that curtailed expenditures are similar to event-generated expenditures. Two variants of the neoclassical story have been proposed, both of which depend on labour being fully employed.

One story runs as follows. An event transfers expenditure from the regions of visitor origin to the region holding the event. In all regions, labour is fully employed. Increased expenditure in the region holding the event causes wage rates there to rise, while reduced expenditure in the regions of visitor origin causes wage rates there to fall. These changes in wage rates precipitate a flow of labour from the regions of origin to the region of the event. The transfer of expenditure is matched by a transfer of labour. This prediction is easily tested in practice. For no event that NIEIR has examined has there been any evidence that the required changes to wage rates have taken place or that the event has been staffed (either directly or indirectly) by labour migrating from the visitors’ home states.

A more plausible version of the neoclassical story runs as follows. As in the first neoclassical story, visitor spending raises the demand for labour in the region that holds the event and workers can only be attracted to provide for the demand by offering increases in wages. However, in this story, the response to the increased wages comes not from different geographical regions, but from the effect of the increased wage rates in reducing profitability in all other local industries. These industries sack employees who promptly transfer to the industries serving the increased visitor demand. The net effect on employment and the total value of output depends on price responses, but it is normally claimed that they more or less balance out: the increase in production to meet the increase in visitor demand is countered by a decrease in local production. Thus, a subvention to an event, even when it increases income earned from outside the region, does not increase net income except perhaps marginally where the price responses fail to balance out.

In theory, similar reasoning could be applied to capital capacity. Neoclassical economics includes the concept of the ‘short run’, defined as a period in which capital capacity cannot be altered. Because events are ephemeral, this would appear to be the relevant assumption. If capital capacity is fully employed, no changes in real output can take place in the short run and the capital capacity required to service visitor expenditure can only be made available by shifting it from alternative production, the same result as for labour.

Realistic assumptions

The neoclassical analysis depends heavily on two assumptions:

  • labour supply is very nearly fixed, although labour can be found to service additional demand at the cost of transferring it from alternative production and/or from valued leisure; and
  • capital is fixed, although capital can be found to service additional demand at the cost of transferring it from alternative production (although this is the strict neoclassical position, some analysts assume that capital utilisation can vary and put the weight of their analysis on the labour supply assumption).

Whether or not capital capacity is assumed to be fixed, the operative assumption is that marginal costs are rising and translate into rising supply curves, not only in the industries serving visitor demand but generally. This assumption is made on purely theoretical grounds, without any investigation of labour market conditions applying in the area affected by the event at the time of the event. NIEIR does not contend that this assumption is always irrelevant: there can be times and places where additions to demand in one industry raise wage rates generally, and, more frequently, where they raise wage rates for particular skills; similarly, there can be times and places where additions to demand in one industry run slap into infrastructure or other capacity constraints. For example, mining booms raise wage rates generally in the remote mining regions and specifically for particular mining-related and construction skills, where they increase wage rates not only in the boom zones but across whole countries and, indeed, worldwide. Mining booms also crash against capital capacity constraints in the mining industry and for related transport, energy and water infrastructure. But is this universally true for events?

The obvious capacity constraint affecting events concerns venues. However, unlike mining booms, events are planned in advance with meticulous attention to venue availability. Only in the case of very large events, such as the Olympic Games, is venue availability a potentially limiting factor. Impact analysis for very large events is complicated by the need to evaluate the costs of the resulting planned construction program and to assess the benefits of the resulting assets after the event has taken place. Most events that NIEIR has been called upon to evaluate utilise existing venues. Where this is the case, the opportunity cost of the venue is reasonably represented by arm’s length venue hire charges. NIEIR includes these with the costs of staging the event.

Having dealt with venue and staging costs, the major question concerns the capacity of the local economy to service the addition to visitor expenditure, where visitors are defined as people coming from outside the region in which the venue is located. Judging by the composition of additions to demand revealed by the surveys conducted by NIEIR at events, these additions to demand chiefly concern accommodation, restaurants and other eateries, entertainment (not only the entertainment provided by the event itself) and transport. Except for the additions to transport demand, the additions are concentrated near the event venue.

The additions to expenditure on entertainment and private motor vehicle transport caused by a typical event (in size up to a Commonwealth Games or a papal visit) are minor in relation to total demand, even at the LGA level, and are likely to be within existing capacity: a few extra seats are sold and the average delay in the queue to pay the cashier at the petrol station increases by a minute or less.

Events can impose significant demand on local public transport. However, the transport authorities have the great advantage of fairly accurate estimates of likely demand and have shown themselves capable of marshalling their resources to meet the demand. Similarly, large events generate surges in air traffic, but the airlines have sophisticated demand management systems in place. If a surge in traffic is anticipated, their first step is to withdraw discount fares and the second is to schedule additional flights. If these flights require aircraft placement flights in the contrary direction the airlines may offer discounted fares to take people away from the event rather than to it. Additional flights are usually provided from reserve capacity in the existing fleet, including flying at unattractive times of day, and are manned from existing personnel resources. The increase in the demand for air transport that results from an event does not, therefore, withdraw labour from other industries. However, there may be an offset to the increase in demand from attendees at events from two sources:

Travellers who would have visited the event location in the absence of the event but who are put off by the increased fares (a group that also includes travellers who are put off by increased accommodation charges). Not all of these potential visitors are completely put off; some (helpfully) reschedule.

Residents of the event location who are persuaded to leave the area, either by discount airfares or simply to avoid being at home when the event is held. Once again, these departures may be opportunistic and merely rescheduled departures that would have taken place in any case.

For events significant enough to affect airfares, NIEIR estimates the offset to demand.

A stronger case can be made that events strain capacity in the hospitality industries: accommodation, restaurants and related services. Any event that is worth assessing will cause an increase in local demand for hospitality services sufficient to raise the demand for labour in these industries. The additional demand is met from two main sources:

  • the offer of additional hours of work, either to existing part-time employees or to persons otherwise not in employment, at standard rates of pay; and
  • the offer of additional hours of work at enhanced rates of pay.

Where additional employment is taken, at standard rates of pay, by people who would otherwise be in paid work there is no reason why rates of pay in other industries should be affected or that labour should be withdrawn from these industries. Whether or not labour can be recruited to an event on this basis is a matter of practical observation. The evidence that it can be includes the following:

The hospitality industries rely heavily on part-time workers. There is ABS evidence that, for most Australian locations and for most times since the end of full employment in the 1970s, many part-time workers desire additional hours at the going rate of pay.

The hospitality industries also rely quite heavily on low-skilled and semi-skilled workers. There is ABS evidence that, for most Australian locations and for most times since the end of full employment in the 1970s, many persons are available who would be happy to work at the going rate of pay were more jobs available at these levels of skill. Such workers include many more than those who are unemployed as officially defined. The surveys confirm the presence of significant numbers of people who do not meet the official definition of unemployment in terms of work search but who would, nevertheless, happily take on paid employment were it offered to them. We may also note that Australian labour-force participation rates are below those of many OECD countries, which would indicate the presence of potential employees to take jobs made available.

This said, some employers may prefer to meet the extra demand by raising wage rates. The obvious strategy is to employ existing staff on overtime, which raises costs in the hospitality industries but does not threaten to withdraw labour from other industries. If the increased costs are passed on in terms of increased prices there may, however, be a small offset to real demand in the form of reduced patronage by local residents who have to pay more to eat out.

Finally, demand may be met by the neoclassical mechanism of offering higher wage rates to attract workers who are already employed. In view of the excess supply of low and medium skill workers, increased wage rates are likely to be offered only to skilled personnel such as chefs. The point here is that hospitality skills are industry-specific; an increase in wage rates for skilled hospitality personnel cannot be guaranteed to generalise across all industry as required by the neoclassical hypothesis. However, as with overtime, there is a possibility of increased prices in hospitality reducing the real incomes of local residents and, hence, their real expenditures.

It can be concluded that an increased demand for labour in hospitality is unlikely to generalise to general increases in wages affecting all industries unless the region concerned is closer to full employment than has been the case in most Australian regions over the past three decades.

The position is similar with capital capacity. Event organisers generally organise hospitality at the same time as they organise the event and hospitality providers have shown themselves capable of a flexible response, much like the public transport providers and airlines. Hospitality providers customarily work with a level of excess capacity and also use flexible pricing. This means that a lack of discount accommodation reduces casual visitation during the event, although some of this is rescheduled. NIEIR makes an allowance for visitors who would have visited but for the event, deducting their estimated expenditures from those of the visitors who come because of the event.

For significant events occurring in the capital cities, it is possible to check whether an event was associated with price increases in the hospitality sector. The relevant indicator is the relationship between the price index for hospitality and the consumer price index in general. For several reasons it is expected that hospitality prices will trend upwards more rapidly than consumer prices: productivity increases in services are generally less than in manufactured goods; there is no competition from low-priced merchandise imports; and the hedonic price adjustment for information technology slows the rate of increase of the general index. Given these expectations, price increases for hospitality have been low and have not corresponded with surges in the demand for hospitality: indeed, the reverse has been the case, and periods of high increase in demand have tended to be associated with low increases in prices, as would occur if hospitality were an industry subject to increasing returns to scale.

It is argued by NIEIR that the supply of labour and capital to the hospitality industry in response to events has been cordoned off from the supply to other industries in most Australian locations at most times during the past three decades. This conclusion applies even in places like seasonal tourist resorts because the resorts draw on labour from the nearby cities or from sources such as young overseas tourists with 2-year work permits. If this is the case, additions to demand translate directly into increases in income. The offsets that neoclassical analysis assumes are, indeed, possible, but under typical conditions do not apply.

 

Multiplier effects

The stage is then set for multiplier effects. In traditional Keynesian fashion, an increase in demand generates an increase in incomes, the spending of which generates a further round of increased demand. The process continues subject to ‘leakages’, in the form of savings and capacity constraints, although we have checked the hospitality industry and noted that these are unlikely, and in conditions of generally less than full employment they are not particularly likely in other industries. However, it is admitted that skill supply and capital capacity constraints apply in some places at certain times, and when they do they limit multiplier effects as surely as leakage into imports.

NIEIR models these multiplier effects using:

  • input–output tables, concentrating first on income generation in industries that supply the hospitality industry and then in second and subsequent rounds being more general;
  • data on industry employee characteristics, to determine the kinds of household into which the additional incomes will flow, again concentrating on the hospitality industry in the first round;
  • data on the characteristics of households receiving capital incomes;
  • household expenditure patterns, to determine the directions of spending of households with increased incomes; and
  • data on commuting patterns and trade matrices, to determine the locations of spending.

The results of this analysis are directly contrary to the neoclassical analysis. Instead of the initial increase in export demand being whittled away by reductions in production in other industries, it is expanded by increases in demand for the products of those industries. The result is that public subventions to events that attract visitor expenditure from outside a region generally benefit the region, the exception being where they hit capacity constraints. The returns to public expenditure can be attractively high, although there is no guarantee: NIEIR has come across events that have failed to attract non-local visitors and where the economic impact has been negative. Subventions to such events may still be justified on cultural or other grounds, but not on grounds that the events generate income or employment.
Should generally positive returns guarantee priority in public budgets?

The finding that, under present circumstances of less than full employment, events are often effective means of translating public funds into employment increases is good news for event organisers but less to the taste of those in Treasuries whose unenviable but worthy task is to balance the public budget and to ensure that public spending yields value for money. Rather than rely on spurious neoclassical arguments that event subsidies cannot, by assumption, yield positive economic impacts, Treasuries would do better to rely on the following arguments.

First, the assessment that a subvention to an event yields increases in income and employment does not give the event an absolute claim on government funds. Technically speaking, the rate of return on each event should be compared with the rates of return on the following: subventions to other events; other government expenditures; tax cuts; and increasing government saving. These comparisons depend on the macroeconomic circumstances of the day and also rely on similar assessments being available for alternative government expenditures. Needless to say, this is a rather tall order, but the principle remains that governments have the unenviable task of deciding the relative urgency of different expenditures. Although rates of return are helpful in determining priorities, they do not do away with the necessity to choose.

A second argument sees event promotion as a zero-sum competitive game between the Australian states. According to this view, event promotion is as pernicious as local preference in awarding manufacturing contracts and it simply encourages inefficiency. This argument is incomplete in that it fails to recognise that events increase national exports as well as interstate exports; competition by states to stage events is not a zero-sum game. Competition between places goes beyond competition for the tourist dollar; it is, in part, competition for identity and recognition. Success in such competition brings intangible benefits to residents, which have not so far been mentioned in the analysis. Turning to a visitor point of view, competition between cities and towns increases the range of visitor experiences available: efficiency arguments that assume that events are homogenous miss the point of this type of competition. Also note that the Australian states not only compete for interstate tourism, but combine to promote international tourism. There may be a point where competitive tourism promotion by the Australian incurs diminishing returns but it is unlikely that this point lies at zero expenditure.

Third, events are not the only ‘industry’ to benefit from public support. For example, subventions for events and capital investment in venues are small compared to government expenditures on road construction and maintenance. Both provide direct consumption benefits to citizens and both generate benefits to private businesses. This is the exact point of calculating the income generation benefits from different forms of public expenditure. Instead of assuming benefits away, as they do when they adopt the neoclassical assumptions, Treasuries should compare the benefits of alternative spending patterns and adjust their spending accordingly.

Fourth, the benefits from event subventions need to be placed in the context of general macroeconomic policy, which in Australia for several decades has favoured the generation of demand by the encouragement of bank lending, and, more specifically, the encouragement of mortgage lending to households. The Commonwealth was so anxious to pursue this policy that it was unwilling to increase real taxes and limited government borrowing, thus limiting the flow of funds available for event subventions and for all other forms of government spending. The tragedy pointed out in recent State of the Regions reports was that the policy of high mortgage lending has failed to generate either full employment or affordable housing, the ultimate culprit being the constrained supply of accessible urban land, which is partly due to the constraints to government investment required to create an enhanced supply.

This brings us back to the question of constraints more generally. While it is argued here that there are no constraints that prevent the operation of income multipliers arising from visitor expenditure, there may be constraints at a more general macroeconomic level.

As described in the National Economic Review as far back as June 1987, Australia suffers from a number of serious macroeconomic constraints:

  • a public sector constraint – broadly, the unwillingness to pay sufficient taxes to finance desirable public expenditure, particularly public investment;
  • various capital capacity constraints, including shortages of highly specialised skills and an inability to make the public investments required to alleviate these shortages, and various infrastructure inadequacies arising again from low public investment; and
  • a balance of payments constraint, arising from reliance on an exchange rate that has failed to settle at rates justified by the economic fundamentals coupled with industry policies that pay insufficient attention to investment in export industries – not merely the mining industry, but industries that are capable of generating jobs that match the skills available.

In view of these constraints, the high benefit–cost ratios commonly observed for subventions to events should be assessed in the context of a long-term strategy for Australian economic development. Event assessments are but a tiny part of the analysis required to develop and implement such a strategy.

 

Conclusion
Neoclassical economics purports to show that economic policy should concentrate on leaving decisions to markets. As applied to the analysis of events, the neoclassical policy recommendation is for reliance on user charges except where there are non-economic reasons for free or subsidised provision.

NIEIR’s analysis of event provision shows that this recommendation relies on assumptions that have not applied in most parts of Australia over the past 30 years. Instead, subventions to events that increase tourist visitation can increase incomes and employment. Thus, the case for subventions becomes one of priority against other expenditures, preferably exercised in the context of a coherent strategy for the future.