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

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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.

Capture6

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.

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).

An Overview of the National, State and Regional Modelling System

 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

An overview of the national, state and regional modelling system

Peter Brain, Executive Director, NIEIR

Ian Manning, Deputy Executive Director, NIEIR

Abstract

The present paper provides an overview of NIEIR’s national, state and regional modelling system. NIEIR’s forecasting methodology provides a strong and realistic basis for policy evaluation. An economic projection incorporating a policy change is compared with an otherwise similar ‘base case’ projection without the policy change.

Although using general equilibrium models is exceedingly fashionable in policy analysis, based as they are on a fundamental assumption that economies can usefully be divided into autonomous markets and analysed in terms of price-mediated balances of demand and supply in each market, NIEIR’s models are significantly closer to reality. They do not assume away mathematically inconvenient aspects of the economy and, hence, are less likely to deliver counter-productive advice.

 Introduction
The National Institute of Economic and Industry Research (NIEIR) originally entered the field of economic modelling as a forecaster. It maintains this role, preparing regular forecasts and checking them against actual forecast realisation, a process that results in learning from experience. However, NIEIR’s forecasting methodology provides a strong and realistic basis for policy evaluation. The concept is simple: an economic projection incorporating a policy change is compared with an otherwise similar ‘base case’ projection without the policy change.

After more than 25 years experience in economic forecasting and analysis, NIEIR has confirmed the value of dealing always in time sequences. This allows not only for the modelling of causation involving driver and driven variables but for the insertion of response lags and for the inclusion of lagged feedbacks. This time-driven structure of causation means that considerable complexity can be handled without major problems in ensuring analytical consistency.

A second benefit of experience is that NIEIR has developed a sense of relevance and used it to identify the drivers that have influenced the major forecast variables over the past six decades and more. These drivers have all been incorporated into the forecasting and analytical models in ways that reflect their perceived causative role. This is not to claim that a new wild card might not emerge (NIEIR continually scans the horizon in case one does) nor is it to claim that influences are constant in direction or strength, but it is to claim that the Institute has incorporated all historically-relevant drivers into its models and, furthermore, has endeavoured to ensure that their influence is determined by the data and not by assumption. Incorporation in the model is not the last word: historical behaviour is never completely replicated, especially the capricious historical behaviour of exchange rates and other variables strongly influenced by speculative financial markets. Again, although econometric relationships can provide evidence of the direction of causation, this evidence is never conclusive and the estimates of the strength of influence are not always stable. However, model specification emphasising lags and feedbacks provides a structure in which the complexities revealed by econometric analysis of historical experience can be formalised and brought into a logical relationship for forecasting purposes.

In the course of model development, NIEIR has learnt the benefit of a major simplifying device: the geographic layering of forecasting models. Some of the prices, flows and balance sheet values relevant to Australian forecasts are determined primarily on world markets, some are determined primarily at the all-Australia level, some at the level of large city-regions (which approximate to states in Australia) and some at the regional level. The Institute has thus evolved a tiered structure of models: the world is represented formally by the LINK models, to which NIEIR adds its own scenarios of world economic growth; the primary model is the National IMP model (from NIEIR’s IMP modelling suite), which is of particular importance in determining the values of variables influenced by imports, exports and the balance of payments and variables influenced by Commonwealth policy: broadly, the variables emphasised in the National Accounts.

It is also important as a means of ensuring that all-Australia markets add up; the state models include their own range of National Accounts variables and have their own city–region dynamics, but are individually constrained to national values for variables such as the exchange rate and inflation rate, and (subject to feedbacks) are constrained to national totals for a wide range of macroeconomic variables. Within these constraints there is scope for divergence from national trends, some brought about by differences in demography or by differences in industry mix, some by policy effects (particularly state government policies) and some by differences between states in the operation of markets, particularly such markets as housing; and the regional models again have their own dynamics, but are even more constrained by state and national values for variables, and state and national totals. When operated in ‘top down’ mode the regional models determine the local consequences of state and national forecasts. However, the modelling system can also be configured so that regional model results feed back to the state and national level.

All models are disaggregated by industry, with an emphasis on inter-industry relationships. Where a particular forecast or policy study emphasises a particular industry, the modelling of that industry is reviewed to ensure that the peculiarities of the industry are accurately represented. This can apply to industry modelling at national, state or regional levels.

The Institute originally developed two sets of models: annual models based on detailed annual data and projecting in 1-year increments, and stripped-down quarterly models. However, the modelling system has recently been rebuilt on a quarterly basis, this being the minimum time interval used in the National Accounts. Although this creates problems due to seasonality, it has major advantages in the treatment of causation.

The National (IMP) model

For operational and conceptual convenience, NIEIR’s integrated system of forecasting models is divided into modules. The most convenient point of entry to the system as a whole is the national model, because this model is most readily explained in relation to academic economics. It is also important to understand the national model because it determines many of the drivers that operate at the more detailed levels, and also guarantees the coherence of results at those levels.

Macroeconomics

The main data source at the macroeconomic level is the Australian Bureau of Statistics (ABS) System of National Accounts. The National Accounts comprise three main segments:

estimates of national income, expenditure and production;

financial or flow-of-funds accounts; and

the national balance sheet.

Although there is a tendency to regard the first of these as the most important, the other two provide information that is essential to forecasting growth in national income, expenditure and production. In particular, the national balance sheet includes important information on assets and liabilities.

The National Accounts are of fundamental importance for economic forecasting, for several reasons. They provide the following:

a guide for average or typical experience – if aggregate income is rising, individual incomes will also rise on average; consistency checks not only (by definition) within the National Accounts themselves, but checks useful in more detailed analysis, often expressed as column and row totals;

driver variables for more detailed analysis; a variable set within which a number of important dependant variables can be determined, particularly such variables as GDP, inflation, the exchange rate and the unemployment rate (these variables are also the subject of multiple feedbacks from the variables they drive: e.g. GDP drives energy use but any resulting changes in the efficiency of energy use feedback to GDP); and

a set of variables that is very attractive for econometric analysis, because data quality is high and virtually all the variables are the product of highly decentralised decision-making (the major variables affected by centralised decisions are government expenditure and taxation).

A disadvantage of the National Accounts is that they are published after a delay, and are subject to revision for many quarters after publication. This means that projections inevitably take off from a mixture of estimates of varying quality. NIEIR has tackled this problem and emphasises ‘lead indicators’ in its treatment of the latest published observations.

Forecasts of National Accounts variables provide invaluable background to forecasts at the industry and regional level and to policy-oriented analytical projections. NIEIR approaches the task of forecasting the National Accounts with the utmost seriousness. By longstanding practice, National Accounts forecasts have been ‘top down’; that is, the National Accounts variables, which are either aggregates or conceptually broad indices, are forecast in terms of other aggregates and indices, most of which also occur in the National Accounts or are easily related to the Accounts (e.g. national population). When forecasting in top-down mode, more detailed forecasts are largely driven by the national totals and, as a methodological principle, are reconciled to these totals, although not always completely: differences that can be highly significant at the industry and regional level are not always significant nationally, where they might lie within the acceptable range of forecast errors.

Although the top-down approach is standard, it is possible to move in the opposite direction, working from forecasts at the industry and regional level back to the national aggregates. and then down again to a further round of industry and regional detail.

Keynesian macroeconomics

National Accounts were first prepared after the Keynesian revolution and their basic structure continues to support Keynesian analysis. The familiar categories of aggregate demand are documented, including consumption, investment (fixed capital accumulation), government demand and net exports. Therefore, the National Accounts lend themselves to forecasting using the simplest of Keynesian models in which national income and GDP are determined by the sum total of consumption, investment and net export demand. As explained in university classes in elementary macroeconomics, this model is inherently dynamic. The consumption multiplier, which raises GDP following an exogenous increase in (say) investment demand, is usually explained as taking place in a series of steps, each step following one time period after its predecessor. This model is far too simple to yield useful forecasts, but it reveals two important points.

Demand is a very important underlying concept in economics. Marketed goods and services will not be produced unless they can be sold somewhere. Demand limits production.

Although the Keynesian multiplier can be explained as governing the transition from one steady state to another, it does not take much imagination to see it operating in conditions where exogenous shocks are occurring continuously. These do not prevent the multiplier from operating, but do prevent it from ever yielding a steady state.

Crude demand-dominated Keynesian models were common in the early days of National Accounting, in the 1950s and perhaps the 1960s. However, the

Institute’s forecasting model was never in this crude category. From the beginning it recognised the importance of Keynesian microeconomics and also the importance of explicit growth theory.

 

Keynesian microeconomics

Keynesian macroeconomics is founded on Keynesian microeconomics, summarised as import parity pricing for trade-exposed goods and services and cost-plus pricing for all others. Where market structure indicates that monopoly or oligopoly pricing are present, these can be handled by varying the cost-plus mark-up.

The microeconomics of import-parity and cost-plus is not standard economics as taught in first year courses. Economic doctrine privileges pricing at the equilibrium of demand (which increases as price falls) and supply (which reduces as price falls). The fundamental reason for teaching this doctrine is its association with the normative defence of competitive markets. This apart, the equilibrium theory of price formation has been variously defended, for example on the grounds that it follows from the logic of optimisation in conditions of diffused economic power, or that it is approximated in at least some markets. The reasons that it is not assumed in NIEIR’s models are as follows.

The demand/supply concept is closely bound up with the concept of perfectly competitive markets. In practice, very few, if any, Australian product and service markets meet the onerous conditions required if competition is to be perfect. Instead, competition is generally restricted to a limited number of firms, each of which has incentives to adopt strategic pricing behaviour. In these circumstances, cost-plus subject to an import-parity maximum provides a reasonably accurate approximation to actual price formation.

A particular case where demand/supply pricing is inadequate is that of increasing returns to scale, which generate downward-sloping supply curves and indeterminate price. This is no small problem, because increasing returns to scale are endemic in manufacturing and possibly in other industries such as retailing. Once again, the import parity/cost plus theory yields determinate prices.

Even if competitive equilibrium provides a reasonably accurate account of price formation in some of the markets of an economy, the existence of cost-plus import-parity pricing in significant sectors is sufficient to generate Keynesian macroeconomic behaviour.

The fundamental reason for not using competitive equilibrium in forecasting models is that equilibrium is timeless and, therefore, unhelpful in a forecasting context.

Although the general import parity/cost plus approach remains, the disaggregation of the Institute’s modelling system by industry has made it possible to vary the approach to price formation by industry. For manufacturing industries, NIEIR’s developed models use the cost-plus approach with the mark-up a function of unit capital costs and export and import prices. Demand in relation to capacity is included as a short-period influence to allow for profit-taking during booms and price-cutting to generate cash flow during recessions.

Although NIEIR avoids the assumption that prices vary to bring markets into equilibrium, it respects the National Accounts identity: aggregate demand must equal aggregate supply. The difference is that this equality is generally unsatisfactory to the economic actors. It is a temporary accommodation rather than a lasting balance of forces.

 

Growth theory and inflation

In the 1950s, Keynesian macroeconomic theory was developed into a series of growth models (Harrod, Domar, Hicks and Robinson). These models recognised that investment (in the Keynesian sense of gross fixed capital formation) not only adds to current demand but also adds to the capital stock, resulting in increased productivity of labour and increased incomes for both workers and the owners of capital. Because the Institute forecasting model was designed to yield policy analysis over a time horizon of a couple of decades, it included these relationships, by contrast with a great many contemporary Keynesian forecasting models, which are limited to a time horizon of a few years.

This explicit treatment of the capital stock was of great importance in meeting the challenge of the 1970s: the failure of simple Keynesian models to predict the stagflation of those years. As Keynesian economics developed, it was quickly realised that demand was not the only determinant of GDP. There were also constraints on the supply side, and it was possible for ex-ante aggregate demand to exceed the aggregate supply capacity of the economy. Three relationships were posited

quick-working relationship by which demand which could not be satisfied due to limits to productive capacity spilled over into inflation,conventionally known as excess demand inflation;a quick-working relationship by which demand spilled over into imports and, less spectacularly, into reductions in exports (these relationships raised the whole question of the incorporation of international trade into economic analysis); and

a slow-working relationship by which excess demand for goods and services created additional demand for capacity-creating investment (this ‘accelerator’ relationship further increased capacity utilisation and initially worsened inflation, but to the extent that investment demand crowded out consumption it increased the capital stock, raised capacity and eventually dampened inflation).

Further investigation and experience transformed the accelerator into a relationship between investment and business retained surpluses: the greater the surplus, the greater the level of investment. Further investigation also transformed the account of the relationship between capacity and inflation. Current modelling allows for inflation resulting from the following:

excess-demand;

cost-push (fundamentally a result of incompatible income claims);

imports (reflecting the net effect of inflation overseas and movements in the exchange rate); and

monetary sources (fundamentally a result of lack of control in the financial sector, public and private).

Capacity was gradually transformed from a near-engineering concept to one much more closely related to levels of activity above which inflation was likely to accelerate, and which itself depended on such variables as workforce skills.

Although long-run growth analysis is conveniently carried out in values adjusted for inflation, it is still important to include the inflation rate in forecasts, partly because it is a policy target (hence, a determinant of RBA behaviour and in some policy eras of Treasury behaviour as well) and partly because of its influence on economic behaviour, for example the behaviour of firms when assessing investment in fixed capital. NIEIR keeps in mind the various types of inflation, and makes an assessment of the strength of each mechanism. In the immediate wake of the global financial crisis the following assessments applied:

excess demand inflation was reasonably under control, but could break out if there was a reduction in the supply of imports;

cost-push inflation was initially defeated by the 1980s Accord and the probability of recurrence was further reduced by the Commonwealth’s moves to weaken the unions and transfer wage bargaining to the enterprise level;

a break-out of imported inflation will accompany any devaluation of the Australian dollar but was not a threat at current exchange rates, given the world outlook; and

monetary inflation was not a threat, given that the banks were more likely to be trimming their balance sheets than expanding them.

However, with the world economy in turmoil nothing should be taken for granted.

 

The overseas sector

There is a sense in which the overseas sector fits neatly and naturally into the Keynesian variables of the National Accounts. Exports add to demand and imports add to supply. Australian export earnings can be modelled as essentially demand-driven, industry by industry, from projections of world growth. Allowance can also be made for domestic supply constraints. Imports can likewise be modelled, industry by industry, by estimating domestic supply at the world-parity price and calculating imports as domestic demand less domestic supply and exports.

In this context, NIEIR has benefited as the Australian representative of the United Nations LINK project. Under this project, NIEIR annually prepares forecasts of Australian economic activity, including exports and imports by commodity. Along with its colleagues in other countries (most UN members participate), NIEIR submits its forecasts to the LINK secretariat, which reconciles the national forecasts using the requirement that one country’s exports are another country’s imports. The revised estimates are published and contribute to NIEIR’s forecasts.

Turning to the financial components of the balance of payments, earnings on Australian overseas investments can be calculated from the value of these investments and the rate of return, which is influenced by world growth and monetary conditions. Likewise, the earnings of overseas investors in Australia can be calculated from the value of their investments and the rate of return, as influenced (for equity investments) by the profitability of businesses in Australia and (for debt) by the Australian interest rate. As a consequence of Australian net indebtedness to the rest of the world, Australian interest rates are reliably above world rates, a requirement that limits the RBA’s capacity to influence interest rates.

It is agreed by all analysts that imports and net debt servicing have to be paid for and the ultimate source of foreign exchange with which to pay is export revenue. However, imports can also be paid for from capital inflow, known as a deficit on the balance of trade. Capital inflow results in net debt servicing costs and the addition of these to the balance of trade yields the balance of payments. The question for forecasters contemplating the typical Australian balance of payments deficit is how long it can be sustained by continued capital inflow and how far it will blow out. This involves forecasting both overseas willingness to lend to Australia and Australian willingness to borrow on the terms offered by overseas lenders.

Analysing Australian experience up to 1990, NIEIR employed the concept of the balance of payments constraint to growth. When the balance of payments deficit threatened to become excessive, three mechanisms came into play. First, the high interest rates required to attract overseas loans cut into Australian demand, reducing incomes and so reducing imports. Second, when alarmed over the deficit, the Reserve Bank imposed credit squeezes: quantitative controls over borrowing that acted to reduce incomes and imports. If these were not enough, the Treasury would tighten fiscal policy, further reducing incomes and imports. In the era of exchange and interest rate controls, up to the 1980s, the Commonwealth institutions alternated between periods when they used ‘high’ interest rates to support a ‘high’ exchange rate in the hope that low-priced imports would curtail inflation and periods when they used ‘low’ interest rates to support a ‘low’ exchange rate to encourage export and import-competing industries.

At deregulation the Reserve Bank forswore the quantitative regulation of the banks and the Treasury forswore active fiscal policy. The balance of payments constraint seemed to evaporate as the banks demonstrated a hitherto unsuspected capacity to absorb overseas loans, which they on-lent to the household sector. Successive national balance sheets chronicled an increase in bank liabilities to overseas and in household liabilities to the banks. The policy authorities regarded the resulting balance of payments deficit as benign: it was incurred between private parties and imports of low-cost consumers’ goods were welcome because they kept inflation down. The question for economic analysts is how long this pattern of household and bank debt accumulation can last. There was a severe wobble during the global financial crisis and the indications are for a return to balance of payments constrained growth, but when, and with how much of a bump, is one of the current conundrums of forecasting.

When deregulation was being pursued, one of its expected benefits was that market determination of the exchange rate would ensure appropriate pricing of imports and exports and so equilibriate the balance of payments. In the event, since 1990, the AUD/USD exchange rate has fluctuated between parity to AUD2 for each USD without any commensurate relationship to economic fundamentals. The exchange rate matters for forecasting – it affects the AUD values of all entries in the balance of payments and so finds its way into GDP – but has turned out to be very difficult to forecast. This would not have surprised Keynes, who had sufficient experience of financial markets to know their speculative jitteriness. In its forecasts, NIEIR takes into account commodity prices (which seem to influence the exchange rate far more than their significance for the economy) and interest rate differentials.

 

Investment

In neoliberal economics, finance for fixed capital investment is distributed by a cool and rational finance sector. By contrast, in the macroeconomics of Keynes’ General Theory, investment depends largely on animal spirits. NIEIR makes use of the Flow of Funds statistics, which show that there is very little net flow of funds from Australian financial intermediaries to businesses making major investments in fixed capital: funding is generally from internal sources backed up by direct access to international equity markets. In these circumstances, the Taylor rule is generally appropriate: fixed capital accumulation depends on industry retained surpluses with inflationary expectations taken into account through a downward adjustment when the inflation rate rises. This rule has the technical advantage of ease of econometric estimation at the industry level. 

It has been argued in economics that forecasts of real capital accumulation should be forward-looking, emphasising the expectations of investors. For many years, NIEIR experimented with the data from surveys of investment expectations but found that realisation rates varied cyclically except for large-scale committed projects. NIEIR continues to use project lists to forecast expenditure for committed construction projects but otherwise argues that recent retained profits are as good a proxy as any for profit expectations. They accordingly exercise a strong influence on both the ability and willingness to invest.

Although based on the National Accounts and macroeconomic theory, NIEIR’s models have been extended from the world of Keynesian aggregates to include inter-industry accounting as pioneered by Leontief. As perceived by Leontief, the industries of any region take inputs and create outputs. The inputs comprise capital, labour and ‘materials’, the outputs of other industries in the region plus imports from other regions. The outputs of each industry are divided between inputs to other industries in the region, exports to other regions and consumption of final products by households in the region. This classification elaborates the Keynesian aggregates. For example, aggregate consumption is the total of industry outputs sold to consumers plus imports sold to consumers, while gross domestic product is the sum across all industries of the cost of capital and labour inputs. For this reason, it fits very neatly into NIEIR’s modelling system.

For reasons of data availability, this scheme is most readily actualised at the national level. Data are required on the values, by industry, of output, labour inputs, capital inputs, inputs from each other industry, inputs from imports, outputs sold to each other industry, outputs sold as exports, outputs sold to consumers and taxes paid less subsidies received. Price series are also required for all inputs and outputs. At the national level, all of these values are either directly estimated by the ABS or can be derived from ABS data. The input–output matrix is a central element. Unfortunately, it is not produced as frequently as the other data but after allowing for this it is possible to develop time series for all the variables required to describe activity in Australian industries as classified by the ABS: over 100 in the input–output table.

A crucial element in the analysis of this plethora of data is the functional form of the relationship between inputs and output. Because there are several inputs, the functional form must be able to deal with the choice of inputs. Assuming standard qualities for each input, this amounts to the rate of substitution of input for input when the ratio of input prices changes. Leontief responded to this problem by letting the data speak for itself. He specified a relationship in which outputs increased with inputs, but inputs could be either substitutes or complements: substitutes when purchases increased when relative price fell; and complements when purchases increased when the relative price of the complementary input fell. Apart from these limited priors, Leontief allowed the data to determine the parameters, including lagged changes. Applying this approach to Australian manufacturing industry data, NIEIR found that the response to an increase in demand is indeed dynamic, with inputs tending to be harder worked initially followed by an adjustment as capacity was increased. The effect of working inputs harder shows up as a short-term increase in productivity, or returns to scale, and the effect of increasing capacity is to remove at least some of these economies of scale. However, even after 5 years of adjustment, there were many industries in which increasing returns to scale persisted. Similarly, industries were identified in which at least some inputs were complementary: most commonly capital and inputs purchased from other industries (‘material’ broadly defined to include services). All of these estimates, including the dynamics, were well suited to incorporation into the model outlined above. Incorporation allowed the drivers of many of the macroeconomic variables (demand for labour, capital accumulation, value of output, imports and exports) to be calculated by aggregation from the industry level, subject to consistency conditions (e.g. total sales of consumption goods must equal total demand for consumption goods as determined by household incomes, wealth and the like).

 

The generalised Leontief cost function

Underlying the generalised Leontief production function is a cost function that has the desirable property that it can be regarded as a second-order approximation in prices to any arbitrary cost (and, hence, production) function.

The general form of the desired factor input function can be derived from the generalised Leontief production function as follows:
i=1

+ bj,n+1 fj(Q) + exogenous variables}

(j,k = 1, 2, …, n)

where fj(Q) and f(Q) are unspecified, monotonically increasing functions in output. For the equation to describe an underlying production technology, the regularity condition summarised above must be satisfied, for which bj,1 … bj,a+1 must be zero or positive for all j.

The generalised Leontief cost function is comprehensive, because it describes all the types of production technology that produce positive outputs. There will be a variable elasticity of substitution between factors j and k if at least one bj,k, j ≠ k, is non-zero. The function also allows for complementarity between factors, which exists if bj,k is negative: if bj,k is positive, the traditional substitutability assumption applies.

Although this approach to the data is straightforward, it requires a certain amount of unlearning by those who have previously encountered input–output tables only in the context of equilibrium theories. The first difference is the introduction of dynamic instead of instantaneous adjustment, the second the unrestricted form of the relationships (hence, for example, increasing returns to scale can occur), while the third, and more subtle, difference is that changes in outputs and inputs are not so strongly driven by prices. Instead, quantity adjustments can occur, in the same way as they occur in the macroeconomic model.

As an example, the energy industries are identified in the national model complete with input–output relationships with other industries and with their own internal relationships by which inputs are transformed into outputs. In the energy industries, inputs of capital are particularly important, reflecting not only the capital-intensive nature of the industries but the importance of technology in governing the transformation of fuels and other energy sources into useful energy. At the broad level, the various transformation technologies are represented by coefficients that reflect the productivity of capital embodied in succeeding vintages of the various technologies employed. The system thus describes the changing sensitivity of costs to the prices of fuel and capital. This summary account of the energy industries is incorporated into the model at the national level; however, much more detailed modelling of the demand for energy is required when preparing forecasts for particular energy industries.

The national model is complemented by state and local models, to which we now turn.

 

The state and regional models
Australia is geographically a large country, and the growth rates of economic variables generally diverge regionally. A first step in analysing these divergences is to move from the national to the state and territory level.

State activity

The ABS estimates and publishes most of the National Accounts data at the state and territory level, so providing the basis for constructing similar models to the NIEIR national model at the state/territory level. The main differences are as follows:

A number of drivers are determined at the national level and applied across the board to the states. These include the exchange rate, financial variables, such as the interest rate, and variables reflecting Commonwealth policy.

Capacity constraints are a little more flexible. For example, a state that is growing faster than the others will be better able to attract skilled labour, allowing its skilled labour supply to grow more rapidly than the national total.

Some of the statistical detail used in the estimation of the national model is not available at the state level, and has to be estimated. This is particularly true of the input–output table, which NIEIR estimates at the state level using a methodology similar to that used by the ABS for the national table, subject to national-level constraints.

At the state level, particular construction and investment projects increase in prominence in relation to the general flow of economic activity. Because they result from individual decisions, these are unsuited to econometric modelling. Instead, NIEIR maintains project lists and decides on the basis of such information as is available when listed projects are likely to be undertaken. Care is taken to avoid double counting.

When preparing general economic forecasts, which to a large degree are driven by world and all-Australia trends, NIEIR runs the national model and then estimates state impacts using the state models. This involves operating the state models in top-down mode, in which state estimates of macroeconomic variables are derived from the national estimates by applying ‘shift-share’ functions. These functions might be simple

(e.g. allocation by state in proportion to a single driver) or sophisticated (multiple drivers, feedbacks or lags). The simplifying assumption underlying this methodology is that national trends are experienced pro-rata by the states, without any interaction between the states. If interaction is expected, it is necessary to go to much more detailed modelling that covers the dynamics of each state and its effects on the other states and territories.

Although state models remain relevant to the assessment of state-level policies, their main role is to provide control totals for the regional modelling system. These align the regional models with National Accounts data, the state being the smallest jurisdiction for which these data are published.

 

Regional models

Reflecting the structure of Australian governments, NIEIR generally defines local regions as local government areas (LGAs). However, other definitions are possible: virtually any geographic area can be defined as a region for modelling purposes.

As at the state level, reasonably accurate business-as-usual forecasts can be prepared with relatively little effort using top-down methods, applying shift-share functions to allocate national and state totals to LGAs. Similar methods are appropriate for most policy changes at the Commonwealth level, such as the effect on regional incomes of a change in tax rates. It is even appropriate to use top-down methods in the case of major investment projects that impact particular LGAs, one or a small number, provided there is no direct impact on their neighbours. In this case, the projects can be added to the LGAs concerned, to the state concerned and to the national total. The revised national forecast, excluding the effect on the directly affected LGAs, can then be allocated to the remaining LGAs by shift-share.

This approach is inadequate for the assessment of developments where regions interact with each other.

Interaction can only be described using ‘bottom-up’ modelling, in which each region is modelled in its own right as though it represents a country in a world model. This requires replication of the structure of the national model for each region. The national model then disappears from forecasting, national totals being calculated by summing the regional totals.

Replication of the national model at the regional level requires that each region should have its own household sector, its own industries and its own inter-industry relationships, all joined to other regions by explicit trade links (imports and exports) and explicit financial flows (including transfer incomes and commuter incomes and expenditures). The data requirements for this approach are very large, because for each region the following datasets are needed:

– aggregate household income and expenditure accounts showing income received, income outflows, savings and aggregate housing and consumption expenditures;

– basic aggregate household balance sheets, including property values and debt;

– input–output tables or inter-industry flows for industries operating within the region;

– foreign trade flows showing how each industry in a given region allocates exports to overseas markets and purchases imports from overseas;

– inter-regional trade flows showing how each industry in a given region sells goods and services to, and buys them from, industries in each other region in Australia;

– income flows showing how incomes flow between regions due to commuting, property incomes, government benefits and government-financed services; and

– expenditure flows showing how expenditures flow between regions due to taxes, superannuation contributions and out-of-region shopping.

 

The main problems in estimating models at the LGA level are due to data availability. Therefore, we name the major sources:

at 5-yearly intervals the Census provides detailed information on household demography, incomes, occupations, industry of employment and even basic information on asset ownership and indebtedness;

the Census also provides detailed information on the location of employment by industry and occupation. This is derived from the Census

‘journey to work’ question, and requires manipulation before it can be reconciled with Census data on employment by place of residence;

the Taxation Office provides detailed information on taxpayer characteristics by postcode, which NIEIR converts to LGA using a concordance produced by the ABS;

Centrelink likewise provides postcode data on the take-up of pensions and benefits;

at a variety of time intervals (generally getting longer) the ABS has conducted censuses of tourist accommodation, retail activity, manufacturing, mining and agriculture. For many years the ABS conducted a very basic census of businesses, known as the business register. This has been partially replaced by data from Dun and Bradstreet; sample surveys rarely yield valid data at LGA level, the partial exception being the labour force surveys of employment and unemployment produced by the Commonwealth Department of Education Employment and Workforce Relations. However, data from a variety of ABS surveys have been incorporated into NIEIR’s regional modelling; building approvals data are a source; the Real Estate and Stock Institute provides data on dwelling sales and values; and various other sources, mostly administrative data from state and local governments, are relevant from time to time.

Many of these data are costly and their use is limited by agreements to safeguard privacy and commercial confidentiality.

The model estimated for each LGA is structurally similar to those estimated at the national and state levels. However, the small size of LGAs results in a number of differences:

projects undertaken and decisions made by large employers (e.g. plant closure, plant upgrading) can completely dominate local economies and leave them open to idiosyncratic business and investment decisions. Where this is known to be the case, data on the particular project or employer decision is substituted for model-based forecasts; and LGAs, being small, are particularly open economies. Typically, a large proportion of total output is exported (to other LGAs, to overseas) while a large proportion of total supply is imported.

The lack of self-containment of LGAs also expresses itself in the flow of incomes from outside the LGA. These include commuter incomes (earnings of residents who work outside the LGA), private asset incomes and government pensions and benefits. LGA residents also contribute to taxation, and receive health, education and other publicly-financed services. These, in turn, generate employment, which is located at the discretion of governments. Although fixed capital capacity constraints apply strongly at the LGA level, labour can be imported readily, subject only to national constraints. However, labour imports may require incentive payments, particularly if the regional housing market is tight.

The household sector in the National Accounts includes households in their domestic activities plus family businesses and not-for-profit organisations. The incomes of the household sector are estimated from a combination of sources, including the Census, the Taxation Office and Centrelink, plus Institute calculations for the activities of unincorporated business. Consumption expenditures are estimated through microsimulation by matching the Household Expenditure Survey with the characteristics of local households. Consumption expenditures are initially classified by consumption item as in the Expenditure Survey, but these are translated into industry outputs (including imports from overseas by industry). Balance sheets are estimated by microsimulation from the balance sheet portion of the Household Expenditure Survey coupled with the limited Census data on assets and debts and data from other sources on dwelling prices and household debt. 

Estimates of the quantum of agricultural output are available by LGA. For modelling purposes, past agricultural production is normalised to standard weather patterns, after which the quantum can be converted to a value by application of price indices (which themselves might require normalisation for weather). For other industries the value of output is estimated primarily from employment data by industry multiplied by regional labour productivity differentials based on postcode income tax data. The estimates for knowledge-based industries are further modified to take into account the productivity effects of regional industry clusters.

A separate input–output table is estimated for each LGA by matching industry input requirements to industry outputs in the same LGA, given the total outputs of each and the patterns revealed in the national input–output table, which, incidentally, restricts disaggregation to 106 industries.

The first step in the estimation of trade flows is the construction of household accounts for each region. On the income side, regional household income is known reasonably accurately from the Census, taxation and social security data. Microsimulation models are used in conjunction with information about house prices, rents, mortgages and survey data to estimate total financial assets, financial liabilities, savings and consumption expenditure of households resident in each region. Microsimulation modelling involves matching survey data at unit record level, principally the ABS Household Expenditure Survey, to Census and regional activity data (such as retail sales) to estimate household consumption expenditure by region. The estimates are highly disaggregated. Expenditures are constrained so that the sum of expenditures by commodity equals the total regional household expenditure estimate. This process ensures that income and socio-demographic factors are reflected in the estimates of regional expenditure patterns.
Households do not necessarily spend their incomes in their LGA of residence. Expenditures are accordingly allocated to local and nearby retailers by a gravity model. Similarly, households do not necessarily earn their incomes in their LGA of residence. The Census ‘journey to work’ question allows accurate allocation of work incomes received in each LGA to the LGAs in which they were generated.

The foundation for production estimates is the Census estimate of four-digit Australian and New Zealand Standard Industrial Classification employment in each LGA. Given the employment base, the value of production can be estimated by multiplying employment for each industry by regional productivity differentials based on postcode income tax data. Farm income is also checked from agricultural output data. The estimates are checked for consistency with state-wide industry output data and the National Accounts state-level estimates.

Aggregate demand in each region totals net consumption (after allowance for sales to residents of nearby regions balanced against cross-border purchases by residents of the region), government expenditure, tourist expenditure (estimated from employment structure), investment expenditure and industry demand. Investment expenditure by households is mainly on housing and is modelled with reference to household formation, the supply of dwellings and household balance sheets (which document the capacity to borrow). Business investment covers both construction and equipment and is modelled (as in the national model) on the basis of business cash flow. Industry demand comprises investment demand and the demand for business inputs, which are calculated from regional input–output relationships.

 

Regional input–output

At the national level, the ABS publishes input–output tables that represent the flow of goods and services between industries. This information for the Australian economy as a whole can be adapted for regional use by taking four steps.

A national indirect allocation of imports table is prepared, showing the overseas import content of supply in each industry, the destination of supply (either inputs into various industries or final demands) and the mark-up between import costs and the prices charged to purchasers.

The information already described on industry output and consumption expenditure spent in the region is gathered. From the national input–output table, the region’s input requirements by industry are estimated given its industry outputs and consumption. How much of this input requirement is likely to be sourced locally is determined. This requires not only that local supply be available but that it be competitive with outside suppliers. The indicator used to assess likely local competitiveness is the import share in national supply as estimated in step 1.

For each industry, an increase in sales to other regions (exports) will yield increases in demand for the outputs of local industries, either directly as purchases of inputs or indirectly through the generation of household incomes which are spent locally. Dividing the resulting increase in local production by the increase in exports yields an estimate of the Type 1 multiplier: the increase in local output as a result of increased local sales, all other factors held constant. In further analysis there might be feedbacks: for example, increases in local wage rates that cause wage-sensitive local production to be curtailed, thus offsetting the initial stimulus. Whether or not this or other offsets occur depends strongly on local circumstances.

In addition to this basic analysis, regional input–output estimates can be strengthened by the addition of data, including details on employment, incomes and the extent to which profits generated in the region are retained within the region.

 

Freight flows

For each industry, data on overseas exports and imports is available by port and by state of origin/destination in both dollar value and tonnes. Given these constraints, a cost minimisation algorithm is used to allocate international exports and imports by port to the industries of each region. This assignment is iterated until a consistent balance is achieved across all regions and ports. Once international imports and exports by industry have been allocated by region, inter-regional exports and imports can be estimated as a residual. This is done using a gravity model. The gravity factors in the model are adjusted for variations in the substitutability of the items included in the output of each industry in a given location. The lower the substitutability, the greater will be the tendency of production in a given location to sell to the national market. Over time, increasing specialisation in production will tend to lower the degree of substitutability between plants in the same industry in different locations. The substitutability factors for each industry were estimated on the basis of differentials in net interstate imports by industry and by state.

A similar gravity model approach is taken with services, on the grounds that many services involve physical travel, which causes friction of distance, as with freight.

Although the basic unit of calculation is monetary values, trade flows in industries with physical outputs (as distinct from services) can be converted to tonnes using estimates of $/tonne. These can be compared to data on truck movements and reviewed if necessary.

Regional forecasting and analysis using the integrated regional model structure

Forecasts are prepared at the LGA level for the major economic indicators: population (including migration as a result of economic incentives), business value-added (or gross regional product, by industry), employment, income (by source) and consumption (by good or service purchased). The main factors driving the forecasts in each LGA include the following:

the dynamics internal to the LGA, including local demography, local holdings of wealth and debt, dwelling prices, local productive capacities of both capital and labour and local accumulation of capital and skills;

the effect of specific local changes, such as investment projects where the decision lies outside the forecasting model proper;

the local effect of changes in other LGAs through inter-LGA trade and income transfer mechanisms (these include the local effect of changes driven at the national, and occasionally state, levels, and these drivers are applied in each LGA-level model); and

in practice, and depending on judgement concerning the closeness of LGA relationships, changes in peripheral LGAs might be estimated by calculating a national total then cascading down from the national and state models through the effect of drivers determined in these models (e.g. interest rates and prices) and through the pro-rating process.

 

The regional modelling system is updated annually (with a special update after every Census). The update involves calculation of variables, such as regional value-added, which are not otherwise published. NIEIR groups Australia’s LGAs into 67 regions, and values for these regions along with short-term forecasts for each region are published annually in the ‘State of the Regions’ report for the Australian Local Government Association.

 

Modelling in practice

The NIEIR modelling system comprises a family of interacting, mutually-compatible econometric models adapted for both forecasting and analysis. Forecasting and analytical tasks are carried out using appropriate subsets of the family of models.

Because they are inherently dynamic, the models by their nature generate forecasts. These forecasts are driven partly by relationships internal to the models, but also by factors treated as exogenous, of which the most significant are world trade and finance. Exogenous variables become less and less reliable as they recede into the future, and so do endogenous relationships embedded in the models; therefore, beyond a decade or so, projections should not be regarded as forecasts, but rather as exploratory scenarios: business as usual perhaps, but not really business as expected.

Because the models cover all industries and all parts of the country, they can be used to prepare detailed forecasts for quite specific variables. A major area of forecasting expertise concerns energy demand, where the usual economic drivers have been supplemented by meteorological probability functions to predict peak electricity demand.

The models have also turned out to be powerful for policy analysis, using the simple methodology of dual projection: a business-as-usual or base case compared with a policy case. Welfare judgements can be made by a variety of variables, such as the effect on GDP, the effect on disposable income, the effect on sustainable consumption and the effect on the distribution of disposable income. Policies modelled can involve changes to prices, changes to technology, particular project investments variously financed, and changes to taxes, regulations and expenditures at all three levels of government. There is no difficulty in accommodating differences in timing.

Despite this general usefulness, when analysing particular proposals it has usually proved desirable to review and if necessary reconstruct the parts of the model(s) directly relevant to the proposal. This can include detailed attention to the local economy of an LGA, detailed review of the economics of an industry or perhaps detailed work on skills or finance. In these studies the general modelling provides background to the sector or region examined in detail. Lessons learnt at these detailed levels are fed back into the general modelling.

In the construction of forecasting models, the general methodology used by NIEIR has no serious competitors. However, in policy analysis it has been fashionable to resort to general equilibrium models, which claim to cover the whole ground of relationships relevant to economic policy assessment but in practice do so largely by assumption. General equilibrium models are exceedingly abstract, based as they are on a fundamental assumption that economies can usefully be divided into autonomous markets and analysed in terms of price-mediated balances of demand and supply in each market. NIEIR claims that its models are significantly closer to reality. They do not assume away mathematically inconvenient aspects of the economy and, hence, are less likely to deliver counter-productive advice.

 

 

 

 

 

 

 

 

 

 

Demand Side Management in California

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

Demand side management in California: current and proposed measures

Graham Armstrong, NIEIR

Abstract

Although definitions vary, demand side management (DSM), demand management (DM) and demand response (DR) measures generally encompass energy efficient improvement, load shifting and peak load control. Over the past five years, increasing peak load demands and regional supply shortfalls (due to one or a combination of inadequate inter-connections, generator capacity, unexpected summer load peaks) have focused DSM/DR/DM efforts on peak load control of air conditioning equipment.

In Australia air conditioning loads are increasing at a rate of about 50 per cent above overall load growth. Although there has been increasing interest over the past five years in DSM to address this peak load growth, there have been few actions beyond analysis and discussion of the issue. Peak load growth has been met by supply augmentation.

On the other hand in California, where electricity prices soared and supply shortfalls were experienced in 2000, a range of measures has been introduced.1 Today, California is almost certainly the jurisdiction with the most comprehensive array of DSM/DM/DR measures. These measures are mainly designed (often with overall government direction by the State’s Government) and delivered by energy utilities operating in the State.

Graham Armstrong believes that the United States experiences with measures for addressing peak loads are useful when considering the situation in Victoria and Australia in general – with the important qualification that policy design must be based on our particular circumstances and provides a preliminary program design for consideration and analysis.

Introduction

California can in some ways be viewed as a stand-alone nation state which has the fifth largest economy in the world. The Californian electricity demand requires a capacity of nearly 55,000 MW (about 25 per cent imported): this compares with total Australian generation capacity of about 50,000 MW (Victoria 8,000 MW). 2 Accordingly, California is a very significant global entity in the energy field.

California – A Nation State

  • Population of 34 million in 2002, 41 million by 2010.
  • 5th largest economy in the world.
  • 5th largest consumer of energy in the world.
  • 2nd largest consumer of gasoline and diesel – only the total United States uses more.
  • Lowest US per capita electricity consumption.
  • 1.5 per cent of world’s greenhouse gas emissions but low per capita emissions.

Source:   California Climate Change Programs: An Overview, Conference of the Producers, The Hague, 12 May 2003 presented by James D. Boyd, Californian Energy Commission.

In 2004 the State electricity usage was about 265,000 gigawatt hours of electricity per year. Consumption is growing at 2 per cent annually. Over the 1994-2004 period, between 29 per cent and 42 per cent of California’s in-state generation used natural gas. Another 10 -20 per cent was provided by hydroelectric power that is subject to significant annual variations. Almost one third of California’s entire in-state generation base is over 40 years old. California’s transmission system is also ageing. While in-state generation resources provide the majority (average annual of about 75 per cent) of California’s power, California is part of a larger system that includes all of western North America. Fifteen to thirty per cent of state-wide electricity demand is imported from sources outside State borders.

Peak electricity demands occur on hot summer days. California’s highest peak demand was 52,863 megawatts which occurred on 10 July 2002. On average peak demand is growing at about 2.4 per cent per year, requiring the equivalent of about three new 400 MW peaking power plants per year. Residential and commercial air conditioning represent at least 30 per cent of summer peak electricity loads.

California’s demand for natural gas also is increasing. Currently the State uses 2 trillion cubic feet (2,100 PJ, Victoria approximately 250 PJ) of natural gas per year. Historically the primary use of this fuel was for space heating in homes and businesses. Electricity generation’s dependence on relatively clean burning natural gas now means that California’s annual natural gas use by power plants is expected to increase. Overall, natural gas use is growing by 1.6 per cent per year. Eighty five per cent of natural gas consumed in California is supplied by pipelines from sources outside the State.

Californian initiatives in DSM/DR/DM have evolved in three fairly distinct phases over the past 30 years.

In the first phase, extending from the mid 1970s to around 1990, the emphasis, led by utilities such as Pacific General Electric (PGE), was on energy efficiency in an integrated resource planning (IRP) framework, in which the costs of reducing energy demand were compared with the costs of expanding supply. In this phase measures focused on energy efficiency with some attention to load control.

In the second phase, extending into the 1990s, less attention was paid to DM/DSM/DR as supply pressures (costs, levels) eased: a situation common around the world. Environmental concerns increased, particularly urban air quality and greenhouse, but more attention was paid to transport rather than stationary energy. DSM funding, focused on energy efficiency improvement (EEI) varied considerably in the period as regulatory wrangles remained unresolved.

The third phase, commencing in 2000, was precipitated by the electricity supply disruption and soaring wholesale prices. Since then DSM/DR/DM measures (both voluntary and the use of incentives) have been vigorously pursued with substantial public spending. The 2001 summer peak, weather and growth adjusted, was 10 per cent below the 2000 peak. The immediate response to the 2000 events was to install emergency peaking plants and to engage in a publicity campaign and incentive measures (lower tariffs for reducing demand below the previous year) to curtail demands. Rebates for the purchase of higher efficiency products were also tried to curb power consumption in 2000-01, but this approach was judged to be relatively ineffective as take-up was low and wholesale electricity prices fluctuated from one hour to the next, but retail prices did not.

Program funding has mainly been based on a combination of State funds provided on measured energy savings and utility funding, but in 2000 -01 the Californian Energy Commission (CEC) was appropriated an additional $ 380 million from special taxpayer funds for a range of DSM programs.

Recent developments

Although rebates continue, the policy focus has shifted to the potential use of time-of-use (interval) meters, which could be used with time -of-use (t-o-u) pricing (dynamic pricing in Californian terms, which includes consideration of real time pricing, RTP, covering price changes as wholesale prices change).

Backed by data from the t-o-u meters, rates can be adjusted according to several market variables, including demand, supply, wholesale prices and individual use. The State, with the major utilities, conducted a test to gauge customer response to variable pricing. About 2,500 small scale users across the State were given t-o-u meters and put on different pricing plans. In one plan, consumers were charged 13 cents a kilowatt hour for most hours except for 2:00 p.m. to 7:00 p.m. on weekdays, when the price went to 25 cents. On a few occasions the price was increased to 66 cents a kilowatt hour to mimic a period of special system needs. Evaluation indicated the program reduced peak demand by about 13 per cent.3

Results of the evaluation of 2003 programs is presented on www.energy.ca.gov.

Test results and results from general use of t-o-u might be quite different. Some customers might adjust their use to realise cost savings, while others might ignore the pricing changes. However, utilities, the Californian Energy Commission (CEC) and the Californian Public Utilities Commission (CPUC) are confident that, on the basis of the t-o-u pilots, this approach is effective.As a result, three major Californian utilities – PGE, Southern California Edison (SCE) and San Diego Gas and Electric (SDGE) are planning to replace conventional gas and electricity meters with up to 15 million t-o-u meters at a cost of around US$6 billion, beginning in 2006. The t-o-u meter expense will be offset to an unknown extent (depends on implementation policies and responses to them), by reduced peak usage: rate increases as a result of the meter rollout is expected by PGE to be small. In the period before t-o-u metering can make an impact, the California Energy Commission (CFC) estimates, that a 1 in 10 summer could result in a Southern Californian region shortfall of capacity of 2,000 MW (3.3 per cent) below demand by September 2005. Normal weather would not result in a shortfall and reserves would be adequate.As a response to the potential shortfall situation, the Californian Public Utilities Commission (CPUC) approved SCE’s request to implement additional energy efficiency programs aimed at reducing peak demand by 36 MW: insignificant compared to the potential shortfall. The decision orders SCE to expand four energy efficiency programs to immediately and significantly reduce peak demand – from residential customers and small, medium and large businesses.7

The programs:

  •  expand residential customers’ options for “instant rebates” – which are done at the point of sale – and are currently only available for compact fluorescent light purchases. The expanded program will include pool pumps and motors, refrigerators, air conditioners and whole house fans;
  • give  small  businesses  “no-cost”  lighting retrofits.  SCE    estimates    reaching approximately 10,000 customers through this effort; and
  •  allow larger business customers to apply for incentives of up to 100 per cent of the cost of the project on lighting retrofits.

Review of the Californian situation indicates that:

  • despite a range of in-place DSM/DR/DM programs the Californian system is still susceptible to disruptions;
  • t-o-u pricing may still some time off; and
  • the supply system is not being expanded at a sufficient rate to meet increasing demands.

 

The Californian Energy Commission (CEC) Integrated Energy Report8

This report, which is prepared every two years, with an update each alternative year, reports on the status of the State’s energy system and makes recommendations for action where it is deemed necessary.

Key issues identified in the 2004 Update are as follows:

  • implementation of the Energy Action Plan’s loading order strategy;
  • improved transmission planning is required to address inadequate transmission as it presents a significant barrier to accessing renewable energy sources critical to diversifying fuel sources;
  • reliability issues with ageing power plants;
  • the need for accelerated renewable energy developments; and
  • the need for acceleration of demand response programs that signal the actual price of electricity to customers in peak periods.

In the demand response area, the primary focus of this report, the 2004 Update calls for electrical utilities to aggressively implement the 2007 State-wide goal of reducing peak demand by 5 per cent. The 2004 Update appears to rely essentially on “dynamic pricing” (implemented through tariffs using t-o-u, interval meters) to meet this target.

Given the interval metering rollout schedule, likely rollout delays and uncertainty regarding peak tariffs and their impacts, it would seem that attention to other peak demand reduction and supply security are required if the target is to be attained. Thus, despite the 2000-01 disruptions actions to avoid a repeat the Californian system continues to be vulnerable to high (1 in 10) summer peaks.

The lesson for Victoria (and Australia generally) is that even after actual and significant supply disruptions, the implementation of preventive actions lags the requirements. Victoria/Australia has different circumstances: the private sector is responding on the supply side (but the Basslink delay reminds us of supply side reliance fallibility). BUT after five years of discussion, etc. little DSM to address peak loads has been implemented.9 (Would a serious disruption help?)

The 2004 Update, reviews progress on 2003 recommendations. In the DR/DSM/DM area:

(i)                        significant progress is reported on increasing energy efficiency funding and evaluation and monitoring of energy efficiency programs;

(ii)                       improved efforts are needed is reported on maximising energy efficiency of existing buildings; and

(iii)                     improvement is needed on rapid deployment of advanced (t-o-u, interval) meters and implementation of dynamic pricing tariffs.

In the case of (i) the Energy Commission recommended that the State10:

  • “Ramp up public funding for cost effective energy efficiency programs above current levels to achieve at least an additional 1,700 MW of peak electricity demand reduction and 6,000 gigawatts (GWh) of electricity savings by 2008.
  • Standardise and increase the evaluation and monitoring of energy efficiency programs to ensure that savings and benefits are being delivered. (Importance to be noted in VEES development.)

The State has made significant progress in this area, with the CPUC’s recent decision to adopt more aggressive goals for the investor owned utilities (IOUs) than the 2003 Energy Report recommended. These new goals, based on collaborative staff work between the Energy Commission and CPUC, require peak electricity demand reductions of 2,205 MW by 2008, exceeding the 2003 Energy Report goal by 505 MW, and energy consumption reductions of 10,489 GWh by 2008, exceeding the 2003 Energy Report goal by 4,489 GWh. These new goals will require approximately $522 million in annual funding by 2008 compared to the annual spending level of $348 million for 2004 and 2005.” And in the Executive Summary of the Update11 it is stated that “As recently as the 2000-01 electricity crisis, Californians embraced energy efficiency and demand response programs, reducing State demand by approximately 6,000 MW, more than 10 per cent of peak demand.”

In both cases (the 2003 Energy Report goals and the reductions to 2000-01) no evaluations are provided. This detracts from the credibility of the program results (see an outline of recent evaluation policies below). The Californian energy agencies (CPUC, etc.) proposed in a 2003 Energy Action Plan, in the energy conservation and resource efficiency area, that:

“California should decrease its per capita electricity use through increased energy conservation and efficiency measures. This would minimise the need for new generation, reduce emissions of toxic and criteria pollutants and greenhouse gases, avoid environmental concerns, improve energy reliability and contribute to price stability. Optimising conservation and resource efficiency will include the following specific actions:

  1. Implement a voluntary dynamic pricing system to reduce peak demand by as much as 1,500 to 2,000 megawatts by 2007.12
  2. Improve new and remodelled building efficiency by 5 per cent.13
  3. Improve air conditioner efficiency by 10 per cent above federally mandated standards.14
  4. Make every new state building a model of energy efficiency.
  5. Create customer incentives for aggressive energy demand reduction.
  6. Provide utilities with demand response and energy efficiency investment rewards comparable to the return on investment in new power and transmission projects.
  7. Increase local government conservation and energy efficiency programs.
  8. Incorporate, as appropriate per Public Resources Code section 25402, distributed generation or renewable technologies into energy efficiency standards for new building construction.
  9. Encourage companies that invest in energy conservation and resource efficiency to register with the State’s Climate Change Registry.”

The Decision builds upon Decision (D.) 04-09-060 and D.05-01-055 and an 21 April 2005 Decision 05-04-05, establishing the goals, policies and administrative framework to guide future energy efficiency programs funded by the ratepayers of the four largest investor-owned utilities (IOUs): Pacific Gas and Electric Company (PGE), San Diego Gas & Electric Company (SDGE), Southern California Edison Company (SCE) and Southern California Gas Company (SoCalGas).

D.04- 09- 060 established aggressive energy savings goals to reflect the critical importance of reducing energy use per capita in California. For the three electric IOUs, these goals reflected an expectation that energy efficiency efforts in their combined service territories should capture on the order of 70 per cent of the economic potential and 90 per cent of the maximum achievable potential for electric energy savings, based on the most recent studies of that potential. If successful, these efforts are projected to meet 55 to 59 per cent of the IOUs incremental electric energy needs between 2004 and 2013. On the natural gas side, adopted savings goals represent a 116 per cent increase in expected savings over the next decade, relative to the status quo. A three year cycle for updating savings goals, in concert with a three year program planning and funding cycle for energy efficiency (“program cycle”) was established and load reductions were included in savings goals.

In addition, an administrative structure for evaluation, verification and measurement (EM&V) was established to create a clear separation between “those who do” (the Program Administrators and program implementers) and “those who evaluate” the program or portfolio performance. (Victorian EES to note!) In particular, for program year (PY) 2006 and beyond, the Californian Energy Division will assume the management and contracting responsibilities for all EM&V studies that will be used to:

(i)                 measure and verify energy and peak load savings for individual programs, groups of programs and at the portfolio level;

(ii)                generate the data for savings estimates and cost effectiveness inputs;

(iii)              measure and evaluate the achievements of energy efficiency program, groups of programs and/or the portfolio in terms of the “performance basis” established under Commission-adopted EM&V protocols; and

(iv)               evaluate whether programs or portfolio goals are met.

The budget for EM&V was set, as a guideline, at 8 per cent of total energy efficiency program funds. (Note the significant resources that could be available for program evaluation at this level of funding.)15

Case study: Sempra Energy Inc/San Diego Gas and Electric (SDGE)16

Sempra/SDGE, serving a region in capacity constrained Southern California, operates a range of DSM programs, covering:

  • reduction of load during peak periods;
  • dynamic pricing; and
  • energy efficiency.

The utility claims over the past ten years to have cumulatively saved 1.9 million MWh, reduced peak load by 409 MW and provided cost savings to customers of over US$200 million.

2004-05 energy efficiency programs

Residential sector

Description of market segment:

Includes single family homes, condominiums, multi-family units, mobile homes and multi-family common areas.

The utility territory mainly has moderate coastal climate with high density housing and sparsely populated rural high desert and desert climates.

Provides electric service provision to approximately 1.2 million households.

Residential sub-segments:

  • single family customers;
  • multi-family customers; and
  • hard to reach.

Further segmented by end-use – air conditioners, all-electric homes.

Statewide residential rebates

Target market

All residential customers residing in SDGE’s service territory living in dwellings of 4 units or less, including condominiums and mobile homes.

 

Measures – rebates for:

  • Appliances;
  • Building shell – insulation;
  • Building shell – windows;
  • HVAC – air conditioning systems;
  • HVAC – controls;
  • HVAC – Ventilation systems;
  • Lighting – comprehensive products; and
  • Water heating – systems.

Industrial and commercial sectors

Commercial/industrial market segment includes over 138,000 electric meters and close to 30,000 gas meters.

Approximately 20 per cent of market consists of “large” customers – monthly kW demand above 500 kW.

Remaining 80 per cent of market consists of small and medium sized business with monthly demand of 500 kW or less.

  • Majority of the customer segment are considered “Hard-To-Reach”: rent or lease space; where English is the second language; businesses have less than ten employees; are outside urban San Diego, and annual electric demand is less than 20 kW or annual gas consumption is less than 10,000 therms, or both.
  • Almost 90 per cent of small and medium sized business customers have a monthly demand under 20 kW.

Industries are varied, including food service, property management, manufacturing, lodging, grocers and food growers.

Programs in these sectors include:

  • rebates for high efficiency HVAC systems and electric motor: delivered through system/product distributors;
  • provision of energy audits;
  • education and training programs for contractors, retailers, manufacturers;
  • building operator training and certification;
  • standard performance contract development and dissemination; and
  • incentives to participate in savings by design targeted at building owners and design teams to achieve “better than code” performance.

More information on the Sempra/SDGE program is set out in overheads from the utility’s Energy Efficiency Programs, Public Workshop, 3 March 2005. Although these programs are not targeted at peak load control, which will be addressed through t-o-u metering and tariffs, the SDGE’s comprehensive DSM measures that are summarised above:

  • can have a significant impact on peak loads; and
  • are well ahead of anything being implemented by Australian utilities.

It might be argued that the southern Californian situation has brought about such action and that program evaluation detail is lacking, but the SDGE programs (current and planned) indicate an innovative attach on energy efficiency improvement and peak load control that appears to be accepted by the government and its agencies.

Other USA state measures

A 2004 paper, Demand Response in the United States, prepared by the Wedgemere Group for the New Zealand Energy Efficiency and Conservation Authority (EECA) outlines DR/DSM/DM programs in a range of USA states17 and Ontario, Canada.

The outlines are a useful summary of these initiatives (websites are provided). TOU meters, coupled with dynamic pricing, is strongly supported in the EECA paper based mainly on the results of pilot programs in the USA: an average 0.3 demand elasticity is reported (for example, a 30 per cent demand reduction for a 100 per cent increase in price).

Program packages to address peak loads are not critiqued. Attachment B of the EECA report outlines reasons why new direct load control programs were not proposed in California.

The reasons provided are:

(i)                 the load impacts from these programs are already well understood;

(ii)               they limit customer choice: the utility determines the end-use (usually AC) and response level and does not allow customer overrides;

(iii)             they limit peak reduction potential to the chosen end-use load;

(iv)              they are inequitable because they offer a reward to owners of AC units, but not to non-owners; and

(v)                they are expensive because customers are paid even when the program is not used.

However, the possibilities for designing innovative load control programs in combination with t-o-u dynamic pricing and EEI programs are not considered in the EECA paper. This detracts from the usefulness of the paper from a policy perspective in the Victorian/Australian context.

Briefly, the reasons for rejecting direct load control are critiqued as follows.

(i)                 Load impacts from the earlier direct control may be well understood but are not for new designs of direct load control programs.

(ii)               More innovative designs can allow customer overrides: but if overridden full peak pricing would apply.

(iii)             They could be extended to other than A/C peak loads but A/C load is the load which is overwhelmingly weather dependent.

(iv)              They can be designed to reward non-A/C owners with lower rates than all A/C owners: that is, A/C owners taking direct load control would still pay more than non-A/C owners, but less than A/C owners not taking direct load control.

(v)                In combination with t-o-u meters, there is no reason why customers taking direct load control need not be paid when the program is not used.

Concluding comments

The United States experiences with measures for addressing peak loads are useful for analysis and consideration in the Australian/Victorian situation.

However, policy design here must be based on our particular circumstances.

Preliminary program designs for consideration and analysis (modelling, etc.) are set out in Attachment A.

Attachment A:

Scenarios for long run projections of Victorian peak demands

Introduction

This paper outlines potential measures for addressing summer peak load demands and suggests three scenarios for analysis of these measures.

For given weather patterns, population, income, economic trends, and consumer preferences, peak electricity demands will be driven by:

  • overall electricity prices (peak prices are considered separately), which rise to some extent as new plants are commissioned, but significant price increases will be mainly due to greenhouse (carbon price/permit) policies;
  • efficiencies of air conditioning units;
  • peak pricing policies; and
  • building trends.

Over the past five years, when it has been very evident that summer peak demands were increasing rapidly, the “non-policy” has been to build low capacity peaking plants or inter-connections. There has been virtually no policy directed at peak load control. This brief paper suggests how peak load control might be addressed. The study focuses on scenarios of policies to reduce (from BAU) peak demands in the residential sector: commercial and industrial sector analysis of peak demands requires separate analysis.

Three scenarios, two of which progressively reduce peak demands below BAU, are presented below for the 2005-50 period.

Under the BAU scenario electrical energy summer peak demand will continue to grow as population and incomes increase in each scenario. Income growth and consumer choice may translate into increases in average dwelling size, cooling of a greater proportion of space volume (whole house rather than one or two rooms), longer hours of operation and perhaps lower summer space temperatures. In the projections presented, these economic and social factors are held constant: further scenario development work would be required to assess their impacts.

Potential peak reducing policies

Emissions trading (carbon pricing)

Although the Federal Government continues to oppose the introduction of an emissions trading system for the pricing of carbon and trading of emission permits, States and Territories are continuing to work on the design of an ETS appropriate for Australia.

Action by the States/Territories and the possibility of a change in federal policy, suggests a carbon/permit price of $5/t CO2e by 2010 in a mild policy scenario and a price of $20/t CO2e by 2010 in a stringent policy scenario.

In the study these prices are assumed to remain over the 2010 to 2020 period, but increase to $10/t CO2e and $30/t CO2e respectively over 2020-2050 as the global greenhouse policy regime becomes more stringent, offset to some extent by technology advances which constrain the emissions permit price.

No explicit carbon pricing is included in the BAU scenario.

Peak load pricing and direct load control

In Victoria the installation of interval meters in all buildings will not be completed until about 2020. By 2013 only about one third of households will be fitted with interval meters (GWA, p.2918). Accordingly, unless there is a roll-out schedule change, universal time of use (TOU)/peak pricing in Victoria will not be possible until 2020.

There are several alternatives for direct control (for example through radio waves) of air conditioner loads and several trials are underway (New South Wales, South Australia, Western Australia) and a Ministerial Council on Energy (MCE) Committee is addressing the options. Work in this area commenced in 2000, but to date progress on developing policies and measures has been very slow.

Minimum energy performance standards (MEPS)

Levels for three phase air conditioning units were raised in 2004 and MEPS for single phase units introduced in 2004 are due to be raised in 2006 and 2007, with the final stage to match 2004 world’s best regulatory (not economic) practice in 2007. An indication of the impact of these MEPS changes is provided by GWA 2004, Table 4, p.23 and in the accompanying text.

There will be a rated performance improvement for the least efficiency split system units permitted to be marketed in Australia from April 2006. This improvement will be about 2 per cent for <4 kW and 5 per cent for >4 kW units compared with the average units sold in mid- 2004. Of current models available, about 10 per cent of <4 kW and 17 per cent of >4 kW would meet the proposed 2006 standard (GWA, 2004).

It is estimated (GWA, 2004) that the sales weighted efficiency for single phase units will then be 13-14 per cent higher, compared with 2004, than it would have been without the new 2006 MEPS.

World best practice for air conditioners is led by Taiwan and South Korea. The Australian MEPS lag the use of regulatory world best practice. As indicated above, MEPS applies, as the name implies, to the minimum acceptable rating (1- star) when the most efficient units (5-6 stars) are up to 40 per cent more efficient. The impact of higher air conditioning unit efficiencies on peak demands is debatable. Wilkenfeld, in a recent paper (GWA, 2004) claims, “where operation is intermittent and/or limited to one space, it is more likely that an increase in efficiency will lead to somewhat cooler internal conditions but have little effect on peak load”. (p.4, GWA 2004)

Why cooler internal conditions would result is not explained. In any case, this type of limited, intermittent situation is likely to become less important over time. MEPS levels could be raised by 2008 (or at least by 2010 -12) and/or greater efforts made to promote higher efficiency (5-star and higher) units.

Building trends: stock, sizes, retrofits and standards

The energy efficiency of buildings is increasing due to increased awareness of the net economic and environmental benefits achievable by improving the thermal efficiency of building envelopes and systems. Stock increases form a standard part of NIEIR’s projection methodology, but judgments on thermal efficiency trends must be made on the basis of policy and underlying trends.
In the case of new buildings, the Building Code of Australia (BCA) is moving to higher levels of thermal efficiency. From the early 1990s to 2004 there was only a slow and moderate increase in the thermal efficiency of new buildings. For example, in Victoria the 1992 thermal efficiency standard for new residences of about a 2 star rating had only increased to an average of about 2.7 by 2003. However, in 2004 a 4 star rating was mandated and on 1 July 2005 a 5 star rating will become mandatory. And work is being undertaken on a 6 star rating which is being achieved in a small proportion of homes.

Similarly, in the commercial sector movement to a 5 star rating for new buildings is likely (but not certain) in 2006. In the existing buildings area, retrofits are achieving higher thermal efficiency but the trend has not been quantified. Offsetting these trends, which reduce peak demands for a given stock, is an increase in building size (new or through refurbishment). Again, this trend has not been quantified.

No peak load pricing or direct load control is assumed in the BAU scenario. Faced with this uncertainty the following scenarios are suggested by NIEIR.

Scenarios for analysis of summer peak demands

Business-as-usual (BAU)

Over the past eight years, peak electricity demands have been increasing at about 4.0 per cent per year and are projected to increase at 2.6 per cent per year based on a 10 per cent POE through to 2015.

Although interval metering continues to be rolled out throughout the NEM, differential peak electricity pricing and specific load control measures are not introduced in this scenario. MEPS are held at 2004 levels in this scenario.

A 5 star requirement for new residences over the entire projection period (30 per cent net reduction in space cooling requirement compared with pre- 2005 new residences). No net increase in building size. No explicit carbon price is assumed in the BAU scenario.

Mild policy intervention

In this scenario the following new policy measures are introduced.

  1. An emissions trading system (ETS) is introduced in 2010 which results in a permit price of $5/t CO2e over 2010-2020 and an average electricity price increase of $6.5/MWh in Victoria over 2010-2020 (GHC4E), compared with 2005 levels. Over 2020-50 as the permit prices increase to $10/t CO2, average electricity prices increase by $10/MWh ($10/t CO2) as Victoria’s electricity greenhouse gas intensity reduces to an average of 1.0t CO2/MWh compared with 1.3t CO2/MWh over 2005-20).
  2. Air conditioner MEPS are accelerated resulting in an average 15 per cent increase in efficiency of new air conditioner units sold from 2008. (This means in effect, for example, that a previously rated 2 MW unit becomes a 1.7 MW unit from 2008 to 2020 compared with 2004.) This can be modelled by reducing the 2008 on growth in temperature dependent demands by 15 per cent.

By 2050 efficiencies are assumed to improve by 35 per cent (compared to 2004 levels).

(i)                 Peak pricing policies increase summer (October-April) peak prices by 30 per cent over 2005-20.

Customers are offered a lower price increase of 10 per cent if they agree to direct load control achieved through fitting devices to AC units which enable central control of AC units (for example through radio waves). Thirty per cent of customers accept this offer by 2020. Over 2020-50 peak prices increase by 50 per cent and customers are offered a lower price increase of 20 per cent if they agree to direct load control: 50 per cent of customers accept this offer by 2050.

(ii)               A 5 star requirement (30 per cent net reduction) for new residences from 2005-20 and 6-stars (40 per cent net reduction) from 2020 to 2050. No net increase in building size.

Stringent policy intervention

In this scenario the following policy measures are introduced.

  1. An ETS in 2010 results in a permit price of $20/t CO2e and an average electricity price increase in Victoria of $26/MWh over 2010-2020. Over 2020-2050 the average price increase is $40/MWh from a permit price of $40/t CO2e.
  2. Air conditioner MEPS are accelerated resulting in a 30 per cent increase of new air conditioner units sold from 2008 to 2020. (This means in effect that a previously rated 2 MW unit becomes a 1.4 MW unit.)

Over 2020-2050 average efficiencies of new air conditioner units increase by 50 per cent compared with 2004 levels.

  • Peak pricing policies increase summer peak prices by 50 per cent over 2005-2020.

Customers are offered a lower price increase of 20 per cent if they agree to direct load control as in 2. above. Fifty per cent of customers accept this offer.

Over 2020-2050 peak prices increase by 80 per cent and customers are offered a lower price increase of 30 per cent if they agree to direct load control: 75 per cent accept this offer.

5 stars for new residences over 2005-10, 6 stars over 2010-2020 and 7 stars (50 per cent net reduction from 2004 new residences) over 2020-30. No net increase in building size.

Note that in the latter two scenarios customer behavioural attitudes (for example in temperature control) to air conditioning is assumed to be similar to those in the BAU scenario. Behavioural changes scenarios could be introduced into the analysis but would require considerably more resources than proposed above.

Demand side management in California: current and proposed measures

Footnotes:

1        See Armstrong, G., California South: Coming to a Network Near You?, National Economic Review, No. 50, February 2002, for a review of the electricity situation which spawned many of these measures. 

2        Bob Thorkelson, Executive Director, Californian Energy Commission (CEC), Statement to Californian Senate Energy Utilities and Communications Committee, April 2005. 

3        Wall Street Journal, Rebecca Smith, 11 May 2005. 

4        The CPUC regulates the older so-called investor-owned-utilities (IOUs). Newer utilities are referred to as private utilities. In addition, there are municipally-owned utilities. 

5        Joint press release, 11 May 2005. 

6        CPUC press release, 5 May 2005 (www.cpuc.ca.gov). 

7        Thorkelson, op. cit. 

8        Californian Energy Commission, Integrated Energy Report, November 2004 update. 

9        Energy Australia time-of-use meter implementation 

Energy Australia announced in June 2005 that it will offer Sydney, Central Coast and Hunter Valley residents lower cost electricity in shoulder and off-peak prices via new “smart” power meters. The meters will allow Energy Australia to introduce different rates at different times. Lower prices will be offered in the morning and overnight, with customers able to reduce power bills by choosing the pricing period in which they use appliances such as dishwashers and air conditioners. 

The three tiered pricing structure will mean peak prices are charged between 2:00 and 8:00 p.m., “shoulder” prices from 7:00 a.m. to 2:00 p.m. and 8:00 p.m. to 10:00 p.m., and off-peak prices from 10:00 p.m. to 7:00 a.m. 

The new system will be phased in gradually, with new residential homes, those upgrading their electricity installation and big users with annual bills in excess of $4,000 the first to be offered the new meters. Existing customers can convert to the new meters if they pay for installation. According to Energy Australia, prices will be 70 per cent higher in the peak period than current prices, 20 per cent cheaper in the shoulder period and 60 per cent cheaper during off-peak times. 

The company claims a family with a $900 bill could save $100 by changing 5 per cent of their peak electricity usage to off-peak and another 5 per cent to the shoulder times. An audit of Energy Australia customers has found changing operating times for pool pumps, washing machines, dryers and dishwashers could have a marked impact on bills.

10      2004 Update, p.54.

11      Ibid, p. xiii. 

12      California continues to actively evaluate and implement such pricing systems under a CPUC rule-making (R.02-06-001) edict. 

13      The Energy Commission’s new building standards, to be adopted in 2006, when combined with training and enforcement, are expected to reduce energy needs in new buildings by approximately 5 per cent. 

14      New federal appliance standards will increase air conditioner efficiency by approximately 20 per cent by 2007. However, if California were granted a waiver from federal standards, by 2007 the CEC estimates that California air conditioner efficiency could increase by another 10 per cent. 

15      Interim Opinion: Updated Policy Rules for Post-2005 Energy Efficiency and Threshold Issues Related to Evaluation, Measurement and Verification of Energy Efficiency Programs, Decision 05-04-051, 21 April 2005. 

16      Summary of Sempra Energy/SDGE presentation, Energy Efficiency Programs, Public Workshop, 3 March 2005. 

17      The paper regards Demand Response (DR) as only applying to peak load reduction measures, including distributed generation (DG), but including EEI in only a long term sense. This definition is not universally accepted. 

18      A National Demand Management Strategy for Small Air Conditioners, for the National Appliance and Equipment Energy Efficiency Committee (NAEEC) and the Australian Greenhouse Office (AGO), November 2004 (GWA 2004).