Brian Fallow: Powerful exporter at the crossroads

COMMENT

Who needs the Comalco smelter?

New Zealand does. The question arises because it is starting to dawn on people that the country faces the risk of serious under-investment in electricity generation, a gap between supply and demand not just in occasional dry years, but structurally.

We are in transition from an era of cheap power founded on the abundance of the Maui natural gas field and a hydro system whose capital costs are long sunk and whose fuel is free.

But Maui is running out, sooner than expected, and the outlook is for a much more hand-to-mouth gas supply.

Renewable sources have their own problems. Their local environmental impact is liable to arouse local opposition and embroil would-be generators in the Resource Management Act.

Coal, meanwhile, lies under the shadow of a carbon tax.

With the introduction of the market model it is no longer anyone's job to ensure that enough new generation is commissioned; the hidden hand of the market will provide.

Given the problematic character of this menu of options, it is inevitable that eyes turn to the Tiwai Pt smelter, which consumes about a seventh of the country's electricity at prices that look enviably low to the rest of us.

At this point, economists are likely to start talking about opportunity costs and freeing up resources.

The contention is that if the electricity and labour (much of it highly skilled) which are used in the smelter were made available to the rest of the economy, there might be a net gain in economic output and national income.

But would the country really be better off if the electricity which now flows from Manapouri across the Southland plains to Tiwai Pt were instead hauled the length of the country to the main area of load growth, Auckland?

How much would it cost to upgrade the national grid, over and above the $1.5 billion Transpower already wants to spend?

How much electricity would disappear through transmission losses?

Would we be better off if that electricity was used in the dishwashers and neon lights of the metropolis instead of producing about $1 billion of aluminium a year, largely for export?

The smelter is a tempting target. Its power usage represents about eight years of average growth in electricity consumption by the rest of the economy.

But because its load is continuous, more relevant is the fact that its 600MW load equates to about four years' normal growth in demand for generating capacity.

In other words, pulling the plug on the smelter would buy only a temporary deferral of hard decisions about the trade-off between electricity costs and reduction of greenhouse gas emissions.

And the cost of that breather would be high.

You only have to look at the parlous state of New Zealand's external accounts.

We spent $6 billion more than we earned in our dealings with the rest of the world in the year to September.

That equates to 4.6 per cent of the value of all the goods and services produced in the country and is in line with the long-run trend for that ratio.

The cumulative effect of decades of such deficits is that New Zealand's net overseas debt is $102 billion, or 75 per cent of GDP, a very high level by international standards.

That level of indebtedness is risky and already costs us. Interest rates are higher than they would otherwise be, and Governments don't dare run budget deficits for fear of the market reaction.

We are up to our chins in debt to the rest of the world. Lose the smelter and we could find ourselves up to our nostrils.

Over the past two years aluminium exports have earned about $1 billion a year. Offsetting that is the cost of the imported raw material and the profits of the smelter's owners.

The net contribution to the balance of payments is about $500 million a year, representing what the smelter pays within New Zealand for electricity, labour, local outsourcing, tax, harbour dues and the like.

The metal it produces is of a purity matched by only one other smelter in the world, in the Gulf, and it commands a premium.

The smelter will be 40 years old when the current power contract expires in 2012. But smelters are long-lived assets.

The pots or cells where the metal is made are replaced every six years, so the heart of the smelter is on average only three years old. Comalco and its minority partner Sumitomo spent around $500 million upgrading the smelter in the 1990s, but they have made it clear there is no prospect of any more for the foreseeable future.

The reason is rising electricity costs. Five years ago the smelter's electricity costs were among the lowest 25 per cent of smelters worldwide; they are now among the most expensive 25 per cent.

That leaves it lying low in the water in periods when weak economic growth or over-capacity depresses prices.

Although its power contract with Meridian Energy runs until 2012, it requires the parties to negotiate a new one next year.

Some comfort is to be had from the fact that these are commercial negotiations between two companies.

The problem is that they will occur against a background of significant uncertainty about how much, and how quickly, wholesale electricity prices are set to rise.

Central to that uncertainty is the Government's climate change policy.

The Government plans to introduce a tax on the carbon content of fossil fuels in 2007 as part of a suite of measures to meet obligations under the Kyoto Protocol.

But it is an open question whether Kyoto will come into force; it will do so only if Russia ratifies it.

If it does not, will the carbon tax come in anyway? A case for a fiscally neutral carbon tax could be made on tax policy grounds alone.

Even if Kyoto gets up, its first commitment period, 2008 to 2012, will expire about the time the smelter's existing power contract does. There is even more uncertainty about whether there will be a second commitment period, or a third.

If a carbon tax is imposed, how heavy will it be? It will depend on the value of carbon credits on the international market, but the Government has initially put a cap of $25 a tonne on the tax.

It estimates that would boost electricity costs for industrial users by 16 per cent, but the estimate may be on the low side.

Comalco is seeking to conclude a negotiated greenhouse agreement with the Government's Climate Change Office this year.

Such agreements are intended to insulate energy-intensive industries whose international competitiveness would be at risk from a carbon tax, in return for their moving to world's best practice in managing greenhouse gas emissions.

As far as the emissions generated at the plant are concerned (about two tonnes of CO2 are produced for every tonne of metal) the smelter would appear to be on solid ground. It has already reduced unit emissions by about a half from their level in 1990, Kyoto's baseline year.

But Comalco is also exposed to the effects of the carbon tax on wholesale electricity prices, to which its contract price is linked, at least under the current contract. Getting around that will be tricky.

The principle behind negotiated greenhouse agreements is that it does the global atmosphere no good if emissions-intensive industry is driven from Kyoto to non-Kyoto countries.

It remains to be seen whether Comalco can strike deals with the Climate Change Office and Meridian that will keep it in business at Tiwai Pt beyond 2012.

If it can't, Southland and the whole country will have cause to lament.